Should mutual funds be corporations? A legal & econometric analysis.

• Author: Warburton, A. Joseph

There has been significant policy debate in recent years about whether mutual fund boards of directors, and the corporate paradigm imposed upon mutual funds in the United States, serve the interests of mutual fund investors. It is imperative that the effectiveness of the mutual fund corporate form be evaluated, as mutual funds are increasingly competing with alternative investment vehicles, such as hedge funds, with greater organizational freedom. If mutual funds in the United States are organized in corporate form simply to satisfy legal requirements, those requirements represent a deadweight cost to mutual fund investors. If mutual funds are organized in corporate form as a market solution to the agency problems that characterize mutual funds, corporate mutual funds should, in total, benefit funds and their investors. This Article finds empirical evidence in favor of the mutual fund corporate form. In the United Kingdom, where corporate and non-corporate mutual funds exist side-by-side, mutual funds organized as corporations charge significantly lower front-end loads and annual management fees than mutual funds not organized as corporations, after controlling for other factors. This difference in expenses is not reflected in significantly different fund performance on a gross (pre-expense) basis. In all, the corporate form's downward impact on fund expenses, and its insignificant impact on gross performance, provide empirical support in favor of corporate funds.

1. INTRODUCTION II. MUTUAL FUNDS IN THE UNITED STATES A. Organization of Mutual Funds B. Pros and Cons of the Corporate Model 1. Mutual Fund Boards: Watchdogs or Sleeping Dogs 2. Shareholder Voting III. MUTUAL FUNDS OUTSIDE THE UNITED STATES (THE CONTRACTUAL MODEL) A. Differences Between the Corporate Model and the Contractual Model 1. Fund Versus Adviser as the Focal Point 2. Rules Versus Discretion 3. Shareholder Voting B. Purported Advantages of the Contractual Model C. SEC Consideration of Contractual Fund Proposals IV. EVIDENCE FROM THE UNITED KINGDOM A. The Literature B. Data C. Methodology & Results 1. Expenses 2. Returns V. CONCLUSION TABLE 1 TABLE 2 I. INTRODUCTION

   Since the inception of the Investment Company Act of 1940 (the "Investment Company Act"), the U.S. Securities and Exchange Commission (SEC) has sought to enhance the independence and effectiveness of mutual fund boards of directors and to improve their ability to protect the interests of the funds and fund shareholders they serve. Most recently, in 2004, after discovering that a number of mutual fund complexes had been engaging in late trading, inappropriate market timing activities, and misuse of nonpublic information about fund portfolios, the SEC proposed numerous changes pertaining to fund governance, including requirements that independent directors comprise at least 75% of each mutual fund's board, and that an independent director chair each fund's board. (1) These changes followed the SEC's adoption, in 2001, of rules that required independent directors to comprise at least a majority of each mutual fund's board (the previous requirement had been 40%), and that required independent directors to be selected and nominated only by other independent directors. (2) In fact, the SEC has been reviewing, revising, and adopting rules and regulations pertaining to fund governance throughout the more than six decade existence of the Investment Company Act. (3)

   This continuing need to revisit fund governance issues raises the possibility that the SEC is not asking the correct questions. (4) Instead of asking how to enhance the effectiveness of mutual fund boards, perhaps the SEC should consider whether mutual funds should have boards at all. Similar consideration might also be given to the requirement that mutual fund investors be shareholders in the fund with full voting rights. That is, perhaps the SEC should question, more broadly, the assumption that mutual funds must be organized in accordance with a corporate model. This reevaluation is particularly important as mutual funds increasingly compete with collective investment arrangements, such as hedge funds, that have freedom in their choice of organizational form. If mutual funds in the United States are organized in corporate form simply to satisfy legal requirements, those requirements represent a deadweight cost to mutual funds and their investors. This Article analyzes whether mutual fund investors in the United States could be better served by mutual funds organized according to an alternative, non-corporate governance structure.

   Part II of this Article explores the corporate model required in the U.S. mutual fund industry. Part III examines the contractual model that characterizes many mutual fund industries outside the United States. Part IV assesses empirically the impact, if any, of requiring mutual funds to take a corporate form. Specifically, this Article analyzes data on British mutual funds, which can be organized in either corporate or non-corporate form. This Article tests whether the corporate mutual funds charge significantly different expenses than the non-corporate mutual funds, and/or generate significantly different returns. This Article finds evidence in favor of corporate mutual funds. In the United Kingdom, mutual funds organized as corporations charge significantly lower front-end loads than mutual funds not organized as corporations, after controlling for other factors. Similarly, mutual funds organized as corporations charge significantly lower annual management fees than mutual funds not organized as corporations, after controlling for other factors. However, this difference in expenses is not reflected in significantly different fund performance on a gross (pre-expense) basis. In all, the corporate form's downward impact on fund expenses, and its insignificant impact on gross performance, provide empirical support in favor of the corporate form. Part V concludes.

2. MUTUAL FUNDS IN THE UNITED STATES

   This Part details the corporate paradigm that governs mutual fund regulation in the United States, and a critique of that paradigm.

   1. Organization of Mutual Funds

      Mutual funds in the United States, or "investment companies" as they are referred to in the statutes, are organized pursuant to a corporate model. In the United States, the mutual fund is an independent legal entity, owned by shareholders, with a board of directors. It has full corporate powers, including the capacity to enter into contracts, to sue, and to be sued. The mutual fund raises money by issuing shares and invests the pooled proceeds in securities. The shares entitle their owners to a pro rata interest in the pooled assets. Investors in mutual funds are shareholders in the fund, with voting rights.

      Virtually all mutual funds are externally managed. That is, they do not have their own employees, other than a few officers. Instead, each fund contracts with an entity, the investment adviser, which manages the fund's investments for a fee, which is typically a percentage of assets under management. The investment adviser, from a legal perspective, is an entity that is separate and distinct from the mutual fund. The investment adviser, or its affiliate, is usually the entity that created the fund and promoted its sale to investors. (5) Acting through its board, the mutual fund enters into contracts with not only an investment adviser, but various other service providers as well, including an administrator, a distributor (or principal underwriter), a custodian, and a transfer agent. Each mutual fund, and its relationships with these outside service providers, is overseen by a board of directors (or trustees) elected by the fund's shareholders.

      While the law does not expressly require that mutual funds be organized as corporations, it does impose requirements that assume a typical corporate form: a board of directors (whose function is to oversee the operations of the mutual fund and review contracts with service providers, such as those with the investment adviser) and shareholder voting (to elect directors, accept or reject fee arrangement, and approve fundamental changes). These requirements equally apply to investment companies that are not corporations but are organized in some other form, such as business trusts or limited partnerships. That is, the Investment Company Act, which regulates mutual funds in the United States, imposes the corporate paraphernalia of boards of directors and shareholder voting on all mutual funds, whether they are organized as corporations, trusts, limited partnerships, or simply pools of investment funds. (6)

      The reason the Investment Company Act takes this approach is straightforward when one considers the state of the industry in 1940. At the end of 1940, mutual fund industry assets totaled $2.1 billion. (7) Of that amount, only $450 million were in open-end mutual funds (which were then commonly organized as trusts). (8) The remaining $1.65 billion were in closed-end investment companies. (9) Closed-end investment companies were (and are) organized in traditional corporate form. Given the dominance of investment companies organized on a corporate basis, it is understandable that, in 1940, Congress and the SEC would apply to investment companies the corporate mechanisms of boards of directors and shareholder voting. And it is equally understandable why the industry accepted this form. In short, the Investment Company Act was crafted to regulate an industry that was dominated by closed-end funds organized along corporate lines. (10) Moreover, given that shares of closed-end mutual funds trade in secondary markets which, in 1940, were thin and not very liquid, investors were deemed vulnerable to expropriation by fund managers and in need of safeguards that boards of directors and voting rights were to provide. (11) Today, however, the investment company industry is dominated by open-end funds...