Shared series trusts – an entity structure of recent vintage used in organizing mutual funds or exchange traded funds – are a strange species in the world of business entities.  Simply put, such entities are designed to provide governance in a commoditized form.  Essentially, the structure permits a participating business to outsource governance issues by assigning governance of the business to an “off-the-rack,” or, more precisely, “ready-to-serve,” board of directors. This type of arrangement would be counterintuitive for most corporate law scholars since the board typically occupies a position of primacy in the affairs of any business[1] (i.e., governance is typically viewed as a core internal function of any entity). Shared series trusts are an exception to the rule.

Governance is commoditized when a business outsources that function, directly or indirectly, to a dedicated third-party governance provider whose connection to the underlying business (or fund, in this case) is its provision of governance, which it also provides on similar terms to other businesses (or funds). In the case of shared series trusts, the trust provides an umbrella entity governed by its pre-established board to house separate and distinct funds that choose to avail themselves of the umbrella entity. This concept of governance is alien to most conventional notions of entity governance because governance is traditionally considered a core function internal to any business entity.

Although not using the term “commoditized governance,” professors Steve Bainbridge and Todd Henderson several years ago formulated a proposal that would represent one possible path toward commoditized governance, a proposal that would violate existing legal standards applicable to entities.^[2] Their proposal imagined a professional firm, rather than individuals constituting a governing board, that would provide board services much the same way that independent auditors provide audit services to corporations. This idealized proposal represents one way to achieve commoditized governance, but would probably be unworkable. However, contrary to their assumption, commoditized governance already exists as a form of entity governance. In a recent paper, I explore the logic and limits of commoditized governance as it actually exists with the example of shared series trusts used to organize mutual funds and exchange-traded funds.

Under current practice, new investment funds are routinely organized in series entities (most commonly, a trust), which means the entity can house many different funds in one entity, and each fund’s assets and affairs remain separate and distinct from the assets of other funds (i.e., each series in the trust is separate and distinct from every other series in the trust). Most of the assets under management in the $22 trillion fund industry are managed by funds organized within a series trust. In most cases, however, the series trust does not involve unrelated funds but rather funds from the same family of funds.  Although each fund will have its own shareholders, the many series of funds will be managed by a single asset management firm. In contrast, a shared series trust is comprised of funds sponsored by unaffiliated advisers, and hence the trust entity’s relationship to the various funds and their sponsors is largely as a governance provider. The trust serves as an umbrella entity that offers a pre-established board to govern each fund operating under its umbrella. Typically, the trust sponsor will also provide a suite of non-advisory services to each fund as well as a board. Nevertheless, a major reason that a fund chooses to participate in a shared series trust is to avail itself of commoditized governance for the fund.

There are two different levels in unpacking this particular story of commoditized governance. How did this type of arrangement come to be? This part of the story is rooted in historical circumstances and provides an intuitive sense of the issues informing the legal-theory side of the story. The changing character of the fund industry, as well as evolving federal regulatory governance mandates, are the driving factors in making shared series trusts a viable and indeed preferred governance alternative for some funds.

Over the last 60 years, the structure of the fund industry has evolved so that funds outsource (or externalize) all aspects of their operations, although rarely governance itself. Most importantly, the fund manager for a fund is typically external to the fund, bound by a contractual arrangement, and affiliates of the fund manager or third parties will deliver a host of non-advisory services. In short, most funds are hubs that serve as a nexus for outsourced services.

Simultaneously, federal governance requirements in the fund industry have, perhaps unintentionally, created an environment conducive to commoditization of the governance function. A variety of structural measures and affirmative regulatory mandates put in place by Congress and the SEC combine to produce this effect. Over time, fund boards have become increasingly independent in their composition and operation and, pursuant to affirmative regulatory mandates, must directly engage in overseeing detailed aspects of fund affairs. These regulatory mandates have fostered an intensively routinized role for fund boards in which board meetings involve review of a prescribed agenda of regulatory items. Thus, the role of a fund board may differ from the typical role of a board in other business entities, and this difference may make a commoditized arrangement more feasible in the fund context. The shared series trust arguably provides a means to obtain more efficient and economical board oversight of highly routinized review processes.

Against this backdrop, the example of shared series trusts poses challenges as a matter of regulatory policy in two respects: (i) whether shared series trusts result in high quality fund governance and (ii) whether shared series trusts reveal broader underlying challenges in the way regulation has sought to shape governance of funds.  Little has been said about the first issue, although a few SEC enforcement actions have documented the seemingly perfunctory discharge of board oversight in isolated cases. However, one should be chary of generalizations that link shared series trusts to lower quality governance in light of familiar race-to-the-bottom and race-to-the-top arguments.  Governance quality in shared series trusts could competitively gravitate to relatively high quality governance practices over time and, therefore, offer higher quality governance than a stand-alone fund would provide if not affiliated with a shared series trust.

The existence of shared series trusts also sheds light on the goals and limits of regulatory policy with respect to fund governance generally. There is much debate regarding the efficacy of federal regulatory mandates relating to governance.[3] The ability to commoditize the board’s role is directly traceable to highly routinized governance processes that have developed in response to federal mandates. Do these prescriptive mandates enhance the quality of governance? While the mandates themselves may not translate into easily measurable differences in governance outcomes, they may nevertheless prove valuable if they promote greater deliberation and reflection with respect to the decisions being made.

When viewed from a legal theory perspective, shared series trusts in the fund industry also shed light on the purpose and function of entity governance. Commoditized governance is unusual because it likely exists only where governance is not a core function of a business entity. Under the right circumstances, a business’s governance may be outsourced. This view has clear underpinnings in the law-and-economics literature. Investment funds, unlike other forms of businesses, are literally organized as a nexus of contracts,[4] and commoditized governance by its very nature suggests its viability will be limited to businesses that can readily outsource its various functions. Moreover, economic theory provides some basis for predicting the rare circumstances where commoditized governance might actually work: in circumstances not merely where ownership and control are separated (a feature characteristic of any public entity), but where the control function of the firm can be partitioned to separate entrepreneurial and managerial control of the business from control of governance of the entity. Fama and Jensen recognized years ago that “control” in a firm may be partitioned differently in different business organizations, including mutual funds.[5] The extreme possibility of commoditized governance in shared series trusts represents a radical method for partitioning control. In this respect, commoditized governance should be understood as a special and exceptional case of entity governance that underscores that governance in a business entity, like each of its many functions, ultimately is arranged to serve the needs of the given business. While commoditized governance likely will prove unsatisfactory for most businesses, it may prove viable in some cases, as is the case for some externally managed investment funds.

ENDNOTES

[1] See, e.g., Stephen M. Bainbridge, Director Primacy: The Means and Ends of Corporate Governance, 97 Nw. U. L. Rev. 547 (2003).

[2] Boards-R-Us: Reconceptualizing Corporate Boards, 66 Stan. L. Rev. 1051 (2014).

[3] Compare Anita K. Krug, Investment Company as Instrument: The Limitations of the Corporate Governance Regulatory Paradigm, 86 S. CAL. L. REV. 263 (2013) (questioning the utility of fund governance mandates); and Alan R. Palmiter, The Mutual Fund Board: A Failed Experiment in Regulatory Outsourcing, 1 BROOK. J. CORP. FIN. & COM. L. 165, 165 (2006) (finding deficiencies of fund governance and advocating greater professionalization of independent directors of funds); with Eric D. Roiter, Disentangling Mutual Fund Governance from Corporate Governance, 6 HARV. BUS. L. REV. 1 (2016) (defending as a matter of policy the distinction between fund governance and governance in conventional business entities in terms of different purpose served in the two contexts).

[4] This represents a far-more circumscribed use of the nexus of contracts concept than was formerly commonly used to describe corporate organizations generally. See Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, 3 J. FIN. ECON. 305 (1976).

[5] See Eugene F. Fama & Michael C. Jensen, Separation of Ownership and Control, 26 J.L. & ECON. 301, 302 (1983).

This post comes to us from Professor Joseph A. Franco at Suffolk University Law School. It is based on his recent article, “Commoditized Governance: The Curious Case of Investment Company Shared Series Trusts,” available here.