Legal Research On The Conflict Of Interest Of Securities Investment Fund

The growth of securities investment fund, as an aggregated investment of such a mechanism based upon sharing of interest and risk, has made it an indispensable investment tool for financial markets, domestically and internationally, and has found itself playing an ever-growing role in the securities markets. Nevertheless, there is much concern about how to effectively protect the interest of fund investors ever since the birth of securities invested fund. Such scandals related to securities investment fund in China of 2000 and such in the United States in 2003 have triggered more thoughts on the protection of investors by theorists and practitioners. Behaviors causing or resulting in damage to the interest of fund investors are always found related to conflict of interest and the inconsistency of interest are generally the warm-bed of the above-mentioned events. Therefore, the interest of parties related to fund, the relationship between such parties and how the interest conflict with each other will be such issues, an in-depth research of which may lead to how to resolve the conflict of interest in connection with fund more effectively from legal perspective. Law is a tool to solve the inconsistency and conflict of interests. It is an either theoretical or practical legal issue to scheme out effective legal mechanisms based on the characteristics of conflict of interest in fund market to prevent unfair behaviors of conflict of interest and to provide a working legal framework for the resolution of conflict of interest among parties related to securities investment fund. This article attempts to analyze the above issues systematically from a theoretical perspective and to study the conflict of interest related to securities investment fund and regulation by laws. This article is composed of eight parts, and its structure and main contents are as follows:Introductory Notes: briefly introduce the background and significance of the topics of this article, research of securities investment fund domestically and internationally and the methodology adopted in the article, and summarize the contents of this article.Chapter 1: Fundamental Legal Analysis of Securities Invested Fund. The term of reference, concepts, forms and organizations and mechanism of securities investment funds vary in different countries for the difference between history and legal environments. From a formal perspective, a securities investment fund generally takes a form of aggregated investment and is managed by professionals with its main business as securities investment. From the perspective of Transaction Cost and Enterprises Theory of Ronald Coase, securities investment funds is a systematic arrangement of"inter-firm organization", a regulatory structure established upon the mutual-penetration of two market allocation mechanisms: enterprise and market, and a relatively static credit-based contractual arrangement established among market subjects for the purpose of cooperation. The system of trust, with its history of development and based upon the equity law, has become a fundamental legal system of securities investment funds, for its unique function of property aggregation and standard clauses, its conforming with the systematical needs of"inter-firm organization", and its function of reducing transaction cost in the capital markets and property management. There are mainly three parties to securities invested fund: the manager, the custodian and the fund holder. The legal relationships among such three parties may vary under the corporate fund and the trust fund, and for trust fund, different countries may have different structures.Chapter 2: The Fundamental Analysis of Conflict of Interest of Securities Investment Funds. This part analyzes the concepts, characteristics, subjects, generalization and major forms of conflict of interest of funds. Conflict of interest is the dispute and contest of interest among interested parties for difference of interests. Institutional Ecumenists propose that optimization of self-interest or self-utility is a fundamental motive of individuals, and an individual will, by its light of nature, optimize its choice according to its calculation of cost and benefit, where various goals conflict with each other. Conflict of interest is also an important concept under the Anglo-American equity law, and is closely connected with the trust law system. Among the legal relationship of securities investment funds, the existence of individual interest may place the individuals in such positions that their interests conflict with each other, and may harm the interest of the fund holders. The conflict of interest in securities investment funds are generally found diversified, complicated and concealed. The major conflict is between the fund management company and the fund holders, which is the essential issue to solve other conflicts. The parties to conflict of interest are interested parties, and the factors of"control"or"material influence"are the standards for deciding whether a party is an interest party. In the legal relationships of securities investment funds, investors, managers, custodians, commission agents and related natural persons are associated with each other, directly or indirectly through trust, ownership, agency, employment and etc. Such associated relationships lead to the possibility of conflict of interest, and are, by themselves, channels of transfer of interest. It is a complicated and difficult job to identify interested parties, and thereby the identification of interested parties reflects the scope and depth of regulation of conflict of interest in securities investment funds of a country. Why conflicts of interest come into being? The Neo-Institutional Economics provides some strong theoretical support to the existence of conflict of interest in securities investment funds: entrustment-agent relationship is the root of conflict of interest; the"long-term"and"imperfection"of fund contracts are the prerequisite of conflict of interest, while the break-away of residual right of control and residual claim provides sufficient condition. There are plentiful forms of conflict of interest in securities investment funds, which may be categorized into three types: a. conflict of interest resulting from transfer of residual revenue among interested parties; b. conflict of interest arising from insufficient incentive of managers to generate revenue; c. conflict of interest caused by decrease of quality of residual revenue by managers.Chapter 3: Theoretical Analysis of Legal Regulation of Conflict of Interest of Funds. This part makes theoretical analysis of legal regulation of conflict of interest of funds from the law-economics approach, the focus of which is upon the establishment of fiduciary duty and the regulation of conflict of interest in securities investment funds. The Coase Theory has provided us a fundamental objective and path of legal regulation, according to which the significance of legal regulation in such respect is how to find and stabilize in legal form a systematic arrangement and mechanism to minimize the transaction cost. Kaldor-Hicks Principles may replace Pareto Efficiency as the standard to measure the regulatory methods of conflict of interest, and such law-economic approach as Posner Theorem, Externality and Internalization of External Cost and Benefit, Game Theory Analysis Model and Path Dependence Theory are also of assistance in such analysis. The duty of fiduciary, which includes the duty of faithfulness and the duty of care, has its root in the equity law which focuses on the utmost interest of beneficiaries, and enables to solve the maze of entrustment-agency and conflict of interest (such as imperfection of contracts and information asymmetry). One may not find the concept of fiduciary duty in the continental legal system, however, the most corresponding concept therein is the principle of good faith. As most efforts being made on the build-up of the all-embracing tower of code in the modern civil law system and the judges being deprived of their right of discretion, the principle of good faith has never grown into a florid garden as the duty of fiduciary, and thus the civil law countries has, by degrees, introduced the concept of fiduciary duty into their system of trust law and funds law. There is lack of equity and case law tradition in China, and the absence of legal fundamental, structure and rules of fiduciary duty of trustees has led to various problems in such industry of trust and funds management without the support of equity law. The current necessity is to adopt the obligation of faithfulness and the standard of prudent investors which have been widely used in England and the United States, to set up behavior standards of the duty of fiduciary of trustees, and to establish a credible system of funds management.Chapter 4: Arrangement of Funds Governance Structure and Regulation of Conflict of Interest. This part analyzes, in details, the structural arrangement of internal governance of funds. Arrangement of funds governance structure is to set up a check-and-balance system to provide necessary incentives for and constrains over the behaviors of the parties to the funds, to reduce the cost and risks of agency and to prevent the deviation of interest. The pros of regulation of funds governance is that it may internalize the externality and make the parties reach the Kaldor-Hicks Standard during the internal game. It may further reduce the regulatory cost and prevent inaccuracy caused by interference from third parties. The difference of the legal forms and operation of funds will make significant effect upon the result of regulation. The right of redemption of investors of open-end funds may positively prevent the behaviors of conflict of interest. The funds trusteeship is a unique structural arrangement for funds, which may effectively avoid the risks of conflict of interest through checking and balancing by trustees. The assembly of fund holders has not turned into a commonly adopted tool to regulate conflict of interest for its cost which resulting in"ration apathy","free-riders"and the replacement of"vote by hand"by"vote by feet", though it may play such a role of administering the fiduciary duty of fund managers and is, to some extent, more conforming with the principles of trust law. The board of directors and independent director in a corporate fund represent the interest of fund holders and protect their rights, thus many countries are attempting to introduce the system of board of directors and independent directors to enhance the check and balance, though the traditional structure of trust funds do not have boards of directors. Such regulatory methods of fund trustees, assembly of trust holders, board of directors and independent director each has its own pros and cons, and requires further improvement.Chapter 5: State Interference-The External Regulation of Conflict of Interest of Funds. This part mainly analyzes certain methods of external regulation of conflict of interest of funds. As the typical entrustment-agency relationship between the investors and managers of securities investment funds makes the investors in a weaker position, it is essential to soften the information asymmetry between the investors and fund managers by the state, which plays as a"visible hand", and to place necessary regulation over the behaviors of fund managers. Fund governance also requires support from external power. The simplest way to prevent the adverse effect of conflict of interest is to bar conflict of interest, which is also the most severe one. However, law may not bar the occurrence of all conflicts of interest. Laws of different countries do not forbid every form of conflict of interest, but will inhibit certain severe conflict of interest the harm of which exceeds the benefit, and will, in most case, combine the legal and administrative tools together, with the ban by law as general principles and administrative exemption as exception. Because of the complexity and invisibleness of conflict of interest and the polytropy of the securities markets, the needs to observe and measure the performance of fiduciary duties by fund manager give birth to procedural administration of internal control. The procedural administration of internal control requires fund managers to establish procedures preventing and resolving the problems of conflict of interest in funds, and to administer its execution. However, there are many detriments of the administration mechanism, and there has been increasing calls for deregulation of the financial markets and enhancement of self-regulation. The combination of government administration and self-regulation has become the recent trend of securities markets administration of various countries. China has the tradition of"a strong government and a weak public", with its unitary and mechanical administration regulation and weak self-regulation system. Self-regulation in China does not work effectively and it is necessary to carry out the institutional improvement and the systematic reform. Information disclosure is of importance in protecting the interests of investors of the securities markets, and the government may require compulsory disclosure of information that may cause trading of conflict of interest by management of funds by law, so that the investors may thereby determine wither the management has engaged in behaviors violating the duty of fiduciary. The information disclosure of conflict of interest of funds of China is not as mature as those developed countries such as the United States, and requires further improvement. A sound system of judicial remedy would be enough of a threat to the injurious acts of conflict of interest, however, there has not been any case in China on the ground of conflict of interest in funds. The well-developed civil procedure system of the United States has led to numerous cases in this respect, and such system as the evidence support of SEC, aillicus curiae and the alternative dispute resolution may be models for China to improve its funds litigation system.Chapter 6: The Analysis of Forms of Conflict of Interest in Funds and Its Legal Regulation. This part analyzes some typical forms of conflict of interest in real practice so as to add our understanding of the conflict of interest in funds and its regulation. This part includes: treating the conflict of interest occurred fairly, conflict of interest trading, conflict of interest acts in fund investment, conflict of interest of proxy rights of fund managers, conflict of interest of compensation, conflict of interest in individual trading.Conclusion: This part summarizes the article's key points and main contents. The article is primarily dedicated to following exploring researches:(1) Discussing the forms of securities investment fund's"inter-firm organization"and the institutional functions of trust by using the transaction cost and enterprise theory of Neo-Institutional Economics, to support the legal natures of trust fund.(2) Explaining the generation of securities investment fund's conflict of interest by using"entrustment-agent","long-term contract","imperfect contract","the breakaway of residual right of control and residual claim"and other Neo-Institutional Economics theories, analyzing factors such as the concept, the subject characteristics, and the forms of the securities investment fund's conflict of interest.(3) Systematically analyzing and explaining the objectives and approaches of legal regulation on securities investment fund's conflict of interest from the perspective of Law-Economics theory, discussing the functions and effects of fiduciary duty in details.(4) Analyzing various legal regulations on securities investment fund's conflict of interest, and their cons/pros internally and externally, proposing own views of how the securities investment fund industry of China may make use of and further improve such methods.(5) Analyzing typical forms of conflict of interest in real practice based on the above theoretical analysis.However, due to the limits of the author's theoretical accomplishment and experience, there must be the limitations in this article. For example, the combination of methodologies of general legal research and economic-law research is insufficient, more modern Law-Economics analyzing tools could be used in the article; Information collection and preparation could be more sufficient, Empirical analysis could be more affluent.