Alex Tabarrok on the mutual fund scandal

Few blogs are consistently as thought-provoking as Marginal Revolution. I am an unabashed fan. Every once in a great while, however, the thoughts they provoke are those of utter astonishment. So it was with Alex Tabarrok's post The Mutual Fund Scandal - much ado about nothing. In the following table, the text of Alex's post is in the left-hand column, my comments are on the right.

Alex Tabarrok

Steve Bainbridge

Let's take it for granted that insiders have used the peculiar pricing practices of the mutual fund industry to transfer some profits from buyers. According to some accounts, hundreds of millions of dollars have been transferred in this way ....

1. It's important to make clear that the scandal is not just self dealing by insiders. A big part of the scandal relates to mutual fund companies allowing certain investors to engage in market timing trades and late trading. These mutual fund companies all had policies against such trading, which were stated in their prospectuses. As such, we not only have self dealing, we also have discrimination among investors and securities fraud.

2. The gist of what is to come is signaled by the dismissal of siphoning of hundreds of millions of dollars as the transfer of "some profits."

But remember mutual fund buyers get quarterly statements showing their returns net of all chicanery. Is it so hard to believe that buyers make their decisions based upon their actual returns? A mutual fund that performs poorly is a mutual fund that performs poorly regardless of whether this was due to bad investment decisions, high expense ratios, or a slick transferring of funds. A few investors might buy and then accept any return as a matter of luck but the marginal investor can and does move funds around easily (what market is more contestable?) - not to mention the institutional investors.

Alex seems to be assuming zero transaction costs. In fact, the transaction costs of switching mutual funds can be significant. Many funds charge back-end load fees (a.k.a. exit fees or deferred sales charges) of 3-7% when investors pull their money out. Many more fund charge front-end load fees that reportedly run "5.75% for equity funds, [albeit] less for bond funds, and [which] are simply deducted from the amount being invested." In addition, many investors hold their mutual funds through brokerage accounts, which is another potential source of fees. As such, the transaction costs of switching may well be significant. (Alex's co-blogger Tyler Cowen likewise has suggested that mutual fund investments are sticky. I doubt whether mutual funds are quite as sticky as Tyler seemed to think, for reasons explained here, but that doesn't mean I think the mutual fund market is a zero transaction cost environment.)

Because there are non-trivial transaction costs to switching funds, investors should care why a fund is under-performing. A fund that has a bad quarter because they got unlucky with a couple of big positions presents a very different problem than a fund that has a bad quarter because insiders have been self dealing and letting favored investors violate stated policies. The latter fund is much more of a long-term threat to investor wealth than the former. If you don't know why the fund is underperforming, however, you can't distinguish between the two.

The last observation suggests that self dealing by insiders at a few funds could have negative externalities for the industry as a whole. If investors cannot distinguish between underperformance caused by a run of bad luck and self dealing, they may begin to perceive the whole industry as a lemons market. Assume there are two classes of investors. One class believes the magnitude of the harm posed by insider self dealing justifies restricting such self dealing. Accordingly, this class is willing to pay higher fees to funds who promise not to allow self dealing. The other class is willing to allow self dealing by managers of its funds, so long as those funds charge lower legal fees. An unscrupulous fund will try to maximize its income by attracting investors in the first class while secretly self dealing. Investors in the first class will be aware of this phenomenon, but the high detection and enforcement costs associated with self dealing make it almost impossible for them to distinguish between honest and dishonest funds. A prohibition of self dealing enforced by public law enforcement agencies makes these investors better off, but makes the second class worse off. If one believes that most investors fall into the first class, however, a prohibition of insider trading would be efficient (so long as one is willing to use the Kaldor-Hicks definition of efficiency.) Hence, a prohibition of self dealing may have advantages for the industry as a whole, by giving credibility to their promises not to allow self dealing and thus reducing agency costs.

UPDATE: As Leaderlog observes, "non-transparency is usually synonymous with rent-seeking."

As a result, it makes little difference whether the managers get their return through the above-board expense ratio or the under-handed exploitation of stale pricing.

Sure, there may be some exploitation at the margin but this is akin to banks that charge fees for "free checking" or restaurants that include a gratuity in their bill. It's annoying and the occasional consumer may be dunned but once consumer and competitor responses are taken into account the net transfer is small.

This is the part that really surprised me. If Alex is right, then generations of corporate lawyers have wasted their time worrying about the duty of loyalty and generations of economists have wasted their time worrying about agency costs. So long as markets are liquid, we apparently don't need either prohibitions of self dealing or institutional constraints on agency costs such as hostile takeovers. Investors can fully protect themselves by switching out of underperforming funds. Of course, if I'm right about the transaction cost and transparency points above, maybe that isn't true. (I also think Alex is too glib about the "net transfer" from self dealing.)

In any event, I think it is instructive that corporate law long has drawn a distinction between bad management and self dealing. At first blush, you might think that the agency costs associated with bad management and self dealing differ in degree but not in kind. Both reduce shareholder wealth. Both are forms of shirking, at least in the broad sense that term is used by agency cost economists. On closer examination, however, self dealing in fact differs in kind, not just in degree, from bad management. Managerial decisions typically are collective actions of the board or top management team as a whole. In making such decisions, the board and/or management is constrained to exercise reasonable care by a combination of external market forces and internal team governance structures.

In contrast, self dealing transactions rarely implicate the entire board or management team. To the contrary, they often involve misconduct by a single director or even a mid-level employee. Those who intentionally self deal, moreover, likely also actively seek to conceal their defalcations. Given the potential gains of self dealing in an organization characterized by a separation of ownership and control, legal liability thus is a necessary deterrent against such misconduct.

If you doubt the above, assume that we eliminate all under-handed practices. Do you think that consumers will now earn higher returns? Or, do you think, that other fees will rise to make up the difference? I predict the latter.

 Here is where we come back to the point that the problem is not just self dealing but also securities fraud. Even if Alex is right that investors would (should?) view self dealing and disclosed fees as interchangeable, it is not clear that they would view fraud and fees as interchangeable. (Anyway, another aspect of Alex's argument puzzles me. Because fees benefit the fund management firm, while self dealing benefits individual managers, even if investors don't care about self dealing, fund management firms should.)

We also come back to the points about the transaction costs of switching funds and the risk that a lemons market will emerge. If investors care whether their funds lie about things like market timing and late trading by favored investors, honest firms could attract investors by promising to prevent such trading. In order to work, however, such promises must have credibility. Investors will demand that fund management provide a credible promise—a bond—that guarantees that the fund will abide by its stated policies. Law can facilitate private ordering by providing such a bond. Candidly, I am somewhat skeptical that one needs the full panoply of disclosure and procedural rules imposed by U.S. securities law in order to provide such a bond (see here). At the very least, however, facilitating the making of credible commitments requires an antifraud rule (like present Rule 10b-5) and enforcement regime.

The only danger is that in their haste to make political hay the politicians will end up passing some dumb law that makes everyone worse off. Here we are in complete agreement. Regular readers know I am a skeptic of much recent corporate governance reform legislation and regulation. At the same time, however, I think that current laws against self dealing and fraud ought to be enforced with vigor. I would have thought Alex would too.

But, as they say, decide for yourself.

Posted on Tuesday, November 18 2003 | Permalink

Why do Restaurant IPOs Perform So Badly?

According to yesterday's WSJ (sub. req'd), there have been 75 restaurant chain IPOs in the last ten years. Overall, the sector has gained only 2% from their initial offering price, which is staggering given the evidence that IPOs generally are way underpriced. The sector's results become even more surprising, however, when you strip out the two success stories -- PF Chang China Bistro and Krispy Kreme Doughnuts. If you remove them from the data set, the sector as a whole lost 20%. On top of this data, moreover, one might note the anecdotal results from such high-profile flame-outs as Boston Chicken and Planet Hollywood. Granted, the restaurant game is a perilous one, as most restaurants fail in their first year. Restaurant IPOs, however, involve chains that are reasonably well-established and geographically diversified. The failure of any one location (or even several) should not take down the whole chain. Also, of course, the restaurant business was particularly hard hit by the combination of the recession and 9/11. Yet, it seems that restaurant IPOs were not doing all that well even before the stock market bubble burst. So I don't have a good theory for why this sector underperforms. (Ideas, anyone?) All I know for sure is that it's a sector I would avoid.

Posted on Tuesday, November 18 2003 | Permalink

Securities Lawyers as Gate-Keepers and the Economic Incentives of Modern Legal Practice

Securities Litigation Watch blogged on a talk by Columbia University law professor John Coffee at which Coffee advanced his argument that outside legal counsel should take on an auditor-like role in certifying the accuracy of the client's financial disclosures. Mike O'Sullivan at Corp Law Blog picked up on that post, linking the report about Coffee's talk to Coffee's recent law review article The Attorney as Gatekeeper: An Agenda for the SEC, 103 Columbia Law Review 1293 (2003). Mike does a typically excellent job of explaining why Coffee's proposal should "die a quick death and be quietly buried in the academic legal writing cemetery." Ouch.

I don't disagree with anything Mike said, but my take on the problem would start by thinking about incentives. Some might say I am too cynical about my fellow lawyers, but I can't help thinking that people respond to incentives (and cognitive biases). And, as I see it, the incentives of lawyers are such that they would not do a very good job at the task Coffee wants to assign them. The remainder of this post is derived from my article, The Tournament at the Intersection of Business and Legal Ethics. (You might also be interested in Managerialism, Legal Ethics, and Sarbanes-Oxley Section 307.)

Posted on Monday, November 17 2003 | Permalink

My new policy on answering emails from non-UCLA students who ask for help with their law review comm

I received the following email today:

I am a second year student at [Ed.: name of law school deleted] and a member of the [Ed.: name of law review deleted]. I am writing a student note about the [Ed.: name of case deleted] case this semester. I was concerned about the comments you wrote at the end on your website. I’m wondering if you could please expand upon your analysis of [Ed.: deleted]. Do you think this is a compelling issue ... I would appreciate any assistance you could offer me. Thank you very much for your time.

I will be happy to answer these sorts of requests, provided you: (1) can prove that you have bought at least one copy of each of my books (listed in the right sidebar); (2) you swear a blood oath to cite at least one of my books and my blog in your comment; and (3) you pay my usual hourly rate of [Ed.: outrageous figure, which nobody ever pays him anyway, deleted]. PS: Half-price for UCLA students!

Posted on Monday, November 17 2003 | Permalink

GoogleRacing the Candidates on “Corporate Governance”

As all and sundry know, corporate governance is my bread and butter (well, at the very least, it's what puts food on the table). GoogleRacing that keyword phrase produced the following results:

  1. Joe Lieberman
  2. John Edwards
  3. John Kerry
  4. George Bush
  5. Wesley Clark
  6. Al Sharpton
  7. Howard Dean

Could there be a more pointless exercise?

Posted on Monday, November 17 2003 | Permalink

Why I’m Opposing the SEC Proposal to Let Shareholders Nominate Directors (II)

My friend and fellow law professor/blawgger Gordon Smith responded to my post Why I'm Opposing the SEC Proposal to Let Shareholders Nominate Directors by arguing that:

Steve is right to oppose the proposed rule, but he has the wrong reason. This is not a problem of the SEC going too far, but rather not going far enough. I hope to share a more complete explanation of my position in a letter to the SEC, but here it is in a nutshell: shareholder voting on board composition is the most important thing that shareholders can do; while we should not allow the shareholder proposal rule to become a vehicle for hostile takeovers, we should enable meaningful ballot access without triggers that evidence managerial dysfunction.

Steve is rightly worried about the costs associated with corporate reform, but this is not the place to draw the line. The SEC should reduce other regulatory burdens, but not stop short of the most important potential corporate governance reform since the adoption of the federal securities laws.

The problem here, of course, is that Gordon and I are coming from very different places with respect to the proper role of shareholders in corporate governance. I start with the premise that the corporation is not a thing capable of being owned. Hence, it is error to view the corporation as being owned by the shareholders. Once you recognize that private property concepts are not relevant, it becomes much harder to see a case for privileging shareholders within the corporate governance structure. Instead, as I see it, the shareholders properly are viewed as just one of many factors of production. Put another way, the corporation is a vehicle by which the board of directors hire, inter alia, equity capital. Of course, in return for their investment of equity capital, the shareholders are entitled to the residual claim on corporate assets and the concomitant shareholder wealth maximization norm. If I'm right about that, then the legitimacy of the corporate governance structure does not depend on shareholder voting. Rather, shareholder voting rights are just one of a myriad of systems by which directors are held accountable for how they exercise their authority. I call this model "director primacy." From a director primacy-based perspective, expanding shareholder voting rights as proposed by the SEC make no sense -- none. Bear with me -- the explanation is pretty long (it also pulls together a number of earlier posts, so it will look familiar to regular readers).

Posted on Sunday, November 16 2003 | Permalink

Today’s Shareholder Access Post: What About That Third Trigger?

As proposed, the SEC’s shareholder access rule incorporates two triggers:

  1. A shareholder puts forward a proposal to authorize shareholder nominations, which is then approved by the holders of a majority of the outstanding shares; or
  2. Shareholders representing at least 35% of the votes withhold authority on their proxy cards for their shares to be voted in favor of any director nominated by the incumbent board of directors.

In addition, the SEC’s proposing release solicited comments on a possible third triggering event, which would have three criteria:

[A] A security holder proposal submitted pursuant to Exchange Act Rule 14a-8, other than a direct access security holder proposal, was submitted for a vote of security holders at an annual meeting by a security holder or group of security holders that held more than 1% of the company's securities entitled to vote on the proposal for one year and provided evidence of such holdings to the company; [B] The security holder proposal received more than 50% of the votes cast on that proposal; and [C] The board of directors of the company failed to implement the proposal by the 120th day prior to the date that the company mailed its proxy materials for the annual meeting.

As the SEC acknowledged, this proposal just invites time-consuming disputes on such minutiae as whether the board failed to implement the proposal.

There is a more fundamental flaw with this third trigger, however. State corporate law provides that the key player in the statutory decisionmaking structure is the corporation’s board directors. As the Delaware code puts it in section 141, the corporation’s business and affairs “shall be managed by or under the direction of a board of directors.” The vast majority of corporate decisions accordingly are made by the board of directors alone (or by managers acting under delegated authority). Shareholders essentially have no power to initiate corporate action and, moreover, are entitled to approve or disapprove only a very few board actions. The statutory decisionmaking model thus is one in which the board acts and shareholders, at most, react.

The proposed trigger shifts that balance of power in favor of the shareholders. At present, the vast majority of shareholder proposals under SEC Rule 14a-8 must be phrased as recommendations rather than as directives to the board. If a precatory proposal passes but the board of directors decides after due deliberation not to accept the shareholders’ recommendation, the board’s decision currently is protected by the business judgment rule. Hence, the board’s power of direction is insulated from being trumped by the shareholders.

To be sure, the proposed trigger would not mandate that boards implement precatory proposals. It would, however, ratchet up the pressure on boards to accede to shareholder proposals even when the board in the exercise of its business judgment believes the proposal to be unwise. As we shall see, if adopted, Rule 14a-11 would impose significant direct and indirect costs on the corporation. In order to avoid a shareholder nomination contest, the board therefore might implement a proposal it deems unsound.

Posted on Tuesday, November 11 2003 | Permalink

The blog as scholarship: Omnicare and DGCL §§ 146 and 251(c)

I received an email today at my blog address from a fellow law teacher who is getting ready to teach the Delaware supreme court's decision in Omnicare (see Omnicare v. NCS Healthcare: The precommitment issues). He asks:

I'm teaching Omnicare tomorrow. Any idea what promoted the DE legislature to delete the § 251(c) language and replace it with the same language in § 146 post-Omnicare?

I discussed Omnicare's impact on § 251 in my post Omnicare v. NCS Healthcare: The Section 251 issue. In that post, however, I omitted the amendment to which my reader refers.

Was that amendment intended to reverse Omnicare insofar as that decision dealt with § 251? I don't think so. The legislative summary of the relevant statute explains that:

The deletion of the language from subsection (c) of Section 251 and the addition of new Section 146 clarify that the rule previously codified at Section 251(c) applies to any matter submitted to stockholders. Under this rule, directors may authorize the corporation to agree with another person to submit a matter to stockholders, but reserve the ability to change their recommendation.

Because § 251 related only to mergers, people thought you could not include a so-called "force the vote" provision in, say, an asset sale agreement. It seems unlikely that the Legislature was responding to Omnicare. Instead, they wanted to make clear that any matter to be put to a shareholder vote pursuant to contract could be subject to a "force the vote" clause. The Delaware supreme court's holding in Omnicare that "Such provisions ... may not, however, ‘validly define or limit the directors' fiduciary duties under Delaware law or prevent the [NCS] directors from carrying out their fiduciary duties under Delaware law’” (818 A.2d at 938) presumably is still good law and will be applied under new § 146.

Many more posts like this one and I'll be able to start counting the blog on my annual report of to the dean of new scholarship.

Posted on Tuesday, November 11 2003 | Permalink

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