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Paper Recommends Reduced Role for Fund Directors

Eric Roiter, a lecturer at Boston University School of Law and former Senior Vice President and General Counsel of Fidelity Management & Research Company, thinks that fund directors should take a reduced role in fund governance. In a forthcoming paper in the Harvard Business Law Review, he posits that the SEC and the court system in recent years have treated mutual funds as simply a type of ordinary corporation and seen “mutual fund governance as simply a variation on the theme of corporate governance.” However, Roiter argues that differences between mutual funds and ordinary corporations have “important implications for the governance of mutual funds, differences that should lead not to further entanglement of fund governance with corporate governance but to disentanglement.”

Roiter first notes that mutual funds are both an entity and a product, making investors both customers and shareholders. This stands in opposition to ordinary corporations where the shareholders and customers are two distinct groups. Second, the right of redemption in mutual funds allows investors to take their investment elsewhere and directly reduce an adviser’s compensation. Ordinary corporations instead “lock in” shareholder capital. According to Roiter, these features differentiate the investor/shareholder relationship from that of an ordinary corporation shareholder relationship and thus should affect the way regulators view the role of directors.

The paper argues that “[t]he emphasis should not be upon expanding the ‘business judgment’ decision making of a fund’s directors, but rather upon their role as monitors of legal and fiduciary duty owed by the fund’s adviser.” Such a role “comports with the economic reality that fund directors do not occupy, and generally do not see themselves as occupying, a position to negotiate with advisers in any sense comparable to how corporate directors or officers negotiate deals.” Not only is the fund’s adviser integral to the fund’s existence, “fund directors are keenly aware that investors, by choosing a fund, have also chosen a fund adviser.” Roiter argues that “[t]he business of funds—investment management—is fundamentally the province of the fund adviser, and investors can make their own business decisions on whether to entrust their capital to the adviser.”

Roiter points to several areas in which a conflation of the duties of corporate directors and fund directors has led to negative consequences. In implementing rule 12b-1, Roiter suggests that the SEC attempted to insert the business judgment of fund directors into the distribution process. This insertion “has led to a virtually unbroken streak of approvals by fund boards for over 30 years.” Roiter acknowledges that, were a fund’s board to reject the industry standard fee, “brokers will decline to market the fund’s shares and the fund will self-liquidate over time, as existing shareholders redeem their shares and are not replaced by new investors.” Rule 12b-1 has “spawned unnecessary complexity and has distorted the proper functioning of mutual fund boards.” He argues that the experience has shown that “[t]he value of fund boards arises from their policing role, safeguarding funds and their shareholders from over-reaching by fund advisers” and not by exercising business judgment. He suggests that market forces and investor choice, not the business judgment of directors, have driven funds to put forth a broad spectrum of distribution expense options.

The paper also notes past proposals for a proxy access rule, in which the SEC included mutual funds in rules that would make it easier for shareholders to nominate board candidates. He calls the inclusion of mutual funds an “afterthought” and points to arguments that that structure of boards in many fund complexes (such as the use of unitary boards or cluster boards) would make the shareholder access rule unworkable. Additionally, he feels that it is unlikely that a mutual fund shareholder would utilize the proxy access process instead of merely redeeming shares and leaving the fund.

Roiter suggests a new structure for mutual funds that would utilize a fund’s board of directors as “compliance monitors” but remove their input over the adviser’s fee. Instead, investors would determine whether a fee was appropriate by choosing to invest in the fund or not. This structure, called a Unified Fee Investment Company (UIFC), draws upon an SEC staff recommendation from the 1980s. Alternatively, Roiter suggests that like-minded investors could join together to “crowdfund” mutual funds that “would not owe their formation to any particular adviser, but to sponsoring banks or service firms and, ultimately, to the fund’s investors.”