Jones raises both legal and policy questions. The legal question is: what is the nature of the “fiduciary duty” that Congress imposed on investment advisors in Section 36(b) the Investment Company Act, specifically regarding the fee the advisor charges? The policy question is: What duty should the advisor have? Since it’s rather unclear what Congress wanted to do in 1970 when it adopted Section 36(b), policy can inform the applicable legal standard. Legal and policy questions accordingly converge.
In theory, as I discussed in Are Partners Fiduciaries, a “fiduciary duty” is one of unselfishness by one who has substantial discretion to manage another’s property. An investment advisor arguably would fit this description. But this is only a default rule that can be waived, particularly as to the fiduciary’s compensation. So the real question is what limits did Congress intend to impose on the fund’s power to contract for compensation?
In answering this question, I will emphasize the importance of viewing the mutual fund as a type of standard form contract. What fiduciary duties are appropriate to this particular standard form? I see three possible approaches here. First, we could view mutual funds as products. There is significant evidence of vigorous competition in the market for mutual funds, as discussed extensively by Coates & Hubbard and in the Jones amicus brief that I joined . This arguably supports a minimalist approach to regulation. On the other hand, Congress’s imposition of a “fiduciary duty” must have been intended to accomplish something. These considerations lead me to accept Judge Easterbrook’s conclusion in Jones that the fiduciary duty is one of candor.
The second analogy is to a corporation. There is plenty of competition in the corporate governance market too. However, the corporate analogy highlights the fact that although investors can choose which fund to enter, the market doesn’t fully protect them from fiduciary abuse once they’ve invested. This arguably leads us to Judge Posner’s conclusion that there should be some limit on compensation, perhaps meaning that Harris can’t charge its controlled funds more than it charges independent funds. As Judge Posner argues, this duty is supported by “evidence that connections among agents [in the mutual fund industry] foster favoritism, to the detriment of investors.”
The corporate analogy is imperfect because, unlike shareholders, mutual fund investors can cash out at any time at the asset value of the fund. As a result, investors’ sale price is not freighted with managerial agency costs as it may be in closed end funds. This suggests that maybe investors in open end mutual funds don’t need as much fiduciary duty protection as corporate shareholders. On the other hand, exit is not costless, and even if it were fund managers could still inflict high fees and other possible harm on investors for whatever period they remain in the fund. Competition in the industry evidently has reduced agency costs, but not to zero. Of course we can’t expect zero agency costs. But what level of agency costs did Congress want to achieve?
If we accept the corporate analogy, then the panoply of corporate protections would apply, including independent directors and fairness standards where directors are not independent. The question is whether the corporate analogy is appropriate given investors’ ability to exit.
Fortunately we don’t have to choose between the product and the corporate analogies. There is a third possible analogy, what I’ve called the “uncorporation” – that is, partnerships, limited partnerships, LLCs and other unincorporated entities. I’ve argued, most recently in my Rise of the Uncorporation, that a critical difference between the corporation and the uncorporation is investors’ ability in the latter to get their money out of the firm. This ability supports a lower level of monitoring managers than in the corporation.
The uncorporation analogy is not perfect either. On the one hand, mutual fund investors have greater access to their cash than uncorporate investors, arguably supporting less need for fiduciary duties. Uncorporation statutes and agreements generally limit investor exit. This enables the firms to engage in long and intermediate-term business and investment strategies. On the other hand, the mutual fund industry has less sophisticated investors than many uncorporations such as private equity and hedge funds. Congress accordingly has imposed “fiduciary duties” on investment companies regulated by the ICA without a clear power to fully opt out of duties as there is for uncorporations under state (i.e., Delaware) law.
So where does that leave us? I would stick with Easterbrook's fiduciary duty of candor. A lower duty would ignore Congress’s intent to impose some duty, while a higher duty would ignore the fundamental distinctions between mutual funds on the one hand and corporations on the other particularly regarding exit.
More generally, I think the above analysis illustrates the usefulness of analyzing the array of governance structures available in distinct standard business forms.
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