Alert November 02, 2010

Federal District Court Dismisses Amended Complaint in Derivative Suit Based on Alleged Unlawfulness of Asset-Based Rule 12b-1 Payments by Mutual Fund Distributor to Selling Broker-Dealers

The U.S. District Court for the Northern District of California granted a motion to dismiss the amended complaint in a derivative suit brought by a mutual fund shareholder against the fund’s distributor and trustees alleging (a) a violation of Section 47(b) of the Investment Company Act of 1940, as amended (the “1940 Act”), by the distributor, and (b) state law claims of (i) breach of contract by the distributor, (ii) breach of fiduciary duty by the defendant trustees, and (iii) waste of fund assets by the defendant trustees.  Section 47(b) provides that “[a] contract that is made, or whose performance involves, a violation of [the 1940 Act], or of any rule, regulation, or order thereunder, is unenforceable by either party . . . unless a court finds that under the circumstances enforcement would produce a more equitable result than nonenforcement and would not be inconsistent with the purposes of [the 1940 Act].” 

The suit claimed that because the fund’s Rule 12b-1 payments to brokers to sell and service fund shares are calculated on the fund’s net asset value, such asset-based compensation constitutes “special compensation” with respect to brokerage accounts and is unlawful under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).  Plaintiff based his theory on a decision in Financial Planning Association v. SEC, 482 F.3d 481 (D.C. Cir. 2007), which overturned a new SEC rule but did not address Rule 12b-1 payments.  He further alleged that the trustees’ malfeasance and/or failure to exercise adequate oversight in approving that compensation violated their duties under the 1940 Act, including Rule 38a-1 under the 1940 Act (which is the compliance program rule for registered funds).  In June 2010, the court granted defendants’ motion to dismiss the complaint, but allowed leave to amend the Section 47(b) claim.  For more detail on Plaintiff’s theory and the court’s prior decision, see the June 15, 2010 Alert.

The court granted the defendants’ motion to dismiss the amended complaint with prejudice as to the Section 47(b) claim.  Consistent with its prior decision, the court found that a claim under Section 47(b) could not be sustained because the plaintiff had failed to allege predicate violations of the 1940 Act under either Section 36(a) or Rule 38a-1.  The court noted that Section 36(a) does not create a federal fiduciary duty or regulate the improper use of fund assets, nor does it provide a right of action for such claims, but rather authorizes the SEC to file a breach of fiduciary duty action.  The court also stated that Rule 38a-1 does not impose on funds a duty to ensure that broker-dealers comply with registration requirements.  Having dismissed the Section 47(b) claim, the court declined to exercise supplemental jurisdiction over the state law claims, and dismissed them without prejudice to re-filing in state court.  Smith v. Franklin/Templeton Distributors, No. C 09-4775 PJH (N.D. Cal. Oct. 22, 2010)

Goodwin Procter LLP represented the independent trustees in this proceeding.