Reforming the Taxation and Regulation of Mutual Funds: A Comparative Legal and Economic Analysis

June 10, 2009 Reforming the Taxation and Regulation of Mutual Funds: A Comparative Legal and Economic Analysis John C. Coates IV* John F. Cogan, Jr. Professor of Law and Economics Harvard Law School 1525 Massachusetts Avenue Griswold 400 Cambridge, MA 02138 Email: jcoates@law.harvard.edu Abstract Most Americans invest through mutual funds. A comparison of US tax and securities law governing mutual funds with laws governing other collective investments, in both the US and in the EU, shows: (a) the US fund industry continues to be the world leader, but now lags domestic and foreign competitors, primarily because of US tax and securities law; (b) mutual funds are taxed less favorably and regulated more extensively in the US than direct investments or other collective investments, including alternatives available only to wealthy investors; (c) the structure of US regulation – numerous proscriptive bright-line rules written nearly 70 years ago, subject to SEC exemptions – makes success of US mutual funds dependent on the resources, responsiveness and flexibility of the SEC; (d) while the high-level formal framework for mutual funds in the EU is as or more restrictive and inflexible in most respects than the Investment Company Act, competitive pressures in the EU constrain supervisors in EU countries to be more flexible in adopting implementing regulations, and EU regulators have greater resources and are more responsive than the SEC, which could achieve the same flexibility and responsiveness through exemptive orders but has been unwilling or unable to do so in a timely fashion. The paper discusses a number of reforms to improve the treatment of middle class investments, including improvements in mutual fund taxation, ways to enhance the flexibility and resources of US fund regulators, modifications of the existing ban on asymmetric advisor compensation and the exclusion of foreign funds, and unjustified disparities in the treatment of mutual funds and mutual fund substitutes. 1 Over the past 50 years, mutual funds have become the primary way middle class Americans invest: • 44% of US households own fund shares, up from 6% in 1980, but down from its peak at 48% in 2001.1 • 33% of all families earning between $25,000 and $50,000 invest in mutual funds,2 and half of households owning funds earn less than $75,000.3 • Over a quarter of all retirement plan assets are held in mutual funds.4 With over $9.6 trillion in assets (down from $12 trillion in 2007),5 US mutual funds are an important channel for investment to flow through capital markets into new businesses around the world. In 2007, for the first time, US mutual funds held more stock in US companies than did either individuals or any other type of financial institution.6 Other forms of US collective investments for individuals – private funds, common trusts, managed accounts, annuities, real estate investment trusts, and commodity pools – together held over $9 trillion in assets in the US in 2007.7 Most individuals cannot invest without services from others: advice, research, execution, etc. The US regulates such services, and regulates differently depending on the investment asset, and the number and nature of the services. The largest asset class for most US investors is real estate8 – their homes – yet investments in individual homes receive large federal tax subsidies and are largely unregulated.9 Investments in securities, by contrast, are regulated through disclosure and anti-fraud laws enforced by the SEC and other regulators and through supervision and regulation of the service-providers and their services (e.g., broker-dealers, investment advisers, bond indenture trustees, securities research and analysis, rating agencies, etc.). * This paper benefited from comments and conversations with Sandy Bieber, Chris Christian, Jack Cogan, Buddy Donahue, Susan Ervin, Tamar Frankel, Ron Gilson, Dan Halperin, Terri Hyde, Howell Jackson, Louis Kaplow, Keither Lawson, Si Lorne, Martin Lybecker, Karrie McMillan, Liz Osterman, Gary Palmer, Bill Paul, Deb Pege, Bob Plaze, Bob Pozen, Mark Ramseyer, Brian Reid, Eric Roiter, Hal Scott, Paul Stevens, Lynn Stout, Eric Talley, Peter Tufano, David Weisbach, and an anonymous referee. The paper also benefited from presentations and discussions at Harvard Law School, Northwestern Law School, and the Mutual Fund Directors Forum. I also thank Mike Doore, Brett Hartman, Ken Leung, Laura McIntyre, Joel Pulliam, and Jason Steinman for research assistance. The paper was requested by but has not yet been reviewed by the Committee on Capital Market Regulation. All errors are mine. 1 ICI 2008 Factbook at 70; Trends in Ownership of Mutual Funds 2007, available at www.ici.org/pdf/fm-v16n5.pdf, at 2. Mutual funds manage 23% of household financial assets, up from <3% in 1980. ICI 2008 Factbook at 8. 2 Trends in Ownership of Mutual Funds 2007, available at www.ici.org/pdf/fm-v16n5.pdf, at 4. 3 Trends in Ownership of Mutual Funds 2007, available at www.ici.org/pdf/fm-v16n5.pdf, at 1, 5. 4 ICI 2008 Factbook at 99. 5 www.ici.org/home/trends_10_08.html; ICI 2008 Factbook at 7. 6 See Board of Governors of the Federal Reserve System, Flow of Funds Data, reported at www.iii.org/financial2/savings/investments/. 7 See Fig. 3, at note 89 infra. Institutions also invest in mutual funds (~10% of mutual fund assets) and other collective investments, and some collective investments (e.g., securitizations) are marketed primarily to institutions. Such vehicles, and the role of institutional investors in collective investments, are beyond the scope of this report. 8 J. Campbell, Household Finance, 61 J. Fin. 1553 (2006) (Figure 2). 9 There is nothing comparable to the SEC or the federal securities laws regulating the sale of homes. State law does provide limited anti-fraud protection, limited mandatory disclosures, and regulation of estate brokerage services, and federal law does mandate certain disclosures for home financing, but not for the investment in the home itself. 2 Most individuals also cannot cost-effectively invest in unique investment portfolios, but invest collectively, in standard ways, pooling investments to achieve economies of scale. Collective investment in securities is (with limited exceptions) heavily regulated. Mutual funds, in particular, are governed by several federal laws;10 chief among them are: • The Investment Company Act of 1940 (ICA), the primary regulatory statute; and • The Internal Revenue Code (IRC), which creates strong tax incentives for regulated investment companies to diversify and distribute earnings annually. Regulation and oversight of mutual funds in the US has generally been good. Relative to other financial sectors, mutual funds have been tainted by few scandals – the hue and cry over late trading in 200111 is the exception12 that proves the rule. Governance of funds is generally better – with more oversight and better disclosure – than for other collective investments; fees charged by mutual funds compare favorably with those charged by competitors, including other US collective investments and foreign mutual funds;13 and regulatory costs for mutual funds compare favorably with those in some (but not all) developed countries. The rapid growth of “exchange-traded funds” shows US regulation is not so stringent as to choke off innovation in the industry. True, the current financial crisis has greatly eroded the value of mutual fund investments – but that has been true of every class of financial asset. Conventional funds marketed to retail investors had a relatively limited role in causing the current crisis, and has performed remarkably well compared to other financial sectors, which have either vanished (e.g., investment banks) or been severely impaired (e.g., banks). To date the only structural flaw exposed in the basic design of US fund regulation was that money market mutual funds (MMMFs) were permitted to invest in what historically had been 10 J. C. Coates IV & R. G. Hubbard, Competition in the Mutual Fund Industry: Evidence and Implications for Policy, 33 J. Corp. L. 151 (2007); T. Frankel & A. Schwing, The Regulation of Money Managers (2001 2d ed. & 2007 Supp.). 11 SEC Press Release 2003-136, SEC Chairman Donaldson Releases Statement Regarding Initiatives to Combat Late Trading and Market Timing of Mutual Funds, available at http://www.sec.gov/new/press/2003-136.htm (Oct. 9, 2003) (“staff is aggressively investigating . . . allegations [of] . . . late trading and market timing,” announcing staff consideration of new rules and rule amendments to prevent late trading abuses); SEC Office of Legislative Affairs, Summary of SEC Initiatives in Response to Scandal, (Mar. 1, 2004), available at www.americanbenefitscouncil.org/documents/ sec_mutual_fund_ initiatives.pdf (listing 11 rule-making responses). For investor reaction to these scandals, see S.J. Choi & M. Kahan, The Market Penalty for Mutual Fund Scandals, 87 B.U.L. Rev. 1021 (2007). 12 The scandals affected only a small portion of the US fund industry: the SEC established 26 Fair Funds with $3.3 billion to compensate investors, 0.05% of fund assets in 2001. See www.sec.gov/about/secpar/secpar2006.pdf at 23; Coates & Hubbard, supra note 10 at Table 1; ICI 2008 Factbook. That figure overstates the harm caused by mutual funds or their advisors: many Fair Funds received payments from individual investors, brokers, and hedge funds, and in several cases were larger than any plausible loss to affected mutual funds. Cf. L. Rapoport, Auction-Rate Crackdown Widens (July 25, 2008) (losses to investors in auction-rate securities estimated at $40 billion). The out-of-pocket cost to US taxpayers of the scandals was zero. Cf. National Commission on Financial Institution Reform, Recovery and Enforcement, Origins and Causes of the S&L Debacle: A Blueprint for Reform: A Report to the President and Congress of the United States (1993) at 44, 79 (cost of to taxpayers of S&L failures 1980-1988 estimated at $160 billion); D.M. Herszenhorn, A Mortgage Rescue Strains Calculations, N.Y. Times (July 23, 2008) (bailout of Fannie Mae and Freddie Mac expected to cost taxpayers $25 billion). 13 M. Kritzman, Who Charges More: Hedge Funds or Mutual Funds?, 20 J. App. Corp. Fin. 121 (2008) (showing that under plausible assumptions, hedge fund and mutual fund fees are comparable); A. Khorana, H. Servaes & P. Tufano, Mutual Fund Fees Around the World, __ Rev. of Fin. Stud. __ (forthcoming 2008) (Table 2) (reporting that US mutual fund fees are lower than fees in mutual fund fees in most other countries). 3 safe and liquid securities (e.g., commercial paper, short-term bonds) that turned out to have much greater liquidity risks than anyone had appreciated, leading the U.S. Treasury Department to create an emergency guaranty program for MMMFs. In retrospect, greater disclosure should have been required of MMMF sponsors that had maintained their share values only with the benefit of subsidies from affiliates, and greater oversight or regulatory reform for MMMFs may be required going forward. Still, even the few MMMFs that “broke the buck” and failed to maintain the traditional $1 price for their shares imposed relatively modest discounts – the largest such fund, the Reserve Primary Fund, repriced to $0.97 – and the emergency guaranty program stemmed an incipient “run” on MMMFs despite being available only for assets in place as of Sep. 19, 2008: MMMF assets actually increased in both September and October 2008.14 Thus, both historically and in the current crisis, US fund regulation has proven relatively successful. Nevertheless, as in other sectors of US capital markets, continued US competitiveness cannot be assured, and opportunities to enhance collective investment in the US exist. Current US tax law governing mutual funds, in particular, has a number of unfortunate economic effects, including the discouragement of saving and investment by middle class Americans, misallocation of capital to sectors such as real estate, and the essential walling-off of the US from competition from or with foreign mutual funds, in the US or overseas. Part I describes current US tax law and its negative effects, and suggests changes that would improve both the efficiency and fairness of the taxation of investments in US mutual funds, and enhance cross-border investment and competition. In addition, although much less important than US tax law, the current design and implementation of US securities law applicable to mutual funds is inhibiting innovation and growth in the fund sector, again with the effect of reducing investment. Part II reviews US regulation of collective investments, comparing regulation and data on the size and growth of US mutual funds with their major competitors, in the US and abroad. The review shows: (1) the US fund industry continues to be the world leader, but its growth and international competitiveness now lags that of its domestic and foreign competitors, primarily because of US tax law, (2) within the US, regulation of mutual funds is more extensive and restrictive than for other types of collective investments, (3) the structure of US regulation – mutual funds are tightly restricted by bright-line rules written into a statute nearly 70 years ago, subject to SEC exemptions – makes continued success of US mutual funds dependent on the resources, responsiveness, and flexibility of the SEC, (4) while the high-level formal framework for mutual funds in the EU is as or more restrictive and inflexible in most respects than the Investment Company Act, competitive pressures in the EU constrain supervisors in EU countries to be more 14 www.ici.org/home/trends_10_08.html. 4 flexible in adopting implementing regulations, and EU regulators (particularly in Ireland and Luxembourg) have greater resources and are more responsive than the SEC, which could achieve the same flexibility and responsiveness through exemptive orders but has been unwilling or unable to do so in a timely fashion. Part III describes potential improvements in US regulatory oversight of collective investments, including ways to enhance the flexibility and resources of US fund regulators, modifications of the existing ban on asymmetric advisor compensation and the exclusion of foreign funds, and unjustified disparities in the treatment of mutual funds and mutual fund substitutes. Together, the initiatives in Parts I and III should increase long-term investment and capital formation and reduce risk without reducing returns by expanding investor choice, increasing competition and encouraging diversification.15 I. US Taxation of Funds, Its Effects on Competition, and Potential Changes A. Current US Taxation of Mutual Funds and Its Effects US tax law has four sets of effects on US mutual funds investors. First, it taxes US mutual fund investors less favorably than those US investors who invest directly in securities or who invest in alternative collective investments, such as private funds, annuities, and common trusts. Second, it essentially prevents US funds from selling to foreign investors. Third, it essentially prevents foreign funds from selling to US investors. Fourth, it imposes crude, bright-line rule-of-thumb diversification tests that constrain fund investment flexibility and can force funds to liquidate positions, which, ironically, can increase the funds’ taxable distributions. Together, these tax effects undermine the competitiveness of US mutual funds relative to their domestic competitors, wall off US investors from the potential benefits of competition between US and foreign mutual funds, including efficient international diversification, and prevent US mutual funds from competing on a level playing field with foreign funds for foreign investors’ assets. 15 For evidence that direct investments can reduce investor returns or increase risk, see, e.g., B. Barber & T. Odean, Trading is Hazardous to Your Wealth, 55 J. Fin. 773-806 (2000) (individuals tend to trade too frequently, generating transaction costs, and frequency of trading is inversely correlated with net investment performance); T. Odean, Do Investors Trade Too Much?, 89 Am. Econ. Rev. 1279-1298 (2000) (individual investors trade more often than is optimal, incurring significant transaction costs and reducing net returns); T. Odean, Are Investors Reluctant to Realize Their Losses?, 53 J. Fin. 1775-98 (1998) (individual investors sell winners more frequently, and sell losers less frequently, than would be optimal); R. Dhar & N. Zhu, Up Close and Personal: An Individual Level Analysis of the Disposition Effect, 52 Mgt. Sci. 726 (2006) (tendency to sell winners more than losers stronger in non-professional investors with less wealth); V. Polkovnichenko, Household Portfolio Diversification: A Case For Rank-Dependent Preferences, 18 Rev. Fin. Stud. 1467–1502 (2005) (based on data from the Survey of Consumer Finances, reporting evidence of under-diversification among U.S. households); W. Goetzmann & A. Kumar, Equity Portfolio Diversification, Rev. Fin. (Forthcoming 2008) (individual investors’ equity portfolios are much less diversified than would be optimal in portfolio theory, that this is most pronounced among investors who are younger, low income, less educated, and less sophisticated, and that the least diversified earns 2.40% lower annual returns than the most diversified)(available at papers.ssrn.com/sol3/papers.cfm?abstract_id=627321). 5 ... - tailieumienphi.vn