Felony Conviction: Ineligible to Manage Mutual Funds.
The Investment Company Act of 1940 (the “Act”), the federal statute that provides for the regulation of mutual funds, is widely known to be a model for poor corporate governance. The statute permits outrageous conflicts of interest and serves to mislead investors regarding the risks related to investing in mutual funds. We refer to the statute as “enabling legislation.” That is, the Act enables mutual fund investment advisers who structure and operate their funds in accordance with its provisions to represent to investors that the funds are owned and managed by investors. They aren’t.
The reality, which is becoming increasingly clear to the public, is that mutual funds are created by and operated primarily to benefit their investment advisors. Managers use fund assets, i.e. brokerage commissions, to pay for or “soft dollar” investment research they would otherwise have to purchase themselves. Managers also use commissions to entice brokers to sell their funds, i.e., for marketing. And brokers who assist in selling fund shares are rewarded with fund trades at higher commission rates than would be required if execution of the trade alone was all that was involved. Mutual funds pay investment advisory fees exponentially higher than the fees negotiated by pensions and other institutional investors. A portion of these excessive investment advisory fees may be shared with brokerages that assist in marketing the manager’s funds. Fund managers affiliated with underwriters “park” shares of investment banking clients in fund portfolios, to the benefit of the investment bank (and its clients) and often to the detriment of the fund. Portfolio managers personally profit by front-running fund trades and expropriating investment opportunities. Hedge funds are preferred over mutual funds when allocations of hot investment opportunities are scarce because hedge funds pay significantly greater investment advisory fees to their managers. All of these practices diminish mutual fund shareholder returns and this is hardly an exhaustive list.
In summary, managers treat mutual funds like retail sucker pools they can gingerly dip into to further their own financial objectives. Public confidence is retained by the avoidance of conspicuous misappropriation and horrific performance. (Mediocre performance, compromised by self-dealing, can be dealt with by providing the brokers who sold fund shares to their clients with incentives to keep clients in the funds.) The applicable law doesn’t protect investors from any of the harms detailed above.
So long as managers comply with the Investment Company Act the SEC says they can fill investors’ heads with legal fictions like “the mutual fund’s board of directors exists to protect shareholders;” “the majority of the board is independent of the advisor,” “portfolio trades are allocated consistent with the manager’s “best execution” obligation,” and “investment advisory fees are vigorously negotiated.”
Reading a mutual fund prospectus is wonderfully reassuring. Unfortunately the disclosure is almost entirely meaningless. A mutual fund board of director’s meeting or annual meeting of shareholders is a beautifully orchestrated, serene event to witness. Too bad these rituals are devoid of substance. Investors are learning that the mutual fund industry’s years of acting as if it took the public’s trust seriously was just that: an act. And the SEC believed the fiction it had scripted in the applicable statute.
There is, however, one provision of the Act that has real teeth. Section 9 entitled “Ineligibility of Certain Affiliated Persons and Underwriters” provides that a person convicted of a felony related to securities or mutual funds is ineligible to serve as an investment advisor to a mutual fund. For those who are not familiar with mutual fund history, the application of this provision has resulted in the death of at least one major mutual fund player. Soon after E.F. Hutton pled guilty to “check-kiting” in the mid-1980s, a felony, lawyers representing the firm came running to the SEC in Washington seeking emergency relief from the provisions of Section 9 of the Investment Company Act. Technically Hutton was no longer eligible under the Act to manage the billions in its mutual funds. The funds were in limbo without a manager. While the SEC granted Hutton temporary emergency relief, the felony conviction meant Hutton’s days of managing mutual fund assets were about to end.
With all the allegations of mutual fund wrongdoing that remain unresolved and the additional matters that are surfacing virtually daily it is worthwhile to remember that law enforcement and regulators have a very effective tool for combating mutual fund criminality in this statutory provision. If a mutual fund advisor is involved in felonious activity, it can be thrown out of the business of managing funds. In the case of certain fund managers it is clear that illegal activity occurred at the highest levels, was widespread and longstanding. CEOs, CFOs and portfolio managers were involved. Fraudulent documents were created to conceal the wrongdoing.
We believe law enforcement and regulators have enough evidence related to certain mutual fund investment advisors to secure criminal convictions. Are these agencies willing to vigorously pursue wrongdoers if it means that entire mutual fund complexes may be shut down? That is the question that remains unanswered. What is clear to us is that the country has more than enough mutual funds. The few bad apples that deserve to be shut down will not be missed.
Setting Standards For The Investment Management Industry
