Mutual Funds Scandals - Comparative Analysis of the Role of Corporate Governance in the Regulation of Collective Investments

89 Pages Posted: 11 Nov 2010

See all articles by Jerry W. Markham

Jerry W. Markham

Florida International University (FIU) - College of Law

Date Written: Fall 2006


The mutual fund market timing and late trading scandals initiated by New York Attorney General Eliot Spitzer in 2003 led to settlements from industry participants that totaled over $4.25 billion. However, Spitzer's actions were controversial and undercut the role of the Securities and Exchange Commission (“SEC”), which had been given pervasive regulatory authority over mutual funds by the Investment Company Act of 1940. The SEC had been embarrassed by earlier Spitzer prosecutions of financial analyst conflicts on Wall Street and by a spate of accounting scandals at Enron and elsewhere. The individuals and companies involved in those scandals had all been under the SEC's purview, but that agency did nothing to prevent or uncover those problems. Spitzer's actions against the mutual funds made the SEC look even more ineffective. In order to restore its tarnished image, the SEC imposed additional regulations on mutual funds, including a requirement that they increase the number of outside directors on their boards and split the role of chairman and chief executive officer.

The actions taken by the SEC were highly politicized, and critics noted that there was no empirical evidence that such a requirement would have prevented the mutual fund scandals or assured better performance results. Adding further embarrassment to the agency, those corporate governance rules were struck down twice by the District of Columbia Court of Appeals. An effort by the SEC to regulate hedge funds because of their role in the late trading and market timing scandals met the same fate. The SEC's proposals were, in all events, nothing more than face-saving gestures. There already existed a pervasive regulatory scheme for mutual funds under the Investment Company Act of 1940, including requirements for outside directors. However, those restrictions provided little or no protection to mutual fund shareholders, and adding more bells and whistles will not produce a better result. The corporate governance model for mutual funds simply failed. This raises the issue of whether other governance structures would be more effective in providing shareholder protection or would at least serve equally as well. Are mutual fund investors really shareholders in a traditional sense who need the protection of a board of directors and attending fiduciary duties? Alternatively, are they simply consumers who base their investment decisions on product price in the form of investment returns after expenses?

This article will examine the SEC's response to the late trading scandals and provide a comparative analysis of alternate mechanisms for regulating collective investments. The article first traces the growth and development of mutual funds and their regulation. This includes a description of the early history of investment companies, the development of the open-end mutual fund in the 1920s, the problems encountered by investment companies in that era and the regulation that followed under the Investment Company Act of 1940. The article next describes the late trading and market timing scandals and the SEC's response, as well as the role of hedge funds in those scandals. Alternative regulatory schemes for collective investments are then examined, including hedge funds, commodity pools, and common trust funds, collective investment funds for pensions, endowments and insurance company reserves. Some other alternative regulatory and market schemes are also considered, including unitary investment funds, unit investment trusts and trust indentures. None of the latter mediums provide shareholder status for the persons supplying the funds that are under management and some do not provide the protections of fiduciary duties. The article concludes that, alternative mechanisms, even those that do not have a board of directors, would serve equally as well as the current regulatory structure for mutual funds, which has proved to be overly costly, complex, and ineffective.

Keywords: Mutual funds, scandals, collective investments, Eliot Spitzer, Securities and Exchange Commission (SEC), Investment Company Act of 1940, corporate governance, hedge funds, shareholders, commodity pools, common trust funds, unit investment trusts, trust indentures.

Suggested Citation

Markham, Jerry W., Mutual Funds Scandals - Comparative Analysis of the Role of Corporate Governance in the Regulation of Collective Investments (Fall 2006). Hastings Business Law Journal, Vol. 3, No. 1, 2006, Florida International University Legal Studies Research Paper No. 10-55, Available at SSRN:

Jerry W. Markham (Contact Author)

Florida International University (FIU) - College of Law ( email )

11200 SW 8th St.
RDB Hall 1097
Miami, FL 33199
United States

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