John Morley of Yale Law School Center for the Study of Corporate Law, and Quinn Curtis of the Yale School of Management recently published a paper, Exit, Voice and Fee Liability in Mutual Funds, putting forth a provocative hypothesis. In the paper, Morley and Curtis argue that, because mutual fund investors may redeem at any time, fund investors have no incentives to use their voting powers to affect board composition and fees. As expressed in the paper's abstract:
Unlike shareholders of ordinary companies, mutual fund shareholders do not sell their shares - they redeem them from the issuing funds for cash. We argue that this uniquely effective form of exit almost completely eliminates mutual fund investors’ incentives to use voting, boards and fee liability. Investors will never become active in their funds regardless of the investors’ sophistication or the size of their stakes and regardless of whether the mutual fund market is competitive. We also catalogue a number of unintended and harmful ways in which exit distorts voting, boards and fee liability. Exit interacts with voting, for example, to make firing managers impossible and to prevent investors from receiving notice of fee increases. Exit also interacts with fee liability to cause recoveries to go to the wrong investors and to discourage investors from moving to lower-fee funds. Though exit gives investors a powerful tool to protect their interests, the net effect of exit on many investors is ambiguous, because investors who do not use their rights to leave underperforming funds cannot expect activism by other investors to improve the funds. Ultimately, exit causes mutual funds to look more like products than ordinary companies. Voting, boards and fee liability should therefore be eliminated. Whatever benefits they now achieve could be achieved more effectively and at lower cost by product-style regulation that applies automatically without investor action or that prompts investors to use exit rights effectively.
As the SEC and Congress reexamine proxy access and nomination of directors by shareholders, Morley and Curtis's provocative hypothesis cuts against relying on shareholder activism to improve the funds in which they invest. This only highlights the vital role independent fund directors play in protecting their funds' investors and negotiating advisory and other contracts on their behalf.
The full text of "Exit, Voice and Fee Liability in Mutual Funds" may be downloaded at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1547162