(Article from Registered Funds Regulatory Update, April 2023)
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The U.S. Court of Appeals for the Fifth Circuit affirmed a District Court’s decision to dismiss a shareholder derivative suit against the trustees of the Highland Capital Global Allocation Fund and the Fund’s investment adviser, Highland Capital Management Fund Advisors, L.P. (“Highland Capital”). The Court of Appeals held that the District Court (i) applied the correct Massachusetts legal standard to evaluate whether the trustees were “independent;” (ii) properly analyzed and concluded that the majority of the trustees were independent; and (iii) correctly found that the trustees’ decision to reject plaintiff’s demand was made in good faith and based on a reasonable investigation.
Plaintiff brought a shareholder derivative action under Massachusetts law on behalf of the Fund against Highland Capital and five of the Fund’s six trustees alleging breach of contract and breach of fiduciary duty. Plaintiff alleged that the adviser invested a portion of the Fund’s portfolio in an affiliated master limited partnership fund, at a time when the MLP’s value was falling. Defendants brought a motion to dismiss the derivative suit arguing that a quorum of its independent trustee—the five trustees above—voted to reject Plaintiff’s demand after conducting a reasonable and good faith investigation. The District Court agreed with Defendants, dismissing the case. Plaintiff appealed the decision. On appeal, Plaintiff argued that the District Court (i) utilized the wrong legal standard to evaluate whether the trustees were independent; (ii) erred by finding that a majority of the trustees were independent; and (iii) erred by finding that the decision to reject Plaintiff’s demand was in good faith and based on a reasonable investigation.
In reviewing Plaintiff’s claims regarding trustee independence, the Court of Appeals noted that Massachusetts law states that the Investment Company Act definition of director independence applies to trustees of a trust organized as a registered investment company under the Investment Company Act. The Court of Appeals found that the trustees were independent under the Investment Company Act and, therefore, Plaintiff’s claims were invalid.
The Court of Appeals then concluded that the Board made a good faith recommendation to reject Plaintiff’s demand based on a reasonable investigation. The Court of Appeals noted that Massachusetts law presumes that a decision to reject a shareholder demand is a valid exercise of a board’s business judgment. The Court of Appeals further described how, following Plaintiff’s demand, the Board formed a Demand Review Committee consisting of two independent trustees that held 16 meetings, hired independent counsel, reviewed thousands of pages of
documents and interviewed 10 witnesses, and prepared a 96 page report recommending to reject Plaintiff’s demand.
The Court of Appeals’ decision highlights the importance of a reasonable and good faith investigation by a fund’s independent trustees, as well as the support of courts to defer to a board’s business judgment, in determining whether a shareholder derivative action should be maintained.
Lanotte v. Highland Capital Management Fund Advisors, L.P., et al., No. 20-10649, available at: https://www.ca5.uscourts.gov/opinions/unpub/20/20-10649-CV0.pdf.