John Morley

Yale Law School

Why Do Investment Funds Have Special Securities Regulation ?

29/07/2020

For almost every type of company, the United States has just one body of securities regulation. Pet stores, hospitals, for-profit universities, and iron mines all have to comply with the same securities laws in basically the same way. There is, however, one important exception: investment funds. Mutual funds, closed-end funds, exchange-traded funds, hedge funds, private equity funds, and venture capital funds have their own special body of securities regulation that applies in place of or in addition to the regular securities laws that apply to other types of companies. Why? This 7,000-word essay, prepared for publication in the Research Handbook of Mutual funds, contemplates a number of possible answers and concludes that the most distinctive and legally salient feature of an investment fund is its structure. Investment funds divide their assets from their managements in much more radical ways than other types of companies. The surprising implication is that for purposes of regulation, an investment fund’s investments are much less important than its pattern of organization.

I. INTRODUCTION

America’s securities laws are generic. We have only a single body of securities law for all types of companies. The two centerpieces of American securities regulation, the Securities Act of 1933 and the Securities Exchange Act of 1934, regulate almost every industry imaginable, from software making to clothing retail to food service, banking, coal mining, insurance, for-profit higher education, hotels, book publishing, art dealing, and real estate investing. American securities regulation contains multitudes.

Except, that is, for one very special industry: the investment company industry. Unlike all other companies, mutual funds, closed-end funds, hedge funds and private equity funds have their own special securities regulatory regime in the form of the Investment Company Act of 1940. This act is administered by the Securities and Exchange Commission, the same agency that administers the other securities laws, but it imposes a different body of regulations in place of (and sometimes on top of) the generic securities regulations that apply to every other kind of company. No other large industry has a special securities regulatory scheme of this scope and magnitude.2 The investment company industry is one of a kind.

But why? What exactly makes an investment company so different from every other kind of company that it alone deserves special securities regulation? Surprisingly, the answer has never been very clear and (in living memory, at least) even the question has never been directly posed.

This chapter tries to find an answer. My conclusion is that, whatever the historical rationales for investment company regulation, the most compelling rationale for this regulation today is an investment company’s unique organizational structure. An investment fund almost always has a separate legal existence and a separate set of owners from the managers who control it. A fund investor thus relates to her managers in a radically different way from an investor in every other kind of company. Though this pattern of organization is often efficient in investment funds, it is nevertheless often imperfect and it poses an array of serious problems that call out for regulation. The special job of the Investment Company Act is to provide that regulation.

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