Alert June 28, 2011

Two Federal District Courts Dismiss Derivative Suits Based on Alleged Unlawfulness of Asset-Based Rule 12b-1 Payments by Mutual Fund Distributor to Selling Broker-Dealers

The November 2, 2010 Alert reported that 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.  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”).  Smith v. Franklin/Templeton Distributors, No. C 09-4775 PJH (N.D. Cal. Oct. 22, 2010).

Recently, two other federal district courts dismissed similar complaints brought by the same plaintiff’s counsel and asserting the same claims.  The United States District Court for the District of Massachusetts held that the Rule 12b-1 payments are not illegal, finding that the SEC’s rulemaking effort and the rejection of that effort in Financial Planning Association v. SEC, 482 F.3d 481 (D.C. Cir. 2007), was not dispositive with respect to the interpretation of “special compensation.”  The court therefore declined to find that the Trust’s payment of the asset-based Rule 12b-1 fees automatically disqualified use of the broker-dealer exemption.  It found “no facts alleged that would demonstrate that the 12b-1 fees at issue here constitute special compensation for advisory services,” and said that even if broker‑dealers were required to treat accounts as advisory accounts, “[t]he Trust has no legal obligation to ensure that these actions are taken.”  The court further held that even if the Rule 12b-1 payments somehow violated the Advisers Act, they did not constitute a violation of Section 36(a) or Rule 38a-1 of the 1940 Act.  Even though the court said that a private right of action exists under Section 47(b) of the 1940 Act for a party to a contract to void or rescind a contract for a violation of the 1940 Act, it dismissed that claim here because no predicate violation existed.  Lastly, the court concluded that the state law claims for breach of contract, breach of fiduciary duty and waste likewise failed because the Rule 12b-1 payments were not illegal.  Wiener v. Eaton Vance Distributors, Inc., No. 10‑10515‑DPW (D. Mass. March 30, 2011). 

The United States District Court for the Southern District of New York also dismissed the plaintiff’s complaint, but for different reasons.  It held that in order to seek rescission under Section 47(b), the plaintiff must assert a predicate violation of a substantive provision of the 1940 Act which itself has a private right of action.  The court cited Second Circuit precedent in concluding that neither Section 36(a) of the 1940 Act – which gives the SEC authority to bring an action for breach of fiduciary duty – nor Rule 38a-1 provides a private right of action.  Therefore, the court dismissed the Section 47(b) claim, and declined to exercise jurisdiction over the state law claims.  Smith v. Oppenheimer Funds Distributor, Inc., Nos. 10 Civ. 7387 (LBS) and 10 Civ. 7394 (LBS) (S.D.N.Y. June 6, 2011). 

The plaintiffs in Smith v. Franklin/Templeton Distributors and in Wiener v. Eaton Vance Distributors, Inc. initially appealed dismissal of their complaints, but now have voluntarily dismissed both appeals.

Goodwin Procter LLP represented the independent trustees in the Wiener and Franklin/Templeton proceedings.