Alert March 10, 2009

US Court of Appeals for the Seventh Circuit Affirms Dismissal of Mutual Fund Investors’ Breach of Contract Claim against Investment Adviser over Best Execution

The US Court of Appeals for the Seventh Circuit (the “Appeals Court”) affirmed the decision of the US District Court for the Southern District of Illinois (the “District Court”) dismissing a claim by former investors in mutual funds (the “Funds”) managed by an investment adviser and its affiliate (collectively, the “Adviser”) that they were entitled to damages as third party beneficiaries of “confirmation agreements” between the Adviser and the broker-dealers through which the Adviser executed transactions on behalf of the Funds.  The plaintiff investors alleged that the confirmation agreements (which their attorneys did not produce) contained an implied term providing that the broker‑dealers were chosen on the basis of their ability to provide best execution for the Funds.  The plaintiffs alleged that this implied term arose under the rules of the National Association of Securities Dealers (now, FINRA) and the New York Stock Exchange.  The plaintiff investors based their allegations regarding the Adviser’s failure to achieve best execution on the findings in settled administrative procedures brought by the SEC against the Adviser and certain of its personnel related to travel, entertainment and gifts provided by brokerage firms executing transactions for the Adviser’s clients, and by the SEC and NASD against one of those brokerage firms (See the December 19, 2006 Alert, the March 25, 2008 Alert, and the December 16, 2008 Alert for a discussion of those proceedings).

The District Court dismissed the suit on the grounds that it was precluded by the Securities Litigation Uniform Standard Act of 1998, (“SLUSA”).  In general terms, SLUSA prevents a plaintiff from bringing certain class actions based on state law in either state or federal court if the plaintiff alleges “a misrepresentation or mission of material fact” or “a manipulative or deceptive device or contrivance,” and the conduct to which the allegations relate is “in connection with the purchase or sale of a covered security.”  The District Court found that the plaintiffs’ claims amounted to “allegations of untrue statements or missions or a material fact” because according to the plaintiffs’ allegations, at the time they entered into the confirmation agreements, the Adviser and the broker-dealers did so based on the receipt of gifts and other benefits rather than on the promise of best execution, and thus the agreements reflected a misrepresentation of a material fact, rather than a promise that was not subsequently kept.  In affirming the District Court, the Court disallowed any state law contract claim under the facts alleged and observed that a securities law claim based on the plaintiffs’ allegations would fail given the expiration of the federal statute of limitations and the class’ inability to show loss causation.