The money management industry had become an outpost for scoundrels in the 1930s.
In the midst of the Great Depression, top executives at money management firms rigged special deals to favor themselves over their investors. Funds imposed performance fees in which management shared profits but not losses. Investment companies connived with the companies in which they invested.
"There was looting, embezzlement and self-dealing; and control of investment companies was a salable commodity," Tamar Frankel, a professor at Boston University Law School, wrote in 1978 in her four-volume work on mutual fund regulation, "The Regulation of Money Managers."
Sixty years ago this month, Sen. Robert Wagner of New York tried to put a stop to the thievery. Wagner introduced the legislation that would become the key federal law that governs the mutual fund industry - the Investment Company Act of 1940 - known among mutual fund lawyers as "the 40 Act" or "the Act."
Mutual fund industry lawyers, unhappy with Wagner's proposal, brokered a compromise with the SEC. Congress adopted the measure in August. Legal commentators at the time suggested that the industry could have killed the bill but instead worked for a compromise. In light of the history of the 1930s, it was a wise move.
"The industry wanted regulation to resurrect its reputation," Frankel said in an interview.
The mutual fund and closed-end fund industries now are known for their absence of scandal, a fact widely attributed to the existence of the 40 Act. But stopping bad practices is only half of the story.
On its 60th anniversary, the Investment Company Act remains relevant today not just for the troubling practices it prohibits, but for the change the law allows, according to industry lawyers, regulators and academics. In passing the 40 Act, Congress gave the SEC latitude to retrofit the law's rigid prohibitions to changing industry practices, a fact that has allowed the industry to grow while avoiding the widespread scandals of the 1930s, lawyers said.
Congress recognized that professional money management was a good business model and knew enough to prohibit poor practices without prescribing precisely what were good practices, said Joseph Franco, a professor at Suffolk University Law School in Boston.
"This was the goose that was going to lay the golden egg," Franco said of the investment management industry. "You didn't want to do anything to keep it from maturing."
The Act's primary purpose was to prohibit the sort of practices that had caused scandals in the 1930s, Alfred Jaretzki, Jr., a lawyer who helped draft the Act, wrote in a 1941 Washington University law review article. But, in more than 30 separate instances, the Act allows the SEC to issue orders that make exceptions to the Act's requirements, the SEC noted in a 1992 report on the state of mutual fund law. That flexibility was deliberate, Jaretzki wrote.
"Without these exemptive powers and without a wise exercise of discretion thereunder, the Act would be unworkable, unduly restrictive, and would cause unnecessary hardships," Jaretzki wrote.
The SEC, in its 1992 report, described section 6(c) of the Act as a leading example of an exemptive rule that has served investors and the industry well. The section permits the SEC to make exceptions to the Act so long as the exceptions are in the public interest and consistent with the protection of investors. Probably more than any other provision, it allowed the industry to evolve in ways Congress could not have anticipated in 1940, fund lawyers said.
"Somebody in his genius put in section 6(c), which meant the Act was flexible," said James Storey of Boston, a lawyer, fund director and writer on mutual fund law. "If the Act wasn't flexible, it would have been scrapped or amended."
One of the most important exercises of that discretion came on the issue of money market funds, according to industry lawyers. The Act made no provisions for money market funds because they did not exist in 1940. The first money market fund did not exist until 1972 and its unusual structure - a constant net asset value with varying yield - was unlike any fund that had come before it.
The SEC had to decide whether the money market fund was a mutual fund and, if so, how to regulate it. The eventual solution was permitting money market fund practices through exemptions allowed under section 6(c). Ultimately the SEC adopted a new rule governing how money market funds must work. The money market fund represented the leading example of the SEC's ability to use exemptions to keep up with industry changes, the SEC said in its 1992 report.
"If it weren't for a highly progressive view of regulation by the SEC, [the money market fund] never would have happened," said David Silver, president of the Investment Company Institute at the time the SEC was considering the money market fund proposal.
The importance of money market funds should not be underestimated. Fund lawyers who recall the 1960s and 1970s are unanimous in describing the money market fund as a key to the industry's success and evolution. The money market fund provided the lynchpin for the mutual fund complex because it allowed investors to keep their cash in a fund company and move it among a variety of investments all sponsored by the same firm, Silver said. It also provided the mutual fund industry with a popular product at a time when equities faced a bear market, lawyers said.
"The great development that really pushed the mutual fund industry was money market funds," said Jeremiah Bresnahan, a lawyer at Bingham Dana LLP of Boston, whose work on mutual fund issues dates back to the early 1960s at the SEC. "That's what really put the mutual fund industry on the map."
On its 60th anniversary, the staying power of the Act lies both in what it has prohibited and what it allowed, according to fund lawyers, regulators and academics.
"The whole thing is an amazing statute," said Alan Rosenblat, a lawyer in the Washington office of Dechert Price & Rhoads of Philadelphia and chief counsel at the SEC's Division of Investment Management from 1968 to 1976. "It's a remarkably effective and very complicated structure that works amazingly well."
