Financial Services Alert - August 30, 2011

The U.S. District Court for the Northern District of California (the “District Court”) (Judge Koh presiding) issued an order (the “Order”) that dismissed with prejudice the final remaining claims in an investor class action suit against a bond index fund (the “Fund”), its trustees, the Fund’s adviser (the “Adviser”) and related entities, alleging losses incurred as a result of investments in mortgage-related securities that were inconsistent with the Fund’s investment objective and violated its industry concentration policy.  This suit, which was filed by a financial advisor that had invested its clients’ assets in the Fund, had already been the subject of a series of decisions addressing the sufficiency of its claims.

Prior Decisions.  In its initial complaint, the plaintiff alleged violations of Section 13(a) of the Investment Company Act of 1940 (the “1940 Act”), breach of fiduciary duty, breach of contract based on representations contained in the Fund’s registration statement and other filings, breach of the covenant of good faith and fair dealing, and a breach of contract claim based on third party beneficiary status under the Fund’s investment advisory agreement with the Adviser (the “Advisory Agreement”).  Ruling on a motion to dismiss the complaint, the District Court (Judge Illston presiding) found that there was an implied private right of action under Section 13(a) of the 1940 Act.  In relevant part, Section 13(a) prohibits a registered investment company from deviating from certain investment policies absent shareholder approval, among those policies being (1) a fund’s policy regarding industry concentration recited in the fund’s registration statement and (2) any policy designated as fundamental in the fund’s registration statement, which in the Fund’s case included its investment objective of tracking a designated bond index.  (This 2009 decision by the District Court is discussed in greater detail in the March 10, 2009 Financial Services Alert.)  The defendants were allowed to appeal this decision to the U.S. Court of Appeals for the Ninth Circuit (the “Ninth Circuit”).  In 2010, the Ninth Circuit reversed the District Court and held that the SEC alone may enforce Section 13(a) of the 1940 Act.  The Ninth Circuit remanded the case to the District Court with instructions to dismiss the plaintiff’s federal law claims.  (The Ninth Circuit’s decision was discussed in greater detail in the August 17, 2010 Financial Services Alert.)

Following the Ninth Circuit’s decision, the plaintiff amended its complaint to remove the Section 13(a) claim and asserted claims of breach of fiduciary duty (against all defendants), breach of contract (against the Fund), breach of the covenant of good faith and fair dealing (against the Fund and the Adviser), and a claim as third party beneficiary for damages arising out of a breach of the Advisory Agreement (against the Adviser).  In March 2011, the District Court (Judge Koh presiding) issued an order holding that (1) Plaintiff’s claims were precluded by the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) because they were covered class action claims based on state law that alleged a misrepresentation or omission of a material fact in connection with the purchase or sale of security subject to SLUSA.  The District Court did, however, allow that the breach of fiduciary duty claim would not be subject to SLUSA preclusion if it fell within SLUSA’s so-called “Delaware carve-out” for a claim based on the statutory or common law of the state where the issuer is organized – in the Fund’s case, Massachusetts, the Fund being a series of a Massachusetts business trust.  The District Court granted leave to amend the complaint to allege the breach of fiduciary duty and third party beneficiary claims without triggering SLUSA preclusion.  (This District Court decision was discussed in greater detail in the March 15, 2011 Financial Services Alert.)  In response to the March 2011 decision, the plaintiff filed an amended complaint asserting (a) breach of fiduciary duty against the Trustees and the Fund; (b) breach of fiduciary duty against the Adviser; (c) aiding and abetting a breach of fiduciary duty against the Trustees and against the Adviser; and (d) as third party beneficiary of the Advisory Agreement, breach of contract against the Adviser.

Fiduciary Duty Claim.  The District Court found that the plaintiff had failed to successfully allege a breach of any duty owed by the defendants directly to Fund investors.  The Court observed that the damages asserted to have resulted from the defendants’ breach of fiduciary duty were a diminution in value of the Fund’s shares.  Citing Lapidus v. Hecht , 232 F.3d 679,683 (9th Cir. 2000), among other decisions, the District Court held that that diminution-in-value claims alleged by mutual fund shareholders are derivative under Massachusetts law, and therefore, the plaintiff’s fiduciary duty claims against the defendants had to be asserted derivatively.

Noting that since July 1, 2004 Massachusetts law has required that written demand be made before a derivative suit may be brought, and that unlike other states, Massachusetts provides no exception (such as futility of demand) to this requirement, the District Court concluded that, having already brought suit without making a written demand, the plaintiff could not cure the deficiency in its claim by amendment.  Accordingly, the District Court dismissed the plaintiff’s breach of fiduciary duty claims with prejudice.  Citing the lack of an underlying primary claim for breach of fiduciary duty, the District Court also dismissed with prejudice the plaintiff’s claims for aiding and abetting a breach of fiduciary duty.

Dismissal of Third Party Beneficiary of the Investment Adviser Agreement.  The Court rejected plaintiff’s argument that the investor class was entitled as third party beneficiaries of the Advisory Agreement to damages from the Adviser’s breach of the Advisory Agreement alleged to have resulted from its direction of investments in mortgage-related securities inconsistent with the Fund’s investment objective and concentration policy.  The District Court stated that under California law a contract must be clear in its intention to benefit a third party in order for that party to have beneficiary status, noting that the third party need not be named or identified individually to be an express beneficiary, if it was a member of a class identified as the subject of such an intention.  The District Court observed that it was undisputed that the Advisory Agreement did not mention Fund investors, and found that references in the Advisory Agreement to the Fund did “not equate to referencing a class of beneficiaries to which the Fund investors belong.”  The District Court went on to comment that “a finding that [Fund] investors enjoy third-party beneficiary status to enforce this contract would mean that investors could enforce any third-party contracts if the execution of such contracts affected the value of the Fund. This rule would be overbroad, likely encompassing employment agreements between the [Adviser] and its employees.”  On that basis, the District Court dismissed the plaintiff’s breach of contract claims based on third party beneficiary status under the Advisory Agreement with prejudice.

The SEC announced that at its open meeting on August 31, 2011 it plans to consider the following agenda items: (1) issuing a concept release and requesting public comment on issues under the Investment Company Act of 1940 raised by the use of derivatives by registered investment companies; (2) issuing an advance notice of proposed rulemaking to solicit public comment on possible amendments to Rule 3a-7 under the Investment Company Act, which excludes from the definition of investment company issuers of asset‑backed securities that meet certain conditions; and (3) issuing a concept release to solicit public comment on interpretive issues related to the status under the Investment Company Act of companies that are engaged in the business of acquiring mortgages and mortgage-related instruments.

The CFTC published final rules to implement its whistleblower program.  As it did for the SEC (see the May 31, 2011 Financial Services Alert for a discussion of the SEC’s whistleblower program), the Dodd-Frank Act established a whistleblower program that requires the CFTC to pay an award, subject to certain limitations and conditions, to an eligible whistleblower who voluntarily provides the CFTC with original information about a violation of the Commodity Exchange Act (the “CEA”) that leads to the successful enforcement of a covered judicial or administrative action, or a related action.  The Dodd‑Frank Act also prohibits retaliation by employers against individuals who provide the CFTC with information about possible CEA violations.  The final rules (a) define certain terms critical to the operation of the CFTC’s whistleblower program, including what persons are eligible to make claims, (b) adopt the forms and procedures for filing a whistleblower claim, (c) detail the standards that the CFTC will use to decide whether to make an award, and in what amount, (d) establish a process for appealing award determinations and (e) provide guidance on the Dodd-Frank Act’s anti-retaliation provisions.  To a large extent, the CFTC’s whistleblower rules resemble the SEC’s although there are differences in a number of areas.  The CFTC’s final rules become effective October 24, 2011.