Investment Indiscipline: A Behavioral Approach to Mutual Fund Jurisprudence

Next Term, in Jones v. Harris, the Supreme Court will be called upon to resolve philosophical divergences on a massive, critical, yet academically slighted subject: the dysfunctional system through which almost one hundred million Americans attempt to save more than ten trillion dollars for their retirement. When this case was in the Seventh Circuit, two of the foremost theorists of law and economics, Chief Judge Frank Easterbrook and Judge Richard Posner, disagreed vociferously on competing analyses of the investment industry. The Supreme Court’s ruling will not only resolve the intricate fiduciary and doctrinal issues of this dispute but also have profound implications upon several major theoretical debates in contemporary American jurisprudence: the clash of classical versus behavioral economics; the judicial capacity to evaluate increasingly sophisticated econometric analyses of financial systems; and the determination of the legal constraints - if any - upon executive compensation decisions. In this Article, I advance a positive account of the economic and legal context of this dispute and then argue normatively for a behavioral approach to its resolution. Because of the unique structure and history of the personal investment industry in the United States, the architecture of this segment of the economy is singularly bereft of beneficial market forces and thus vulnerable to significant fiduciary distortions. The ultimate judicial resolution of this dispute should take full account of the behavioral constraints upon individual investors and their advisors to avoid nullifying a federal statute and to impose discipline in a vital segment of the U.S. economy

Compensating Power: An Analysis of Rents and Rewards in the Mutual Fund Industry

The allegations of malfeasance in the investment management industry - market timing, late trading, revenue sharing, and several others - involve a broad range of mutual fund operations. This Article seeks to explain the common source of these irregularities by focusing upon a trait they share: the practice of investment advisers\u27 capitalizing upon their managerial influence to increase assets under management in order to generate greater fees from those assets. This Article extends theories of executive compensation into the context of investment management to understand the extraction of rents by mutual fund advisers. Investment advisers, as collective groups of portfolio managers, interact with the boards of trustees of mutual funds in ways analogous to the dealings of business executives with corporate boards of directors. In this setting, the managerial power hypothesis of executive compensation provides a useful paradigm for understanding distortions in arm\u27s-length bargaining between investment advisers and fund boards, as well as limitations of the market\u27s ability to ensure optimal contracting between those parties

Breaking Bucks in Money Market Funds

This Article argues that the Securities and Exchange Commission’s first and most significant response to the economic crisis increases rather than decreases the likelihood of future failures in money market funds and the broader capital markets. In newly promulgated regulations addressing the breaking of the buck in the $3 trillion money market - a debacle at the fulcrum of the 2008 financial meltdown - the SEC endorses practices that obfuscate rather than illuminate the capital markets, including fixed pricing for money market funds, potentially riskier portfolio requirements, and the continued use of discredited ratings agencies. These policies, premised implicitly upon doubt in the ability of markets to process information effectively, obscure the true perils of money market funds. Rather than swaddling investment risks in misleading regulatory padding, the SEC should illuminate the possible menace of these funds. This Article offers transparent solutions to alleviate moral hazard and systemic risk in the broader market and to end the regulatory subsidy of these specific investments

One Hat Too Many? Investment Desegregation in Private Equity (symposium) (with M. Henderson)

The nature of private equity investing has changed significantly as two dynamics have evolved in recent years: portfolio companies have begun to experience serious financial distress, and general partners have started to diversify and desegregate their investment strategies. Both developments have led private equity shops - once exclusively interested in acquiring equity positions through leveraged buyouts - to invest in other tranches of the investment spectrum, most particularly public debt. By investing now in both private equity and public debt of the same issuer, general partners are generating a host of new conflicts of interest between themselves and their limited partners, between multiple general partners in the same consortia, and between private investors and public shareholders. In this essay, we identify and explore these various new tensions that have begun to arise in the private equity industry. We then propose and examine an array of possible ways to eliminate or alleviate those conflicts, exploring the regulatory, fiduciary, and pragmatic strengths and weaknesses of each approach. General partners can seek investor unanimity or consent for follow-on investments, but certain tax and practical barriers complicate that approach. Alternatively, they can opt for a range of architectural prophylaxes to protect against conflicts. These add costs on everyone, however, and, experience in related fields shows, they do not work. Investors, for their part, can attempt to diversify their own investment holdings to counterbalance risk, but this still leaves some vulnerable to opportunistic fund managers, and may increase costs for all investors as well. We propose a less costly and more efficient solution: advisers and investors should work together to create a vibrant secondary market for private equity interests to create a salutary exit option, which would in turn discipline the investment behavior of fund managers in this turbulent new investing environment

Football Most Foul

The 2006 FIFA World Cup was a disappointing display of soccer, comprising forgettable athletic contests that turned most critically on the administration of justice. Referees, more than athletes, emerged as the central protagonists in each game by providing the most dramatic plot twist - either by handing out red cards, which they did at a record pace, or awarding penalty kicks, which provided the winning goal in almost ten percent of the tournament\u27s games. For much of the viewing public, the footballers\u27 performances were even more deplorable, as players constantly flopped to the ground at minor or nonexistent contact and thrashed about in apparent agony. Of course, the power of the referees and the acting of the players are closely intertwined, as any system of human order that bestows sweeping authority on its magistrates invites perjury. This article explores the cynical state of World Cup soccer and examines a number of proposals to reduce the game-changing power of referees and the melodramatic chicanery it inspires. If the array of referees\u27 punishments and rewards can be adjusted, we might be able to increase players\u27 incentives to play a more beautiful game in future World Cup tournaments

Breaking Bucks in Money Market Funds

This Article argues that the Securities and Exchange Commission’s first and most significant response to the economic crisis increases rather than decreases the likelihood of future failures in money market funds and the broader capital markets. In newly promulgated regulations addressing the breaking of the buck in the $3 trillion money market - a debacle at the fulcrum of the 2008 financial meltdown - the SEC endorses practices that obfuscate rather than illuminate the capital markets, including fixed pricing for money market funds, potentially riskier portfolio requirements, and the continued use of discredited ratings agencies. These policies, premised implicitly upon doubt in the ability of markets to process information effectively, obscure the true perils of money market funds. Rather than swaddling investment risks in misleading regulatory padding, the SEC should illuminate the possible menace of these funds. This Article offers transparent solutions to alleviate moral hazard and systemic risk in the broader market and to end the regulatory subsidy of these specific investments

Breaking Bucks: SEC Regulation by Obfuscation

This Article argues that the Securities and Exchange Commission’s first and most significant response to the economic crisis profoundly contradicts widely accepted theoretical and regulatory approaches to financial oversight. More alarmingly, the SEC’s newest rules increase rather than decrease the likelihood of future failures in money market funds and the broader capital markets. Scholars – of both neoclassical and behavioral economic theory – have long insisted that transparency and disclosure play essential roles in ensuring efficient capital markets and sound financial regulation. Professors Gilson and Kraakman notably argued that the efficient capital market hypothesis, and its reliance on a market for information, “is now the context in which serious discussion of the regulation of financial markets takes place.” The SEC itself subscribes – at least publicly – to a corresponding regulatory framework: its mission statement declares that “[o]nly through the steady flow of timely, comprehensive, and accurate information can people make sound investment decisions.” Yet in newly promulgated regulations addressing the “breaking of the buck” in the $3-trillion money market – an unstudied debacle at the fulcrum of the 2008 financial meltdown – the SEC endorses practices that obfuscate rather than illuminate the capital markets, including fixed pricing for money market funds and the continued use of discredited ratings agencies. These policies, premised implicitly upon doubt in the ability of markets to process information effectively, obscure true perils of money market funds. Rather than swaddling investment risks in these misleading, self-sabotaging regulatory buffers, the SEC should emphasize the menace of these funds. This Article offers transparent solutions to alleviate moral hazard and systemic risk in the broader market and to end the regulatory subsidy of these specific investments

Federalism of Personal Finance: State & Federal Retirement Plans

In this Article, I consider possible approaches that attempt to improve the plans through which millions of Americans tend to their life savings. I begin by considering the inadequacies of our current system of defined contribution accounts and then address two possible alternatives: the first being a federal account universally available to Americans based largely on the model of the Thrift Savings Plan; the second being a system of statebased retirement accounts like those that have already been developed in a handful of states. Though I conclude that a single, federal plan would be superior, either alternative approach would be an improvement over our current system