As revelations of improprieties cascade upon one another, it is now reasonably clear that various mutual funds violated their fiduciary duty to investors. Some might argue that since the victims are mostly retail investors, large pension funds do not have a dog in this fight. In fact, any large institutional investor with a traditional diversified portfolio has lost money as asset management company stock prices dropped in response to the recent turmoil. More importantly, breaches of fiduciary duty—in some instances, blatantly illegal behavior–in the $7 trillion-plus mutual fund industry impair public confidence in the securities markets. In a worst case scenario, competition among regulators could produce excessive policy sanctions causing reverberations across financial markets. Under any scenario, a loss of public confidence in the integrity of financial intermediaries hurts all investors.
In today’s climate, securities law infractions will be dealt with forcefully, and careers are being obliterated. The patterns of abuse are stunning in their breadth and, in some cases, flagrancy. My concern is that focus on the particularly egregious behavior and the penalties imposed on that behavior will obscure the less sensational, but more important, structural problems.
Mutual fund governance, codified in 1940 federal legislation, rests on a set of legal constructs. Each mutual find is a separate company whose sole employees are its board of directors. Ostensibly independent directors appointed and compensated by the investment company which created the fund enter into purportedly arm's-length negotiations with the investment company over whether to retain its services as fund manager and the terms and cost of those services. In theory, the independent directors act as a buffer for faceless shareholders.
The difficulty is that the theoretical constructs are fictions. Fidelity’s 300-plus funds each has its own board of directors making ostensibly independent decisions to employ Fidelity as its investment manager; nobody would expect directors selected by Fidelity to do otherwise, and people who invest with Fidelity presumably want a Fidelity manager.
The core problem is the age-old agency issue. While investment companies benefit from generating strong returns for their investors, on certain issues the interests of investment companies and their investors may diverge. Investors may not want their fund managers to trade in and out of their own mutual funds or to draw excessive compensation; management companies have an interest in keeping that information private. Investors may wish to know the total operating costs which reduce their returns; investment companies are not anxious to publish that information. For investors, compliance departments exist to prevent them from being treated as dupes; for some investment companies, short-term economic benefits trumped their long-term interest in protecting the franchise value of the firm. For investors, the commissions generated on mutual fund trades are assets to be used to enhance the value of their investments; for investment companies, commissions may be used as compensation to brokers who send them more customers. For investors, directors are paid to protect their interests; for some companies, directors are paid to create the formal trappings of oversight. Most important, there are occasions when an aggressive attitude toward sleepy or self-interested management is required to protect shareholder interests; for too many investment companies, the marketing imperative of maintaining strong relationships with the corporate community induces funds to be passive in the face of management abuse at the expense of existing investors.
As public pension funds and other nonprofit entities do business with private sector firms, they can use their leverage to insist on more independent boards, more accountability, and greater disclosure. Fiduciaries have an obligation not to ignore these issues.
In addition, a regulatory regime to reinvigorate investor confidence would include four elements:
- Every mutual fund should have an independent board chairman, and two-thirds of each fund’s directors should be independent.
- Every fund should have a chief compliance officer responsible for controls and oversight and reporting directly to the board.
- Every fund should make full disclosure of all fees and costs, and the board chair and compliance officer should be required to make Sarbanes-Oxley certifications that such costs are fully disclosed and negotiated in the interests of shareholders.
- Every board should have an independent audit committee based on Sarbanes-Oxley standards and disclose insider transactions, compensation for sales of fund shares, directed brokerage arrangements, and compensation to senior investment company management.
Investor confidence in corporate governance is an economic imperative for the investment management industry. Conversely, ugly facts lead to bad public policy; there is a real risk that the most extreme cases of impropriety will elicit a counterproductive, excessive regulatory response. The securities markets are dependent on absolute trust in the governance of the mutual fund industry, and a balanced approach to reform is critical.
*Orin S. Kramer is chairman of the New Jersey Investment Council. He served as associate director of the Domestic Policy Staff under President Jimmy Carter, taught financial regulatory law at Columbia Law School, and has written extensively on the financial services industry. The views expressed here are his alone.