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Commissioner Paredes Weighs in On IM Issues

Last week, at an address before the ICI's Annual Capital Markets Conference, SEC Commissioner Troy A. Paredes shared his thoughts on, among other things, the Jones v. Harris Associates case to be heard by the Supreme Court in November.  Though he did not mention the SEC's amicus brief in the case, Paredes did discuss two key points of his own, in which he emphasizes the role of the "faithful and diligent board"

First, adequate market discipline can obviate the need for more exacting and burdensome regulation, including demanding judicial scrutiny of advisory fees. One can conceive of the section 36(b) fiduciary duty as compensating for a lack of competition in the mutual fund industry. Put differently, the legal accountability of section 36(b) can be thought of as substituting for a lack of market-based accountability. The industry, however, has changed since section 36(b) was adopted in 1970 and Gartenberg was decided in 1982. To the extent the industry has become more competitive, it may argue for greater judicial deference to the bargain the adviser and the fund strike. In the face of sufficient market forces that constrain advisory fees, the need for courts to monitor as strictly the adviser/board fee negotiations is mitigated.

Second, courts are not well-positioned to second-guess the business decisions that boards and others in business make in good faith. Judges may exercise expert legal judgment, but not expert business judgment. A judge may be equipped to monitor a board's decision-making process, but should steer clear of the temptation to override substantive outcomes. These sensibilities cut against reading section 36(b) as implementing a sort of substantive limit on fees and instead recommend that courts focus on the process by which the fees were determined.

An especially large advisory fee that appears to be "disproportionate" would seem to evidence that the decision-making process that produced the fee was inexcusably tainted, giving rise to a section 36(b) fiduciary duty breach. However, if on further scrutiny a court determines that careful, conscientious, and disinterested mutual fund directors agreed to the fee, little, if any, room is left for the court to declare that the fee is nonetheless so large that it could not be the result of an arm's-length bargain. To the contrary, if a faithful, diligent board decided that the fee was appropriate, it would seem to rebut any preliminary determination that the fee ran afoul of section 36(b). The prospect that perhaps a better bargain could have been driven is a slim justification for allowing judges — who have no comparative expertise negotiating or setting advisory fees — to substitute their judgment for the collective judgment of independent directors acting in good faith. (emphasis added)

In addition to his remarks on Jones v. Harris, Paredes also touched on custody issues, laying out his disagreement with the extent of the surprise exams in the proposed rules:

Although I voted in favor of the Commission's custody proposal, I raised certain reservations at the open meeting, particularly about extending the surprise exam to the extent proposed.3 First, I questioned whether the surprise exam should cover investment advisers with an independent qualified custodian or be targeted to instances where the investment adviser or a related person is the qualified custodian. Given that non-affiliated custodians already serve as an important safeguard of client assets, it is not self-evident that the cost of a surprise exam is warranted. Second, I sought comment on whether the custody rules should cover investment advisers who have custody only because they withdraw fees from client accounts. Is the ability to withdraw fees a sufficient basis upon which to subject an adviser to the cost of yearly surprise exams? I expressed a related reservation that surprise exams may undercut competition if they were disproportionately costly and burdensome for smaller advisers.

Commissioner Paredes also addressed money market reform, where he questioned the need to ban money market funds from using "Second Tier" securities.

I continue to question the proposal to eliminate Second Tier securities from money market fund holdings. Today, Rule 2a-7 caps at five percent the portion of a money market fund's assets that may be invested in Second Tier securities. The SEC's proposal would reduce this to zero percent.

Is such an unequivocal step as banning money market funds from investing in Second Tier securities warranted? In short, the Commission's proposal release reasons that it is possible that Second Tier securities could contribute to the instability of money market funds because Second Tier securities are of lower credit quality than First Tier securities.

. . .

I have not seen any evidence showing a causal link between Second Tier securities and the stresses that strained money market funds last year.  Indeed, the Commission's release does not suggest any such link.

Paredes also questioned the wisdom of the prospect of replacing the stable $1 NAV of money market funds.

Such a departure from a stable $1.00 NAV would fundamentally change money market funds. The question is whether the change would be for the better or for the worse.
. . .
[I]t's not clear that a floating NAV would prevent a run during a serious financial disruption. On the other hand, one could imagine that a stable $1.00 NAV makes the threat of a loss in value more salient and thus more psychologically impactful to investors in a way that could precipitate a rush to exit; whereas over time, investors may become less sensitive to the ups and downs of a floating NAV, so that a decline is less likely to trigger a run.
. . .
[W]e need to consider that if NAVs float, investors likely will turn to alternative investment options, such as various bank products. A considerable outflow from money market funds could adversely impact our markets generally, including companies for which a key source of financing dries up.

The full text of Paredes' address is available at: