Alert March 15, 2011

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.