VIRGINIA LAW & BUSINESS REVIEW VOLUME 10 SPRING 2016 NUMBER 3 FUND GOVERNANCE: A SUCCESSFUL, EVOLVING MODEL Amy B. R. Lancellotta†, Paulita A. Pike††, & Paul Schott Stevens††† I. THE FIRST PHASE OF FUND GOVERNANCE: COMPREHENSIVE FUND REGULATION AND ITS AFTERMATH ........................................................... 458 A. The ICA’s Provisions for Fund Board Composition ........................... 460 B. Dealing with Conflicts of Interest ........................................................... 462 II. A SECOND PHASE OF FUND GOVERNANCE: EXPLOSIVE GROWTH, THE 1970 AMENDMENTS, AND THE ECONOMICS OF FUND INVESTING ..... 463 A. Director Independence ............................................................................. 464 B. Approval of the Advisory Agreement .................................................... 466 C. Regulation of Management Fees ............................................................. 466 D. Litigation Surrounding Management Fees ............................................ 468 E. The Economics of Fund Investing ......................................................... 470 III. A THIRD PHASE OF FUND GOVERNANCE: CONTROVERSY, SCANDAL, AND REFORM–AND THEIR LASTING EFFECTS ......................................... 472 A. The Yacktman Proxy Battle ..................................................................... 473 B. Governance Reforms from the SEC and Congress ............................. 475 C. Market-Timing and Late-Trading Scandals............................................ 479 D. The SEC’s Fund Compliance Program Rule ........................................ 481 † Managing Director, Independent Directors Council †† Partner, Ropes & Gray LLP; Adjunct Professor, Northwestern University Pritzker School of Law and University of Notre Dame Law School ††† President & CEO, Investment Company Institute This essay is a contribution from the Virginia Law & Business Review 2015 Symposium, “The 1940 Acts at 75: Reflecting on the Past, Present and Future Regulation of Investment Companies and Investment Advisers.” Copyright © 2016 Virginia Law & Business Review Association 455 456 Virginia Law & Business Review 10:455 (2016) E. The SEC’s 2004 Governance Reforms .................................................. 483 F. Reverberations of the Governance Reforms in Today’s Boardroom.484 IV. LOOKING AHEAD ........................................................................................... 486 HE Investment Company Act of 1940 (“ICA”), one of the last pieces of T legislation to come out of the New Deal, should be recognized as one of the most important. In the seventy-five years since President Franklin Roosevelt signed the ICA into law, investment companies (“funds”)1 have grown enormously under its framework, giving rise to a form of financial intermediation that stands today as one of the most important developments in U.S. and global financial markets in the second half of the 20th century. At the end of 1940, assets under management in U.S. registered open-end funds were about $450 million, in about 300,000 shareholder accounts.2 By the end of 2015, assets under management in these funds had reached nearly $16 trillion,3 in more than 250 million shareholder accounts.4 Today, U.S. registered open-end funds are the predominant savings vehicle for more than 90 million investors in an estimated 53.6 million (or 43% of) U.S. households.5 Viewed collectively, U.S. registered funds—which generally include mutual funds, closed-end funds, and most exchange-traded funds (“ETFs”)—rank among the most important aggregators and allocators of capital in global financial markets, and among the largest participants in the U.S. stock and bond markets. A wide range of factors have had a hand in this remarkable growth— including the ICA’s robust investor protections; pass-through tax treatment 1 For purposes of this article, “funds” include, except where otherwise specified, open-end funds, exchange-traded funds, closed-end funds, and unit investment trusts registered with the U.S. Securities & Exchange Commission (“SEC”). 2 U.S. SEC. & EXCH. COMM’N, PUBLIC POLICY IMPLICATIONS OF INVESTMENT COMPANY GROWTH, H.R. REP. NO. 89-2337, at 2 (1966) [hereinafter PUBLIC POLICY REPORT]; see generally INV. CO. INST., 2014 INVESTMENT COMPANY FACT BOOK: A REVIEW OF TRENDS AND ACTIVITIES IN THE U.S. INVESTMENT COMPANY INDUSTRY (54th ed. 2014), available at https://www.ici.org/pdf/2014_factbook.pdf. 3 See INV. CO. INST., 2016 INVESTMENT COMPANY FACT BOOK: A REVIEW OF TRENDS AND ACTIVITIES IN THE U.S. INVESTMENT COMPANY INDUSTRY 172 (56th ed. 2016) [hereinafter 2016 FACT BOOK], available at https://www.ici.org/pubs/fact_books (forthcoming). 4 See Memorandum from the Inv. Co. Inst. on Supplementary Data for the Quarter Ending December 31, 2015 to Members 32 (March 2016) (on file with the Investment Company Institute). 5 See 2016 FACT BOOK, supra note 3, at 112; see also Kimberly Burham et al., Ownership of Mutual Funds, Shareholder Sentiment, and Use of the Internet, 2015, ICI RES. PERSP., Nov. 2015, at 1, available at http://www.ici.org/pdf/per21-05.pdf. 10:455 (2016) Fund Governance 457 established in the Revenue Act of 1936; diversification of risk and professional investment management; and effective administration of the ICA by the SEC. Other major influences include intense competition in the fund marketplace, which has fueled innovation in types of funds, fund structures, and shareholder services; the rise of defined contribution plans and the role of funds as attractive vehicles for long-term retirement saving; demographic trends, particularly the post–World War II baby boom and longer life expectancies; and the generally strong performance of U.S. and global financial markets. One especially important factor, sometimes overlooked, is the unique system of fund governance outlined in the ICA. Since the ICA was passed, funds have enjoyed a statutory form of governance in which the role of independent directors was important from the outset and has since evolved significantly. Reaching back before the ICA, fund governance has evolved in three distinct phases. The first phase. After the 1929 market crash and ensuing Great Depression revealed a litany of abuses in the fund industry, the government and the industry worked together to develop a new statutory regime for funds and fund governance—one that ultimately would be enshrined in the ICA. The ICA would institute a strict regulatory framework on funds—including a number of provisions for fund directors—and precipitated tremendous growth across the industry. A second phase. Following two decades of strong industry growth, regulators and lawmakers began to conduct studies focusing on the implications of funds as a rising new form of financial intermediation, and particularly on the economics of fund investing. The studies led to an array of congressional amendments to the ICA, several of them directed at the roles and responsibilities of fund directors. Amendments relating to the regulation of management fees set the stage for court rulings that would reinforce the value of directors’ oversight role in protecting shareholder interests. A third phase. By the mid-1990s, continued growth had put funds and fund investing at the center of a “seismic shift in American finance.”6 The tectonics influencing this third phase are still felt today. They include higher public expectations of funds, their advisers, and their boards, as stewards of so great a portion of U.S. household wealth; the reverberations of controversy and scandal, especially the market-timing and late-trading abuses 6 The Seismic Shift in American Finance, THE ECONOMIST, Oct. 21, 1995, at 117. 458 Virginia Law & Business Review 10:455 (2016) that emerged in 2003; and a renewed focus, from both the industry and regulators, on ways to further improve fund governance. This article examines these three phases in greater detail, and concludes with a look at what might lie ahead for fund governance. I. THE FIRST PHASE OF FUND GOVERNANCE: COMPREHENSIVE FUND REGULATION AND ITS AFTERMATH Investment funds played a major role in the financial innovation of the Roaring Twenties.7 After the formative early part of the decade, funds experienced tremendous growth, largely due to the accompanying stock market boom. Nearly 600 funds formed between 1927 and 1929, doubling the industry total.8 At the peak of their 1920s expansion, funds “were literally being formed at the rate of almost one each business day”—with 265 forming in 1929 alone.9 But the growth was a facade—masking “various deficiencies, inequitable structures, and patterns of improper practices.”10 The industry lacked professional fund advisers, and so people from a wide variety of backgrounds—industrialists, commercial bankers, economists, lawyers, accountants, and more—began to sponsor funds.11 Advisers had no obligation to make a “substantial personal investment” in their funds.12 Coupled with a lack of regulation, this all but ensured improper transactions between funds and their affiliated persons, including advisers’ domination of the funds and use of fund assets to promote their own interests at the expense of shareholders’ interests.13 With the fund business seemingly thriving, Congress and the investing public appeared little concerned with its inner workings. The press and some regulatory entities, however, were paying attention.14 “No investment trust can be successful except under the most careful management and with the 7 See U.S. SEC. & EXCH. COMM’N,