Taking exit rights seriously: Why governance and fee litigation don't work in mutual funds

Yale Law Journal

Volumn 120, Issue 1, 2010, Pages 84-142

  Morley, John ^a   Curtis, Quinn ^b  

^a UNIVERSITY OF VIRGINIA SCHOOL OF LAW   (United States)

^b YALE SCHOOL OF MANAGEMENT   (United States)

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EID: 78149383679     PISSN: 00440094     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (177)

1. ALBERT O. HIRSCHMAN, EXIT, VOICE, AND LOYALTY: RESPONSES TO DECLINE IN FIRMS, ORGANIZATIONS, AND STATES (1970). Hirschman's original categories included loyalty in place of liability. The substitution of liability for loyalty was recently made by Henry Hansmann and Reinier Kraakman. Henry Hansmann & Reinier Kraakman, Exit, Voice and Liability: The Dimensions of Organizational Structure (June 2008) (unpublished working paper, on file with authors).
2. INV. CO. INST., 2010 INVESTMENT COMPANY FACTBOOK 9 fig.1.1, 10 fig.1.2, 112 fig.7.17 (50th ed. 2010).
3. Jones v. Harris Assocs. L.P., 130 S. Ct. 1418 (2010).
4. Jones v. Harris Assocs. L.P. (Jones I), 527 F.3d 627 (7th Cir. 2008), reh'g denied, 537 F.3d 728, 729 (7th Cir. 2008) (Posner, J., dissenting), vacated and remanded, 130 S. Ct. 1418 (2010).
5. Brief of AARP & Consumer Federation of America as Amici Curiae in Support of Petitioners, Jones, 130 S. Ct. 1418 (No. 08-586); Brief of Law & Finance Amici Curiae in Support of Respondent, Jones, 130 S. Ct. 1418 (No. 08-586); Brief of Amici Curiae Law Professors in Support of Petitioners, Jones, 130 S. Ct. 1418 (No. 08-586); Brief of Robert Litan, Joseph Mason & Ian Ayres as Amici Curiae Supporting Petitioners, Jones, 130 S. Ct. 1418 (No. 08-586).
6. See infra Section I.B for a literature review.
7. Imagine, for example, two funds with identical portfolios and identical numbers of shares outstanding today but different fees and different changes to the portfolio expected during the coming year. The returns on shares in these two funds will be different in the coming year, but their NAVs today will nevertheless be the same.
8. See infra notes 92-99 and accompanying text.
9. 130 S. Ct. 1418 (2010).
10. This is usually the case, but it is not required by law.
11. The extent to which the legal distinction between funds and their advisers generates conflicts of interest has been debated extensively. See William A. Birdthistle, Compensating Power: An Analysis of Rents and Rewards in the Mutual Fund Industry, 80 TUL. L. REV. 1401 (2006); Tamar Frankel, Advisory Fees: Evolving Theories, INV. L., Feb. 2003, at 21; John P. Freeman & Stewart L. Brown, Mutual Fund Advisory Fees: The Cost of Conflicts of Interest, 26 J. CORP. L. 609 (2001); Paul G. Mahoney, Manager-Investor Conflicts in Mutual Funds, 18 J. ECON. PERSP. 161 (2004).
12. For a summary of voting rules, see TAMAR FRANKEL & CLIFFORD E. KIRSCH, INVESTMENT MANAGEMENT REGULATION 265-300 (3d ed. 2005).
13. Investment Company Act of 1940 § 15(a), 15 U.S.C. § 80a-15(a) (2006).
14. SEC, DIV. OF INV. MGMT., PROTECTING INVESTORS: A HALF CENTURY OF INVESTMENT COMPANY REGULATION 277 (1992) [hereinafter SEC HALF CENTURY REPORT], available at http://www.sec.gov/ divisions/investment/guidance/icreg50-92.pdf; Bibb L. Strench, Board Structure and Processes, in MUTUAL FUND REGULATION § 14:3 (Clifford Kirsch ed., 2010).
15. 15 U.S.C. § 80a-15(a)(2) (2006).
16. Id. § 80a-15(a).
17. Id. §§ 80a-8(b), 80a-13(a).
18. Id. § 80a-2(a)(42).
19. 17 C.F.R. § 270.20a-1 (2009).
20. The desire to avoid statutory annual meeting requirements is a key reason why mutual funds have long organized as Delaware or Massachusetts statutory business trusts or Maryland corporations. See John H. Langbein, The Secret Life of the Trust: The Trust as an Instrument of Commerce, 107 YALE L.J. 165, 171, 187 (1997).
21. The ICA does not directly require funds to have boards, but it does require boards to perform several functions that no fund could legally do without.
22. Sophie Xiaofei Kong & Dragon Yongjun Tang, Unitary Boards and Mutual Fund Governance, J. FIN. RES. (forthcoming), available at http://ssrn.com/abstract=1033057. Shareholders have occasionally sued over this practice, without success. See, e.g., Krantz v. Fidelity Mgmt. & Research, Co., 98 F. Supp. 2d 150 (D. Mass. 2000).
23. For a summary of boards' responsibilities, see SEC, EXEMPTIVE RULE AMENDMENTS OF 2004: THE INDEPENDENT CHAIR CONDITION 3-30 (2005), available at www.sec.gov/news/studies/indchair.pdf.
24. Supra note 14 and accompanying text.
25. Investment Company Act of 1940 § 16(a), 15 U.S.C. § 80a-16(a) (2006) (limiting terms to five years for members of classified boards but specifying no terms for unclassified boards).
26. 15 U.S.C. § 80a-16(a)-(b).
27. Role of Independent Directors of Investment Companies, 66 Fed. Reg. 3734 (Jan. 16, 2001) (to be codified at 17 C.F.R. pts. 239, 240, 270, 274).
28. 15 U.S.C. § 80a-15(a).
29. 17 C.F.R. § 270.12b-1 (2009).
30. 15 U.S.C. §§ 80a-15(c), -17(f); 17 C.F.R. §§ 270.17g-1,.32a-4.
31. 17 C.F.R. § 270.10f-3.
32. Id. § 270.17a-7.
33. Id. § 270.17a-8.
34. Id. § 270.17d-1(d)(7).
35. Id. § 270.22c-1.
36. Securities Trading Practices of Registered Investment Companies, 44 Fed. Reg. 25,128 (Apr. 27, 1979) (to be codified at 17 C.F.R. pt. 271).
37. 17 C.F.R. §§ 270.18f-3(c)(v), (d), (e).
38. See, e.g., ABA FED. REGULATION OF SEC. COMM., FUND DIRECTORS GUIDEBOOK 49-50 (3d ed. 2006).
39. See, e.g., Investment Management Agreement, The Lazard Funds, Inc., available at http://www.sec.gov/Archives/edgar/data/874964/000093041305006847/c37673_ex99 -d1.txt; Management Contract between Fidelity Advisor Series I, Fidelity Advisor Balanced Fund, and Fidelity Management & Research Company, available at http://www.sec.gov/Archives/edgar/data/722574/000072257407000110/d1.htm.
40. See infra Section II.F.
41. Investment Company Act of 1940 § 10(a), 15 U.S.C. § 80a-10(a) (2006).
42. Role of Independent Directors of Investment Companies, 66 Fed. Reg. 3734 (Jan. 16, 2001) (to be codified at 17 C.F.R. pts. 239, 240, 270, and 274).
43. Investment Company Governance, 69 Fed. Reg. 46,378 (Aug. 2, 2004) (to be codified at 17 C.F.R. pt. 270). The D.C. Circuit blocked the SEC from implementing these rules on the ground that the SEC did not consider the costs of compliance. Chamber of Commerce v. SEC, 412 F.3d 133 (D.C. Cir. 2005). The rules' fate remains uncertain. Adam Cook, Note, Now You See It, Now You Don't: The Uncertain Fate of the SEC's Governance Rule on Mutual Fund Director Independence, 59 RUTGERS L. REV. 603 (2007).
44. For a history and general outline of SEC and private litigation against mutual funds, see H. Norman Knickle, The Investment Company Act of 1940: SEC Enforcement and Private Actions, 23 ANN. REV. BANKING & FIN. L. 777 (2004).
45. Larry D. Barnett, The Regulation of Mutual Fund Boards of Directors: Financial Protection or Social Productivity?, 16 BROOK. J.L. & POL'Y 489, 506-34 (2008); Robert H. Sitkoff, Trusts as "Uncorporation": A Research Agenda, 2005 U. ILL. L. REV. 31.
46. Investment Company Act of 1940 § 36(a), 15 U.S.C. § 80a-35(a) (2006).
47. 15 U.S.C. § 80a-35(b).
48. Id.
49. 130 S. Ct. 1418 (2010).
50. Jones, 130 S. Ct. at 1426; Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923 (2d Cir. 1982). For a more detailed summary of the history of mutual fund fee litigation doctrine prior to the Supreme Court's opinion in Jones, see William A. Birdthistle, Investment Indiscipline: A Behavioral Approach to Mutual Fund Jurisprudence, 2010 U. ILL. L. REV. 61.
51. Jones, 130 S. Ct. at 1426; Gartenberg, 694 F.2d at 928.
52. Jones, 130 S. Ct. at 1425; Gartenberg, 694 F.2d at 928.
53. Another Second Circuit opinion summarized these factors: "(a) the nature and quality of services provided to fund shareholders; (b) the profitability of the fund to the advisermanager; (c) fall-out benefits; (d) economies of scale; (e) comparative fee structures; and (f) the independence and conscientiousness of the trustees." Krinsk v. Fund Asset Mgmt., 875 F.2d 404, 409 (2d Cir. 1989).
54. The Gartenberg court had explicitly declined to compare fees charged to mutual funds and institutional clients, noting that the "services required by each type of fund differ sharply." 694 F.2d at 930 n.3. By contrast, the Supreme Court in Jones held that "courts may give such comparisons the weight that they merit in light of the similarities and differences between the services that the clients in question require...." 130 S. Ct. at 1428 (2010).
55. Jones I, 527 F.3d 627 (7th Cir. 2008), reh'g denied, 537 F.3d 728 (7th Cir. 2008) (Posner, J., dissenting), vacated and remanded, 130 S. Ct. 1418 (2010).
56. Jones I, 527 F.3d at 632.
57. Id.
58. Jones v. Harris Assocs. L.P., (Jones II) 537 F.3d 728 (7th Cir. 2008) (Posner, J., dissenting).
59. Jones, 130 S. Ct. at 1429 (2010) ("[C]ourts should not rely too heavily on comparisons with fees charged to mutual funds by other advisers. These comparison are problematic because these fees, like those challenged, may not be the product of negotiations conducted at arm's length." (citing Jones II, 537 F.3d at 731-32 (Posner, J., dissenting))).
60. The appropriateness of the analogy between mutual funds and ordinary operating companies has been debated directly by a few commentators. See, e.g., Birdthistle, supra note 11; Donald C. Langevoort, Private Litigation To Enforce Fiduciary Duties in Mutual Funds: Derivative Suits, Disinterested Directors and the Ideology of Investor Sovereignty, 83 WASH. U. L.Q. 1017 (2005); Jerry W. Markham, Mutual Fund Scandals-A Comparative Analysis of the Role of Corporate Governance in the Regulation of Collective Investments, 3 HASTINGS BUS. L.J. 67 (2006); Alan R. Palmiter, The Mutual Fund Board: A Failed Experiment in Regulatory Outsourcing, 1 BROOK. J. CORP. FIN. & COM. L. 165 (2006); Richard M. Phillips, Deregulation Under the Investment Company Act-A Reevaluation of the Corporate Paraphernalia of Shareholder Voting and Boards of Directors, 37 BUS. LAW. 903 (1982); A. Joseph Warburton, Should Mutual Funds Be Corporations? A Legal & Econometric Analysis, 33 J. CORP. L. 745 (2008).
61. R. GLENN HUBBARD ET AL., THE MUTUAL FUND INDUSTRY: COMPETITION AND INVESTOR WELFARE (2010); John C. Coates IV & R. Glenn Hubbard, Competition in the Mutual Fund Industry: Evidence and Implications for Policy, 33 J. CORP. L. 151 (2007); see also D. Bruce Johnsen, Myths About Mutual Fund Fees: Economic Insights on Jones v. Harris (George Mason Law & Econ. Research Paper No. 09-49, 2009), available at http://ssrn.com/abstract=1483862 (pointing out that a competitive market should reward good funds). Todd Henderson has criticized section 36(b) more directly, focusing less on the severity of the problem that it is intended to solve than on its costs and benefits as a potential solution. M. Todd Henderson, Justifying Jones (John M. Olin Law & Econ. Working Paper No. 491, 2009), available at http://ssrn.com/abstract=1499410. Larry Ribstein has also criticized excessive fee liability and governance, arguing that the mutual fund industry is competitive and that mutual fund regulation is unresponsive to the needs of the industry and investors because it is administered at the federal level and is not subject to state-level competition. Larry Ribstein, Federal Misgovernance of Mutual Funds, 2009-2010 CATO SUP. CT. REV. (forthcoming 2010).
62. Eugene F. Fama & Michael C. Jensen, Separation of Ownership and Control, 26 J.L. & ECON. 301, 317-18 (1983).
63. Jones I, 527 F.3d 627, 634 (7th Cir. 2008).
64. Coates & Hubbard, supra note 61, at 211.
65. John C. Coates IV, Reforming the Taxation and Regulation of Mutual Funds: A Comparative Legal and Economic Analysis, 1 J. LEGAL ANALYSIS 591, 624 (2009). Coates recently joined a group of law and finance professors in an amicus brief in Jones arguing that courts should be allowed to consider evidence of the mutual fund market's competitiveness for purposes of section 36(b) liability. Brief of Law and Finance Amici Curiae in Support of Respondent, Jones v. Harris Assocs. L.P., 130 S. Ct. 1418 (2010) (No. 08-586). Notably, the brief did not push for the adoption of Easterbrook's standard.
66. See Jones II, 537 F.3d 728, 730 (7th Cir. 2008) (Posner, J., dissenting).
67. See, e.g., Brief of AARP & Consumer Federation of America as Amici Curiae in Support of Petitioners, Jones, 130 S. Ct. 1418 (No. 08-586); Brief of Amici Curiae Law Professors in Support of Petitioners, Jones, 130 S. Ct. 1418 (No. 08-586); Brief of Robert Litan, Joseph Mason & Ian Ayres as Amici Curiae Supporting Petitioners, Jones, 130 S. Ct. 1418 (No. 08- 586); Birdthistle, supra note 50, at 88-96; Lyman Johnson, A Fresh Look at Director "Independence": Mutual Fund Fee Litigation and Gartenberg at Twenty-Five, 61 VAND. L. REV. 497, 505-13 (2008).
68. E.g., Freeman & Brown, supra note 11; John P. Freeman, Steward L. Brown & Steve Pomerantz, Mutual Fund Advisory Fees: New Evidence and a Fair Fiduciary Duty Test, 61 OKLA. L. REV. 83 (2008); Ali Hortaçsu & Chad Syverson, Product Differentiation, Search Costs, and Competition in the Mutual Fund Industry: A Case Study of S&P 500 Index Funds, 119 Q.J. ECON. 403 (2004); Sunil Wahal & Albert Yan Wang, Competition Among Mutual Funds, J. FIN. ECON. (forthcoming), available at http://ssrn.com/abstract=1130822; Ajay Khorana & Henri Servaes, Conflicts of Interest and Competition in the Mutual Fund Industry (July 2004), available at http://ssrn.com/abstract=240596.
69. Quinn Curtis & John Morley, An Empirical Study of Mutual Fund Excessive Fee Litigation: Do the Merits Matter? (July 27, 2010) (unpublished manuscript, on file with authors).
70. At the end of 2006, the SEC compiled a summary of the empirical literature on mutual fund board composition. Memorandum from Chester S. Spatt, Chief Economist, SEC Office of Econ. Analysis, to Inv. Co. Governance File S7-03-04 (Dec. 29, 2006) [hereinafter SEC Literature Review], http://sec.gov/rules/proposed/s70304/oeamemo122906-litreview.pdf (providing a literature review on independent mutual fund chairs and directors); Memorandum from Chester S. Spatt, Chief Economist, SEC Office of Econ. Analysis, to Inv. Co. Governance File S7-03-04 (Dec. 29, 2006), http://ftp.sec.gov/rules/proposed/s70304/oeamemo122906-powerstudy.pdf (providing a power study of evidence on independent mutual fund chairs); see also SEC, supra note 23 (providing a qualitative rationale for changes in board independence rules). Since the summary was compiled, a handful of additional papers have further contributed to the debate. E.g., Martijn Cremers et al., Does Skin in the Game Matter? Director Incentives and Governance in the Mutual Fund Industry, 44 J. FIN. & QUANTITATIVE ANALYSIS 1345 (2009); Lauren Cohen, Andrea Frazzini & Christopher Malloy, The Small World of Investing: Board Connections and Mutual Fund Returns (Nat'l Bureau of Econ. Research, Working Paper No. 13121, 2007), available at http://www.nber.org/papers/w13121; Kong & Tang, supra note 22; Felix Meschke, An Empirical Examination of Mutual Fund Boards (Mar. 15, 2007) (unpublished manuscript), available at http://ssrn.com/abstract=676901.
71. The most widely cited empirical article in the financial economics literature on mutual fund boards pitches itself this way. Peter Tufano & Matthew Sevick, Board Structure and Fee- Setting in the U.S. Mutual Fund Industry, 46 J. FIN. ECON. 321, 322 (1997).
72. SEC HALF CENTURY REPORT, supra note 14, at 283-84; Phillips, supra note 60.
73. Role of Independent Directors of Investment Companies, 66 Fed. Reg. 3734 (Jan. 16, 2001) (to be codified at 17 C.F.R. pts. 239, 240, 270, and 274).
74. Investment Company Governance, 69 Fed. Reg. 46,378, at 46,389 (Aug. 2, 2004) (to be codified at 17 C.F.R. pt. 270.)
75. Id.
76. An alternative way of expressing our point may be located in the "capital lock-in" literature, which views boards not as a form of voice, but as "mediating hierarchs" with the authority to take actions that minimize shirking and mediate disputes about how to divide surpluses among various corporate stakeholders. See, e.g., Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 VA. L. REV. 247 (1999). Boards' roles are premised on the fact that stakeholders cannot receive the full value of their contributions if they exit and are therefore subject to exploitation by other stakeholders. Under this view of boards' roles, they are unnecessary in mutual funds not because they are useless as a form of voice, but because shareholders and other stakeholders can withdraw their contributions from mutual funds more easily than from other corporations and are therefore not subject to exploitation.
77. The daily nature of redemptions in most funds is what made the market-timing and latetrading scandals of 2003 and 2004 possible. See, e.g., Eric Zitzewitz, How Widespread Was Late Trading in Mutual Funds? (December 2005) (unpublished manuscript), available at http://ssrn.com/abstract=456360.
78. This point has been observed before and is a well-known problem in mutual fund taxation, since mutual fund share prices do not reflect expected tax liabilities. See, e.g., Michael J. Barclay, Neil D. Pearson & Michael S. Weisbach, Open-End Mutual Funds and Capital-Gains Taxes, 49 J. FIN. ECON. 3 (1998); Coates, supra note 65.
79. The product analogy has been suggested by others. See, e.g., Jill E. Fisch, Rethinking the Regulation of Securities Intermediaries, 158 U. PA. L. REV. 1961 (2010). One part of our contribution is to point out that the product analogy depends entirely on open-end mutual funds' exit feature and not on the nature of their clientele or any other aspect of their functioning.
80. This is effectively what happened to Bernie Madoff, who redeemed shareholders in his open-end hedge fund at a fictional NAV that was above the fund's actual NAV. A version of this problem is also what makes money market funds unstable and vulnerable to runs. Money market funds try always to redeem at $1, even when their NAVs fall below $1. To complete our example above, if our fund sold new shares at a price below NAV-say, 100 new shares at 1 cent each-the NAV would fall to just slightly more than 50 cents ($101 divided by 200 shareholders). The new shareholders would pay only 1 cent for a share worth 50 cents and the old shareholders would lose half the value of their shares. That is clearly not sustainable.
81. If redemption occurred only at highly infrequent intervals of several years, as it does in private equity funds, then we could imagine the development of a secondary market with prices that departed significantly from NAV. See, e.g., Henry Lahr & Christoph Kaserer, Net Asset Value Discounts in Listed Private Equity Funds (Ctr. for Entrepreneurial & Fin. Studies, Working Paper No. 2009-12, 2010), available at http://ssrn.com/ abstract=1494246. By statute, however, mutual funds must redeem within seven days. 15 U.S.C. § 80a-22(e) (2006).
82. We focus on the decision problem of an investor already invested in a fund rather than an investor investing in a fund for the first time because an investor already in a fund is less likely to shop funds than an investor coming to the market for the first time. Moving funds entails certain costs, such as taxes and redemption fees, that investing for the first time does not. We are trying to address the most difficult case for our argument.
83. See, e.g., Mark M. Carhart, On Persistence in Mutual Fund Performance, 52 J. FIN. 57, 58 (1997).
84. See, e.g., ADOLF A. BERLE, JR. & GARDINER C. MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY (1933).
85. Note that exit does not necessarily reduce the value of activism to future investors. Activism in a mutual fund could conceivably generate value that outlasts an activist's investment, just as it can in an ordinary company. Rather, exit eliminates present investors' ability to benefit from the value that will be enjoyed by investors in the future.
86. You cannot make money by charging less for a product than what it costs to provide it.
87. See infra text accompanying notes 92-99.
88. Section 36(b) does not formally empower judges to enter injunctions dictating fees charged after a judgment, but a judgment or settlement about fees charged in the past will almost always have implications for fees charged in the future.
89. See infra Section III.C.
90. See JAMES D. COX ET AL., SECURITIES REGULATION: CASES AND MATERIALS 1211 (3d ed. 2001); James D. Cox & John W. Payne, Mutual Fund Expense Disclosures: A Behavioral Perspective, 83 WASH. U. L.Q. 907, 923 (2005); Freeman & Brown, supra note 11, at 645-47. The American Funds family recently won a bench trial in a section 36(b) case, with the plaintiffs taking nothing on their claims. In re Am. Mut. Funds Fee Litig., No. 04-5593, 2009 WL 5215755 (C.D. Cal. Dec. 28, 2009).
91. We concede that the smallness and uncertainty of recoveries are not mechanical products of exit and could be remedied by revising section 36(b), but they presently amount to just one more reason why litigation by actual plaintiffs is unlikely.
92. Coates & Hubbard, supra note 61.
93. Id. at 153.
94. Hortaçsu & Syverson, supra note 68; Mahoney, supra note 11, at 169-71.
95. E.g., PETER J. WALLISON & ROBERT E. LITAN, COMPETITIVE EQUITY: A BETTER WAY TO ORGANIZE MUTUAL FUNDS (2007).
96. E.g., James J. Choi, David Laibson & Brigitte C. Madrian, Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds, 23 REV. FIN. STUD. 1405 (2010); Susan E. K. Christoffersen & David K. Musto, Demand Curves and the Pricing of Money Management, 15 REV. FIN. STUD. 1499 (2002); Coates & Hubbard, supra note 61; Javier Gil-Bazo & Pablo Ruiz-Verdú, The Relation Between Price and Performance in the Mutual Fund Industry, 64 J. FIN. 2153 (2009); Javier Gil-Bazo & Pablo Ruiz-Verdú, When Cheaper Is Better: Fee Determination in the Market for Equity Mutual Funds, 67 J. ECON. BEHAV. & ORG. 871 (2008); Hortaçsu & Syverson, supra note 68.
97. FINRA Mutual Fund Analyzer, http://apps.finra.org/fundanalyzer/1/fa.aspx (last visited Sept. 7, 2010).
98. Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923, 929 (2d Cir. 1982)
99. . 99. See, e.g., Freeman & Brown, supra note 11.
100. Only 35% of assets in U.S. domestic equity funds were in front-end load funds in 1999, and the proportion was steadily declining. Brad M. Barber, Terrance Odean & Lu Zheng, Out of Sight, Out of Mind: The Effect of Expenses on Mutual Fund Flows, 78 J. BUS. 2095, 2095 (2005). Average load fees have declined significantly since 1980, and no-load funds have grown much more quickly than front-end load funds since 2002. Funds with redemption fees have experienced net outflows every year since 2003. INV. CO. INST., supra note 2, at 77 fig.5.13. Many redemption fees apply only to shares held for very short periods and are charged only as a way of discouraging abusive quick-trading arbitrage schemes. Eric Zitzewitz, Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds, 19 J.L. ECON. & ORG. 245 (2003).
101. They can also sue their employers and the mutual fund managers who administer 401(k) plans under § 404 of ERISA, which imposes a prudent man standard of care and loyalty. 29 U.S.C. § 1104 (2006); see, e.g., Braden v. Wal-Mart Stores, Inc., 588 F.3d 585 (8th Cir. 2009).
102. Barclay et al., supra note 78; Coates & Hubbard, supra note 61, at 199.
103. See supra Section II.C; infra Section III.A.
104. See, e.g., Gordon J. Alexander, Jonathan D. Jones & Peter J. Nigro, Mutual Fund Shareholders: Characteristics, Investor Knowledge, and Sources of Information, 7 FIN. SERVS. REV. 301 (1998); Choi et al., supra note 96; Michael J. Cooper, Huseyin Gulen & P. Raghavendra Rau, Changing Names with Style: Mutual Fund Name Changes and Their Effects on Fund Flows, 60 J. FIN. 2825 (2005); Don A. Moore et al., Positive Illusions and Forecasting Errors in Mutual Fund Investment Decisions, 79 ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 95 (1999); Christopher J. Malloy & Ning Zhu, Mutual Fund Choices and Investor Demographics, (Mar. 16, 2004) (unpublished manuscript, on file with authors).
105. See, e.g., INV. CO. INST., COSTS OF ELIMINATING DISCRETIONARY BROKER VOTING ON UNCONTESTED ELECTIONS OF INVESTMENT COMPANY DIRECTORS (Dec. 18, 2006), available at http://www.ici.org/pdf/wht_broker_voting.pdf.
106. Independent directors of the Yacktman Fund in 1998 fought a public proxy battle with the fund's adviser, and shareholders ultimately approved a proposal by the adviser to remove the independent directors (the directors did not formally attempt to terminate the contract with the adviser). Paul H. Dykstra & Paulita Pike-Bokhari, The Yacktman Battle: Manager Bites Watchdogs, INV. LAW., Nov./Dec. 1998, at 1. The board of the Navellier Funds in 1997 attempted to change managers and was defeated by shareholder vote. Navellier v. Sletten, 262 F.3d 923, 933 (9th Cir. 2001). The Japan Fund changed managers in 2002. Media sources suggested that the board fired the managers, but our conversations with industry professionals suggest that the managers may have simply walked away from the fund. Chuck Jaffe, Japan Fund Shift Shows Who's Boss, STAR-LEDGER (Newark), Nov. 27, 2003, at Bus. 66; Ian McDonald, Japan Fund's Board Stages a Revolt-Directors Ask Shareholders To Approve Severing Ties with Deutsche Bank, WALL ST. J., July 15, 2002, at C17.
107. In 1991 the shareholders of six T. Rowe Price funds voted on fees that would have applied upon redemption to any shareholder who redeemed less than six or twelve months after purchasing shares. Four funds approved the new fee, and two rejected it. Carole Gould, Mixed Reviews on Redemption Fees, N.Y. TIMES, May 12, 1991, at F14. Arguably, shareholders are more motivated to vote on redemption fees than initial load fees or continuous fees, since redemption fees uniquely impinge on the freedom of exit.
108. A group called Investors Against Genocide initiated proposals in funds in Fidelity, Vanguard, TIAA-CREF, T. Rowe Price, and other complexes to prohibit investing in countries and companies involved in genocide. Daisy Maxey, Drop in Voting Adds to Costs, WALL ST. J., May 19, 2008, at C12; MUTUAL FUNDS WITH SHAREHOLDER PROPOSALS FOR GENOCIDE-FREE INVESTING, http://investorsagainstgenocide.net/shareholderhelp (last visited Sept. 7, 2010). These proposals generally received little support and participation. Investors Against Genocide initiated proposals in twenty-one Fidelity funds in 2008, for example, and after three separate votes, the proposals did not obtain a quorum in seven funds and failed with less than 30% in thirteen funds. Id.
109. INV. CO. INST., supra note 105, at 11-13; Maxey, supra note 108. The ICI's data do not distinguish open-end and closed-end funds.
110. See Order Approving Proposed Rule Change, as Modified by Amendment No. 4, To Amend NYSE Rule 452 and Corresponding Listed Company Manual Section 402.08, 74 Fed. Reg. 33,293 (July 1, 2009), available at http://www.sec.gov/rules/sro/nyse/2009/34-60215.pdf; INV. CO. INST., supra note 105.
111. Curtis & Morley, supra note 69.
112. See supra note 90 and accompanying text.
113. Curtis & Morley, supra note 69.
114. See, e.g., Exhibit List of Defendant at 4, Exhibits 2001-2007, Baker v. Am. Century Inv. Mgmt., Inc., No. 04-4039-CV-C-ODS, (W.D. Mo. July 3, 2006); Attention Investment Fund Investors (Advertisement), POST-TRIBUNE (Jefferson City, Mo.), Mar. 15, 2004, at 6.
115. Curtis & Morley, supra note 69.
116. Consolidated Class Action Complaint, In re Reserve Primary Fund Sec. & Derivative Class Action Litig., No. 08-CV-8060-PGG (S.D.N.Y. Jan. 5, 2010).
117. The managers won, which is surely not the result that most advocates of mutual fund governance would have desired. See Dykstra & Pike-Bokhari, supra note 106.
118. Camelia Kuhnen has collected data suggesting that nearly 30% of funds changed managers at least once between 1993 and 2002 and that nearly 16% changed managers in 2001 alone. Camelia M. Kuhnen, Dynamic Contracting in the Mutual Fund Industry 15, 38 tbl.4 (Feb. 15, 2005) (unpublished manuscript), available at http://ssrn.com/abstract=687530. Kuhnen does not attempt to distinguish among the different reasons why managers change, but apparently assumes that every change is attributable to boards firing managers. E.g., id. at 14, 15, 23-26. Similarly Ajay Khorana, Peter Tufano, and Lei Wedge analyze a significant (albeit much smaller) number of mergers between funds with different managers and assume that all or at least a significant portion of these mergers are initiated by target fund boards who are dissatisfied with their funds' managers and want to get rid of them. Ajay Khorana, Peter Tufano & Lei Wedge, Board Structure, Mergers, and Shareholder Wealth: A Study of the Mutual Fund Industry, 85 J. FIN. ECON. 571, 573, 596 (2007). It is simply not plausible, however, to think that management change initiates with boards-at least not with the frequency these authors describe. Because shareholders have to vote on management changes, genuine conflict between boards and managers would inevitably leave traces in the public record. Our conversations with mutual fund industry professionals, however, have turned up no memories of any significant instances of boardmanager conflict or board-initiated change other than the Navellier and Yacktman funds, with respect to which there is tremendous collective memory and awareness in the industry. See supra note 106. Neither Kuhnen nor Khorana, Tufano, and Wedge supply any anecdotal evidence that any of the instances in their samples involved actual conflict between managers and boards, and we strongly doubt whether there are more than a few such instances in their samples (if indeed there are any). The better explanation for the management changes in these data, therefore, is that managers initiate the changes and boards simply rubber-stamp them. The real motivation for management changes is that one set of managers effectively sells a fund to another set of managers.
119. See supra note 70 and accompanying text.
120. See SEC Literature Review, supra note 70, at 1.
121. See, e.g., Khorana et al., supra note 118.
122. This has long been the central puzzle in the study of closed-end funds. See, e.g., Elroy Dimson & Carolina Minio-Kozerski, Closed-End Funds: A Survey, FIN. MKTS., INSTITUTIONS & INSTRUMENTS, May 1999, at 1-2; Charles M. C. Lee, Andrei Shleifer & Richard H. Thaler, Anomalies: Closed-End Mutual Funds, J. ECON. PERSP., Fall 1990, at 153-54.
123. Michael Bradley et al., Activist Arbitrage: A Study of Open-Ending Attempts of Closed-End Funds, 95 J. FIN. ECON. 1 (2010).
124. See Andrew J. Donohue, Dir., Div. of Inv. Mgmt., SEC, Keynote Address at the Independent Directors Council Investment Company Directors Conference (Nov. 12, 2009), available at http://www.sec.gov /news/speech/2009/spch111209ajd.htm.
125. INV. CO. INST., supra note 105, at 11 fig.7.
126. Id. at 17 tbl.1.
127. Id. at 17.
128. To be sure, these are not the only reasons why boards do not fire managers. Other reasons include boards' lack of independence from managers and the great difficulty of finding and working with new managers once the old managers have been fired. Birdthistle, supra note 11, at 1409-11.
129. Susan E. K. Christoffersen, Why Do Money Fund Managers Voluntarily Waive Their Fees?, 56 J. FIN. 1117, 1120 (2001).
130. These fees typically include the fee approved by the board, the fee that management intends to charge at the time the prospectus is printed, the fee negotiated in a separate contract with the board, and the fee that management actually charges at any given moment.
131. It is unclear what this ought to mean for empirical studies. But the fact that none of these studies even mention the problem suggests to us that their authors are not aware of it and therefore that the format of fee disclosure is genuinely confusing.
132. See supra notes 25-27 and accompanying text.
133. See, e.g., Burks v. Lasker, 441 U.S. 471 (1979). Donald Langevoort has similarly criticized allowing boards to dismiss derivative litigation on the ground that boards are ineffective. Langevoort, supra note 60.
134. See supra notes 73-75 and accompanying text.
135. SEC, PUBLIC POLICY IMPLICATIONS OF INVESTMENT COMPANY GROWTH, H.R. REP. NO. 89- 2337, at 12 (1966), available at http://sechistorical.org/museum/papers/1960/; WHARTON SCH. OF FIN. & COMMERCE, A STUDY OF MUTUAL FUNDS, H.R. REP. NO. 87-2274, at 28-36 (1962).
136. See Jones v. Harris Assocs. L.P., 130 S. Ct. 1418, 1428-30 (2010); Johnson, supra note 67, at 519.
137. John C. Coffee, Jr., Understanding the Plaintiff's Attorney: The Implications of Economic Theory for Private Enforcement of Law Through Class and Derivative Actions, 86 COLUM. L. REV. 669 (1986); Jonathan R. Macey & Geoffrey P. Miller, The Plaintiffs' Attorney's Role in Class Actions and Derivative Litigation: Economic Analysis and Recommendations for Reform, 58 U. CHI. L. REV. 1 (1991).
138. For a similar argument about the incentives of plaintiffs' lawyers in section 36(b) cases, see Henderson, supra note 61, at 14.
139. See, e.g., Coates & Hubbard, supra note 61.
140. Curtis & Morley, supra note 69.
141. Section 36(b) suits are formally distinct from derivative suits because funds themselves cannot bring the suits (only investors and the SEC can). Daily Income Fund, Inc. v. Fox, 464 U.S. 523, 535 & n.11 (1984). Section 36(b) suits are therefore not subject to state law board-demand requirements or dismissal by boards.
142. David M. Geffen, A Shaky Future for Securities Act Claims Against Mutual Funds, 37 SEC. REG. L.J. 20, 24-25 (2009).
143. See, e.g., John C. Coffee, Jr., Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation, 106 COLUM. L. REV. 1534, 1556-58 (2006).
144. Institutional funds may charge lower fees because they are cheaper to manage. See Coates & Hubbard, supra note 61, at 184-87. Additionally, institutional funds charge less than retail funds almost by definition. Since institutional investors can choose between retail and institutional funds, an institutional fund charging more than a retail fund has no reason to exist.
145. See Birdthistle, supra note 50, at 75. The segmentation of the market is probably not complete, because institutional investors may invest in retail funds.
146. For empirical evidence and a theoretical model of mutual fund fee competition to support this intuition, see Christoffersen & Musto, supra note 96, and Gil-Bazo & Ruiz-Verdú, supra note 96. This intuition is also consistent with models developed to explain multiple equilibria in product markets with heterogeneous consumers. See Alan Schwartz & Louis L. Wilde, Imperfect Information in Markets for Contract Terms: The Examples of Warranties and Security Interests, 69 VA. L. REV. 1387 (1983).
147. Khorana & Servaes, supra note 68.
148. Coates & Hubbard, supra note 61, at 221-22 tbl.A4.
149. IRVING BERLIN ET AL., ANNIE GET YOUR GUN 174 (1967).
150. Of course, we do have opinions about whether and to what extent regulation is actually necessary, and these opinions are informed by our foregoing insight about how exit's net effect on investors is ambiguous. But we save for future research the task of commenting on the optimal extent of product-style regulation in mutual funds.
151. SEC HALF CENTURY REPORT, supra note 14, at 273.
152. See supra notes 129-131 and accompanying text.
153. See supra notes 109-110 and accompanying text.
154. For a summary of the technical and compliance matters for which boards are now responsible, see the background portion on boards in Subsection I.A.2. In short, boards review a wide range of matters that involve conflicts of interest, highly technical compliance issues, or both. These include, for example, purchases of securities from affiliates of managers and the setting of policies for valuing illiquid portfolio securities.
155. This type of regulation is common as a result of the fact that the ICA prohibits outright many practices that have subsequently been permitted by rule and are now commonplace in the mutual fund industry. See generally Tamar Frankel, The Scope and Jurisprudence of the Investment Management Regulation, 83 WASH. U. L.Q. 939 (2005) (describing investment company regulation's tendency toward absolute statutory prohibitions tempered by administrative exemptions).
156. 17 C.F.R. § 270.10f-3 (2009).
157. 17 C.F.R. § 270.38a-1.
158. See Sitkoff, supra note 45.
159. WALLISON & LITAN, supra note 95.
160. Wallison and Litan believe that directors are too powerful, and that they keep fees artificially high. Boards are allegedly engaged in a "cost-plus"-style rate-setting process, which they use to force advisers to charge higher fees than the advisers would otherwise charge. Id. at 89. This argument makes little sense, because (a) directors are in fact powerless since they are unelected and incapable of firing advisers, and (b) advisers are free to charge fees below those set by their boards. In fact, under the cap-and-waiver system described above, most advisers actually do charge fees lower than the fees their boards have approved. See supra note 129 and accompanying text. The only evidence that Wallison and Litan offer in support of their unusual view of directors' influence is the divergence in fees among seemingly similar funds. Many coherent explanations have been offered for this phenomenon from many sides of the debate about market competition. See supra note 96 and accompanying text. But Wallison and Litan do not engage these more coherent explanations and do not articulate why boards' alleged role in forcing managers to charge high fees is the real cause of this phenomenon. A softer version of Wallison and Litan's argument might say that boards' involvement in the fee-setting process helps to insulate managers from Jones-style liability under section 36(b) and therefore leads indirectly to higher fees. But this cannot be the cause of the mutual fund market's alleged problems. Every other product we can think of is even more insulated from Jones-style liability than mutual funds are, since no other product market is even subject to such liability. And in any event, the fees that boards set bear little relationship to the fees that advisers actually charge.
161. The Wells Fargo family of funds, for example, recently settled litigation over an alleged brokerage kickback scheme. The plaintiffs alleged violation of both ICA section 36(b) and various general anti-fraud laws, including Exchange Act Rule 10b-5. The settlement included both a payment to the affected funds in consideration of the section 36(b) claims and a payment directly to a class of investors who bought shares during a specified period of time in consideration of the general anti-fraud claims. Stipulation of Settlement at 10-12, Siemers v. Wells Fargo & Co., No. 05-04518 (N.D. Cal. July 5, 2007); Consolidated Amended Class Action Complaint for Violation of the Federal Securities Laws and for Violation of the Investment Company Act, Siemers v. Wells Fargo & Co., No. 05-04518 (N.D. Cal. Apr. 11, 2006).
162. See, e.g., In re Oppenheimer Funds Fees Litig., 419 F. Supp. 2d 593 (S.D.N.Y.), reconsidered, 426 F. Supp. 2d 157 (S.D.N.Y. 2006).
163. Olmsted v. Pruco Life Ins. Co., 283 F.3d 429 (2d Cir. 2002).
164. Jones v. Harris Assocs. L.P. (Jones I), 527 F.3d 627, 632 (7th Cir. 2008). Easterbrook suggested that extremely high fees may trigger liability but only because they is evidence of misconduct in the setting of fees. Id.
165. For a good exploration of many of these costs and benefits, see Henderson, supra note 61.
166. COX ET AL., supra note 90, at 1211.
167. Gartenberg-style liability also appears extraordinary if we compare mutual funds to ordinary companies because litigation over executive compensation in ordinary companies generally must allege fraud or misconduct in the setting of compensation-not merely that compensation is outside of the range of what is reasonable.
168. Note that the SEC already has authority to bring suits under section 36(b). To our knowledge, the SEC has never brought such a suit, probably because the Gartenberg standard and the SEC's mandate for enforcement are unclear.
169. INV. CO. INST., A GUIDE TO UNDERSTANDING MUTUAL FUNDS, http://www.ici.org/pdf/ bro_understanding_mfs_p.pdf; SEC, INVEST WISELY: AN INTRODUCTION TO MUTUAL FUNDS, http://www.sec.gov/investor/pubs/inwsmf.htm (last visited Sept. 8, 2010).
170. RICHARD H. THALER & CASS R. SUNSTEIN, NUDGE: IMPROVING DECISIONS ABOUT HEALTH, WEALTH, AND HAPPINESS (2d ed. 2009). Sunstein and Thaler's suggestions regarding the presentation of utility bills might be particularly useful. Id. at 259.
171. John Beshears et al., How Does Simplified Disclosure Affect Individuals' Mutual Fund Choices? 3 (Nat'l Bureau of Econ. Research, Working Paper No. 14,859, 2009), available at http://www.nber.org/papers/w14859.pdf.
172. Since funds must publicly disclose their portfolios and these disclosures are already compiled into databases maintained by Thomson West and the Center for Research in Securities Prices, discerning portfolio similarity would not be hard. For one possible model of portfolio similarity, see Wahal & Wang, supra note 68.
173. See, e.g., Cox & Payne, supra note 90.
174. In 1940, the open-end fund industry was dominated by three large Boston-based funds: Massachusetts Investors Trust, Incorporated Investors, and State Street Investment Corporation. See John D. Morley, The Origins of Investment Management Regulation 1936-1942, at 17-18 (Mar. 11, 2010) (unpublished working paper, on file with authors). Prior to the late 1930s none of these funds allowed shareholder voting. Natalie R. Grow, The "Boston-Type Open-End Fund"-Development of a National Financial Institution: 1924- 1940, at 76-77, 171, 536 (Apr. 30, 1977) (unpublished Ph.D. dissertation, Harvard University).
175. Investment Trusts and Investment Companies: Hearing Before the Subcomm. on Securities and Exchange of the S. Comm. on Banking and Currency, 76th Cong. 488, 502, 1055 (1940) (statements of Merrill Griswold, Chairman of Massachusetts Investors Trust, and Arthur H. Bunker, Executive Vice President of Lehman Corporation).
176. Investment Company Act of 1940 § 16(c), 15 U.S.C. § 80a-16(c) (2006).
177. See supra note 135 and accompanying text.