Lilli A. Gordon

ESOPs and corporate control

Abstract This paper examines the effects of employee stock ownership plans (ESOPs) on shareholder wealth. ESOPs established in the presence of takeover activity reduce share values, by approximately 4% on average. ESOPs also reduce share values if they are structured to transfer control away from outside shareholders, by creating a new ownership block with veto power over takeover bids. Large ESOPs established with nonvoting stock, so as to preclude any immediate control transfers, result in a significant increase in share values. The wealth effect of any given ESOP thus depends upon both its incentive and control effects on the corporation.

A Study of Current Market Conditions in the Mutual Fund Industry

The purpose of this chapter is to determine whether the mutual fund industry is competitive and, therefore, whether the forces of competition are sufficient to restrain managers of mutual funds from behaving in a manner contrary to shareholders’ interests. If competition prevents abuses, then regulation may not be warranted. In this chapter, we provide a framework for the evaluation of competition in the mutual fund industry.

Litigation under the 1940 Act and the 1970 Amendments

While most of the litigation generated under the 1940 Act and the 1970 Amendments terminated in settlements, the courts have delivered a number of opinions that indicate the judiciary’s views on regulation and patterns of behavior in the mutual fund industry. The litigation has been based on allegations that advisers charged excessive management fees. The standards used to adjudge fees before the 1970 Amendments were very narrow, and the plaintiffs were never successful in cases that were fully litigated. It was partly for this reason that Congress passed the 1970 Amendments. However, plaintiffs continued to be largely unsuccessful under the relaxed standards of the modified Section 36(b). Let us turn to a history of this litigation.

A Cost Study of Mutual Fund Complexes

This chapter investigates the cost structure of mutual fund complexes. Views about the underlying cost structure, whether implicit or explicit, have shaped regulatory policies in a broad range of industries. A striking example of this influence is the regulation and subsequent deregulation in the telecommunications industry, where cost considerations played a major role.117 Such considerations are also evident in policies toward mergers and in questions about appropriate lines of business for regulated firms.

Toward Rational Policy on Regulation of Mutual Funds

This book has examined, both conceptually and empirically, the economic merits of the arguments offered in support of the current regulatory and legal structure. It has offered evidence on the behavior of the industry, the behavior of mutual fund consumers, and the consequent ability of advisers to charge excessive fees.

Analysis of the Adviser-Shareholder Relationship in the Mutual Fund Industry

The main attribute of mutual fund advisory services that makes them the subject of such extensive judicial and legal inquiry is the nature of the relationship between a mutual fund and the supplier of these services. The mutual fund and its adviser are not independent enterprises, since the mutual fund is the creation of the advisory enterprise. As a result, it may appear that there is no freedom to shop around and find the firm that is prepared to supply the advisory services on the most favorable financial terms. Proponents of industry regulation emphasize this feature of mutual funds, which, in their opinion, has permitted fund managers to charge excessive fees or otherwise engage in self-seeking behavior92 at the expense of mutual fund shareholders.

Regulation of the Mutual Fund Industry

One of the primary objectives of the Investment Company Act of 1940 was to protect small investors in mutual funds against abuses by a fund’s adviser. Proponents of mutual fund regulation believed that, because of the inability of investors to replace a fund’s adviser with a new adviser should the adviser charge excessive fees or otherwise take advantage of a fund’s shareholders, the usual bargaining that is part of the competitive process is absent from the adviser-shareholder relationship. This sentiment is articulated in the following language of Senate: Since a typical fund is organized by its investment adviser which provides it with almost all management services and because its shares are bought by investors who rely on that service, a mutual fund cannot, as a practical matter, sever its relationship with the adviser. Therefore, the forces of arm–s length bargaining do not work in the mutual fund industry in the same manner as they do in other sectors of the American economy.20

History of the Development of the Mutual Fund Industry

Evaluating the regulatory measures that affect the mutual fund industry requires a complete examination of the historical and actual structure of the mutual fund industry, the mode of operation of the funds, and the behavior of mutual fund shareholders. The stated purpose of current regulatory measures, primarily those embodied in the 1940 Investment Company Act and the subsequent 1970 Amendments, is to protect shareholders of mutual funds and of other types of investment companies from abuse by a company’s management. Before the passage of the ICA, mutual fund investors had little regulatory protection from alleged unscrupulous management, and alleged abuse of shareholders was persistently reported. Since the passage of the ICA and the 1970 Amendments, however, there have been significant changes in the organizational structure of investment companies, as well as in the economic structure of the mutual fund industry. It is particularly important, then, to examine whether these changes have altered the prospects for abuse and thereby affected the appropriate regulatory policy. The purpose of this chapter is to describe the overall development and the pertinent changes in the industry.

The Demand for Money Market Mutual Funds

As discussed in previous chapters, the Investment Company Act was designed to protect investors from financial abuse of their interests by advisers of mutual funds. One important dimension of the perceived need for such regulation was the determination of the fees charged by mutual fund advisers. It has been suggested that advisers are in the enviable position of being able to set fees that are excessively high with little or no risk of driving their customers away. Underlying this view is the perception that the nature of the contract between the investment adviser and the mutual fund denies investors the opportunity to replace the adviser if his behavior is unacceptable. This view assumes implicitly that mutual fund shareholders are either unable or unlikely to discipline the adviser by shopping around for the most attractive place to invest their money.