Millions of investors rely on the disclosures of U.S. registered mutual funds in making their investment decisions, but some of the most influential industry opinion leaders and legal scholars have criticized the quality of those disclosures. Like public companies, mutual funds are subject to both internal and external oversight. In contrast to public companies, though, the funds have an acute agency conflict between their management companies and investors, while the internal governance for mutual funds, especially the board of directors, is often ineffective. With weak internal oversight, the role of external oversight becomes particularly important. The most important external oversight comes from the Securities and Exchange Commission (SEC).
In a recent paper, we examine SEC oversight of mutual fund disclosures, focusing on three interrelated questions: (i) Is there an association between SEC comment letters and subsequent misconduct by mutual fund companies or their advisory companies and, if so, what types of comment letters help funds remediate disclosure deficiencies before they get worse, and what types of comment letters are manifestations of more serious issues; (ii) Do funds improve their disclosures in response to the SEC’s inquiries; and (iii) Does SEC oversight improve investors’ confidence in using fund disclosures to inform their investment decisions?
We focus on comment letter conversations between mutual funds and the SEC’s Division of Investment Management (IM), which are intended to resolve SEC staff’s questions and help funds improve their disclosures. Our sample consists of 16,161 comment letter conversations from 2004 to 2019. These letters are publicly available through the SEC’s EDGAR system starting in 2004. We find that comment letters are pervasive among mutual funds: More than 93 percent of mutual funds received at least one comment letter during our sample period. The likelihood of receiving a comment letter is higher when the fund receives a comment letter in the previous year, when the SEC scrutinizes the filings before issuing comments, and when the fund is larger, younger, or receives more investments.
Our first research question is how comment letters affect subsequent SEC enforcement actions and misconduct. We find that funds that received comment letters, in general, do not have a significantly different likelihood of being subsequently subject to enforcement actions. However, when examining violation categories, we find that receiving a comment letter reduces the likelihood of subsequent enforcement related to disclosure issues or sale of securities. We further examine comment letters by topics and find that comment letters on accounting issues, internal controls, or legal matters could indicate serious underlying problems and are associated with more future enforcement actions. In contrast, comment letters related to disclosure issues (risk factors or Reg S-K) could help funds remediate deficiencies and are associated with fewer future enforcement actions. We document similar patterns for the monetary penalties assessed in enforcement actions, as well as for fund adviser misconduct. These results suggest that, while the role of comment letters could be nuanced, disclosure-related comments typically help funds mitigate compliance deficiencies.
Our second research question is whether mutual funds respond to comment letters by changing their disclosures. We find that, following a comment letter, mutual funds increase the length and the negativity of prospectuses and proxy statements and the complexity of the prospectuses and shareholder reports in the subsequent filing of the same form type. The results suggest that (i) mutual funds add explanatory language in response to the SEC’s comments, which increases the length and may reduce the readability of the filings; and (ii) mutual funds are less likely to withhold negative information in filings after receiving comment letters.
To the extent that IM comment letters may be associated with the improvement of disclosure quality, they may affect the relative weight mutual fund investors place on fund disclosures. We show that investors do pay attention and access comment letters and the filings commented upon through EDGAR, especially immediately after the comment letter is disseminated to the public. We also find that investors place greater weight on fund disclosures and less weight on past performance when mutual funds receive comment letters. In other words, investors increase their reliance on fund disclosures that are recently subject to SEC scrutiny. The findings are consistent with the notion that fund investors view SEC oversight as improving disclosure quality.
The SEC monitors the disclosures of various types of registrants, including public companies that are under the purview of the Division of Corporation Finance (CF), and investment companies that are under the purview of IM. In contrast to the voluminous academic literature on CF comment letters issued to public companies, there is a lack of empirical research on IM’s oversight of mutual fund disclosures. Our study fills this gap and deepens the understanding of how SEC monitoring affects mutual funds’ reporting and disclosure practices, and how the reviewing process aligns with the SEC’s mission of investor protection. Some legal scholars have argued that limited resources and regulatory capture have made SEC oversight of the mutual fund industry less effective. Lawmakers have also argued that IM “has become far too deferential to the industry” and thus presents “a classic case of ‘regulatory capture’.” By documenting some positive effects of IM scrutiny on fund disclosures, our study sheds new light on the role of IM in the mutual fund industry. In addition, our study identifies an unexplored data source to predict misconduct in the industry. Incorporating such information could be valuable in the early detection of mutual fund misconduct and trading abuses.
This post comes to us from professors Kai Du at Pennsylvania State University’s Smeal College of Business and Shuyang Wang at Northeastern University’s D’Amore-McKim School of Business. It is based on their recent working paper, “Regulatory Scrutiny of Mutual Fund Disclosures,” available here.