Striking the regulatory balance
Since I became president of the European Fund and Asset Management Association (EFAMA) in 2002, I have found strong agreement within the fund industry that adherence to ethical standards and sound conduct of business rules is in our own interest. Investment managers have a particular fiduciary duty to act in the interest of clients. The industry - being aware of reputational risk and vulnerability to scandal - has by and large supported regulation of ‘fund governance’ – rules to assure that customer interests come first. The fund industry itself has also undertaken significant self-regulatory efforts. In France, Germany and Switzerland industry-driven codes of conduct play an important role as part of the regulatory framework.
I have perceived also a growing concern - if not impatience - among fund industry leaders about the direction that public discussions and regulatory efforts in the area of fund governance seem to take. For example:
q Too many proposals are coming from too many sides – global, European and national regulators, academics and the public. Though each idea may deserve careful discussion, if everything become reality we would end up with a barely manageable thicket of unconsolidated rules;
q Fund governance proposals have to provide investor protection. It can be difficult to object that they may not be appropriate to serve the intended purpose – it appears such arguments are not always appreciated.
One may ask, are these the complaints of an industry trying to avoid extra burden? I am convinced that the real concerns go deeper. Even those in the industry with high integrity and standards are increasingly unwilling to accept a flood of new governance rules where there is doubt that they really improve business standards or serve customer protection.
Let us be clear: there are some issues under discussion which actually show where the concerns are and why they have substance.
Independent directors: It is right that funds management has to be conducted in the interests of investors. Therefore conflicts of interest have to be managed accordingly. To ensure this, we have rules and standards in place, and to ensure compliance with these rules a review process has to take place – independent of the executive board, the shareholders and other interested parties. In some countries - particularly the US - independent directors are in charge of conducting this review. In European fund management I see a growing tendency to introduce the independent director concept – the EU Commissions’ recommendation on supervisory directors is just one indication. But shouldn’t we first clarify whether independent directors are the only and the most appropriate ‘tool’ to provide independent oversight? For me, the answer to both questions is “no”. We find across Europe different forms of independent oversight, eg, the depository, the trustee and the auditor. And independent directors are certainly not always the ideal way. In most countries we have contractual funds that are operated by a fund management company owned in most cases by financial institutions. According to general corporate governance principles, supervisory directors have to represent mainly the interest of the shareholder, leaving a limited role for independent directors. So depositories or auditors would probably be better suited to provide an independent review.
If this is plausible, why does the trend to introduce independent directors appear to be somewhat unstoppable?
Shareholder activism: Fund managers - as part of the fiduciary duty - have to make considered use of voting rights attached to the securities they hold. It appears, however, that there is a growing body of people with a vested interest pushing for an ever stronger role for fund managers as active shareholders – to undertake relentless efforts to improve corporate governance standards throughout the economy. The assumption is that fund manager activism is generally beneficial. The argument goes that such activity increases company value and hence investor returns: the investing institution’s fiduciary duty to its customers is thereby fulfilled.
Society is also supposed to benefit from the much healthier corporate sector. In reality this can go far beyond what is in the interests of investors. In his excellent analysis, Arjuna Sittampalam has recently pointed out that these premises are seriously flawed. Far from increasing returns, fund managers’ participation in corporate governance can actually put at risk the performance of clients’ portfolios. This happens when intervention displaces effective active fund management.
Excessive disclosures: There is an established belief that disclosure obligations will help market forces to work, and therefore are an appropriate regulatory tool for customer protection. The theory is that the more disclosure there is the better markets will work, as well as align the interests of fund managers and investors. I believe these assumptions must be challenged. Inappropriate disclosure rules will bring no additional effective transparency for investors, but rather encourage public discussion about the fund managers’ work and thus be the source of additional conflicts of interest (which in turn may give reason for additional rules). Disclosure requirements should concentrate on fund performance, risk and costs, although disclosure of business structures may not be helpful and may even have adverse effects on investors. For example:
q Fund managers should be called to disclose retrocessions they pay to distributors. However, this may increase the pressure coming from distributors to further increase the level of retrocessions and increase the total costs the customers finally have to pay;
q Fund managers should be called to disclose commissions paid for execution of securities transactions to brokers. However, there are no common standards for measuring and calculating these costs, and for parts of orders it may be not possible;
q Fund managers should be called to disclose in detail how they have exercised voting rights. This may lead to public discussions not helpful to using voting rights in the best interest of investors.
Of course there can be and should be standards for fee transparency, best execution and proxy voting. The point is that disclosure will not support such standards in all cases.
Extension of general corporate law: The EU Commission’s company law (and corporate governance) action plan has brought with it a number of instances where corporate forms of investment funds have been brought into the broader context of company law considerations, either resulting from the fund’s legal incorporation or due to a listing on a regulated market. There is little doubt that fund managers need protection from the full force of the various company law measures. The overarching principle is equal treatment of all CIS independent of their legal structure; therefore, full application of company law to funds is not a suitable way. EFAMA has just started to review the implications of forthcoming company law measures on CIS legislation and to engage European public authorities on appropriate adapted/specific considerations.
I believe the basis for some exaggerations in fund governance rules is that an investment fund is regarded as a kind of ‘venue’ where investors have come together to commission a manager to invest their money.
However, funds are competitive financial products. Concerns about the wave of governance rules are growing because financial products and providers are not always subject to comparable standards. And if funds are made less competitive by inappropriate regulation the unintended impact will be that investors are driven into less regulated vehicles.
It is necessary that the fund industry more clearly expresses these concerns. In the meantime, we should not desist in our support of good governance and sound regulation.
Wolfgang Mansfeld is president of the European Fund and Asset Management Association