Morley Finds Surprises, Consequences in Origins of Mutual Fund Regulation

March 2, 2011

Government regulation of mutual funds began as an effort by the mutual fund industry to brand its product at the industry level, Associate Professor John Morley discovered while researching his latest article, Collective Branding and the Origins of Investment Management Regulation: 1936-1942," now posted on SSRN. The repercussions of that finding hold consequences for other potential financial reforms, said Morley, who studies the regulation of investment management vehicles such as mutual funds and hedge funds. Morley joined the Law School faculty in the fall and teaches Trusts and Estates and Corporations.

John Morley

Why did you decide to investigate this topic, and/or why is this topic relevant now?

I was interested in the recent rise of hedge funds and private equity funds. These funds are similar in many ways to mutual funds, but for various reasons they are not subject to extensive regulation in the way that mutual funds are. The growth of these unregulated funds raises basic questions about why we regulate investment managers and whether the considerations that motivate the regulation of mutual funds should also apply to other types of funds. One way to answer those questions is to ask what initially motivated the enactment of mutual fund regulation.

When you investigated how mutual funds came to be regulated, were you surprised at what you found?

I was quite surprised. Mutual fund regulation is very invasive — it goes way beyond requiring disclosure and it prohibits many kinds of activities that investors might rationally prefer, such as high levels of borrowing and shareholder activism. I believed when I first started researching this article that all of these invasive restrictions had probably been forced upon the mutual fund industry by the Roosevelt administration in the late 1930s and early 1940s. It turns out, though, that the industry itself actually sought many of these restrictions and lobbied hard to obtain them.

What are some of the intended and unintended effects of the mutual fund regulation that developed from 1936-42?

In the story I tell, the intended effect of mutual fund regulation was to standardize the mutual fund industry. In many ways this was a good thing, because there is now sufficiently little variation in funds' basic structures that it is quite easy to shop for a mutual fund. This is why the mutual fund industry sought invasive regulation. The industry wanted to codify what I describe as a single industry-wide brand" for a particular style of investing. The downside of standardization is that many investors who rationally prefer a style of investing different from the one that regulation ultimately adopted cannot get what they want. For example, mutual funds cannot issue debt securities; they can only issue common stock. This is great if all you're looking for is common stock, because you don't have to waste time figuring out whether what you're being offered is truly common stock or is actually some strange form of debt security. But if you want to buy debt securities, you're out of luck.

If mutual fund regulation is a result of fund managers' attempts to improve the industry's marketability to a mass audience by standardizing the industry, what does this suggest about regulation (or lack of it) in other parts of the financial sector?

It suggests that standardizing regulation is often beneficial not just for consumers of financial services, but also for producers. This is perhaps why credit card lenders very often support laws that restrict their freedom and standardize credit card lending terms. But the cost of standardization is that you cannot get a credit card on non-standard terms, even if you have good reasons to do so.

How should regulators weigh the financial industry's interest in protecting its brand when crafting financial reforms?

Regulators should be careful. Industry support for regulations that strengthen its existing brands can often be good, but the strengthening of those brands may damage the financial system as a whole and may harm investors and institutions that challenge the status quo. For example, the mutual fund industry recently supported reforms to make money market funds more conservative. The industry was probably motivated by the importance of conservatism to the branding of money market funds, and the reform was probably a good thing. But the industry also thwarted reforms to change the unusual way in which money market funds' shares are priced, because this pricing system is also a very important element of the branding and marketing of these funds. This system benefits the industry and the investors who prefer to have their shares priced in the manner required by this system. But this system also makes money market funds very unstable and it caused several of these funds to collapse during the recent financial crisis. These funds are now large enough that their instability potentially puts the whole financial system at risk.

Some have called for regulators to reform mutual fund taxation. What did you find about how this requirement originated?

The current system of mutual fund taxation may have originated in an attempt by some mutual funds to take assets away from other mutual funds. The distinctive trait of mutual fund taxation is that in order to avoid corporate tax, mutual funds cannot merely pass through their income and losses on a notional basis, the way hedge funds and other partnerships are allowed to do. Mutual funds must actually transfer ownership of their income every year to shareholders by distributing that income. For mechanical reasons that have nothing to do with regulation, in the 1930s certain mutual funds known as closed-end funds could not sell new shares to get back the money that they had distributed. The distribution requirement was thus a slow death sentence for many closed-end funds. They had to give away their assets with no hope of ever getting them back. Open-end funds, which did not have similar problems with raising money, may have sought the distribution requirement in order to hasten the death of the closed-end fund industry.

How does this article fit in with your scholarship overall?

Despite the enormous practical importance of investment management vehicles and their regulation, there has been strikingly little research on them in American law schools. My ultimate goal is to tackle the very basic question of just why it is that we regulate investment managers in the first place. This is one piece of that larger project.

What are you working on next?

I'm finishing up the first empirical study of an unusual form of liability that allows investors to sue their mutual fund managers simply on the theory that the funds' fees are too high. I'm also writing a paper that will explain why most kinds of investment vehicles — including not just mutual funds, but also hedge funds, private equity funds and donative trusts — use a structure in which the managers have a separate corporate existence and a separate set of owners from the vehicles they manage. One contribution is simply to demonstrate that this is a general phenomenon that manifests itself across an array of investment management contexts. Another contribution is to explain why this structure is so common and to compare and contrast how trust law, private contracting and mutual fund regulation deal with the problems and opportunities it raises.

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