The pinnacle of our self-regulatory pyramid, the Securities and Exchange Commission, is not as imperious as its lofty position implies. When it regulates—and regulate it does, believe you me—it does so democratically. Longstanding procedures, common to all regulatory agencies, have bestowed upon the SEC an almost Athenian style of democracy. The SEC’s chief method of regulation is known as the rulemaking process, and you can rest assured that the SEC is more than happy to let you participate in that process, if you so choose.
When John C. Carter of San Dimas, California, expressed displeasure about the payments Smith Barney received for pushing American Distributors funds, he was playing an essential role in the aforementioned process. So were many other individuals who, like Carter, had either written letters to the SEC or sent in their views via the Internet. Literally thousands of people were venting, pleading, persuading, and generally yammering on what to do about brokerages being paid to push mutual funds.
The SEC comment period on pending rules is a gateway through which anyone can enter. It is as accessible as an Internet bulletin board or even one of those “town meetings” that the Investor’s Champion, Artie Levitt, used to convene when he wanted to get investor input before knuckling under to the Street or doing nothing. Anyone can toss in a comment, and you can bet that the SEC will be listening hard. That is its job. To listen to what people have to say, and to act. Well, to listen, at any rate.
When it comes to what actually emerges from the rulemaking process, it is probably safe to assume that the fund industry has more influence than, say, some guy with a Hotmail account and an opinion about mutual funds. A guy with an opinion about mutual funds does not hire law firms to lobby Congress and the SEC, does not have the opportunity to engage in cozy chitchats with SEC officials, and does not represent an industry whose law firms provide employment to SEC officials after they stop being SEC officials. Another reason this is a safe assumption is that the SEC hasn’t written a single regulation that would seriously upset the status quo of the mutual fund industry. It has backed off from the few proposed regulations that have made the fund industry slightly uncomfortable. The end result of all this inaction and backing off is that the SEC hasn’t moved even one millimeter toward correcting any of the fund industry’s abuses—which underlines why reforming the fund industry is up to you.
This is not to say that the SEC hasn’t moved. After the fund scandals were splattered all over the headlines in September 2003, regulators swarmed purposefully, like honeybees on a leftover Sno-Kone. More than a dozen regulations were proposed. That’s a lot of activity. A lot of “changes,” as the financial press puts it. As the regulatory agenda lengthened, media attention waned and regulators were able to face down their most feared enemy—an aroused public. The fund scandal, the subject of an almost hysterical media frenzy in late 2003, gradually drifted out of the public consciousness, smothered in an ooze of busywork and, as MarketWatch correctly observed, “heated challenges.”
One of the first rules concerning the fund industry to come out of the SEC after the scandal outbreak was the one that drew the comment from Mr. Carter. It addressed revenue sharing and several other subjects. The proposal was published for public comment on January 29, 2004. The title of SEC Release Nos. 33-8358, 34-49148, IC-26341; File No. S7-06-04 conveys the clarity of vision that is the hallmark of the SEC: “Confirmation Requirements and Point of Sale Disclosure Requirements for Transactions in Certain Mutual Funds and Other Securities, and Other Confirmation Requirement Amendments, and Amendments to the Registration Form for Mutual Funds.”
When this rule was proposed, it was widely hailed as an example of the SEC’s speedy and vigorous response to the fund scandals. It had been only a couple of months since Spitzer and the SEC had taken enforcement action against brokers taking payments from funds. The regulation had every indication of being “fast, fast, fast relief,” just as in the old Excedrin commercial.
SEC Release Nos. 33-8358, 34-49148, IC-26341; File No. S7-06-04 was not a by-product of hurried thinking or slapdash rulemaking. The pinnacle of our self-regulatory pyramid had been giving the subject a lot of thought for quite some time, without disturbing its repose by actually doing anything.
One key aspect of the SEC’s thought-collection process was a study that the agency staff had conducted, and which had been thoroughly digested by all layers of the SEC bureaucracy as it hummed purposefully in late 2003. This well-researched piece of work found a pervasive practice—“selection of brokers to execute fund portfolio transactions on the basis of their sales of fund shares”—except that instead of calling such things revenue sharing or kickbacks, the name the study used was “reciprocal brokerage arrangements.” These were no good, said the study. Such payments “tend to have undesirable effects on mutual funds and their shareholders,” as did soft dollars, which the SEC also called by another name in this study. “The use of the funds’ brokerage commissions as extra compensation to retail sellers of fund shares primarily benefits the [mutual fund] adviser-underwriters rather than the funds and their shareholders,” said the study. It went on to say that these payments led to excessive trading of fund shares, and encouraged fund managers to direct their trades to markets that were not giving them the best prices for portfolio transactions. Add in the academic studies proving that fund managers stink as traders, and you have a system in which fund managers had a special financial incentive to do a lousy job.
Overall, the SEC study was good and thorough. Just about everything that emerged concerning fund kickbacks from 2003 onward was right there, in the study. The anticompetitive effects were there. The general sleaze was there, described in some detail. Quite a good read by bureaucratic standards. Definitely worth some time studying, digesting.
It’s not unreasonable to expect that it would take the SEC a while to absorb the study—say, a couple of months, or a couple of years. The more time the better, right? So the SEC took the study and began reading it very carefully, for…oh, about thirty-seven years. That is how long it took for the SEC to turn its attention to fund kickbacks to brokerages after they were detailed in Public Policy Implications of Investment Company Growth, which the SEC sent over to the House Committee on Interstate and Foreign Commerce on December 2, 1966.
You know how it is in the weeks before Christmas. Vacation schedules. Uncle Leo flying in from Cleveland, buying the Christmas tree, that sort of thing. Stuff slips your mind. Before you know it thirty-seven years have gone by and it seems like a day.
One SEC official who came strolling by while Public Policy Implications was being chewed over by worms was a man who hated these revenue-sharing arrangements—really despised them. That was, of course, the Investor’s Champion, Artie Levitt. We know how much Artie hated revenue sharing because he harshly condemned it in a 2002 book that was modestly illustrated with his picture on the cover.
Since Artie headed the SEC during the entire Clinton administration, all eight years of it, and since he was the Investor’s Champion, you might expect that in all that time he must have swooped down on revenue sharing like a peregrine falcon and clawed it to pieces. Artie certainly knew about that 1966 SEC study—or he could have fished it out of the basement or the National Archives or the SEC Historical Society if he didn’t have a copy handy—and he probably had a lot of other info at his disposal. Artie concluded in his book that investors are pretty much helpless and ill-informed when it comes to this so-old-its-creaking practice. “When their broker recommends a fund, they don’t know enough to ask: Are you suggesting this fund because your research shows it’s the best investment for me, or because your firm is paid $1 million to push it?”
If you have Artie’s book, don’t bother to thumb through it to find the exciting story of how Artie acted on his hatred and thrashed all those broker-paying funds. It’s not there. As top man at the SEC during the entire 1990s growth of the fund industry into a multitrillion-dollar behemoth, Artie sat back in his leather armchair and watched all those funds paying off brokers, and watched…and watched…and watched…zzzzzzz.
That’s not exactly the story you get from reading Take On the Street, or the forceful condemnations of the fund industry that Artie provided the media as an oft-quoted pro-investor deity. In his book he bragged that “the SEC brought enforcement cases against some of the largest and most respected [mutual fund] companies during [his] tenure.” He pointed out that he put the screws to Van Kampen Investment Advisory Corp. and Dreyfus Corp., two very large fund groups, for allegedly putting out advertisements exaggerating the performance of their funds. He didn’t point out that Van Kampen got a soba-noodle slap—a meaningless censure and $125,000 in penalties. That’s about one-hundredth of the penalties his successor and Spitzer would later impose in far less weighty situations. It was, adjusted for asset size, the equivalent of the “penalty” you’d pay for returning an overdue exercise video to the library.
Artie forgot to mention the Van Kampen soba-noodle slap, which was insanely puny even by pre-Spitzer standards. He went on to say that Dreyfus paid $3 million to settle its case, which would be about what that company spends on umpires for the corporate softball league. As he bragged about that “penalty,” Artie had yet another memory lapse and forgot to mention that two-thirds of it was imposed by Spitzer.
Apparently Artie was distracted by something when he wrote the mutual fund chapters, because he forgot other stuff that might not have made him look very good. He forgot to talk about the other soba-noodle slaps he dealt out whenever fund miscreants came his way, which wasn’t very often. The alleged wrongdoers got small fines, a good scolding, signed papers not admitting to anything, and went on their way. The funds involved included some—Invesco and Alliance Capital were among them—that staged a comeback a decade later in the late-trading extravaganza. They were also “large and most respected,” at least as large and respected as Dreyfus and Van Kampen. How could he have forgotten?
By the time Bill Donaldson took the helm, Artie had already set the gold standard for doing nothing about mutual funds generally and fund payments to brokerages in particular. Donaldson provided the fund industry with needed continuity in the thumb-twirling, brow-knitting, and inaction department as he took over early in 2003. And just in time. In June of that year, just a few months after he came on board, the SEC received a kick in the slats in the form of an annoying, meddling GAO report.
The GAO said there was a thing called revenue sharing that needed attention. Its report observed that “such payments have been increasing and have raised concerns about how these payments may affect the overall expenses charged to fund investors.” The House Capital Markets subcommittee, meanwhile, was sticking its nose into the subject of fees and payments to brokers and generally making a pest of itself. The subcommittee held oversight hearings on fund fees in March 2003, and two members of the subcommittee, Paul E. Kanjorski and Robert W. Ney, sent over to Donaldson a bunch of obnoxious questions. Donaldson, flush from a confirmation hearing that resembled a 1960s-style love-in, responded by sending on to the congressmen a memo he had received from his fundmeister Roye, successor to Barry Barbash of Enron-exemption fame.
Roye made it very clear that the SEC had no canine in this particular fight. He approached the subject of fees, expenses, and revenue-sharing arrangements with a kind of bored indifference, such as you might find in a bartender who has witnessed one too many fistfights. Roye was not even willing to pay lip service to the notion that such payments were problematic. The words “conflict of interest” were nowhere to be found in his analysis of the payments (except for a footnote saying that those conflicts were “addressed”). Roye devoted most of his assessment to a dry legal analysis that made the payments seem about as insignificant as the loose change that falls out of your pocket when you sit on the sofa.
The congressional inquirers asked about the impact of revenue-sharing arrangements on price competition. It was a question that Roye clearly preferred they had not asked. He wasn’t going to touch that one with a ten-foot pole. It was, he said, “difficult to assess whether revenue-sharing payments generally have stimulated or inhibited price competition among funds.” He then proceeded to duck and weave and dance around the subject for a few more sentences.
Several months after the congressional Q and A session, when the fund scandal erupted, the SEC finally “acted.” Release Nos. 33-8358, 34-49148, IC-26341; File No. S7-06-04 was inserted into the Federal Register. Here was the culmination of almost four decades of study and hand wringing and shoulder shrugging and Levittal condemnation. I think this is so momentous that it requires a new paragraph:
The SEC required disclosure.
Isn’t that just what you’d expect from an agency in the forefront of “change?” Now, you might not think that this was a change, seeing as how brokerages already were disclosing fund payments and NASD rules already required that they make some kind of disclosure. That’s why brokerages like Morgan Stanley were nabbed. They weren’t given stern scoldings and soba-noodle slaps because they were taking payoffs. It was because they hadn’t disclosed the payoffs.
Observe the brilliant simplicity of this act of inaction. The SEC could have very simply said no—no to revenue-sharing, kickbacks, or whatever you want to call them. Instead, it said yes—but with a stern frown, a reassuring expression of continued concern, and lots of words.
The SEC’s pirouette around the fund-kickback issue was not an isolated case of failure to regulate. For decades, as hemlines have crept up and down and as the sands of time have poured through the hourglass, the SEC’s approach to regulation of anything it touches has been very much the same. It has withstood periods of tranquility and ferment. The pattern is as follows: a longstanding problem, a period of contemplation and repose, and, finally, a tepid “solution” or a request for more comment, all spaced months or years apart. In the process, time has healed all wounds and preserved the status quo.
It’s not just mutual funds that get this treatment. It’s the way the SEC approaches its job.
The only variation, post-scandals, is that the spin has been more effective as a result of flaccid media coverage. Even when proposals run into opposition despite their lameness and are meekly watered down, the media either doesn’t notice or doesn’t care. Remember what I said earlier: this isn’t Iraq or the White House. The media is on board.
For example, the SEC shocked a lot of people in March 2004 when it suggested actually doing something about market timing. The SEC proposed a mandatory 2 percent redemption fee on fund redemptions within five days of a purchase, with the proceeds going to fund assets and not the fund manager. It was a pretty obvious way of putting an end to market timing—so obvious that it was endorsed by the mutual fund trade association, the ICI. It looked as if the impossible were about to happen, and that the SEC would actually do something about a problem. But when the rulemaking process ground to a halt a year later, the forces of inertia, as usual, carried the day. The SEC said, “Never mind,” and backed off from the whole idea. The SEC decided that instead it would “require a fund’s board of directors either to approve a redemption fee or to determine that a redemption fee is not necessary for the fund.”
In effect, the SEC was slamming its fist on the table and saying, “Goddamn it! You guys absolutely have to stop market timing—unless you don’t want to.”
In a statement explaining the SEC’s about-face, Roye pointed out that there had been four hundred comment letters and that “most investors did not like the proposed mandatory redemption fee and thought it would penalize many shareholders who were not engaged in market timing.” Excuse me. “Most investors”? Had the SEC slipped the Gallup organization a few thousand bucks to conduct a survey of investors? Sure, a bunch of people had written letters opposing the idea, but they were short-term traders who had organized a letter-writing campaign, and it was so transparent that about a hundred of the “investor” letters were identically worded. *
Actually, the coup de grâce didn’t come from a few self-interested fund traders. Major fund groups, including Fidelity and Vanguard, had met with Roye and other SEC officials, and were not at all crazy about the mandatory redemption fees. Now, not all of the criticisms and objections from fund groups and others were bogus by any means. A lot of them were pretty good, constructive suggestions. But the SEC, rather than make intelligent changes in the rule, decided that the best course of action was no course of action. The soon-to-be former head of fund regulation said the SEC would “leave the decision regarding whether a redemption fee is appropriate to those in the best position to make that decision—the fund directors.” In other words, the buck was being passed back to the people who were responsible for the scuzzy trading in the first place.
The same thing happened to another post-scandal rule, also proposed with great fanfare and uncritical media hype, that would have required funds to receive all orders before four P.M. That would have closed a loophole exploited by some late traders. But the fund industry didn’t like it and, hey, their wishes were Bill Donaldson’s marching orders. In March 2005, long after the furor died down, Donaldson backed down.
One thing about the SEC—it is a polite agency. When it proceeds with a mutual fund rulemaking, it always behaves like a well-brought-up regulator, one that is polite and respectful. The SEC is mindful of its place, and doesn’t get uppity. Take the rule issued in October 2004 banning directed brokerage, which is the same kickback arrangement as revenue sharing except that the payments come right out of the fund assets instead of being laundered through the investment advisor. All that funds have to do, if prevented from this kind of kickback arrangement, is to shift over to revenue sharing, which isn’t being banned.
You’ll be pleased to know that this hippotamus-size loophole, which a number of people outside the fund industry pointed out during the rulemaking process, has been duly noted. “Commenters also addressed concerns regarding revenue sharing,” the SEC said in adopting the final rule. “We will take these and other comments we received into consideration as we evaluate whether and how to amend the rule further.” Translation: “If you think we are going to actually do anything massa doesn’t like, don’t hold your breath.”
That point was underlined in February 2005, when the SEC finally acted on its dumb revenue-sharing disclosure rule, which it had been staring at for more than a year. The SEC’s action was typical—it acted by deciding not to act. The SEC decided that a year wasn’t enough, and that more time and more public comment was needed, so that the SEC could figure out how to write a rule that would put the SEC’s stamp of approval on kickbacks.
The SEC’s sterling record of inaction-disguised-as-action reached new heights of splendor in its campaign to put a spit shine on mutual fund governance. Nothing else has covered the SEC in greater glory for regulation fans than its plan, adopted by a narrow vote in June 2004, to force funds to set aside 75 percent of board seats, and the post of chairman, for “independent” directors. It was passed by a split vote of the SEC commissioners, with Donaldson siding with Democratic members in favoring the rule, adding to his reputation for fearlessness and Levitt-like investor protection. Then there was that U.S. Chamber of Commerce lawsuit, which made the whole thing seem even more heroic.
When you survey the vast wasteland of trivia and red herrings that is the SEC’s roster of regulations and proposed regulations, keep in mind that such things are roughly analogous to a traffic accident. If you’ve ever smashed up your car, you know that what matters is not the actual accident but what appears in the police report. What matters in the SEC regulatory agenda is not the purpose of the agenda—which is to maintain the status quo—but how it is portrayed in the media. The actual Bill Donaldson might have been a bumbling, somnolent nonregulator, but that was not what mattered where it counted, which was in the media. One of the reasons for Donaldson’s embrace by the media was that he was a proponent of the virtues of pristine corporate governance, whether the governee was the New York Stock Exchange or mutual funds or companies generally. Donaldson’s credentials in this regard are usually accepted without much reflection on his actual record, even though he headed the NYSE at a time when its supervision of floor trading was so lousy that Artie Levitt’s SEC actually rapped it on the knuckles.
“Corporate governance” is the great corporate-speak buzzphrase of our times. It is a self-evident good thing, like “good government” and “standing up straight” and “chewing thoroughly before swallowing.” Its primary incarnation, the “independent director,” is “good for you,” in much the same quasi-mythical sense as fish was supposed to be “brain food” when we were kids. When the subject of corporate governance has been subjected to rigorous analysis by researchers, independent directors fall into the same mushy category as antioxidants, echinacea, and vitamin C. Nobody has been able to prove that independent directors make much of a difference to how a company is run—the evidence is, to say the least, mixed—but that hasn’t kept corporate governance from being grotesquely overemphasized.
There is certainly some anecdotal evidence that independent directors are more than just window dressing. After all, it was the independent directors of the New York Stock Exchange who eventually nudged and prodded Dick Grasso into calling it quits. (In a lawsuit, he claims that he was fired.) True, it was those same independent directors who had snored loudly, saliva dribbling onto their undershirts, while Grasso rammed through a compensation package that made Cortez’s hunt for El Dorado seem like Gandhi’s walk to the sea by comparison. It’s a pretty sorry history, not that it matters. Corporations nowadays have to eat their spinach, and mutual funds are no exception.
This independent-board-member rule was a special love of Bill Donaldson’s, who had headed a board at one time and had served on a few as an independent director. As a matter of fact, Donaldson was a prime example of the kind of independent guy you want on your board if you are a CEO and you don’t want to be bothered very much. Don’t forget that Donaldson was on the board of that corporate turd EasyLink Services, which as we’ve seen was dreadful enough to require touting by paid analysts. Just before Donaldson came to the SEC, the man appointed to head the new SEC accounting standards board, William Webster, turned out to have served as an independent director of a sickening little company called U.S. Technologies, whose CEO eventually was bundled off to prison.
Webster, like Donaldson, was the kind of good soldier you see filling the “independent” slots on corporate boards throughout the country. When U.S. Technologies auditors pointed out that the company’s financial controls were crummy, Webster, as head of the auditing committee, fired them. Now, that’s independent!
Having himself served as an independent director, Donaldson was anxious to bring the joys of independent corporate governance to mutual funds. What worked so well at U.S. Technologies and his old stomping grounds, EasyLink, clearly had a place amid the grim mutual fund landscape.
The only problem was that it was not necessary. Mutual fund governance was just fine, thank you very much.
Take the American Funds Distributors group, the Beaver Cleaver of a fund group that turned out to be a revenue sharer with “approximately fifty” unnamed brokerages. If its conduct was any measure of the quality of its governance, you’ve got to figure that American Funds’ directors were insiders and management lackeys, bereft of the independence and jaw-jutting courage that a William Webster would bring to the fore. Let’s take the American Funds flagship, the Growth Fund of America, founded in 1973, with 3.3 million customer accounts. This was one of the funds that Mr. Carter of San Dimas mentioned as having been pushed too severely by his broker at Smith Barney.
The Growth Fund of America board had nine members when the American Funds group was paying off those fifty or so unnamed brokerages. Seven of the nine directors—78 percent—were as independent and free as the wind. It was the same story at the group’s other funds.
It was the same pristine picture at the Janus fund group. Its Mercury fund was involved in the very first late-trading scandal. At Janus, directors are called trustees. Seven trustees, and all except one were independent. That’s 86 percent. And you have to figure that these were hardworking types, as each of these trustees—not unusual for funds in general—served on the boards of no less than fifty-nine portfolios.
Ditto at the Invesco Dynamics fund—that’s the one where investors lost 34 percent at the same time hedge fund late traders saw a 110 percent return on their money, according to Spitzer. In 2003, all of the Invesco stock funds were under the loving care of eight independent directors, far outnumbering the three insider directors. True, that was under the 75 percent threshold Donaldson set, but not by much—73 percent of the board. But after the unpleasantness with Spitzer it was all fixed, and by 2005 Invesco had two insiders and fourteen outside directors on each fund board. A veritable model of propriety, with independent directors occupying 88 percent of board seats.
Oh, and don’t think for a moment that Invesco Dynamics shareholders stood naked and unprotected while the fund was letting them be systematically screwed by late traders. On the contrary, in July 2002, Invesco laid down a code of ethics that was one of the toughest in the world. It’s thorough. It covers every possible sin imaginable—except allowing some of its clients, such as a certain hedge fund cited by Spitzer, to engage in late trading that screws other clients. It’s such a wonderful code of ethics that it is pretty much standard throughout the fund industry—so commonplace that the SEC decided in mid-2004 to pass a rule requiring codes of ethics for an industry that already had them and already had been ignoring them.
Superb governance is also to be found in pretty much all the other fund groups caught up in the scandals. You couldn’t swing a cat in the boardroom of the sleaziest mutual fund without clawing a director who was “independent” in the sense of not being employed by, or doing business with, the fund company. Such pristine independence was the norm while the scandals were taking place.
Here’s the percentage of independent directors on the boards of the major scandal-beset fund groups, while all the late trading and other nastiness was under way:
MFS Funds: 75 percent
Nations Funds: 60 percent
Strong Funds: 83 percent
Alliance Capital Management: 86 percent
Putnam: 77 percent
Pilgrim Baxter: 75 percent
Note the really good score for Pilgrim Baxter. Way to go, Pilgrim Baxter! Those guys really had some terrific corporate governance over there, at the very same time that their president and board chairman—Gary L. Pilgrim and Harold J. Baxter—were allegedly engaged in some really off-the-charts sliminess, allegedly screwing over the fund’s investors by allegedly letting some of their hedge fund pals engage in late trading. Gary Pilgrim even had the chutzpah to allegedly invest in one of the hedge funds that was screwing his investors. Note my use of the word allegedly, and that brings me to the good part. Both dodged a bullet, agreeing to fines and bars from the industry, without having to admit or deny guilt. No criminal prosecution—not from the feds and not from Spitzer, who had the power to send folks to prison but rarely exercised it. Way to go, Mr. Pilgrim and Mr. Baxter!
Actually it wasn’t just the scuzzball mutual funds that have terrific governance. Independent fund directors already comprise solid majorities of fund boards, and most have done so for many years. In 2002, Artie Levitt’s SEC codified the status quo by requiring independent board majorities. The lion’s share have long exceeded that 75 percent level set in Donaldson’s new rule, the one that makes him look like a hero because it resulted in a suit from the U.S. Chamber of Commerce. True, most funds need to play a little musical chairs because they don’t have an independent chairman, as the new SEC rule requires. But what’s the difference? They’re so top-heavy with independent directors that any selfish, grasping insider directors would be consistently and resoundingly outvoted by all those brave, forthright independents.
That is the fun part of these “fund governance” changes. They’re the regulatory equivalent of the fake news shows that you see on Comedy Central. Nobody is supposed to believe that Samantha Bee is “Senior Baghdad Correspondent” on The Daily Show with Jon Stewart, and nobody was supposed to believe that Bill Donaldson was really a “market regulator.” He was just playing it for laughs. Having been an independent director himself, he surely must have known that it doesn’t matter in the real world if independent directors are 50 percent or 75 percent or even 100 percent of a fund’s board. The ICI itself proposed back in 1999 that two-thirds of fund directors be independent. The ICI knows full well that having an “independent” fund board doesn’t mean a thing—because if it did mean a thing, they wouldn’t be proposing it, would they?
The inanity of “independent” fund boards has been established fact for ages, and was one of the central findings of the Freeman-Brown study in 2001. They observed in their analysis of the fund industry that even though “independent fund directors have the right to demand advisory or distribution fee cuts or to fire the fund’s advisor or underwriter, those rights are virtually never exercised.”
Fund boards have no reason to act as burrs under management saddles. Keep in mind that the Investment Company Act shortchanges investors by providing a lesser standard of fiduciary duty than do most state laws. The act is a veritable bulletproof shield protecting overreaching fund managers and lazy or inattentive fund directors. Among other things, it denies plaintiffs the right to a jury trial, and limits damages to the actual losses suffered by shareholders—thereby preventing the kind of punishing punitive damage awards that might kick crummy funds where it hurts. Sure, people can still sue in state court to take advantage of stricter state fiduciary duty standards—and chances are they will lose. The courts have found that the Investment Company Act supersedes state laws.
You’ll lose in federal court too, more than likely, if you challenge fund taking. The landmark case on fund fees, which was decided by the Second Circuit Court of Appeals in 1982, found that a fee is no good only if it is “so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” This standard, which was established in the case of Gartenberg v. Merrill Lynch Asset Management, is sensible—until you realize that investors simply don’t have access to the facts they need to pursue cases like this. Admissible evidence, the Freeman and Brown study observed, is not available, so, as a practical matter, fund practices are untouchable.
“Independent” directors aren’t the answer to the fund industry’s problems, any more than they were the answer to the problems of the NYSE or Enron or any of the other pillars of Corporate America where they sat quietly and did nothing. The Chamber of Commerce lawsuit against this ridiculous, meaningless, goofy, and unnecessary regulation has, however, performed a service—not to the public by any means, or even to a fund industry that could care less if this fund governance rule is passed. The service it performed for the SEC was to give the mistaken impression that the pinnacle of our self-regulatory pyramid, and its chairman Bill Donaldson, were doing something worthwhile for investors. That was the line, and it has been swallowed—along with the hook and the sinker—by the financial press.
Donaldson’s emergence as another Investor’s Champion became evident in early 2005, when he began to back off from some of his early proposals after the Street had begun to squawk. In February 2005, SEC flacks went on the offensive, arranging for Donaldson to have interviews—all on the same day, apparently—with every major media outlet in the country. This produced the usual glowing coverage and a particularly orgiastic outburst in Business Week. The nation’s leading financial weekly was so overjoyed by its access that it went a little overboard. BW portrayed Donaldson in the kind of terms that no flack would dare to use, as it would be too embarrassing: “crusader,” “activist agenda,” a “zealous enforcer” who “set a blistering pace,” and, last but not least, the man who “cleaned up the mutual-fund mess.”
If you’ve ever had a fender-bender, you might know what it’s like to do something a little careless with the Chevy, and the cop on the beat isn’t very bright and gives you a pass. That’s how Donaldson must have felt when he read the BW story. What really happened is not important. What really matters is what’s in the police report, or, in this case, the pages of BW.
A few months later, Donaldson retired. He left behind a legacy of achievement not just in the meaningless realm of mutual fund governance but in a rapidly growing corner of Wall Street that was of increasing consequence to investors—hedge funds. Those are a kind of supercharged mutual fund that used to be the exclusive preserve of the rich, but now are eager to share their blessings with you.