11 "Institutions Hold Stock Reins", Pensions & Investment,
September 30, 1991
22 Id.
January 16, 1992
TO: INVESTMENT ISSUES COMMITTEE NO. 2-92
RE: THE PROPER ROLE OF A MUTUAL FUND AS CORPORATE MONITOR
__________________________________________________________
According to a recent study sponsored by the Columbia
University Center for Law and Economic Studies Institutional
Investor Project entitled "Institutional Investors and Capital
Markets: 1991 Update", institutional investors owned more than
half of all outstanding public and private equities in 1990. 11
The Columbia Study also found that institutional asset holdings
grew in 1990 to $6.52 trillion, up from $6.25 trillion in 1989. 22
Yet despite the absolute size and growth of these holdings,
institutional investors and particularly mutual funds rarely
participate in corporate governance or serve as a corporate
monitor of the companies in which they have made significant
investments. Similarly, there have been virtually no efforts by
mutual funds and other institutional investors to coordinate the
voting of proxies so as to enhance their overall ability to
influence the affairs of portfolio companies by acting in
concert.
In recent years, there has been increasing debate whether
institutional investors, including mutual funds, should become
more actively involved in monitoring and, where appropriate,
opposing proposals of or actions taken by the managements of
their portfolio companies. Accordingly, it is appropriate to
focus on the legal and political forces which over the years have
largely restrained mutual funds from assuming an active role in
influencing corporate affairs.
I. THE 1940 ACT RESTRICTIONS
A. Power of Control
According to Professor Mark Roe in a recent article in the
University of Pennsylvania Law Review, Congress was highly
suspicious of the power of mutual funds to control companies when
the federal securities laws were originally enacted in the 1930's
and early 1940's, and the provisions of the various federal
33 Mark J. Roe. Political Elements in the Creation of a Mutual
Fund Industry, 139 University of Pennsylvania Law Review 6
(1991) (Hereinafter Roe, Political Elements)
44 See Stock Exchange Practices: Report of the Commission on
Banking and Currency S. Rep., No 1455, 73rd Congress, 2nd
Session 333-334 (1934).
55 Id. at 393
66 Investment Trusts and Investment Companies: Hearing on S
3580 Before Subcommittee of the Commission on Banking and
Currency, 76th Congress, 3rd Session, note 10, pt.2 at 434.
77 A. Berle and G. Means. The Modern Corporation and Private
Property 153-88 (1932)
securities laws amply reflect that suspicion. 33 According to
Professor Roe, a 1934 Senate securities report identified two
functions for mutual funds: investment and control of management.
The report asserted the control function was highly improper for
mutual funds. The report concluded that mutual funds should only
passively invest.44 Similarly, another Congressional report in
that era noted that "The investment company has become the
instrumentality of financiers and industrialists to facilitate
acquisition of concentrated control of wealth and industries of
the country." The report asserted that as a consequence,
Congress must "prevent the diversion of these [investment] trusts
from their normal channels of diversified investment to the
abnormal avenues of control of industry". 55
In a similar expression of suspicion about the voting power
of institutional investors, the SEC declared in its proposed bill
that ultimately led to the 1940 Act that "the national public
interest...is adversely affected...when investment companies have
great size... and have excessive influence on the national
economy".66 This country historically has supported a strong
separation between ownership and control of the typical American
corporation as originally characterized by Berle and Means, 77 and
this strong separation has been amply protected by various
provisions in securities and tax law according to Professor Roe.
B. Diversification Standards Under the 1940 Act
Congress manifested those strong reservations against
mutual fund control or influence by providing that under the
Investment Company Act of 1940, a mutual fund cannot advertise
itself as "diversified" if it owns in the regulated part of the
portfolio more than 10% of the voting stock of any company.
Three quarters of the portfolio is subject to this fragmentation
rule, even if that influential block of stock is only a small
portion of the fund's entire portfolio. The SEC wanted that
restriction to disable mutual fund control of portfolio
88 Roe, Political Elements at 1474
99 Id.
1010 Roe, Political Elements at 1476
companies. According to Professor Roe, some mutual funds might
have attempted to act as monitors of their portfolio companies by
owning large blocks of stock. That prospect was severely limited
for diversified investment companies. Today, virtually all
mutual funds call themselves diversified: they do not control
public firms.88
In addition, several states have imposed even more severe
restrictions: to sell mutual fund shares to their residents, the
fund cannot own more than 10% of any portfolio company. As a
result, many mutual funds have adopted an investment policy of
not permitting themselves to use even the limited portfolio
concentration that the 1940 Act permits. 99
The 1940 Act also requires that mutual funds calling
themselves diversified have no more that 5% of the mutual fund's
regulated assets in the securities of any one issuer. The effect
of this limitation tends to prevent a mutual fund from
controlling a portfolio company, although with the growth of
mutual funds in recent years, the 5% limitation is becoming less
meaningful as a control limitation. Similarly, Guide 16 to Form
N-1A requires that if one of the registrant's significant
investment policies is to invest in companies for the purpose of
exercising control, the registrant must explain in the prospectus
the extent to which and the circumstances under which, such
investments will be made. Most mutual funds respond to this
disclosure item by disclaiming any intent to invest for the
purpose of exercising control.
C. Networks and Affiliates
If a mutual fund owned 5% of the stock of a portfolio
company's stock and acted in concert with a group of other
institutions owning 5% of the stock of the portfolio company, all
would become 1940 Act affiliates under the affiliation definition
contained in the 1940 Act. Section 17(d) of the 1940 Act would
prohibit the mutual fund from acting jointly with an affiliated
financial institution to join a portfolio company's board of
directors, or be otherwise jointly asserting influence. Hence,
the 1940 Act by defining affiliates and prohibiting joint
transactions, effectively further operates to limit mutual funds
from asserting influence over the corporate affairs of portfolio
companies.1010
II. RESTRICTIONS UNDER TAX LAW
A. Subchapter M of the Internal Revenue Code
If a mutual fund were to deploy most of its portfolio in
1111 Id. at 1478
1212 Coffee, John C. Jr., Liquidity Versus Control: The Ins
tit
uti
ona
l
Inv
est
or
as
large influential blocks, it would be taxed unfavorably on its
entire portfolio, because Subchapter M of the Internal Revenue
Code allows only diversified RICs to avoid income tax at the fund
level. Under the Code's diversification requirement, investments
in companies could constitute no more than 5% of the portfolio
and constituting no more than 10% of the portfolio company's
outstanding stock.
According to Professor Roe, witnesses at the Congressional
hearings considering the Investment Company Act suggested that
the principal basis for the distinction between diversified an
nondiversified companies was not tax policy. The distinction was
to establish "good" mutual funds-- those that did not exert
control--which would be favorably taxed, and all other mutual
funds, which would be unfavorably taxed. 1111
Congress liberalized the portfolio fragmentation
requirements of Subchapter M in 1942, but left in place
restrictions on mutual fund control of portfolio companies. No
more than 25% of the mutual fund's portfolio could go into the
stock of a single company. Nor could more than 25% go into stock
of two or more controlled companies "engaged in the same or
similar trades or businesses or related trades or businesses".
The fund could put all of its assets into a single industry and
get pass-through tax status and diversified status under the 1940
Act. But it could not control companies in the single industry.
With this strong Congressional bias against mutual funds
exercising control, to the extent that mutual funds would become
active in influencing corporate affairs there is the fear whether
real or exaggerated that Congress might repeal or severely cut
back the favorable tax attributes Subchapter M status confers on
mutual funds.
III. PRACTICAL LIMITATIONS UPON MUTUAL FUNDS EXERCISING CONTROL
In addition to the statutory restraints described above,
there are numerous practical limitations upon mutual funds
desiring to exercise institutional activism in the affairs of
portfolio companies which are discussed in an October 1991
Columbia Law Review article by Professor John C. Coffee, Jr. 1212
Cor
por
ate
Mon
ito
r,
91
Col
umb
ia
Law
Rev
iew
6
(19
91)
(he
rea
fte
r
Cof
fee
,
Liq
uid
ity
)
Initially, the need for liquidity in the mutual fund portfolio
can operate as an effective limitation upon the ability of a
mutual fund to accumulate the large block of securities necessary
to exert influence over a portfolio company since large blocks of
securities are often illiquid. Such illiquid positions can be
1313 Roe, Political Elements at 490-92
difficult to value and can run afoul of SEC restrictions limiting
such investments. Also, there is the fear of conflicts of
interest between an activist mutual fund and a portfolio company
and the possibility that a portfolio company may retaliate
through litigation or through complaints to Congress and
regulators if a mutual fund attempted to exercise influence upon
portfolio companies.
Similarly, the fear of political retaliation is ever
present if mutual funds and other institutional investors would
band together to exercise influence upon portfolio companies,
with all the attendant concentration of economic power in the
hands of fund managers. Given the political and legal barriers
already engrafted into the federal securities and tax laws
against individual mutual funds exercising a controlling
influence upon portfolio companies, the prospect of mutual funds
acting in concert to effect control of portfolio companies could
provoke a decidedly negative response on the political and
regulatory arena.1313
Another practical concern is that portfolio companies
could cut mutual funds off from helpful financial and investment
information the fund needs to monitor its investment in the
portfolio company if activism by the mutual fund alienates the
management of the portfolio company.
Moreover, the fact that some mutual funds have near term
profit orientations in making an investment in a portfolio
company often lessens the ability to exercise any meaningful
influence in the affairs of portfolio companies because the
mutual fund is not an investor sufficiently long enough in a
particular company to effect meaningful change. In addition, the
costs to a mutual fund in monitoring and changing corporate
policies in the portfolio companies often is not adequately
compensated by the fairly narrow margins inherent in investment
advisory fees of the 50 basis point range or less. There is also
the concern that mutual funds may simply not have the sufficient
expertise resident on staff to monitor and exercise influence
over the affairs of portfolio companies. Finally, a mutual fund
is accorded certain relief from detailed federal filing and
disclosure requirements if securities are acquired in the
ordinary course of business and not with the purpose of changing
or influencing control of the issuer under Section 13(d) of the
Exchange Act or if securities are acquired solely for the purpose
of investment under the premerger filing requirements of the
Hart-Scott-Rodino Act. All these practical limitations upon the
ability or desire of mutual funds to exercise control or
influence in the management of portfolio companies operate
individually or in combination to restrict active investing by
mutual funds.
1414 "Institutions May Use Negotiation More in 1992 to Change
Corporate Governance", Federal Securities and Law Report,
January 3, 1992, p. 13.
IV. LIMITED INSTANCES WHERE MUTUAL FUNDS HAVE INFLUENCED
CORPORATE AFFAIRS
While much has been said about the various political,
legal, and practical limitations upon active investing by mutual
funds, it is important to acknowledge that there are limited
instances where mutual funds historically have influenced
corporate affairs in their portfolio companies. Initially,
mutual funds as well as other institutional investors have used
the proxy voting process to oppose corporate actions by their
portfolio companies which would have adverse economic impact upon
the securities held by the mutual fund, namely proxy proposals
(1) to adopt "poison pills" and other anti-takeover devices which
could deprive a mutual fund from receiving the price appreciation
realized in tender offer or corporate merger proposals, (2)
seeking approval of executive compensation and stock packages
which are excessive, and (3) to limit liability of corporate
officers and directors for mismanagement. In such instances,
mutual funds, often working under guidelines from their boards of
directors will oppose the adoption of such proposals with varying
degrees of success. Some institutional investors such as the
California Public Employee's Retirement System have increased
their use of private negotiations to obtain changes in corporate
governance, rather than rely on shareholder proposals. 1414
A second major area where mutual funds attempt to influence
the activities of portfolio companies arises where the portfolio
company becomes financially distressed and a work-out or
restructuring effort is necessary. In such instances, many
mutual funds will use all available legal remedies to protect the
interests of the class or classes of securities held in the
distressed portfolio company to ensure that mutual fund
shareholders are protected in any restructuring, even if that
translates into intervening in corporate affairs.
A third area of mutual fund activism occurs when mutual
funds vote upon shareholder proposals involving social issues,
e.g. investment in South Africa, limits upon charitable
contributions, participation in defense research, etc. While
many funds have adopted policies of abstaining from voting on
proxy proposals involving social issues, a limited although
possibly increasing number of fund groups evaluate and vote proxy
proposals involving social issues.
V. RECENT DEVELOPMENTS IN MUTUAL FUND ACTIVISM
Fidelity Investments recently amended the investment
restrictions of certain of its funds to remove the restriction
that the fund not invest "for the purposes of exercising control
or management". However, spokesmen for Fidelity have repeatedly
asserted that Fidelity has no intent to becoming involved in a
company's day to day operations, but wants to be able to express
its views to management or others, without being accused of
violating the investment policies of the funds it manages. The
intent of removing the restriction by Fidelity is to give its
funds the power to give or withhold consent to a proposed action
by the management of an authority or agency or the issuer of
portfolio securities, to solicit support from other holders of
the same or similar securities, or take other action, including
instituting litigation when Fidelity believes such action may be
appropriate in order to protect the value of the portfolio's
investments.
Representatives of other major fund groups have asserted
that maintaining the investment restriction of not investing for
the purposes of exercising control of management in no way
restricts their ability to accomplish the stated goals of
protecting the value of the portfolio's investments by taking
such actions as are necessary in voting proxies or initiating
litigation against portfolio companies, where appropriate.
Of additional interest is the fact that the SEC recently
proposed major revisions to its proxy rules which, among other
things, would have greatly enhanced the ability of institutional
investors to communicate among themselves for the purposes of
deciding how to vote proxies and for purposes of influencing
corporate governance. Major corporations and The Business
Roundtable expressed considerable reservations to allowing
institutions to communicate among themselves in the proxy voting
process without going through the presently required routine of
filing a proxy statement with the SEC. According to the comment
letter filed with the SEC by The Business Roundtable, the SEC's
proposed changes in the proxy rules "would plunge the proxy
process into the secret back-room dealings among powerful
institutional investors with billions of dollars of assets, rely
on expensive, after the fact, private litigation... and would
place the fate of the corporations in the hands of many of the
same financial intermediaries who were the driving force behind
the excessive take-overs of the 1980's". Not only did business
groups resist the SEC's proposal to loosen the proxy rules for
communications among institutional investors, but in some
instances, argued for tightening the existing rules. In
particular, the business groups argue that the current exemption
permitting up to 10 shareholders to talk to each other should be
replaced by a new threshold exempting only investors whose total
shares amount to no more than 5% of a company's outstanding stock
to communicate with each other without the need to file a proxy
statement. (The Institute's comment letter on the proposal
recommended that the exemption be limited to communication among
institutional investors, defined as those entities permitted to
file ownership reports on Schedule 13G.)
1515 Roe, Political Elements 1508-1509
1616 Coffee, Liquidity at 1367
Due to an unprecedented volume of public comment opposing
the proposed revisions, the SEC has postponed final adoption of
the proposed liberalizations pending further study. While it
would be speculative to suggest the SEC will ultimately back away
from liberalizing proxy rules vis a vis institutional investors,
the fact that the SEC has delayed adopting the proposed
liberalizations in the face of strong opposition from major
public companies and groups representing such companies means
that institutional investors will continue to have significant
restrictions upon their ability to communicate with each other
without running afoul of the proxy solicitation rules of the SEC.
VI. OUTLOOK FOR THE FUTURE
While there has been increasing discussion of mutual funds
becoming more active in monitoring and influencing corporate
activities, to date there has been but modest experimentation in
paving the way for increased activism rather than such activism
being implemented in its own right. Moreover, the same political
and legal constraints which have effectively worked to restrict
mutual fund activism continue to remain in effect and without a
significant change in the political environment will likely
remain in effect for the foreseeable future. Also, many mutual
fund managers strongly believe that mutual funds must not engage
in controlling or attempting to control corporate affairs of
their portfolio companies and will act accordingly in avoiding
any such intervention. The net result may well be that any
increased activism by mutual funds will occur by a relatively
limited number of mutual funds in highly specific fact situations
such as work-outs of distressed investments, litigation, and
proxy and control battles where mutual funds are forced to take
sides in battles waged by outside parties.
Nevertheless, it is important to acknowledge that law
review commentators are increasingly suggesting substantive
modifications to the very stringent barriers against mutual funds
exercising influence in corporate affairs. Professor Roe argues
that some restrictions should be lifted for mutual funds and
other institutional investors as long as the financial entities
do not sell their products to the portfolio company. 1515
Similarly, Professor Coffee argues that public policy should
encourage some institutional investors such as pension funds and
closed-end mutual funds to assume a monitoring role. 1616
To the extent that the academic literature continues to
argue for limited modifications to the barriers and to the extent
that certain mutual funds continue to experiment with reserving
the right to exercise influence whenever it is in the interest of
fund shareholders, it is likely that there will be continuing
developments and debate concerning the proper role of a mutual
fund as a corporate monitor. The Institute will keep you
informed of ongoing developments.
Lawrence A. Rogers
General Counsel