(Article from Registered Funds Alert, February 2017)
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A recent ruling requiring that a mutual fund’s independent trustees produce e-mails with board counsel despite an attempt to invoke attorney-client privilege is making waves in the mutual fund industry.
Attorney-client privilege is a long-standing and well-established doctrine that protects certain communications between clients and their attorneys from disclosure. Its necessity and purpose—to encourage full and frank communication between attorneys and their clients—is rarely questioned, and few people thought it would become an issue in the context of excessive fee litigation under Section 36(b) of the 1940 Act. It came as a surprise to almost all observers when the federal judge presiding over Kenny v. Pacific Investment Management Company LLC [1] issued an order doing just that in November.
The plaintiffs in Kenny are suing the adviser over the fees the adviser charged its flagship fund, and sought access to hundreds of e-mails and other documents involving the fund’s independent trustees in relation to that suit. The independent trustees complied with many of the discovery requests on their own, delivering over 2,300 pages of documents, including some communications between independent trustees and board counsel, but also held back or redacted an additional 200 documents, arguing that those documents were protected from disclosure by attorney-client privilege because they contained confidential legal advice regarding board meetings, director retirements, board governance and contract approvals.
Generally speaking, parties to federal litigation may obtain discovery of any relevant information, and relevant information is construed to mean anything that is reasonably calculated to lead to the discovery of admissible evidence. It is a wide umbrella to be sure, but privilege usually constrains its reach. If requested discovery is resisted, the requesting party may move for an order compelling such discovery.
In Kenny, the plaintiffs moved for such an order to compel the discovery materials the independent trustees withheld as attorney-client privileged material. But rather than contest whether the withheld documents were in fact privileged, as usually happens in these contexts, the plaintiffs focused the court’s attention on a centuries-old, but rarely invoked, aspect of the attorney-client privilege doctrine in the context of fiduciary litigation.
In those jurisdictions where it is recognized, the so-called “fiduciary exception” precludes a fiduciary from asserting the attorney-client privilege against beneficiaries who seek disclosure of fiduciary-attorney communications. Essentially, application of the fiduciary exception compels disclosure to beneficiaries where the fiduciary sought legal advice in exercising the fiduciary’s duties and responsibilities to those beneficiaries on the theory that the fiduciary’s duty to administer the trust solely for the benefit of the beneficiaries takes priority over the attorney-client privilege.
The fiduciary exception to the attorney-client privilege was imported to the United States through English common law, where courts concluded that communications between a fiduciary and his or her attorney must be disclosed to a trust beneficiary, essentially holding that because communications between an attorney and a fiduciary ultimately benefit the beneficiary, such communications cannot be withheld from the beneficiary.
The Supreme Court of the United States reviewed the fiduciary exception to attorney-client privilege in 2011 in the context of the general trust relationship between the United States and Native American tribes, renewing interest in the previously obscure doctrine.[2] It did so based on an evaluation of two criteria: (1) whether the trustee obtained legal advice as a “mere representative” of the beneficiary, making the beneficiary the “real client;” and (2) whether the fiduciary duty to furnish trust-related information to the beneficiaries, rooted in the trustee’s fiduciary duty to disclose all information related to trust management, outweighs the interest in the attorney-client privilege. Under that line of cases, only where the trustee shows that he or she obtained legal advice for his or her own personal protection or independent personal purpose will the attorney-client privilege survive.
The plaintiff in Kenny argued that because the fund is organized as a series of a Massachusetts business trust, the fiduciary nature of the independent trustees under federal law would make the Supreme Court precedent applicable. Specifically, the plaintiffs argued that the communications at issue involved the independent trustees in their role as fiduciaries and related to administration of the fund, and therefore were explicitly not for the trustees’ personal benefit. To bolster this argument, the plaintiffs highlighted the Fund’s administration agreement which states that the trust pays “the fees and expenses of legal counsel retained for [the Trust’s] benefit.”
Counsel for the independent trustees disagreed. Citing 45 years of Section 36(b) lawsuits, they argued that the fiduciary exception has never been extended to the mutual fund context. They went on to argue that the independence of the trustees would be undermined if their ability to freely communicate with independent legal counsel under the attorney-client privilege were chilled, so much so that it would “destabilize the mutual fund industry to the detriment of all shareholders.”
Ultimately, the court concluded that the independent trustees failed to meet their burden of showing why the discovery request should be denied and the plaintiff’s motion to compel discovery was granted. The order rested on the assertion that the independent trustees are supposed to be independent from the fund’s adviser, not the shareholders; and that the fund in question is undisputedly organized as a trust. The presiding judge determined that those facts were analogous enough to Supreme Court precedent to warrant application to the mutual fund context. As of this date, the adviser and the independent trustees have not appealed the order. Although the Kenny decision is less than a few months old, it has already been cited by plaintiffs in other ongoing 36(b) cases as hopeful precedent, although judges in other districts are not bound by the Kenny decision.
To the extent that plaintiffs raise the fiduciary exception in attempting to compel discovery of privileged trustee-counsel communications in other Section 36(b) cases, there are several potential ways in which board counsel in other jurisdictions might try to distinguish the Kenny order. Although the majority of mutual funds are organized as series of a trust, according to the Investment Company Institute’s 2016 Investment Company Fact Book, more than 15% are organized as corporations. Had this particular fund been organized as a corporation, it would have undercut one of the central pillars of the plaintiff’s argument. That the court found that independent trustees lose attorney-client privilege simply because a fund happens to be organized as a series of a trust seems remarkably arbitrary. A necessary corollary of the court’s conclusion here is that any and all written communication between independent trustees and outside counsel will be available for inspection in Section 36(b) litigation, unless the communication is clearly a matter of advice regarding personal protection for the trustee. As a litany of cases have already concluded, it is essentially a maxim that legal advice can only be safely and readily rendered and relied on when free from the consequences or the apprehension of disclosure. Requiring blanket disclosure as a rule could quickly serve to ensure tough questions do not get asked or answered, or at least not on the written record.
Moreover, it is not clear how exactly the court concluded that the board’s outside counsel was actually serving the fund’s beneficiaries as its “real client,” as opposed to the independent trustees they were responding to and communicating with. Undoubtedly, many communications between independent trustees and their outside counsel focus on navigating the multiple legal and regulatory obligations that the independent trustees are obligated to satisfy; duties that can create liability for those independent trustees if improperly performed and are materially separate and distinct from the concerns and obligations of a mere beneficiary of the fund. Further, it would place the board’s counsel in the precarious position of allegedly representing the interests of all of the beneficiaries of the fund without having any way to identify, disclaim or mitigate a situation where that counsel has interests that conflict with those of a beneficiary.
It is uncertain whether other courts will decide to follow the reasoning of this ruling, but the issue will undoubtedly be put before other tribunals soon. Boards and their counsel would be wise to consider whether certain topics should be discussed over the phone instead of via e-mail. Importantly, although the court ruled the documents were subject to discovery, the order states that the documents that were ordered to be produced are subject to a protective order to prevent the public disclosure of their contents.
[1] Kenny v. Pacific Investment Management Company LLC et al, No. 2:2014cv01987 - Document 140 (W.D. Wash. 2016).
[2] United States v. Jicarilla Apache Nation, 564 U.S. 162 (2011).