The Separation of Funds and Managers: A Theory of Investment Fund Structure and Regulation

By Morley, John | The Yale Law Journal, March 2014 | Go to article overview

The Separation of Funds and Managers: A Theory of Investment Fund Structure and Regulation


Morley, John, The Yale Law Journal


ARTICLE CONTENTS INTRODUCTION I. INTRODUCTION TO INVESTMENT FUNDS    A. Types of Investment Funds    B. Literature Review II. INTRODUCTION TO THE SEPARATION OF FUNDS AND MANAGERS    A. Basic Summary    B. The Consequences of Separation    C. Possible Alternatives III. EXPLAINING THE SEPARATION OF FUNDS AND MANAGERS    A. Exit Rights and Performance Incentives       1. Exit Rights          a. Mutual Funds          b. Hedge Funds          c. Private Equity Funds          d. A Note on Imperfections in Exit Rights       2. Performance Incentives    B. Unusually Strong Preferences for Precision in Risk-Tailoring    C. Economies of Scope and Scale and the Operation of Multiple Funds       1. Preventing the Spillage of Risks Across Funds       2. Maintaining Management Companies as Going Concerns       3. Addressing Conflicts of Interest    D. A Note on Causation IV. SPECIAL CASES AND OBJECTIONS    A. Special Cases       1. Closed-End Funds       2. Asset Securitization Vehicles       3. Donative Trusts    B. Objections       1. Taxes       2. Regulation       3. The Limited Partnership Form       4. The Vanguard Mutual Fund Management Company V. POLICY IMPLICATIONS    A. The Desirability of Separating Funds and Managers    B. The Functions of Investment Fund Regulation    C. The Definition of an Investment Fund    D. Distinguishing Open- and Closed-End Funds    E. The Janus Decision CONCLUSION 

INTRODUCTION

Investment funds control a vast amount of wealth. By some estimates, the various types of funds--including mutual funds, hedge funds, private equity funds, venture capital funds, exchange-traded funds, and closed-end funds--collectively hold about $18 trillion in the United States. They hold substantially more assets than the commercial banking system and almost enough assets to equal the value of all domestic equity securities listed on the New York Stock Exchange and NASDAQ combined. (1)

Legal scholars have largely overlooked these enterprises, however. Although financial economists have extensively studied investment funds' performance and operation, (2) legal scholars have rarely examined their structure and regulation. Little is known about foundational issues such as why investment funds adopt their basic patterns of organization, why they are regulated differently from operating businesses, and how we can distinguish them from operating businesses.

In this Article, I offer a broad perspective by suggesting for the first time that the essence of investment funds and their regulation lies not just in the nature of their assets or investments, as is widely supposed, but also--and more importantly--in the nature of their organization. An investment fund is not simply an enterprise that holds "investments"--it is an enterprise that holds investments in a particular way. And the regulations that govern these funds are at least as concerned with the funds' peculiar patterns of organization as with their peculiar kinds of assets.

Specifically, nearly every enterprise that we commonly think of as an investment fund adopts a pattern of organization that I call the "separation of funds and managers." These enterprises place their portfolio securities, currency, and other investment assets and liabilities into one entity (a "fund") with one set of owners, and their managers, workers, office space, and other operational assets and liabilities into a different entity (a "management company" or "adviser") with a different set of owners. The Fidelity management company, for example, operates several dozen mutual funds under the Fidelity brand name. Each fund is a separate entity with separate owners, and so is Fidelity itself. (3) In connection with this system, investment enterprises also tend to radically limit fund investors' control. A typical hedge fund, for example, cannot fire and replace its management company or its employees--not even by unanimous vote of the fund's board and equity holders. …

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