Alert April 13, 2010

US District Court Finds that Mutual Fund Violated Section 13(a) of 1940 Act by Failing to Secure Shareholder Approval of Amendment to Fund’s Industry Concentration Policy Effected Through Change in Status of Privately Issued Mortgage-Backed Securities as a Separate Industry

In a class action claim under California law brought by investors in a mutual fund (the “Fund”) against the Fund, the US District Court for the Northern District of California (the “Court”) granted a motion for summary judgment for the plaintiffs on the issue of whether the Fund violated Section 13(a) of the Investment Company Act of 1940 as amended (the “1940 Act”), by improperly changing its industry concentration policy of investing less than 25% in any industry so that the Fund could invest 25% or more of its assets in privately issued mortgage-backed securities.  The plaintiffs claimed that they suffered losses in their Fund investments when there was a sustained decline in the value of privately issued mortgage-backed securities and that the Fund would not have sustained these losses had the Fund complied with its concentration policy prior to the change.  The plaintiffs did not raise a claim under Section 13(a) directly, but rather did so indirectly through a claim under California’s unfair competition law, Cal. Bus. & Prof. Code 17200 et seq., asserting that defendants had engaged in unlawful business practices by violating federal law in the form of Section 13(a).  The suit also includes claims under Sections 11, 12 and 15 of the Securities Act of 1933 against the Fund, the Fund’s adviser and related entities and the Fund’s officers and trustees; those claims were not addressed in this decision.

Concentration Policy. Section 13(a) prohibits a fund from changing its policy regarding concentration of its investments in a particular industry or group of industries without the approval of a majority of its shareholders.  Form N-1A, which specifies the contents of a fund’s registration statements including its prospectus and statement of additional information (“SAI”), defines concentration to mean investing 25% or more of a fund’s assets in a particular industry or industries.  In 2001, the Fund amended its registration statement to state that it would treat privately issued mortgage-backed securities as a stand‑alone industry.  In 2006, the Fund redefined privately issued mortgage‑backed securities as no longer being part of any industry for purposes of the Fund’s concentration policy.  The statements regarding privately issued mortgage-backed securities appeared in a section of the SAI that indicated the descriptions it contained could be changed without shareholder approval unless otherwise noted.  This section was separate from the section discussing limitations, including the Fund’s concentration limitation, which stated that they could only be changed with shareholder approval.  The plaintiffs alleged that the 2006 redefinition violated the Fund’s concentration policy because it had not been approved by shareholders.

In ruling for the plaintiffs, the Court cited the text of the 1940 Act and its legislative history, including a study conducted by the SEC on the investment company industry prior to the Act’s adoption that highlighted particular abuses by fund managers who violated stated policies of industry non‑concentration, as standing for the broad proposition that a fund may not change its policy regarding industry concentration, either to concentrate or not to concentrate, without a shareholder vote.  In addressing arguments that the definition appeared in a section that could be changed without shareholder vote, the Court stated:

The industry definition appeared under a long list of things that could be changed without shareholder vote “unless otherwise noted.”  Later in the SAI, of course, the concentration policy was “otherwise noted” as something requiring a shareholder vote to change.  The industry definition was placed in a paragraph entitled “Concentration.”  It expressly referenced the fund’s concentration policy.  It even restated it.  The industry definition would have been understood by reasonable investors to be an integral part of the concentration policy represented to be inviolate without shareholder approval.  So the disclosure itself, read in the way reasonable investors would have understood it, disclosed the opposite of what the promoter now supposes.

The Court noted that neither the 1940 Act nor the SEC have defined “industry or group of industries” beyond a reference to standard industry classifications in one of the now withdrawn Guides to Form N-1A, and went on to observe “that a promoter is free to define an industry in any reasonable way when it establishes a fund and assumes for the sake of argument that the promoter may unilaterally, even after the fund is up and running, clarify in a reasonable way a definitional line that may otherwise be vague.  But once the promoter has drawn a clear line and thereafter gathers in the savings of investors, the promoter must adhere to the stated limitation unless and until changed by a stockholder vote.”

Implied Private Right of Action under Section 13(a).  The Court’s decision does not address the underlying issue of whether a private right of action exists under Section 13(a) despite the fact that Section 13 does not expressly provide for one.  The vast majority of recent decisions have held that the only private right of action under the 1940 Act is under Section 36(b) for excessive compensation under an advisory contract.  In March 2009 in a separate case involving a claim against a related fund defendant alleging that the fund had violated its concentration policy through investments in non-agency collateralized mortgage obligations, another judge in the Northern District of California found a private right of action implied in Section 13 (as discussed in the March 10, 2009 Alert) (the “March 2009 Decision”).  In June 2009, the US Court of Appeals for the Ninth Circuit accepted the March 2009 Decision for interlocutory review.