Alert March 10, 2009

US District Court Finds Private Right of Action under Section 13(a) of 1940 Act in Ruling on Motion to Dismiss Shareholder Suit Alleging Index Fund’s Investments in Non-Agency CMOs Violated Fund’s Investment Objective and Concentration Policies

The US District Court for the Northern District of California (the “Court”) granted in part a motion to dismiss a complaint filed by a registered investment advisor (the “Adviser”) on behalf of all persons who owned shares of a bond market index fund (the “Fund”) against the Fund and the Fund’s sponsor and related entities, but gave the Adviser leave to amend the complaint to address the shortcomings in its pleadings found by the Court.  The Adviser had invested its clients’ assets in the Fund.  The complaint alleged that the defendants violated Section 13(a) of the Investment Company Act of 1940 as amended (the “1940 Act”), by failing to follow the Fund’s investment objective of tracking a specified broad bond market index that includes investment grade government, corporate, mortgage-, commercial mortgage- and asset‑backed bonds with maturities greater than one year (the “Index”) by investing in high-risk, non-US agency collateralized mortgage obligations (“CMOs”) that were not part of the Index and entailed a substantially greater risk than the Index.  The Complaint also alleged that the Fund violated Section 13(a) by improperly changing its concentration policy of investing no more than 25% in any industry so that the Fund could invest more than 25% of its total assets in US agency and non-agency mortgage-backed securities.  The plaintiff claimed that Fund shareholders suffered losses when there was a sustained decline in the value of non-agency mortgage-backed securities and that the Fund would not have sustained these losses had the Fund complied with its investment objective and concentration policy, noting that during the period September 4, 2007 through August 27, 2008 the Fund incurred a negative total return of 1.09% as compared to the Index’s positive return of 5.92%.

Standing.  The defendants contended that the Adviser lacked standing to bring the suit because the Adviser had only purchased shares for its clients, not for itself.  The defendants cited a 2008 Second Circuit decision holding that an investment adviser acting as attorney-in-fact for its clients lacked standing to bring a claim on its clients’ behalf against a fund in which it had invested client assets.  (See the December 9, 2008 Alert) for a discussion of the Second Circuit decision.)  Noting that the Adviser never actually owned shares of the Fund, and did not qualify for any of the prudential exceptions to the third-party standing rules, the Court granted the motion to dismiss.  The Court, however, granted the Adviser leave to amend the complaint, noting that the Adviser could cure this deficiency by revising the complaint to include the fact that one of its clients had assigned the client’s claims to the Adviser.  The Court also observed that the Adviser could have standing if it alleged that Fund losses resulting from the improper investments caused the Adviser to lose advisory fee income because its clients’ Fund holdings, the value of which served as the basis for the Adviser’s fee, declined in value.

Implied Private Right of Action under Section 13(a).  The Adviser alleged that by deviating from the Fund’s investment objective of tracking the Index and its policy of limiting investments in any one industry to no more than 25% assets, the defendants had violated Section 13(a) of the 1940 Act, which in relevant part prohibits a registered investment company from deviating from certain investment policies absent shareholder approval.  Among the policies subject to this condition, which are generally referred to as fundamental policies, are a registered investment company’s concentration policy and any policy designated in its prospectus as fundamental in its registration statement filed with the SEC, which in the Fund’s case included its investment objective. 

The Court noted that Section 13(a) does not expressly provide for a private remedy, but proceeded to find an implied private right of action under Section 13(a) based on Congress’ enactment of an amendment to Section 13 in 2007.  The 2007 amendment added Section 13(c), which prohibits any person from bringing an action against a registered investment company, or employee, officer, director or investment Adviser to a registered investment company, based solely upon the investment company’s divestment from, or avoidance of investments in, securities of issuers determined to conduct or have direct investments in business operations in Sudan.  The Court reasoned that if there were no private right of action under Section 13(a), Congress would not have needed to restrict the actions that could be filed under Section 13 by adding Section 13(c).  The Court further observed that if Congress had intended for Section 13(c) to operate as a stand alone safe harbor provision, Congress easily could have added Section 13(c) as an entirely new provision of the 1940 Act rather than amending Section 13, or could have stated that there was no private enforcement of Section 13 whatsoever.  On this basis, the Court concluded that there was an implied private right of action under Section 13(a).

Investment Objective Claim.  The complaint alleged that by making sizable investments (27.3% of Fund assets according to one shareholder report) in non-agency CMOs that were significantly more risky than the agency-issued mortgage backed securities that were part of the Index, the Fund failed to comply with its fundamental investment objective of seeking high current income by tracking the Index.  The Court was unpersuaded by the defendants’ arguments that Fund documents disclosed that (a) the Fund’s investments would be managed through statistical sampling and other procedures to closely approximate the Index’s characteristics, (b) the Fund may invest in CMOs, (c) the Fund only “seeks” and will “attempt” to track the Index, (d) “[t]here can be no guarantee that [the Fund] will produce the desired results,” and (e) the Fund may invest in securities that are not part of the Index, including mortgage-backed securities and CMOs.  The Court found that whether the Fund’s investments in non-agency CMOs were, in fact, inconsistent with its investment objective was a factual matter that could not be resolved on a motion to dismiss the complaint.

Concentration Policy Claim.  The Adviser alleged that in 2006 the Fund violated its concentration policy, which limited investments in any one industry to less than 25% of Fund assets, by redefining non‑agency mortgage-backed securities as no longer constituting an industry for purposes of that policy.  The Adviser claimed that this change enabled the Fund to increase its investments in mortgage-backed securities without seeking shareholder approval to modify the concentration policy.  In analyzing this claim, the Court noted that neither the 1940 Act nor the SEC define “industry” for the purposes of investment company concentration policies.  The Court cited Guide 19, “Concentration of investments in particular industries,” a guideline for mutual fund registration statements first published by the SEC in 1982, as indicating that industry classifications must meet a reasonableness standard, but held that whether mortgage-backed securities are properly considered an “industry” was a factual matter that could not be resolved at the current stage of the pleadings.  (The Court did not note that in its 1998 amendments to Form N-1A, the SEC indicated that the Guides would not apply to mutual fund registration statements going forward, except as they might subsequently be incorporated into a new Investment Company Registration Guide, which the SEC staff has yet to issue.)  The Court did, however, observe that if mortgage-backed securities constitute an “industry,” the Fund bypassed, and effectively violated, its concentration policy by improperly reclassifying mortgage-backed securities.  The Court also observed that if, as the defendants contended, the Fund’s reclassification of mortgage-backed securities was reasonable, there was no violation of the concentration policy.

Other Claims.  The Court refused to rule on the defendants’ defense that because the Fund had disclosed its investments in non-agency CMOs and its concentration percentage in mortgage-backed securities in SEC filings more than one year before the claim was filed, the Adviser’s claims were barred by the statute of limitations.  The Court indicated that the defendants could renew their statute of limitations defense on a fuller, factual record.  The Court granted the Adviser leave to amend its state law breach of fiduciary duty claim to address whether each of the defendants named in the claim could in fact be sued for breach of fiduciary duty and whether the breach of fiduciary claim was governed by California law as the Adviser contended.  The Court also granted the Adviser leave to amend its state law breach of contract claim to add more specific allegations regarding language in the Fund’s 1997 proxy statement and in subsequent prospectuses that caused the formation of a contract as to the Fund’s investment objective and concentration policy.  Finally, the Court found that the Adviser had sufficiently pled its state law claim of breach of covenant of good faith and fair dealing.