(Article from Registered Funds Alert, September 2015)
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An April 2015 opinion from the Ninth Circuit Court of Appeals may open the door for a significant increase in suits by shareholders of mutual funds against trustees and investment advisers. By approving novel interpretations of the law to allow claims for breach of contract and breach of fiduciary duty, as well as finding that shareholders are third-party beneficiaries to an agreement between a fund and its adviser, the Ninth Circuit gave shareholders potentially powerful new tools that the plaintiffs’ bar will likely seek to exploit. There are several steps that mutual funds should consider taking to protect against some of the case’s potential implications.
In Northstar Financial Advisors, Inc., the Ninth Circuit allowed a financial advisor that managed over 200,000 shares of a mutual fund to proceed with claims for breach of contract and breach of fiduciary duty directly against the fund’s trust, trustees, and investment adviser for their alleged failure to operate the fund in compliance with two of its fundamental investment policies. The fundamental policies stated (i) the fund was seeking to track a particular bond index and (ii) the fund would not invest 25% or more of its assets in any one industry, and could only be removed or changed upon approval by shareholders. The plaintiffs alleged that the violation of these fundamental policies exposed the fund and its shareholders to losses in the tens of millions of dollars.
The fund in question was a series of a Massachusetts business trust. The Ninth Circuit applied Massachusetts law to the contract and fiduciary duty claims and, pursuant to a clause in the investment adviser’s contract, applied California law to the shareholders’ claims as third-party beneficiaries of that contract. It remains to be seen whether the Ninth Circuit’s opinion will stand and, if so, whether it will be adopted by other courts. A petition for certiorari has been made to the U.S. Supreme Court to appeal the decision and, of course, courts in Massachusetts could settle what Massachusetts law says on these issues by deciding new cases brought in state court. But, while Northstar is not legally binding on any federal court outside of the Ninth Circuit or on the courts of the states whose laws it purports to apply, other courts may choose to adopt the Ninth Circuit’s reasoning, and future plaintiffs may try to find ways to bring their claims in federal courts in the Ninth Circuit.
The Northstar opinion came to several potentially important conclusions. First, the court held that by having fundamental investment policies approved by shareholder vote through a proxy statement, and by incorporating the approved policies into the fund’s prospectus and registration statement going forward, the fund and the trust created a contract with each shareholder. Read broadly, the language in the opinion indicates that violation of any fundamental investment policy, even if approved by a sole initial shareholder of a fund, may give rise to a breach of the contract claim.
Second, the Ninth Circuit declared that mutual funds “are essentially puppets of the investment adviser” and held that under Massachusetts law shareholders could bring their claims directly against the fund’s trustees, bypassing a demand on the board of directors and a derivative suit.
Finally, the court held that the shareholders of the fund were third-party beneficiaries to the investment advisory contract between the investment adviser and the fund, and could file a claim against the investment adviser for breach of contract for violating the fundamental policies.
The Northstar opinion is seemingly at odds with both federal and state court precedent on key issues and, should other suits be brought under these theories, defense counsel would need to mount a vigorous defense based on these contradictions. For example, the opinion states that Massachusetts law requires a shareholder filing a direct suit to show that his or her injury is distinct from that of the shareholders generally, or that it was connected to a violation of the shareholder’s contractual rights (including voting rights). The court then assumed, however, that Massachusetts would adopt a change in that law articulated by Delaware courts in 2004, eliminating the requirement that a plaintiff’s injury be distinct from that of other shareholders.[1] The Massachusetts Supreme Judicial Court does not appear to have ever cited that case in the intervening eleven years, nor has the Massachusetts legislature explicitly adopted that change in the law. The Ninth Circuit’s concept of fiduciary duty in mutual funds is also difficult to reconcile with other federal decisions, including Goldstein v. SEC, which determined that an investment adviser to a hedge fund cannot owe a fiduciary duty to both the fund and the fund’s investors because the adviser would “inevitably face conflicts of interest,”[2] and Burks v. Lasker, in which the Supreme Court noted that Congress, in enacting the 1940 Act, placed a great deal of trust in the hands of the independent directors of investment companies.[3]
In the event that Northstar is not overturned by the Supreme Court or its interpretation of Massachusetts law is not clarified by the Massachusetts courts or Attorney General, however, mutual funds could potentially take several steps to mitigate the risk of similar suits. Although Section 13(a) of the 1940 Act requires a majority vote of a fund’s shareholders to deviate from or change certain investment policies, including diversification, borrowing and concentration policies, trustees could be given as much control as possible over investment policies. Additionally, funds may consider adding explicit declarations to their prospectuses and registration statements that they are not contracts and do not create contractual rights or obligations. Funds and investment advisers might consider including clauses in new advisory contracts stating explicitly that there are no third-party beneficiaries to make it even clearer that shareholders are not beneficiaries of the contract and should not be able to sue the adviser directly for breach of its contract with the fund.
It may also be possible to use a fund’s trust instruments to limit expressly the fiduciary and contractual rights owed to shareholders. In support of its declaration that trustees owe a fiduciary duty to shareholders of the fund in Northstar, the Ninth Circuit quoted a journal article saying that “[t]he familiar standards of trust fiduciary law protect trust beneficiaries of all sorts, regardless of whether the trust implements a gift or a business deal (unless, of course, the terms of the transaction expressly contraindicate).”[4] This implies that trusts can structure (or restructure) their declarations of trust to contract around the issues raised by the Ninth Circuit’s decision. Some states, like Delaware, specifically provide by statute that a trust may limit or eliminate a trustee’s fiduciary or other duties or liability for breach of contract or duties in its governing document, so long as it does not limit or eliminate the implied covenant of good faith and fair dealing.
As a general matter, fund contracts include forum selection and choice of law clauses, specifying the law that will govern any dispute and in which court litigation will take place. Unless and until Northstar is overruled or Massachusetts law is clarified or changed, it may be advisable to designate a forum outside of the Ninth Circuit in new advisory contracts. Incorporating a change of forum in an existing advisory contract may be more difficult, as it could be considered a material change that requires shareholder approval under the 1940 Act, but if a contract is slated for shareholder approval for any other reason, advisers and funds could consider changing the forum as well, with appropriate disclosure regarding the reasons for the amendments.
[1] Tooley v. Donaldson, Lufkin, & Jenrette, Inc., 845 A.2d 1031 (Del. 2004).
[2] 451 F.3d 873, 881 (D.C. Cir. 2006).
[3] 441 U.S. 471, 484–85 (1979).
[4] John H. Langbein, The Secret Life of the Trust: The Trust as an Instrument of Commerce, 107 Yale L.J. 165, 166 (1997) (emphasis added).