Should Mutual Funds Be Corporations? A Legal & Econometric Analysis*
Warburton, A. Joseph, Journal of Corporation Law
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.
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. …