Do the mutuals need more law?

Ribstein, Larry E.

IN 2002, ELIOTT SPITZER put a scare into investors who pick their own stocks by questioning the reliability of securities analysts. He recently followed that performance with an encore frightening of the millions of Americans who trust their investments to mutual funds.

The New York attorney general decried mutual funds trading that occurs around or after the funds' 4 p.m. closing time by traders with information that makes the closing price "stale." In fairness, some of that trading is illegal "late trading," while a lot of it is late-day "market timing" that may violate some funds' policies against excessive trading. Both practices effectively give the traders who engage in them a price break. Some fund managers also arguably breached their fiduciary duties by engaging in trading themselves or by granting favors to big traders who promised to buy the managers' other funds if the managers allowed the big traders to skirt the 4 p.m. deadline. One analyst estimated that market timing costs passive fund investors at least $5 billion a year, and late trading another $400 million.

Taking Spitzer's cue, Congress is considering rules such as requiring increased disclosure of fees and commissions and more independent fund directors. The Securities and Exchange Commission is also proposing to require more independent fund directors, as well as regulation dealing with market timing and late trading.

Let us assume that those practices are wrong and should stop. Does it then follow that we need, or want, more law? We already have laws to deal with those problems: Late trading is illegal, and injured shareholders can bring state law derivative suits without help from new federal law or politically ambitious attorneys general. What is more, the cost of demonstrating compliance with the new laws could cost investors more than the alleged abuses. The high estimates of the cost of late trading and market timing--$5.4 billion--are less than one-tenth of one percent of the $7 trillion now invested in mutual funds.

The right regulatory response is elusive. It seems obvious that funds should have to more clearly disclose their trading policies, as the SEC is proposing. Informed investors can decide whether to invest in funds that permit market timing or buy funds that make market timing difficult, such as funds with stricter trading policies, exchange-traded funds whose prices are constantly updated, or low-fee index funds whose managers lack incentives to make deals with big investors. Or investors could just hire their own professional portfolio managers.

COST OF REGULATION But even without more regulation, funds already have a big incentive to come clean. And mandatory disclosure is not free; investors would be overwhelmed by even more information and the overburdened SEC would have to spend still more time nitpicking prospectuses rather than catching bad guys.

Beyond stricter disclosure rules, potential policy solutions get murkier. For example, the SEC or Congress might restrict traders' ability to exploit gaps between price and value by mandating higher redemption fees. But while higher fees might reduce market timing, they could also trap investors in poorly managed funds. That is why the SEC has been skeptical of higher fees, though it is considering requiring a two percent redemption fee in some situations. And rigid trading limits ignore significant differences among funds.

Funds might be required to update their prices continuously to current net asset value. That would limit traders' ability to arbitrage stale fund prices. But updating is no panacea. Somebody must appraise infrequently traded stocks, and that often involves guesswork. A lot of the problems at Enron involved marking assets to market. Because funds fear litigation over inaccurate pricing, they might like the comfort of an industry pricing standard. But hard-and-fast standards might also produce inaccurate prices that sophisticated traders will exploit.

Regulators seem to like the idea of requiring mutual fund directors to be independent of the manager and the fired company. But independent directors lack the information and expertise necessary to prevent time next scandal. Indeed, there is ample evidence that more board independence does not mean better management in corporations generally, and some of the funds involved in the recent scandal had independent directors.

Regulators could insist on tying management fees to performance rather than the size of a fund's assets. That would reduce fund managers' incentives to make deals that attract large investors while hurting small ones. Current fees owe a lot to Section 205 of the Investment Advisors Act, which restricts compensation based on fund returns. Ironically, wealthy investors are allowed to buy into private investment pools, or hedge funds, that are not subject to that restriction. In any event, performance-based fees are no panacea. Laws seeking better-designed compensation encouraged corporations to overuse stock options. That, in turn, led to claims that managers were over-compensated or that they managed for the short term.

Optimism about regulation is further tempered by regulators' inherent shortcomings. No single regulation can adequately reflect differences among funds, such as those between international and domestic funds. Nor are regulators necessarily disposed to do the right thing. Regulators are not necessarily seeking the optimal long-term solution. They may just be tempted by some quick fix that gets the public off their backs. Most importantly, regulation has unknowable costs. It institutionalizes practices that deal with yesterday's problems, not tomorrow's. That can inhibit the competitively driven innovations that have done a marvelous job of adapting to new markets and technologies.

The real problem is not a lack of law, but an oversupply of alarmism and political grandstanding. Do we really want people to pull out of mutual funds and pick their own stocks? Or would we rather have investors get out of the stock market altogether and instead put their money in precious metals or hide it under their mattresses? Of course, that trend would only last until some alarm is sounded about gold purity or mattress safety. Worst of all, more laws lull investors into falsely assuming that time government has all potential problems in hand.

Mutual funds have won trillions of dollars in investments from consumers who chose funds over competing banks, insurers, and other financial service providers. Any problems came despite, or perhaps because of, 60 years of pervasive federal regulation. The first question we ought to ask, then, is do we really need more mutual fund laws--or just better enforcement of the ones we already have?

LARRY E. RIBSTEIN

University of Illinois

Larry E. Ribstein is the Richard W. and Marie L. Corman Professor of Law at the University of Illinois College of Law. He can be contacted by e-mail at ribstein@law.uiuc.edu.