Rethinking the regulation of securities intermediaries.

• Author: Fisch, Jill E.

This Article argues that existing regulation of mutual funds has serious shortcomings. In particular, the Investment Company Act, which is based primarily on principles of corporate governance and fiduciary duties, fails to support--and in some cases impedes--market forces. Existing evidence suggests that retail investing behavior and the dominance of sales agents with competing financial incentives further weaken market discipline.

As a solution, this Article proposes that funds should be treated primarily as financial products, rather than corporations; correspondingly, investors should be treated primarily as consumers, rather than corporate shareholders. To implement this approach, the Article proposes the creation of a new federal agency that would develop standardized financial products coupled with corresponding disclosure principles. Sellers of retail financial products would be required either to conform their products to these standards or to explain material differences. The goal is to enhance market discipline while making retail funds less complicated and more understandable for individual investors.

INTRODUCTION I. REGULATION OF RETAIL INVESTOR MARKET INTERMEDIARIES. A. Mutual Funds B. Money Market Funds C. Exchange-Traded Funds D. 401(k) Plans II. THE MARKET FOR MUTUAL FUNDS AND RELATED PRODUCTS.. A. Evidence on the Effectiveness of Market Discipline B. Methodological Challenges to Studying the Mutual Fund Market C. The Effect of Selling Agents on Market Discipline III. LIMITATIONS OF THE EXISTING REGULATORY STRUCTURE A. Corporate Governance B. Disclosure IV. REFORMING REGULATION A. Product Regulation--Conform or Explain B. Intermediary Regulation C. The Consumer Investment Regulatory Authority CONCLUSION INTRODUCTION

The collapse of the capital markets, following a series of corporate governance scandals, has led to a variety of proposals for regulatory reform. (1) Largely absent from the public debate, however, is a response to the changing role and dramatically increased importance of intermediaries to the securities markets. (2) The ownership of public equity has shifted substantially from retail to institutional investors since Congress enacted the federal securities laws in the 1930s. As of the end of the third quarter of 2009, institutional investors held approximately fifty percent of total U.S. corporate equities, (3) while retail investors ("the household sector") held thirty-eight percent. (4) This trend is exacerbated for the largest companies; as of the end of 2007, institutional investors owned an unprecedented 76.4% of the largest 1000 corporations. (5) Although the market collapse reduced these figures, as of the end of 2006, institutional investors still controlled assets totaling $27.1 trillion, a ten-fold increase from 1980. (6)

Many institutional investors are intermediaries in that they invest a pool of capital contributed by other investors, most frequently retail investors. (7) The mutual fund is the dominant form of intermediated investment. (8) At the end of 2008, even after much of the market collapse, (9) equity mutual funds held over $3.7 trillion in assets, ninety-two percent of which were contributed by the household sector. (10) In addition to mutual funds, retail money is invested through other intermediaries including exchange-traded funds (ETFs), pension funds, and money market funds. Although institutions own most U.S. equity, the number of households that are exposed to the capital markets has increased dramatically, fueled in part by growth in various forms of retirement savings, which account for a substantial portion of household investment. (11) Tax advantages and changes in pension regulation have increasingly thrust individual investors into mutual funds and other intermediated investments. (12)

A growing percentage of ordinary citizens are invested in the capital markets through intermediaries, and those investments represent an increasing percentage of their wealth. Small investors who participate in the markets through mutual funds, money market funds, and retirement accounts may be financially unsophisticated and of limited means. At the same time, the number and complexity of intermediated products continue to increase, creating growing challenges for retail investors.

The financial crisis highlighted these concerns. Many individual investors suffered dramatic losses, (13) requiring them to make sacrifices such as deferring retirement or taking second jobs. (14) Many of those who lost money did so because they were invested in unsuitable products, because they did not fully appreciate the risks associated with their investments, or because they received inadequate financial advice. Going forward, policymakers must target consumer protection with respect to these investments as a distinct regulatory objective. (15)

Both the Securities and Exchange Commission (SEC) and Congress have directed reform efforts to retail investment products, but these reforms have been slow, piecemeal, and often delayed reactions to pervasive problems. (16) More problematically, the reforms have not altered the fundamental regulatory approach adopted by the Investment Company Act of 1940 (ICA), (17) which relies on corporate governance, fiduciary principles, and a disclosure approach modeled upon the regulation of investments in operating companies. This Article argues that the ICA approach is conceptually flawed. Governance mechanisms applicable to operating companies do not translate well to intermediated financial products. Empirical research suggests that capital market discipline does not adequately constrain the sponsors of these products and that the structure of these products and the manner in which they are sold precludes the operation of traditional market forces. As Judge Posner, long a champion of market discipline, recently observed, "The governance structure that enables mutual fund advisers to charge exorbitant fees is industry-wide ...." (18) Fees, moreover, are only part of the story--the evidence suggests that many intermediated investments are confusing, misleading, and excessively risky, and that existing regulation creates incentives for the creation of products that are deliberately complex.

This Article offers a bold alternative: rejecting the ICA framework--including its corporate governance requirements and reliance on fiduciary principles--in favor of an integrated product-based approach: "conform or explain." (19) Conform or explain would require a new regulatory agency, the Consumer Investment Regulatory Authority (CIRA), to promulgate specifications for standardized or plain-vanilla versions of the most common intermediated investment products. CIRA's standards would include benchmarks, as well as information about risk, asset allocation, product characteristics, investor suitability, and cost.

Unsophisticated investors or those who want to minimize their research costs could purchase compliant products with the knowledge that these products conform to industry norms. In other words, investors would know that the product had the specified characteristics and that its fees, risk, etc., were within a standard range. Firms would be free to market other products, but would be required to disclose the manner in which their products differ from the standard, including differences in investment strategies, fees, and fee structures. CIRA would also oversee the sales practices used to market nonconforming products and would be free to impose additional regulation on selling agencies, such as disclosure of conflicts of interest. By retaining the freedom for firms to develop new financial products while better tailoring disclosure, this model would increase consumer protection without sacrificing innovation. More importantly, by providing meaningful transparency to often opaque and complex products, conform or explain would enhance market discipline while retaining the range of investment choices available for sophisticated investors.

The Article proceeds as follows. Part I provides an overview of the existing regulatory structure applicable to mutual funds and related intermediated investments--money market funds, ETFs, and 401(k) plans. Part II considers the effectiveness of market discipline and offers some reasons why market forces may not effectively constrain fund companies. Part III identifies critical weaknesses in existing investment company regulation, focusing on the regulation of corporate governance and disclosure. In Part IV, the Article introduces its proposal--product regulation under a conform-or-explain model administered by CIRA--and demonstrates why this approach is superior to the alternatives.

1. REGULATION OF RETAIL INVESTOR MARKET INTERMEDIARIES

   1. Mutual Funds

      A mutual fund is a pooled investment vehicle, (20) regulated by the SEC pursuant to the Investment Company Act of 1940 (ICA). (21) Mutual funds are typically organized as corporations or business trusts under state law. (22) The ICA requires a mutual fund, whether or not it is organized as a corporation, to have a board of directors or trustees elected by the shareholders and consisting of at least forty percent independent directors. (23) Certain SEC exemptive rules extend the ICA's independence requirement; to qualify for these exemptions, fund boards must have a majority of independent directors. (24) The board is responsible for approving the fund's contract with its investment advisor, (25) pricing the fund's assets, (26) and overseeing compliance with the fund's investment policies. (27) The ICA also vests shareholders with the right to vote on alterations to the advisory contract (such as fee increases) (28) and certain changes to the fund's investment objectives or policies. (29)

      The mutual fund is a distinct legal entity that holds title to the fund's assets, but the fund itself is simply a pool of liquid assets with no independent operations or...