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Geffen: Dodd-Frank and Mutual Funds: Approaches to Systemic Risk

In an post at the Harvard Law School Forum on Corporate Governance and Financial Regulation, David Geffen, Counsel at Dechert LLP, asserts that mutual funds played almost no role in the recent financial crisis, and that the regulatory scheme governing mutual funds has protected funds and their shareholders from many of the practices and risk taking behaviors of the firms that failed during the crisis.  He further suggests that the body of regulation that so well insulated the mutual fund industry should be scrutinized carefully before overlaying some of the sweeping financial reforms designed to address systematic risk, and curtail imprudent risk-taking.  

Registered investment companies and registered investment advisers (also referred to herein as “funds” and “advisers,” respectively) were minor players in the Credit Crisis. [1] Nevertheless, the Dodd-Frank Act contains several provisions, rulemaking directives, and required studies that could impact funds and their advisers. The Dodd-Frank Act defers many of its effects to future studies and regulations by federal regulators, which are directed under the Dodd-Frank Act to promulgate a variety of regulations in the six to 18 months following the Dodd-Frank Act’s enactment. [2] These studies and regulations have the potential to impact funds and their advisers significantly.

Today, it is impossible to predict what impacts the Dodd-Frank Act will have on funds and their advisers. However, it is not too early to set the agenda concerning the extent to which these studies and regulations should impact funds and their advisers. While there is no shortage of potential causes of the Credit Crisis, [3] funds and their advisers were largely unaffected by the crisis. Therefore, to determine how, if at all, funds and their advisers should be affected by forthcoming studies and regulations, it is first necessary to understand what differentiated funds from the financial institutions that did fail. It also is important to consider the regulatory regime that already applies to funds and their advisers before new regulations are added to the regime.

Geffen goes on to describe the excessive leverage and complexity that were the downfall of some large financial firms during the financial crisis, while differentiating mutual funds, and laying out how the Investment Company Act of 1940 curtails leverage and complexity of of funds.  He also describes other ways in which the 1940 Act curbs excessive risk-taking, addresses conflicts of interest, and ensures funds are operated in the best interests of their shareholders.  In particular, Geffen notes the vital role independent fund directors play in protecting shareholders:

To assure that a fund is managed in the interest of investors rather than a fund’s adviser, the ICA relies on a board of independent-minded directors. The ICA requires that at least 40 percent of a fund’s directors must be independent. The SEC has increased this percentage further through its rule-making powers such that, today, at least 50 percent of a fund’s board must be independent. In fact, almost all funds have boards with a majority of independent directors. In early 1999, the SEC held a “Roundtable” on the role of independent investment company directors. Arthur Levitt, then Chairman of the SEC, stated that the Roundtable was intended to discuss “the increasingly important role that independent directors play in protecting fund investors, and precisely how their effectiveness may be enhanced.”

In October 1999, in response to the recommendations made at the Roundtable, and after its own review, the SEC issued a release titled, Role of Independent Directors of Investment Companies, [29] along with a companion interpretive release. [30] Taken together, these two releases are intended “to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, [and] reinforce their independence….”

Given their nature and widespread use by retail and institutional investors alike, Mr. Geffen does give money market mutual funds some special attention.  In addressing the systematic risks posed by these funds, Mr. Geffen does not favor the structural changes to money market funds comtemplated by the SEC and the President's Working Group on Financial Markets.  Rather, he suggests a more modest approach may be more prudent, and less damaging to the money market fund industry.  His solution to the potential for widespread liquidity problems caused by "runs" on money market funds  is a temporary redemption fee authorized by a money market fund's board of directors during times of financial stress.  

An alternative interpretation is offered here. Rather than attributing the systemic risk engendered by money market funds susceptibility to runs to the structure of money market funds, the systemic risk could be deemed to arise from institutional shareholders, which can demand liquidity when money market instruments in which money market funds invest are experiencing a period of exceptional illiquidity.

The alternative suggested here is that, during a period of illiquidity, as declared by a money market fund’s board (or, alternatively, the SEC or another designated federal regulator), a money market fund may impose a redemption fee on a large share redemption approximately equal to the cost imposed by the redeeming shareholder and other redeeming shareholders on the money market fund’s remaining shareholders.

While money market funds' susceptibility to runs may create systematic risk, Geffen proposes that a simple mechanism, in concert witht the existing mutual fund regulatory scheme, would be more effective than sweeping structural changes.  

The full text of Geffen's article is available at: