Financial Services Alert - March 15, 2011 March 15, 2011
In This Issue

Federal District Court Grants in Part and Denies in Part Motion to Dismiss Claims Relating to an Investment Company’s Alleged Deviation from its Stated Investment Objectives

The U.S. District Court for the Northern District of California issued a decision in which it granted in part and denied in part a motion to dismiss claims related to allegations that defendants deviated from a bond index mutual fund’s investment objective.  Plaintiffs filed a class action suit seeking to hold defendants liable for alleged losses incurred as a result of the fund’s alleged deviation from its objectives.  Specifically, plaintiffs alleged violations of Section 13(a) of the Investment Company Act of 1940 (the “1940 Act”), breach of fiduciary duty, breach of contract, and breach of the covenant of good faith and fair dealing.  Defendants, in turn, argued that plaintiffs lacked standing and that plaintiffs’ claims were precluded by the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”).

Background.  Plaintiffs alleged that defendants deviated from the fund’s investment objective of tracking a particular bond index in two ways:  (1) the fund invested in high risk mortgage obligations that were not part of the securities that comprised the index and (2) although the fund was prohibited from concentrating greater than 25% of its investments in an industry, the fund invested more than 25% of its total assets in high risk mortgage obligations and certain mortgage-backed securities.  Plaintiffs further alleged that defendants’ deviation from the fund’s investment objectives exposed the fund and its shareholders to losses due to a sustained decline in the value of the mortgage-backed securities.

Standing.  Defendants argued that all of plaintiffs’ claims must be dismissed for lack of standing because standing must be determined at the time a complaint is filed, and plaintiffs did not obtain standing until several months after the original complaint was filed.  The Court stated that in light of a previous decision in the case holding that plaintiffs’ could cure the lack of standing via an amended complaint, it would be unfair to now prohibit plaintiffs from relying on the Court’s specific instructions.  The Court further opined that although there was no published Ninth Circuit authority on this point, courts in other circuits have found that parties may cure standing deficiencies through supplemental pleadings.  The Court concluded that plaintiffs had established standing through a supplemental pleading, and the Court, therefore, denied defendants’ motion to dismiss based on a lack of standing.

SLUSA Preclusion.  Defendants argued that plaintiffs’ claims were precluded by SLUSA, which prohibits class actions brought on behalf of more than 50 people, if the action is based on state law and alleges (a) a misrepresentation or omission of a material fact in connection with the purchase or sale of covered security; or (b) that the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security.  Plaintiffs disputed that (1) they had alleged misrepresentations or omissions of material fact and (2) that any such misstatements or omissions were alleged to have been made “in connection with” the purchase or sale of the fund’s shares.

The Court found that plaintiffs’ claims did in fact allege misrepresentations for SLUSA purposes.  The Court held that plaintiffs alleged that defendants made misrepresentations about the fund’s pursuit of its fundamental strategy to track a particular index.  In sum, plaintiffs alleged that the fund’s deviation from the index was caused by the fund’s investment of more than 25% of its assets in certain mortgage obligations inconsistent with the holdings of the index and that the concentration in such obligations was in violation of the fund’s stated investment objectives.  The Court opined that “[a]ll the asserted claims allege [p]laintiffs’ reliance on the [f]und’s fundamental investment objectives.  In addition, all of the claims allege that [p]laintiffs were harmed due to the failure of the [f]und to follow those objectives.”  Thus, the Court concluded that the misrepresentation element of SLUSA preclusion was met.

Plaintiffs also contended that the “in connection with the purchase or sale of a covered security” element of SLUSA preclusion was not met.  Citing Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71, 82 (2006), the Court found that “there is no question that [p]laintiffs’ allegations arise ‘in connection with’ the purchase or sale of covered securities, as required by SLUSA.”

Plaintiffs then argued that if the Court applied Massachusetts law to their breach of fiduciary duty claim, SLUSA should not apply to the claim pursuant to the “Delaware carve-out.”  This provision of SLUSA states that, notwithstanding the preclusion provision, “a covered class action . . . that is based upon the statutory or common law of the State in which the issuer is . . . organized (in the case of any other entity) may be maintained in a State or Federal court by a private party.” 15 U.S.C. 77(p)(d)(1)(a).  Plaintiffs argued that while the fiduciary duty claim was “asserted under California law,” it was “viable under Massachusetts law as well.”  The Court opined that to the extent plaintiffs relied on Massachusetts law to establish their claim, the claim would not be precluded by SLUSA.  Accordingly, the Court found that as pled, all of plaintiffs’ claims, with the exception of the breach of fiduciary duty claim to the extent it is premised only on Massachusetts law, were precluded by SLUSA and therefore dismissed with leave to amend. 

Dismissal of Breach of Contract Claim.  Plaintiffs alleged that a proxy statement proposed changes to the fundamental investment objectives of the fund, and “formed the terms of a contract to provide shareholders with voting rights in that those ‘fundamental investment objectives’ were only changeable by shareholder vote.”  Plaintiffs further alleged that the contract was formed when plaintiffs held or purchased shares of the fund.  The Court opined that while cases cited by defendants did not broadly hold that a prospectus can never be a contract, as defendants argued, the cases did apply traditional contract law concepts such as offer, acceptance, and consideration in evaluating claims that securities disclosure documents are contracts.

In that regard, plaintiffs were previously ordered to “add more specific allegations regarding the language plaintiffs rely on to allege the formation of a contract, as well as each defendant’s involvement.”  Plaintiffs responded by simply asserting that the proxy statement formed a contract between fund investors and the fund’s registrant.  Plaintiffs argued that they accepted the offer of the proposals in the proxy statement by providing the consideration of purchasing or retaining shares.  The Court cited In re Charles Schwab Corp. Sec. Litig., 257 F.R.D. 534 (N.D. Cal. 2009) which, in rejecting an argument almost identical to that made by plaintiffs in the present case, Judge Alsup explained, “plaintiffs contend that when each investor purchased shares of the fund, the investor entered a contract with the fund and each of its trustees. The contract allegedly included not only the sale of fund shares but also each and every term of the registration statements and SAIs . . . [t]he alleged breach occurred when defendants changed this no-concentration policy by redefining the term ‘industry’ to permit greater investment in mortgage-backed securities, without a shareholder vote.”  Judge Alsup concluded that plaintiffs had not successfully pled the formation of a contract and offered “no coherent theory” explaining how the various filings had been incorporated into a contract, rejecting plaintiffs’ argument that they were accepted by plaintiffs’ purchase of the funds.  The Court found the In re Charles Schwab decision persuasive, and concluded that plaintiffs failed to successfully allege the formation of a contract and that because plaintiffs were previously given leave to amend the claim and failed to state a claim, their breach of contract claim was dismissed with prejudice.

Dismissal of Breach of Covenant of Good Faith and Fair Dealing Claim.  The Court granted the dismissal of the breach of covenant of good faith and fair dealing claim on the ground that a covenant of good faith and fair dealing is an implied term of a contract and that without a valid contract, there can be no implied term.  The Court concluded that plaintiffs failed to allege the existence of a valid contract and thus, because the Court dismissed plaintiffs’ contract claim with prejudice, the Court also dismissed the breach of covenant of good faith and fair dealing claim with prejudice.

Dismissal of Fiduciary Duty Claim.  Plaintiffs alleged that defendants breached their fiduciary duties to plaintiffs by failing “to require a majority shareholder vote prior to deviating from the [f]und’s stated fundamental investment objectives.”  While noting that the Ninth Circuit in Lapidus v. Hecht, 232 F.3d 679, 683 (9th Cir. 2000) held that a claim for violation of contractual shareholder voting rights “satisf[ies] the injury requirement for a direct action under Massachusetts law” and confers standing to pursue individual claims, the Court found that plaintiffs failed to state a claim for breach of contract, because they did not successfully allege the formation of a contract.  Plaintiffs also asserted the 1940 Act as a basis for their alleged voting rights.  However, the Court opined that plaintiffs cannot directly assert a violation of the 1940 Act regarding voting rights and thus that it was not clear that plaintiffs could assert a violation of voting rights under the 1940 Act as the basis for a breach of fiduciary duty.  The Court found that it was unnecessary to determine whether or not any of the named defendants potentially owed a fiduciary duty to plaintiffs until plaintiffs have stated a claim for breach of fiduciary duty that does not implicate SLUSA.

Dismissal of Third Party Beneficiary of the Investment Adviser Agreement.  Plaintiffs’ further alleged a breach of the investment advisory agreement claiming that they were third party beneficiaries of this agreement.  Defendants argued that because the agreement itself does not “explicitly, directly, definitely or in unmistakable terms” state the intent to benefit the fund’s investors, plaintiffs cannot establish third party beneficiary status.  The Court opined that it did not find the cases cited by plaintiffs to be particularly helpful because the cases discussed contracts that expressly named a class of beneficiaries.  The Court further opined that given that the parties devoted limited, unhelpful, briefing to the question of whether plaintiffs can qualify as third party beneficiaries, the Court declined to decide whether or not the agreement could provide a basis for the asserted claim.  The Court granted plaintiffs leave to amend their complaint to re-assert this claim without triggering the SLUSA preclusion, and to specify what specific provisions of the agreement were allegedly breached and how.

SEC Staff Issues No-Action Letter Providing Relief to Registered Investment Companies Seeking to Place Assets in the Custody of Credit Default Swap Clearinghouse or its Members

The staff of the SEC's Division of Investment Management (the "staff") issued a no-action letter stating that it would not recommend enforcement action under Section 17(f) of the Investment Company Act of 1940 (the “1940 Act”) against a registered investment company (a “Fund”) if the Fund or its custodian places and maintains cash and/or certain securities (“assets”) in the custody of ICE Trust U.S. LLC (“ICE”) or a U.S. ICE clearing member (“ICE Clearing Member”) for purposes of meeting ICE’s or an ICE Clearing Member’s margin requirements for credit default swap contracts (“CDS”) that are cleared by ICE. 

ICE, which had requested the relief, acts as a central clearing party by accepting the rights and obligations under eligible CDS transactions entered into with ICE Clearing Members and submitted to ICE in accordance with its rules (“ICE Rules”). Following acceptance of a CDS transaction for clearing, ICE becomes the seller of credit protection with respect to the CDS purchaser, and the purchaser of credit protection with respect to the CDS seller.

Section 17(f) of the 1940 Act and the rules thereunder govern the safekeeping of Fund assets, and generally provide that a Fund must place and maintain its securities and similar instruments only with certain qualified custodians. Section 17(f)(1)(A) of the 1940 Act permits certain banks to maintain custody of Fund assets subject to SEC rules.  Although ICE, as a New York-chartered limited purpose trust company and member of the Federal Reserve System, is a “bank” as defined by Section 2(a)(5) of the 1940 Act, it would be holding a Fund’s assets at least partially for the benefit of its central clearing operations, rather than in the more pure custody context of a Fund custodian under Section 17(f)(1) of the 1940 Act. 

In its analysis, the staff cited ICE’s claim that a Fund’s deposit of assets with ICE or an ICE Clearing Members would be consistent with the principles of custody established by Congress and the SEC in Section 17(f) of the 1940 Act and the rules thereunder.  The staff relied on the assertion that ICE’s framework (the “Non-Member Framework”) for providing access to ICE’s clearing services to clients (including Funds) of ICE Clearing Members (“Third-Party Clients”), which requires that ICE Clearing Members segregate assets held on behalf of Third-Party Clients from proprietary assets, maintain adequate capital and liquidity and keep certain books and records, protects Third-Party Client assets.

In granting the relief, the staff cited representations from ICE that ICE would comply with certain recordkeeping obligations and supply relevant information to the SEC and that ICE Clearing Members would be in material compliance with ICE Rules, would be in material compliance with applicable laws and regulations with respect to CDS cleared by ICE, would provide disclosure regarding the impact of applicable insolvency law on a Fund’s ability to recover assets, would transfer Fund assets promptly to the custodial client omnibus margin account, would provide ICE with a self-assessment and a report of their independent auditors regarding their compliance with applicable SEC orders and would supply relevant information to the SEC.

FDIC Issues Financial Institution Letter Concerning Steps and Procedures Available to Financial Institutions That Wish to Voice Concerns Regarding FDIC Examination Findings

The FDIC issued a financial institution letter (FIL-13-2011, the “Letter”) in which the FDIC reminds FDIC-supervised financial institutions (“FIs”) that they “can voice their concerns about an examination or other supervisory determination through informal and formal channels.”  The Letter states that if an FI disagrees with examination findings, it should communicate the disagreement through the FDIC examiner-in-charge, field office management or the appropriate regional office staff.  The FDIC notes that, should informal efforts to resolve disagreements fail to be successful, an FI may file a formal supervisory appeal with respect to a “material supervisory determination.”

The FDIC states in the Letter that “material supervisory determinations” can include, but are not limited to:

  • CAMELS ratings under the Uniform Financial Institutions Rating System
  • IT ratings under the Uniform Interagency Rating System for Data Processing Operations
  • trust ratings under the Uniform Interagency Trust Rating System
  • CRA ratings under the Revised Uniform Interagency Community Reinvestment Act Assessment Rating System
  • consumer compliance ratings under the Uniform Interagency Consumer Compliance Rating System
  • registered transfer agent examination ratings
  • government securities dealer examination ratings
  • municipal securities dealer examination ratings
  • determinations relating to the adequacy of loan loss reserve provisions
  • classifications of loans and other assets in dispute, the amount of which, individually or in the aggregate, exceed 10% of an FI’s total capital
  • determinations relating to violations of a statute or regulation (unless specifically excluded because the determination is the basis for a formal enforcement action or referral) that may affect the capital, earnings or operations of an FI, or otherwise affect supervisory oversight accorded an FI
  • Truth in Lending (Regulation Z) restitution
  • filings made pursuant to 12 CFR 303.11(f), for which a Request for Reconsideration has been granted, other than denials of a change in bank control, change in senior executive officer or board of directors, or denial of an application pursuant to Section 19 of the FDI Act, if the filing was originally denied by the director, deputy director or associate director of the Division of Supervision and Consumer Protection, and
  • any other supervisory determination (unless otherwise not eligible for appeal or specifically excluded because the determination is the basis for a formal enforcement action or referral) that may affect the capital, earnings, operations, or prompt corrective actions, or otherwise affect the supervisory oversight accorded an FI.

The Letter also provides that material supervisory determinations do not include:

  • decisions to appoint a conservator or receiver for an FI
  • decisions to take prompt corrective action pursuant to Section 38 of the FDI Act
  • determinations for which other appeals procedures exist (such as determinations of deposit insurance assessment risk classifications and payment calculations)
  • formal enforcement-related actions and decisions, and
  • decisions to initiate informal enforcement actions (such as a memorandum of understanding).

The Letter states that FDIC policy prohibits any retaliation by the FDIC or an FDIC examiner against an FI that has formally or informally expressed disagreement with an FDIC examination finding or has filed an appeal.  The Letter also notes that FIs with concerns about their interactions with the FDIC may also contact the FDIC Office of the Ombudsman, which is charged with providing a “confidential, neutral and independent source of information and assistance to anyone affected by the FDIC in its regulatory role.”

Boston Consulting Group Submits Dodd-Frank Mandated Study on SEC Organization and Operations

As required under Section 967 of the Dodd-Frank Act, the Boston Consulting Group, an independent consultant selected by the SEC, submitted a report to Congress and the SEC addressing various issues related to the SEC’s organization and operations.  The report focuses  on four broad areas: organization structure, personnel and resources, technology and resources, and the SEC’s relationship with self-regulatory organizations.

CPSS and IOSCO Publish Consultative Report on the Principles for Financial Market Infrastructures

The Committee on Payment and Settlement Systems (“CPSS”) and the Technical Committee of the International Organization of Securities Commissions (“IOSCO”) published for comment a consultative report on the Principles for Financial Market Infrastructures (the “Report”).  The Report contains a single, comprehensive set of twenty-four principles designed to apply to all systemically important payment systems, central securities depositories, securities settlement systems, central counterparties and trade repositories.  The proposed principles, which are designed to ensure that the essential infrastructure supporting global financial markets is more robust and better positioned to withstand financial shocks, would replace existing CPSS and CPSS-IOSCO standards for payment, clearing, and settlement systems previously published in the Core Principles for Systemically Important Payment Systems, Recommendations for Securities Settlement Systems, and Recommendations for Central Counterparties, and for the first time introduce principles for trade repositories.  The Federal Reserve Board, the SEC, and the CFTC have encouraged interested parties to review and comment on the Report.  Comments are due by July 29, 2011.