Fiduciary Contours: Perspectives on Mutual Funds and Private Funds

My paper, written for a forthcoming book focused on research concerning mutual funds, examines the content, scope, and function of the fiduciary duties owed by investment managers, drawing in particular on contrasts between mutual (or public) funds and private funds (principally hedge funds and private equity funds). The paper surveys the relevant regulatory architectures as well as private-law duties of loyalty. The paper also develops more specific contrasts between mutual funds and private funds concerning principal transactions, fees, fund governance, and regulatory frameworks for internal compliance. The thesis of the paper is that in the mutual-fund context, the specifics of fiduciary duty reflect distinctive and hybrid qualities of this form of investment in securities, conventionally understood to involve an investment company that issues shares to public investors as well as a highly prescriptive regulatory structure, embodied in the United States in the Investment Company Act of 1940. The Investment Company Act, an exemplar of a ‘rules-based’ regulatory regime, addresses many potential breaches of fiduciary duties through prescription, for example, by prohibiting principal transactions, those between the fund itself and its manager or between the fund and the manager’s affiliates.

In contrast, fiduciary duties in the private-fund context exemplify a ‘principles-based’ regime, embodied in the not-so-prescriptive structure of the Investment Advisers Act of 1940, which applies to fund managers required to register with the SEC as investment advisers. In this less prescriptive realm, fiduciary duties are harder to assess, at least in part because many private-fund managers until recently operated behind a thick veil of opacity. Private-fund investors were assumed to require much less regulatory protection, including through disclosure mandates. This assumption relied on the wealth and sophistication hurdles imposed on eligibility for private-fund investment, as well as the related assumption that the risks of agency costs intrinsic to any investment fund were sufficiently controlled by such investors. Much in this realm changed when the Dodd-Frank legislation required that many investment advisers to private funds register with the SEC under the Advisers Act. Registration made private-fund advisers subject to SEC examination and, in some cases, to follow-on SEC enforcement actions. Private-fund registration was also accompanied by enhanced interest from financial journalists.

In general, newly-available information about private funds’ practices called into question their consistency with fund managers’ fiduciary duties to investors, as did quantitative data now available concerning practices of hedge fund managers during the financial crisis. The paper documents investors’ responses to these revelations, arguing that the responses demonstrate how important reliable information can be to investors. This includes information relevant to managers’ compliance with their fiduciary duties. Better informed about the risks of fiduciary transgressions, private-fund investors were able to make better informed decisions about managers and fees. Of course, how long this sensitivity will endure necessarily remains an open question.

The paper’s comparison of fiduciary duties across mutual funds and private funds takes into account another potential structure for investment management, which is a non-fund investment-management relationship structured as an individual management account. An individual-account structure creates a relationship of common-law agency and thereby implicates agency law’s fiduciary doctrines as well as other elements of agency law. The individual-account alternative demonstrates the significance of a fund structure. Investment structured through a fund interposes the fund itself between investors (in the fund) and the fund’s manager, as well as between fund investors and the fund’s assets and liabilities. Prior scholarship examines governance features associated with mutual funds that resemble the governance associated with general-purpose business entities, such as boards of directors and voting rights conferred on fund investors. The relative weakness of such governance institutions in mutual funds is often justified by a fundamental structural feature of shares in most mutual funds (those organized as ‘open-ended’ funds): investors have the right to redeem their shares at any time. Just as the principal in a relationship of common-law agency has at-will power to withdraw or terminate the agent’s authority, an investor in an open-end mutual fund has an ongoing right to require that the fund redeem her shares. However, emphasizing the redemption feature of mutual-fund shares as a powerful way for investors to reduce risks—including risks of fiduciary impropriety—highlights the relative weakness of investors’ redemption rights in private funds, especially hedge funds. Although hedge-fund investors have redemption rights, hedge-fund managers often by contract retain significant discretion over when and how investors may effect redemption. How hedge-fund managers used their discretion during the financial crisis and its aftermath revealed information salient to assessing managers’ loyalty to investors’ interests.

The paper also examines implications of the insight in prior scholarship that shares in mutual funds represent products sold by or on behalf of the fund. This insight is consistent with the fact that, for many investors, an individual mutual fund’s association with a particular adviser operates as a brand on which the investor can rely and is more likely to prompt investor reliance than either the composition or functions of the fund’s board of directors. But the insight goes only so far in explaining observed facts about mutual fund organization and regulation. The Investment Company Act requires that fund investors vote on changes to the fund’s stated fundamental investment objectives. In the Ninth Circuit’s recent analysis, this requirement creates a structural relationship between fund investors and the fund, comparable to a provision in a corporation’s charter. By permitting deviations from the fund’s fundamental investment objectives without shareholder approval, the fund’s directors breach their fiduciary duties to the fund’s investors, and the fund itself breaches its contract with the investors. This analysis is inconsistent with characterizing mutual fund shares as ‘products’: it is hard to visualize how a typical seller of a product would effect post-sale modifications, comparable to unilaterally-adopted deviations from fundamental investment objectives. Instead, by requiring investor approval, the Investment Company Act situates fund investors—at least in this respect—comparably to principals in individual agency relationships with the fund’s adviser, when the adviser as manager proposes action beyond the scope of its actual authority.  

Deborah A. DeMott is the David F. Cavers Professor of Law at the Duke Law Faculty.