Professor Bainbridge...on law, politics, religion, culture & food

Alex Tabarrok

Steve Bainbridge

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."

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.

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.