The U.S. District Court for the Southern District of Iowa (the “District Court”) found that shareholders of a fund of funds (the “Shareholders”) did not have a private right of action under Section 36(b) of the Investment Company Act of 1940, as amended (the “1940 Act”), to challenge fees paid by underlying funds owned by the fund of funds to the underlying funds’ adviser and its distributor affiliate because the Shareholders were not “security holders” of the underlying funds. Under Section 36(b) of the 1940 Act, an investment adviser to a registered fund is deemed to have a fiduciary duty with respect to compensation for services the fund pays to the adviser or its affiliates. A security holder of the fund may bring an action on the fund’s behalf against the fund’s adviser for a breach of the adviser’s fiduciary duty under Section 36(b).
The District Court’s analysis focused on whether the plaintiffs were in fact security holders of the underlying funds within the meaning of the 1940 Act. Noting that the issue before it was one of first impression, the District Court disagreed with the Shareholders’ argument that their interest in the underlying funds was a security by virtue of being an “investment contract” because, among other things, there was no agreement or instrument between the Shareholders and any underlying fund that functioned as a security. The District Court also reasoned that the Shareholders did not hold shares of the underlying funds through their fund of funds investments because the Shareholders did not “enjoy any incidents of ownership or possession” of any security of the underlying funds, such as voting rights, dividends or liquidation rights. On the grounds that they had failed to plead that they were security holders of the underlying funds, the District Court dismissed the Shareholders’ Section 36(b) claim.