One consequence of the subprime mortgage crisis has been an increase in putative class action lawsuits against fund advisers and directors by investors claiming that their funds were over-exposed to risky mortgage-backed securities.

The lawsuits allege inaccurate and misleading disclosure regarding these securities, the purchase of which purportedly violated:

  • The funds’ fundamental policy to track a benchmark index;
  • The 25% industry concentration requirement; and
  • Section 13(a) of the Investment Company Act of 1940 (1940 Act), which prohibits a fund from deviating, without shareholder approval, from the fundamental policies stated in its registration statement.

What has securities practitioners scratching their heads is a recent U.S. district court holding in Northstar Financial Advisors, Inc. v Schwab Investments, et al., that there is an implied private right of action under Section 13(a) of the 1940 Act. Section 13(a) contains no express language conferring any right to bring an action.

The Northstar court, however, found an implied private right of action under Section 13(a) by examining Section 13(c), which was added in 2007 as part of the Sudan Accountability and Divestment Act to restrict the rights of “persons” to bring actions against a fund or adviser for divesting from securities issued by persons that conduct or have direct investments in business operations in Sudan.

The Northstar court reasoned that Section 13(c) expressly limited the types of actions that a “person” could file under Section 13 and “[i]f there were no private right of action under Section 13(a), there would be no need to restrict the actions that could be filed under Section 13… The fact that Congress only limited certain types of actions suggests that Congress intended that there be a private right of action under Section 13(a).”

Significantly for fund directors, at least one of these putative class actions, Smith v. Oppenheimerfunds, Inc., et al., named fund directors as defendants because the directors were authorized to sign the allegedly inaccurate and misleading registration statements.