Enhanced Corporate Governance for Mutual Funds: A Flawed Concept that Deserves Serious Reconsideration

Washington University Law Review, Dec 2005

Mutual funds are the most popular retail investment in America, a testament to the simplicity and transparency of the mutual fund concept. A mutual fund investor owns a share of common stock issued by a company that invests in debt or equity securities issued by other operating companies. Like operating companies, a mutual fund distinguishes itself by its business objective—for example, to exceed the Standard & Poor’s 500 Index (an equity fund), to match the Lehman Brothers Aggregate Bond Index (a bond fund), or to maintain a current net asset value of $1.00 per share (a money market fund). Unlike an operating company that is managed by its officers and employees, most mutual funds are managed by an external investment adviser, pursuant to a contract. In recognition of the obvious conflict of interest between a mutual fund and its investment adviser because of or resulting from that contract, the Investment Company Act of 1940 (“Investment Company Act”) has always required that at least forty percent of the members of the mutual fund’s board of directors be independent. In July 2004, the Securities and Exchange Commission (“SEC” or “Commission”), in a three-to-two vote, amended certain existing exemptive rules (the “Corporate Governance Amendments”) to require that no less than seventy-five percent of the members of a mutual fund’s board of directors be independent, that the chairman of the board of directors be an independent director, and that the board of directors engage in certain specific corporate governance practices. This Article will argue that the Commission’s decision to adopt the Corporate Governance Amendments was without statutory authority and usurped the proper legislative role of Congress, was not adequately justified, and will be of questionable efficacy.

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Enhanced Corporate Governance for Mutual Funds: A Flawed Concept that Deserves Serious Reconsideration

Enhanced Corporate Governance for Mutual Funds: A Flawed Concept that Deser ves Serious Reconsideration Martin E. Lybecker 0 1 Recommended Citation 0 Martin E. Lybecker, Enhanced Corporate Governance for Mutual Funds: A Flawed Concept that Deserves Serious Reconsideration, 83 Wash. U. L. Q. 1045 (2005). Available at: https://openscholarship.wustl.edu/law_lawreview/vol83/iss4/5 1 Thi s F. Hodge O'Neal Corporate and Securities Law Symposium is brought to you for free and open access by the Law School at Washington University Open Scholarship. It has been accepted for inclusion in Washington University Law Review by an authorized administrator of Washington University Open Scholarship. For more information , please contact , USA - * Martin E. Lybecker is a partner of Wilmer Cutler Pickering Hale and Dorr LLP, located in Washington, D.C., and is a Senior Lecturing Fellow in Law at Duke University. Wilmer Cutler Pickering Hale and Dorr LLP represents or has represented some of the entities mentioned in this Article. This Article bears a date of December 15, 2005. 1045 1046 [VOL. 83:1045 INTRODUCTION Mutual funds1 are the most popular retail investment in America,2 a testament to the simplicity and transparency of the mutual fund concept. A mutual fund investor owns a share of common stock issued by a company that invests in debt or equity securities issued by other operating companies.3 Like operating companies, a mutual fund distinguishes itself by its business objective—for example, to exceed the Standard & Poor’s 500 Index (an equity fund), to match the Lehman Brothers Aggregate Bond Index (a bond fund), or to maintain a current net asset value of $1.00 1. Technically, a mutual fund is an open-end management company registered with the Securities and Exchange Commission (“SEC” or “Commission”) under the Investment Company Act of 1940 , 15 U.S.C. §§ 80a-1 to -52 (2000) (the “Investment Company Act”). An “open-end company” is a management company that issues a redeemable security. 15 U.S.C. § 80a-5(a)(1). The term “redeemable security” is defined in section 2(a)(32) of the Investment Company Act to mean a security the terms of which entitle the holder, upon presentation, “to receive approximately his proportionate share of the issuer’s current net assets, or the cash equivalent thereof.” 15 U.S.C. § 80a2(a)(32). Management companies are divided into two categories: “diversified companies” and “nondiversified companies.” 15 U.S.C. § 80a-5(b). A “diversified company” has at least seventy-five percent of the value of its total assets invested in “cash and cash items (including receivables), Government securities, securities of other investment companies, and other securities,” but no more than five percent of the value of the total assets of the management company can be invested in any one issuer and such investment cannot exceed ten percent of the issuer’s outstanding voting securities. 15 U.S.C. § 80a-5(b)(1). A “non-diversified company” is “any management company other than a diversified company.” 15 U.S.C. § 80a-5(b)(2). A closed-end fund is any management investment company other than an open-end fund. 15 U.S.C. § 80a-5(a)(2). After the initial public offering, shares of a closed-end fund trade like shares of an operating company: they can be listed on an exchange, traded in the over-the-counter markets, or bought and sold in direct transactions between individuals or institutional investors. DIV. OF INV. MGMT., SEC, PROTECTING INVESTORS: A HALF CENTURY OF INVESTMENT COMPANY REGULATION 423 (1992). The corporate governance issues facing the boards of directors of closed-end funds are beyond the scope of this Article, as is the general topic of corporate governance for operating companies. 2. See INV. CO. INST., 2004 MUTUAL FUND FACT BOOK 79–83 (2004). 3. A mutual fund that invests in shares issued by other investment companies is known as a “fund of funds.” See Martin E. Lybecker, Fund of Funds: The 1996 Act and Related Industry Developments, INVESTMENT LAW., Jan. 1997, at 33. 2005] 1047 per share (a money market fund).4 Unlike an operating company that is managed by its officers and employees, most mutual funds are managed by an external investment adviser, pursuant to a contract. In recognition of the obvious conflict of interest between a mutual fund and its investment adviser because of or resulting from that contract, the Investment Company Act of 1940 (“Investment Company Act”)5 has always required that at least forty percent of the members of the mutual fund’s board of directors be independent.6 In July 2004, the Securities and Exchange Commission (“SEC” or “Commission”), in a three-to-two vote,7 amended certain existing exemptive rules (the “Corporate Governance Amendments”) to require that no less than seventy-five percent of the members of a mutual fund’s board of directors be independent, that the chairman of the board of directors be an independent director, and that the board of direc (...truncated)


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Martin E. Lybecker. Enhanced Corporate Governance for Mutual Funds: A Flawed Concept that Deserves Serious Reconsideration, Washington University Law Review, 2005, Volume 83, Issue 4,