Rules From 1940: Advising Investment Funds in a Modern Market

Kyle McEntee:

We're joined today by Abigail Hemnes, a partner who works with mutual funds and exchange-traded funds and companies that manage them. Let's start by defining some of the words I just used. So first, what are mutual funds and exchange-traded funds or ETFs as they're more commonly called?

Abigail Hemnes:

So, mutual funds and exchange-traded funds are funds that are registered with the Securities and Exchange Commission. They are registered under the Investment Company Act of 1940 and the Securities Act of 1933. Mutual funds are typically held by, if for example, you have a 401k or a retirement plan, your retirement plan will hold a mutual fund. And the mutual fund typically holds a diversified portfolio of assets, including securities like holding securities of Apple, Meta, NVIDIA, etc.., some debt securities from all over the world. Exchange-traded funds are very similar and they're traded on an exchange, hence their name. But they similarly have diversified portfolios of assets, including equity securities and debt securities.

Mutual funds and ETFs are very heavily regulated because they are available to retail shareholders like you and me because they are held by retirement plans and the government has a really vested interest in making sure that retail shareholders who are not as sophisticated as other shareholders are not taken advantage of, are not being charged excessive fees, are not being exposed to unnecessary risks and are able to access their money. So that's in a nutshell what mutual funds and ETFs are.

Kyle McEntee:

Nobody wants any self-dealing or misinformation.

Abigail Hemnes:

Certainly not. No.

Kyle McEntee:

So I think what's interesting about these funds and ETFs in particular is you see them on the ticker, but I think people don't recognize that they're actually companies themselves, even though they don't have employees. So, if they're companies, but they don't have employees, how are they getting work done?

Abigail Hemnes:

They are typically structured as business trusts, whether it's a Massachusetts business trust or a Delaware trust. The company itself, and I think it's a really important question, particularly for law students who are out there and just taking their first contracts class or first corporations class. So traditional corporate law deals with the company as like an - Apple or a Meta or a Staples - where they are offering widgets or they're offering a service.

That type of company has employees. They are creating something, whether they're creating a book, or whether they're offering a service. A mutual fund or an ETF is not creating widgets. In fact, what a mutual fund and an ETF does is it's a pool of cash and the pool of cash is invested. So, who is responsible for that and who does that? There are a number of different entities and people who provide services to that pool of cash.

There is an entity called the investment advisor that makes decisions about how to invest that cash, whether they want to invest it in Floor & Decor Inc. or whether they want to invest it in Home Depot, whether they want to invest it in China or whether they want to invest it in France. They also have a board of directors that's responsible for making sure that the money is invested appropriately in accordance with the fund's principal investment strategies. It's being managed appropriately.

The fees being charged to the fund are appropriate. And you have a lot of other service providers that provide services to make sure that that pool of money is being watched and maintained and closely guarded. So, there are no employees of the mutual fund, but there certainly are employees of the entities that provide services to the mutual fund and the ETF.

Kyle McEntee:

So you've been practicing in this world for I think about 16 years. How did you find your way to these highly regulated investment companies? I don't think it's the kind of thing that most people are thinking about before they go to law school or even in law school.

Abigail Hemnes:

I sort of came into it by happenstance. I always knew, I knew when I went to law school that I wanted to work at a law firm. And, I always knew that I was not going to be a litigator.

I don't have the mentality to be a litigator. I would crumble under that pressure. So I always knew that I wanted to go into corporate law.

I thought that I wanted to do corporate M&A work. That type of work always sounded sort of fun and exciting. You're closing deals. You're working on deals. There's a lot of money involved, that sort of thing. So that's what I thought I wanted to do.

When I was applying for summer associate positions, I applied to a number of firms, and the firm that I fit with the best was K&L Gates. So I joined K&L Gates as a summer associate in 2008, and the summer associate program at that time was very general. So you got to practice in all areas of law that the Boston office practiced, which at that time actually included trusts and estates, real estate, corporate, commercial litigation, asset management, of course.

So they had all of those practice areas available. And my very first project was for the asset management group, and I loved it. It was actually, the project was comparing different provisions in a variety of agreements.

So just basically making a really big chart and saying, in this agreement, this provision says this, and so on and so on. And just comparing them and seeing how they were different. And I loved it. And more importantly than loving what I did, what I quickly realized is that I really liked the people in the asset management group. The people were really great, but I also really liked the pace of the work, if you will. So, it became immediately apparent to me that unlike litigation or certainly corporate M&A, asset management tends not to have these peaks and valleys of work where you're billing crazy hours and up for weeks on end, and then you do nothing. Asset management tends to be very steadily busy all the time.

And that's a function of who our clients are. Our clients get to work at 8 or 9 in the morning, and they leave work at 5 or 6 at night. There doesn't tend to be, fortunately, because they are heavily regulated, a lot of emergencies in the mutual fund and ETF space.

There's a lot of work to be done, a lot of routine work to be done, a lot of really unique and interesting issues that come up. But it's very rare that there is a true, kind of - I need to stay up all night emergency. So, at the end of the summer, I decided that I wanted to be in the asset management group.

After I joined the firm, at K&L Gates, you get exposure to all of the different areas that asset management practices. And I very quickly started to specialize in registered funds, mutual funds, and ETFs. And that's because I personally have an affinity for rules-based practice.

I loved federal courts and civil procedure and evidence and criminal law because I loved the rules. I loved being able to follow those rules. And what I do right now is entirely governed by the 1940 Act and the rules there under.

Kyle McEntee:

I think the predictability is a really interesting point. And I did find it interesting you said that one of the reasons you didn't want to do litigation is that you feared you would crumble under pressure. But it's not like this isn't a job with a lot of pressure still.

So how do you see the pressure in your eyes distinguished between the different practice types?

Abigail Hemnes:

I've never practiced litigation, so I could have this conversation with a litigator and they could say, you're entirely wrong about this. But in my practice, I always have the ability to say to a client, to another partner, gosh, that's a really great question. You know I’ll say, I think this might be the answer, these are my initial reactions to it, but let me go back, let me do a little research, let me talk to some colleagues, and let me get back to you with my thoughts on that.

And I have found that is always the way that I do my best work is when I take a step back, have time to think about something, process something.

And I always had the impression that litigation was rapid fire questions that you must respond to immediately from a judge. And that could be entirely not true. And in fact, I know that there are many litigators in my law firm who don't do that.

Kyle McEntee:

I think they're going to make you come to their meetings and be like, Abigail, this is, where did you get this impression?

Abigail Hemnes:

I know. I know. I'm the type of person who I just do better when I have some time to think and some time to say, and the capacity to say, let me get back to you on that.

That does not mean that there's not pressure in my practice. And where the pressure comes from is juggling multiple different questions that all will need a little bit of time to think about, a little bit of time to research. And while they might not be the houses on fire type of emergencies, they are, you know, we need an answer by tomorrow type of emergencies.

And I need to figure out how to get all of them answered by then.

Kyle McEntee:

Well also the stakes are really high. As you said, your retail shareholders have these in their portfolios and their retirement funds. And something that adds an extra level of pressure here, because you know what happens if you screw up, it might sink a fund and that might really hurt someone's portfolio and their ability to retire and all the chaos that might ensue from that.

Abigail Hemnes:

Yeah. And I actually think that mentality is top of mind for every single one of my clients. That they are responsible for managing the money of, you know, Abigail Hemnes' retirement account, and this is money that I will depend on to live on when I retire, and they take that responsibility very, very, very seriously. And so, I think it's a really great point that all of the questions, that is underlying every single one of the questions that I get.

Kyle McEntee:

Is the news of the day, something you have to start your day with to make sure that you're ready for these conversations with clients or can foresee what the next set of conversations might look like?

Abigail Hemnes:

Yeah, it is. And it sort of filters down to me. And I definitely need to be aware of what's going on, because what is going on in the world can change the risk profile of a mutual fund or an ETF, a registered fund. And the way that can happen is right now, for example, there's conflicts in a number of places in the world and a number of places in the world that are very closely tied to energy and energy resources. So, if there is a mutual fund that invests in energy or that has exposure to a company that invests in energy, the risk profile of that fund is going to change. And we might get questions on how that impacts a fund, whether shareholders should be made aware through a disclosure document that, you know, first of all, if the risk profile has changed and if it has, whether that should be disclosed to shareholders. And I think that it's also the general economic outlook for the United States and for the world is something that the board of trustees of mutual funds and ETFs tend to be very focused on because they want to know that the people who are managing the money have a really deep understanding of what's going on in the global and domestic economy and are managing the fund appropriately.

Kyle McEntee:

So I'm going to ask you a few questions about risk here. Because I think some people might hear you talking about risk and think you are involved in trading where you're assessing, well for example, this is more risky than it was before, so now my role is to change the proportions within a fund. But that's not exactly what's happening. Can you distinguish your role from the trader's role or the person who is aggregating the purchases for that pile of cash you described?

Abigail Hemnes:

Yes. It goes to a number of different functions for a registered fund. The portfolio managers, the people who are responsible for managing the money, they have a very specific skill set.

So, for example, somebody, a portfolio manager who specializes in equity securities is gonna know all of the ins and outs of a particular type of company. So, recently I understand, again, I'm not a portfolio manager, but there's a lot of talk about Amazon Web Services, how that impacts the capital spend of Amazon and how much money Amazon is spending on AI and how they're spending money on AI and all of that impacts whether and how much that portfolio manager thinks should be invested in Amazon. There's that question.

The question that could come to me is whether or not a particular fund can invest in Amazon. And that would be, for example, if the fund was only permitted by its disclosure documents to invest, and I'm just making this up here, 10% of its assets in United States domestic companies, and they were already up to 10%, and then the answer would be no, you cannot invest more or even at all if you haven't in Amazon.

Kyle McEntee:

Or you have to sell maybe, right?

Abigail Hemnes:

Potentially, you might have to sell. Usually not, but you might have to. So that's where I would come in, whether there is an actual legal prohibition on purchasing that Amazon stock, whether or not it's a good idea to purchase the Amazon stock, is not something I have any knowledge of. But if you are legally permitted to purchase that is a question that I would answer.

And then, so seeing the answer to both of those questions, I say legally you can purchase it. And the portfolio manager, the investment advisor says, yeah, we definitely want to purchase it, we think it's a good investment decision to purchase it, we want to purchase this much of it. That then goes to a broker, and they'll say to the broker, I want you to purchase 100 shares of Amazon. And then the broker is responsible for purchasing those shares on the open market.

Kyle McEntee:

I feel like in the law, there's a lot of gray area. There's a lot of answers of: it depends. Is this more straightforward in terms of rule application, or is there also a lot of gray area here?

Abigail Hemnes:

There's a lot of gray area, as with everything. There's a lot of rules that also what we deal with are rules that were written in 1940, like just following the Great Depression. And they were written to try to prevent the abuses that happened, that led in some cases to the collapse of the economy. No shareholder protection, funds, investing in funds, investing in funds, that sort of thing.

But at the same time, the laws that were enacted in 1940 were enacted in a period of time when there wasn't the internet, when there wasn't AI, when there wasn't the ability to have virtual meetings. So, one of the tenets of the Investment Company Act is that a contract between a mutual fund and its investment advisor, the investment advisor is the entity that manages the money and decides which investments to make, has to be approved by a board of trustees at an in-person meeting at least once a year, two years after it's been approved.

And as you can imagine, certainly since the coronavirus period of time, many folks have wondered about the utility of that requirement, that those contracts be approved at a meeting held in person. And I think that the requirement is a good one. I mean, it says like, this is such an important contract. And it's so important that the board of trustees has an extremely good understanding and is very focused on what services are being provided and how much is being paid for them. And they have all the materials that they need to determine that the fees are appropriate for the services provided. That's why that requirement is there, because of how important that contract is.

But now, like you and I are talking right now, does it need to be there? So that's actually not a gray area, because the requirement is in person.

Kyle McEntee:

I was about to say, this doesn't sound like a gray area. Yeah, it sounds like something that they need to change the law. Not that there could be a different interpretation.

Abigail Hemnes:

That's actually one area where there's actually not a lot of gray area at all, except for there is, because around coronavirus, the SEC relaxed that requirement a little bit. So there was a little bit of a gray area after that, where people were like, well, are we really in coronavirus times? Do we really need to meet in person?

So that did create some gray area.

Kyle McEntee:

Well, what's interesting there is that seems like it might be administration dependent, because if the SEC is saying they're going to relax the requirement, really, they're saying, we're not going to enforce the law as it's written.

Are you having to then stay on top of the changing administrations and the political winds to make sure that the new interpretation doesn't change back?

Abigail Hemnes:

Absolutely. And that's a huge part of what we do. A huge part of what we do is the SEC has political appointees, they change with each administration, and the priorities of the SEC change based on the priorities of the administration.

I think the SEC tries very hard not to change its rules based on whichever administration is in place at the time. But there definitely are things that come out, things that change, priorities that change. For example, under the prior administration, the SEC was very focused on rulemaking and very focused on revising and making new rules to regulate the industry. Some examples include the climate rule, which was at the time was proposed and then adopted to regulate disclosures around climate from an operating company perspective.

Kyle McEntee:

So like, what's the impact of their decisions on climate and things that might impact climate change?

Abigail Hemnes:

And their product line. So what are your total emissions based on your product line? That sort of thing. And then, for investment companies specifically, there was a rule proposed around environmental social governance issues, and how you had to disclose how ESG considerations factored into decisions about whether to invest in a particular company.

That was very important. Those were important issues at that time. And those were important issues to that administration.

Those issues are not important, as important anyway to this administration. So those types of rules have been rescinded or withdrawn, proposed to be rescinded. And so it's absolutely the sort of thing that can change with an administration.

And a huge part of our job is staying on top of those changing winds.

Kyle McEntee:

So you're having a lot of conversations about these changing winds, about different desires that any of these funds want to have.

What happens next? Are you doing the research yourself? Are you handing the work over to your junior associates? How does that work for you these days now that you're a partner and you've been a partner for a little while?

Abigail Hemnes:

Yeah. So, I love working with junior associates. So typically what will happen is, I will get a question from a client. I will ask a more junior associate or a mid-level associate to work with a junior associate to do research into the particular question, into, you know, if there's been any SEC guidance on it, on that question. I'll ask them to see if anybody else in the industry has done something similar. So I will absolutely start with asking a junior associate to look into the issue.

And then I'll work with them on formulating the final advice that I send over to the client.

Kyle McEntee:

So, for this work to be helpful to you and to your clients, it's important to understand the root of the client's concerns.

How do you make sure that they actually understand that perspective?

Abigail Hemnes:

The junior associate? How does the junior associate understand?

Kyle McEntee:

Yes.

Abigail Hemnes:

So I think there's a couple things. There's an onus on me and on the associate. The onus is on me to provide that context because many of the clients I've been working with, I've been working with for a really long time, and so I will understand the business drivers behind a question that they're presenting to me. And in order for me to get the most helpful research and response from the junior associate or the mid-level associate, it's really important for me to provide that background. That being said, I'm not a perfect person. And sometimes I get very busy. And sometimes I will just send an email saying, hey, can you look into this question for me and let me know your thoughts. And in that situation, I really appreciate it when the junior associate or mid-level associate asks me. They say, these are my initial thoughts, but do you have a little bit more information on the background? Is this where this question is coming from? Because my thinking and my research might change depending on the genesis of the question.

Kyle McEntee:

What's the deliverable? Is it an email memo?

Abigail Hemnes:

Yeah. So, it depends on the context. I would say a majority of the time, I provide advice to clients in the form of an email. If they ask me a question, for example, I was dealing with a question about what a mutual fund should disclose in its registration statement. And I worked with an associate on coming up with an answer to that question. And I provided the answer in the form of an email.

And I said - this is the answer to your question, this is how I reached that answer, let me know if you want to discuss.

Other times, there's much more writing involved. And we are producing, for example, our memoranda to the board of trustees. And we'll be asked to do that by an investment advisor. For example, if they want to launch a new fund, the board of trustees has to approve the launch of that new fund. And so we will help them draft a memorandum to the board supporting the launch of that new fund. We also provide, sometimes again, to your point earlier, there are gray areas of the law.

And sometimes clients will ask us for an official legal opinion, providing sort of a well reasoned opinion about our conclusion that we have reached about that particular question of the law. And in that case, it'll be a very [SH1.1]formal legal opinion that has to go through our opinions committee, etc... So most of the time, it's email advice, but we also do lots of other things too.

Kyle McEntee:

I think people underestimate how much lawyers are just professional emailers at this point.

Abigail Hemnes:

I know. Again, this is different the more senior you get. So now I'm a partner.

Most of my day is spent emailing, whether I'm emailing advice or emailing to schedule meetings. When I was a junior associate, I spent more time writing memos and writing opinions. Now I email.

Kyle McEntee:

Do you miss that work?

Abigail Hemnes:

I do. I miss... When you're a junior associate, I think that...

And this is the natural trajectory of life in a law firm. As a junior associate, your only job is to learn the substance and to learn what we're practicing, to learn what the 1940 Act is and what the various sections of the 1940 Act are. And so you have the ability to really dive into those.

And I like that. I miss the opportunity to go down a rabbit hole of the Investment Company Act of 1940. Because as a junior associate, you have the ability to do that.

And when you get more senior, it's a lot more about managing a project because there's so many moving pieces or managing a client relationship, a lot of administrative work. So I do miss that work.

That being said, [SH2.1]one of the things that I love about what I do right now is I love building relationships. I love my clients. I love talking to my clients. So I really love that as I've gotten more senior, I'm able to lean into that much more.

Kyle McEntee:

It depends on the law firm, of course, but there's a distinction, rainmaking partners and service partners. And I don't really know that it's necessarily a super clean division. But how does that look for you in terms of building your book of business?

Abigail Hemnes:

This is a really interesting question, particularly for asset management at large law firms. Many large law firms that practice asset management have really large institutional clients that have been with the firm for a really long time.

I think that the concept of a rainmaker and a service partner in those contexts can be really blurred because it could be the case that a partner (and a number of the clients that I work on fall into this category) a partner who has long since retired brought in that client, and they would technically be like the rainmaker, I guess, who has brought in that client. But since then, there have been a series of partners who have taken over responsibility for that client relationship. So, in that context, I think that there is a blurred line between the rainmaker that's brought in those clients and the service partner who's servicing those clients.

Again, in those contexts, I tend to think of the partner who is managing that relationship as the rainmaker in that context and not necessarily a service partner.

Kyle McEntee:

Because they could still leave, right?

Abigail Hemnes:

Yeah. I mean, that relationship partner, whether they originally brought in the client or not, they would leave with that client. And I think that the other interesting aspect of asset management is that the clients tend to be very sticky, which is a lot of the clients that I work with, I've worked with for a really long time, and I have a really deep institutional knowledge of their business model, their products, what they like to see, their personalities, etc. And it's hard to move that relationship.

It would be hard for one of those clients to say, I'm going to give up all of that institutional knowledge to go to another law firm with really similar structure but no institutional knowledge.

That being said, there are a lot of non-institutional asset management clients out there. And these tend to be asset managers who are smaller, who are up and coming, who are really looking to get the best legal advice.

And so I think the rainmaker in that situation absolutely would be the attorney who's going out there bringing in those clients. And then the service partner would be the partner who is providing services to that client.

Kyle McEntee:

Do you feel like it's kind of outdated then to look at rainmaker versus service when you think of compensation? Because you mentioned the stickiness and the institutional knowledge. So that means that it's harder to take those clients with you, which means there's less incentive on the firm's part to compensate you for all the origination or all the fees generated.

Abigail Hemnes:

Yes. I think that the compensation model we have doesn't adequately address that concept. That concept of who is a real relationship partner, who's really responsible for that work, who could walk with that work, versus, who maybe knew somebody 30 years ago and so, brought in the client, opened the client matter, but now doesn't really know what's on with the client.

It's not to say that it's wrong, because I think there was a reason that compensation model was developed. But what I think is that it needs to be much more nuanced. And more nuanced, I think, means harder.

It's easy to have these clear lines between origination, non-origination, and that sort of thing. It's much more difficult for folks who are in management positions to make the quote-unquote right decision about compensation when they take a more nuanced approach.

Kyle McEntee:

I want to go back to your initial summer. Because I think the timing is really interesting, given your practice area and the fact that you stuck with it.

You summered in 2008. Later, Lehman collapses. The big law world freaks out. I just started law school in August 2008. This is all collapsing around me at the time.

So I'm curious to know, did watching the fallout of that impact your interest in any way?

Abigail Hemnes:

So, it's such an interesting time. For a long time, I think that the fact that I went through that gives me a lot of perspective, actually. Right now, we're going through a more challenging economic period. And I think that can be helpful sometimes to give people perspective.

So I was a summer associate in 2008. And I received my offer to join the firm as a first-year associate a couple of days after the market crashed.

And I very quickly accepted that offer. I say that jokingly. But the reality is, is that I was so fortunate to have that job. Because from a law student perspective, I graduated in 2009. And my start date was deferred to January of 2010 because of the market crash. And all law firms were doing it. But many of the students that I graduated with who were extremely smart and more than capable weren't able to find jobs because of the market. So that was one way that I experienced the market crash is that I felt so fortunate to have a job. Inside the law firm, particularly in asset management where we deal with, I now don't, but we deal with private funds, hedge funds, etc. What was interesting is that the work slowed down significantly in 2009 for associates.

And my understanding of that period is that a lot of the questions that we were getting from our clients were questions that could really only be answered at the partner level. They were so complex. It didn't even translate into a question that an associate could help with.

One of the senior partners that I work with remembers 2009 as being extraordinarily busy for him. Associates remember it as being extremely slow.

And then when I joined in January of 2010, the financial markets were starting to come back. So when I joined, I was really, really busy. So I look back on that period with a huge amount of feeling very fortunate because I know that for associates in 2009 at large law firms and for folks that I graduated with, it was really hard. In addition to the broader economy in general, the whole country was suffering. So I look back on that period with an extreme amount of just gratitude for what I had.

Kyle McEntee:

Do you think it had anything to do with you sticking with it and not trying out some other practices?

Abigail Hemnes:

I mean, it's actually a great point. I think corporate was really busy after that. I don't know about litigation so much, but I am very fortunate.

I started off by saying that one of the reasons I love asset management is that we were pretty busy when the market started picking back up. And so the reason that I chose asset management really paid off for me in that respect.