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SEC Investment Management Chief Speaks on Doing Investment Companies Well

Good morning. Thank you, Eric, for your kind introduction. I appreciate the ICI’s invitation and I hope – if you decide ever to renew it – that I’ll be able to join you all in person someday.

Please allow me, if I may, to make clear that my comments today are my own and do not necessarily reflect the views of the Commission, the Commissioners, or the SEC Staff.[1]

As Eric mentioned in his introduction, I am new to this position. Indeed, today marks the end of only my third month on the job. The SEC announced my appointment so recently that I can still remember one of the reports of that news, which arrived under the following headline: “Fund Critic Birdthistle to Take Reins at SEC’s Division of Investment Management.”[2] Well, that certainly sounds a little ominous.

* * *

But I protest, for at least three reasons.

First, I celebrate funds and their central role in the U.S. economy. They are a critical tool for advancing the tripartite mission of the Securities and Exchange Commission.[3] Funds can help to protect and augment the life savings of ordinary investors; with their significant ownership of equity in American corporations, funds enjoy a large – and growing – role in the orderly and efficient operation of our capital markets; and they facilitate capital formation by deploying money to our most innovative investment strategies.

Second, when teaching corporate law in the classroom, I long privileged the role of funds over the conventional story, which casts operating companies or investment banks as our financial industry’s central protagonist. In courses such as Business Organizations and Securities Regulation, the standard but dated model of an individual investor transacting directly with an issuer is increasingly at odds with the reality that investors today transact their affairs largely through funds instead. The typical retail investor through mutual funds; many sophisticated investors through private funds; and everyone, it seems, through exchange traded funds. Students shouldn’t have to slog through a thousand pages of a casebook before discovering the joys of the Investment Company Act of 1940. And its exemptions.

Third, I’ve long been an observer of the impressive, dare I say imperial, ambitions of funds. Today, registered investment companies hold more than thirty trillion dollars in the United States.[4] Unregistered investment companies – comprising venture capital, hedge, and private equity funds – hold more than fourteen trillion dollars in net assets.[5] And the SEC’s Division of Investment Management collectively oversees the regulation of more than 110 trillion dollars.[6] By comparison, the entire U.S. banking sector holds only a little more than $20 trillion of assets.[7] To paraphrase the historian Francis Fukuyama, the investment company – or at least the collective investment vehicle – might represent the end of finance.[8] The fund as a financial concept appears to have won, for now. Congratulations, we’re all at the right conference.

* * *

So, do I have anything critical to say? I do have one or two aspirational observations to share with you. But first I’d like to suggest that, if I am a fund critic, then I am in the same way that Michiko Kakutani is a book critic, Ruth Reichl was a food critic, and Siskel & Ebert were film critics. That is to say, I’m an aficionado of the form and have a deep appreciation for seeing it done to the best of its ability.

So how can the investment company be done well?

Let’s borrow the rubric of another scholar to consider that question. Albert Hirschman was a historian, philosopher, and economist, and the author of Exit, Voice, and Loyalty. In that work, Hirschman argued that in collective enterprises in which the quality or benefits of membership threaten to decrease, participants can either exit the enterprise or exercise their voice to seek change, and he explored the dynamic of loyalty on those two choices.[9] Efficient market theorists would likely posit that, for an investment company, the salient quality or benefits of membership relate to financial performance, which comprises returns and fees.

So can investors in a fund with poor returns or high fees exit? For the most part, of course they can. Retirement plan menus, market timing rules, and tax considerations can impose practical frictions on the movement of investors, but there are few legal impediments.

Do they exit? For the most part, that depends. Some portions of this very large market enjoy a great deal of movement in response to economic competition. Others don’t. We see inflows of money into funds with low costs and high performance, as economists would expect, but we also see a dearth of outflows from funds that underperform the market while charging relatively higher fees. Entry wasn’t one of Hirschman’s inquiries; he wanted to know about exit. And sometimes in our least exemplary funds, we see less exit than we might expect.

Investors lead busy lives, of course, with jobs of their own, loved ones to care for, and pandemics to navigate. And inertia can affect even sophisticated investors. Consider the recent 403(b) litigation[10]: if even the finest universities in our country, replete with Nobel laureates in economics on their faculties, could hold billions of dollars of retirement assets in retail rather than institutional share classes, we cannot be surprised if individual investors also lack the resources to conduct eternal vigilance.

Perhaps some of that vigilance is simply beyond the scope of a reasonable investor. If a substantial portion of costs are being drawn out of investment companies through revenue sharing, soft dollar, and other practices with little visibility and even less familiarity, how reasonable is our expectation that investors should know when to exit?

Indeed, it’s striking to me that investors do not receive a uniform statement explicitly identifying the dollars they paid in the past year. Banks offer their customers a statement of fees; home mortgage and car lenders offer a statement of fees; credit cards offer a statement of fees. How is it that there is no comparable requirement for statements on the individualized costs for all those trillions of dollars in life savings vouchsafed to investment companies?

For many years, I have been an avid consumer of the ICI’s Fact Book, which really is well named – it’s filled with hundreds of pages of facts and extraordinary data, some of which I cited earlier. Thank you, ICI, for publishing it, and bravo on the excellent work. But one datum that’s hard to find in that remarkable almanac is a single number of great public interest: what does the industry make each year in fees? In my view such information could inform the general discussion about competition in the industry.

On Hirschman’s second inquiry, as to whether fund investors use their voice, I believe the analysis may be simpler. In a word, rarely. I am concerned that fund shareholder votes are – again, for understandable reasons of what scholars like to call rational apathy – something in which shareholders may not participate meaningfully. Many investors may rationally view the costs of becoming informed about the issues and actually voting their fund shares to be greater than any marginal benefit they could attain through their votes, and therefore neglect to participate in the fund proxy voting process by embracing apathy instead. I am also concerned that investors who are interested in using their voice indirectly through the votes of funds in which they invest may not have sufficient information about how portfolio shares are voted.

The extent to which one is concerned about fund investors not using their voice may turn on the extent to which one believes the alternative, the ability for investors to exit, is functioning well. Or the extent to which one believes exercising a voice through investments is a vital principle at all. I believe that both exit and voice are important and that our regulatory regime should provide investors with sufficient tools to participate meaningfully in both those choices. I support the exploration of potential enhancements to address these issues, including, for example, the staff’s consideration of comments on proposals to require streamlined shareholder reports, to amend prospectus fee and expense disclosure, and to enhance the information funds report about their proxy votes.[11]

And what then of the interplay with loyalty? Certain funds and advisers do enjoy a great deal of loyalty from their investors. And a number of famous, sometimes infamous, portfolio managers have attracted legions of followers, both fans and imitators. For others, however, the selection of funds by investors is simply a financial decision, oftentimes made in the first instance by someone else, such as a plan administrator.

Fund advisers do owe the funds they manage a fiduciary duty, which includes a duty of care and a duty of loyalty.[12] The Commission can always enforce a breach of fiduciary duty by a fund adviser. In addition, the Investment Company Amendments Act of 1970 also added Section 36(b), which as you know specifies that a registered fund’s adviser has a fiduciary duty with respect to the receipt of compensation for services or material payments from the fund or its shareholders. To enforce this duty, fund shareholders or the Commission may bring an action under this subsection. No plaintiff has yet won a 36(b) case, but if no adviser can ever lose one – and none has, so far – one wonders whether the duty enacted in the statute is truly being honored.

As I observe these dynamics, I spend a lot of time thinking about the meaning of “loyalty” for advisers, funds, and their investors, and its interplay with investors’ ability to exit and use their voice.

* * *

But enough of thoughts for improvement, let’s return to the boons that investment companies – and collective investment more generally – bring to American society.

Often, when Americans come together in celebrated joint enterprises, we do so to pursue goals far loftier than mere profit. If one casts a broad conceptual net around the idea of a collective investment vehicle, then an example of one first combined efforts as an incipient nation dates back to 1774, with the drafting of the Articles of Association. That document may sound like the better known Articles of Confederation or perhaps something a junior law firm associate would file in Delaware, but they were in fact adopted by the First Continental Congress in response to the Intolerable Acts imposed by the British government upon its North American colonial subjects. This collective instrument used the lever of economic power by proposing a boycott – sanctions, if you will – on goods produced in Britain. The damage to the British economy triggered the counter-sanctions of the Crown’s New England Restraining Act a year later, which precipitated the Revolution.[13] So, a successful debut for the wielding of pooled American economic power focused on something other than maximum financial return.

Collective investment has marked some of the most successful world-building initiatives of the past century as well, embodied by George Marshall, who led his eponymous plan for German reconstruction after World War II.

The economist Andrew Lo also celebrates the power of collective investment, and specifically funds, to harness financial incentives for the public good. In his book, Adaptive Markets, Professor Lo posits the creation of funds large enough to finance a portfolio of hundreds of cancer therapies, with the losses of many failures more than offset by the returns of rare triumphs. Portfolio theory for capital ventured on a massive scale to address the biggest challenges of our time.

I believe that many of today’s investors would agree with Professor Lo. We see some of that interest in the growth of funds focused on environmental, social and governance strategies, wherein investors appear to place a great deal of value on considerations that complement the financial return of their investments.

* * *

I have spent much of my time today discussing collective investment on a conceptual level. How then, you might ask, does this impact the oversight of investment companies today? In the last six months alone, the Commission has proposed amendments to the regulation of money market funds and the way funds and other asset managers report their proxy votes, and proposed new rules for investment companies related to cybersecurity.

Commission staff have also continued to assist registrants in providing the most useful disclosure to fund investors. Illustrating this commitment, the staff of our Disclosure Review and Accounting Office is currently deep into its second busy season reviewing variable annuity and variable life filings. Since the adoption of the variable products summary prospectus almost two years ago, DRAO has reviewed more than 220 filings relating to more than 280 contracts.

As I consider these issues and the other challenges Division staff are facing today, I share Professor Lo’s optimism and faith in the power of investment companies. My desire to see this industry reach its full potential motivates me as Director of this Division and informs my thinking every day. I hope the same may be true for each of you.

* * *

I trust that you will enjoy the rest of the conference. I know that you have much to look forward to with an impressive line-up of speakers, starting with my esteemed colleague, Sarah ten Siethoff (now Deputy Director of the Division of Investment Management), as well as our other colleagues in the agency, Vanessa Horton and Dabney O’Riordan.

I would like to end my remarks today with a note of appreciation to the staff of the Division’s Investment Company Rulemaking Office. They have accomplished a herculean task over the past six months on a remarkable number of rulemakings including updates to Form N-PX, updates on E-Filings, Money Market Funds reform and Cyber Security.[14]

Thank you very much.

ENDNOTES

[1] The Securities and Exchange Commission (“SEC” or “Commission”) disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

[3] “The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.” See Agency and Mission Information, available at https://www.sec.gov/about/reports/sec-fy2014-agency-mission-information.pdf.

[4] See Investment Company Institute, 2021 Investment Company Fact Book, ch. 2, available at https://www.icifactbook.org/21_fb_ch2.html.

[5] See U.S. Securities and Exchange Commission, Division of Investment Management, Analytics Office, Private Funds Statistics: Second Calendar Quarter 2021, p. 5, Jan. 14, 2022, available at https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2021-q2.pdf.

[6] Registered investment advisers report $110 trillion in regulatory assets under management, based on analysis of data reported on Form ADV through the Investment Adviser Registration Depository (IARD) system as of December 31, 2021. The data consists of assets that are reported by both advisers and sub-advisers, including mutual fund and ETF assets.

[7] The data is based on the assets held by large commercial banks in the United States. See Federal Reserve Statistical Release: Large Commercial Banks, available at https://www.federalreserve.gov/releases/lbr/current/.

[8] Francis Fukuyama, The End of History and the Last Man (Free Press, 1992).

[9] Albert O. Hirschman, Exit, Voice and Loyalty (1970).

[10] Hughes v. Northwestern University, No. 19-1401 (2022), available at https://www.supremecourt.gov/opinions/21pdf/19-1401_m6io.pdf.

[11] See Enhanced Reporting of Proxy Votes by Registered Management Investment Companies; Reporting of Executive Compensation Votes by Institutional Investment Managers, 86 FR 57478, (proposed Sept. 29, 2021), available at https://www.sec.gov/rules/proposed/2021/34-93169.pdf; Tailored Shareholder Reports, Treatment of Annual Prospectus Updates for Existing Investors, and Improved Fee and Risk Disclosure for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements, 85 FR 70716 (Proposed Aug. 5, 2020), available at https://www.sec.gov/rules/proposed/2020/33-10814.pdf.

[12] Commission Interpretation Regarding Standard of Conduct for Investment Advisers, 84 FR 33669 (July 12, 2019), available at https://www.sec.gov/rules/interp/2019/ia-5248.pdf.

[14] Thank you to the Investment Company Rulemaking team led by Sarah ten Siethoff: Brian Johnson, Sara Cortes, Angela Mokodean, Joel Cavanaugh, David Driscoll, Adam Lovell, James McLean, Mykaila DeLesDernier, Nathan Schuur, Amanda Wagner, Blair Burnett, Pamela Ellis, Brad Gude, Rachel Kuo, Amy Miller, Zeena Abdul-Rahman, and David Joire.

These remarks were delivered by William A. Birdthistle, director of the Division of Investment Management at the U.S. Securities and Exchange Commission, on March 28, 2022, at the ICI Investment Management Conference in Washington, D.C.

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