II. Industry Hallmarks: Conflicted Management and Redeemable Securities

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Typically, companies are "internally managed" in that the managers are full-time employees working for the benefit of the company's owners, not independent contractors owing their primary allegiance to an outside entity. The typical American business thus has managers and boards of directors who operate with their eyes focused on doing what is best, within legal constraints, to serve the pecuniary interests of the entity and its owners. Most mutual funds are different.

Funds typically have their own boards of directors or trustees, but when it comes to the crucial tasks of investment management and marketing fund shares, the norm in the fund industry is "external management" of the enterprise. (31) A mutual fund is normally created and managed by an outside entity. It is this outside entity's control that gives rise to the fund industry's predominant external management governance structure. (32) The fund's sponsor or an affiliate functions as the fund's investment adviser, managing the fund's investment portfolio, and as the fund's principal underwriter, handling sales and marketing or "distribution" activities involving the sale of fund shares. (33)

This phenomenon means that the investment decision making for most funds is not done by fund employees operating under the oversight of the fund's board of directors or trustees. (34) Indeed, usually the mutual fund itself, as a freestanding entity, has no full-time employees on its payroll. The fund's sponsor or an affiliated entity generally contracts with the fund to supply the fund with key services, ranging from rendering investment advice, to handling fund sales ("distribution" and "underwriting") and record-keeping. Sometimes the sponsor contracts with an outside entity to provide for transfer agent or custodianship services. Workers who serve the fund customarily are supplied by and often employed by the adviser or an affiliate. (35)

In short, contrary to the Biblical aphorism, (36) the conflicted mutual fund sponsor/investment adviser is serving two masters: the shareholders of the management company and the shareholders of the mutual funds to which the adviser sells services. (37) It is the mutual fund industry's chronic conflict of interest affecting the vital governance function, and a documented record of abuses flowing therefrom, that caused Congress to single out investment companies for special regulatory treatment when it enacted the Investment Company Act of 1940. (38)

The fund adviser's financial conflict of interest with fund shareholders is troublesome because the adviser is paid under an advisory contract approved by the fund's board, a number of whose members typically are affiliated with the adviser. (39) The advisory fee typically is calculated as a percentage of the fund's net assets, sometimes with a performance bonus, (40) meaning that as new sales generate asset growth, they also generate more income for the adviser. As a rule, the bigger the size of the fund, the bigger the fund adviser's revenues. The adviser thus has a pecuniary interest in seeing increasing sales, particularly where the costs for generating those sales are paid by someone else, such as the fund's existing shareholders.

This money drain goes to the heart of fiduciary management principles and fund shareholders' welfare. Expenses are a drag on fund shareholders' investment performance. (41) A dollar of unwarranted compensation for the fund's adviser, distributor, or administrator is a dollar taken wrongfully from the fund and its shareholders. As one fund industry pioneer has explained, when it comes to mutual fund financial returns for mutual fund shareholders, "You get what you don't pay for." (42) For mutual fund shareholders, the cost drag is large. The number runs into billions of dollars per year. (43) In early 2004, a U.S. Senator complained: "The mutual fund industry is, indeed, the world's largest skimming operation, a seven trillion dollar trough from which fund managers, brokers, and other insiders are steadily siphoning off an excessive slice of the nation's household, college, and retirement savings. …