The U.S. District Court for the Southern District of New York recently dismissed most of the claims in the long-running litigation over transfer agent fees collected on the Smith Barney family of funds. See In re Smith Barney Transfer Agent Litig., No. 05 Civ. 7583 (WHP) (decision available here). The court only left standing a single securities fraud claim against one individual, alleged to have knowingly signed misleading SEC filings as an officer of the funds.
The case involves a scheme allegedly perpetrated by the investment adviser to the aforementioned Smith Barney funds. In 1999, the investment adviser renegotiated the contract with the funds’ transfer agent, First Data, significantly lowering the transfer agent fees. Rather than pass those savings along to the funds, the adviser allegedly hatched a plan to pocket the savings. It set up an in-house “transfer agent” entity and convinced the board of the funds to approve shifting the transfer agent services to the in-house provider – but at the same pre-1999 rates previously paid to First Data. Meanwhile, the in-house entity subcontracted nearly all of the actual transfer agent duties to First Data. While the existence of a First Data subcontract was disclosed to the board, the adviser did not disclose that First Data was performing nearly all of the same duties it was performing under the previous arrangement, and that the in-house entity merely operated a small call center. The adviser ultimately settled with the SEC, agreeing to pay over $200 million in fines and disgorging the profits generated by the scheme.
A class action was filed on behalf of investors against the adviser, as well as associated entities and individuals, for securities fraud under Section 10(b) of the Securities Exchange Act of 1934 and similar claims. In an earlier stage of the class action, the District Court dismissed the complaint on the basis that it failed to allege a false statement of material fact. The court reasoned that the total amount of fees was disclosed; neither the allocation of services rendered for those fees nor the transfer agents’ profit margin were material. The Second Circuit reversed, holding that the allegation that the “transfer agent fees” paid to the adviser were not paid for actual services but merely to hide kickbacks clearly altered the “total mix of information” available to investors.
In its recent ruling, the District Court again dismissed most of the investors’ claims. The court noted that since the litigation began, the U.S. Supreme Court decided Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011), and Stoneridge Inv. Partners, LLC v. Scientific Atlanta Inc., 552 U.S. 148 (2008). Janus and Stoneridge sharply restricted securities suits against any individuals or entities other than those actually responsible – both legally and factually – for the alleged misstatements. Here, it was the funds themselves that were obligated to submit filings to the SEC, and it was those filings that contained the allegedly misleading information concerning the transfer agent fees. Plaintiffs did not sue the funds or the funds’ trustees, however. Only one individual defendant was an officer of the funds and knowingly signed some of the allegedly misleading filings (as noted, a claim against that one defendant survived the court’s ruling).
Plaintiffs’ theory of liability was that the defendants engaged in a deceptive scheme designed ultimately to dupe investors. While the District Court agreed that the defendants engaged in a deceptive scheme, it found that the plaintiffs could not establish that they detrimentally relied on that scheme. To establish reliance under the common law, a plaintiff must show that he was actually aware of the defendant’s statement and engaged in the relevant transaction based on that specific statement. The plaintiffs clearly could not meet that standard here. Securities law, meanwhile, has carved out two exceptions where the plaintiff is entitled to a rebuttable presumption of reliance without showing actual reliance: 1) where the defendant has failed to disclose material information that it was obligated to share; or 2) where the defendant has made a public misrepresentation about a security that trades on an open, efficient market (the “fraud-on-the-market” theory).
The District Court found that neither exception applied here. The plaintiff admitted that the second exception did not apply because the funds’ shares were not “traded on an efficient market.” While the court’s opinion did not delve into this issue, plaintiffs were likely compelled to admit this because the net asset value of a mutual fund’s shares are computed based solely on the prices of the underlying securities held by the fund. The market does not automatically build information about the fund itself into the fund’s NAV, as it does in the case of the price of, e.g., a publicly traded stock. Thus, plaintiffs could not rely on the NAV of the fund’s shares to incorporate any information regarding the funds’ transfer agent fees, because that in fact would not have happened.
The court then held that the first exception did not apply, either, because the adviser defendants did not have a duty of disclosure – the funds did. While the adviser defendants’ deceptive conduct “arguably” did make it “necessary or inevitable” that the funds would issue misleading prospectuses, the plaintiffs were not aware of those deceptive acts and thus could not have relied on them. Plaintiffs argued that they purchased the funds’ shares in reliance on the more general assumption that “Defendants would honor their fiduciary duties.” But the District Court rejected this theory as a novel “reapportionment” of liability between advisers and mutual funds, which is “properly the responsibility of Congress and not the courts” (quoting Janus).
Therefore, the court dismissed all of the plaintiffs’ claims, except for the Section 10(b) claim against the one adviser defendant who actually signed the prospectuses containing the misinformation regarding the transfer fees. Based on the District Court’s opinion, however, even that one surviving claim is likely doomed, as a practical matter. Since the reliance exceptions do not apply, plaintiffs will need to show that the entire class actually and specifically relied on the representations regarding the transfer fee arrangement when deciding to purchase the funds’ shares.
It might seem harsh that an adviser could commit misrepresentations through an oblivious (yet closely affiliated) intermediary, and thereby avoid a direct suit from investors. However, as the court pointed out in its original dismissal, there is an alternative to a direct suit – a derivative suit. The adviser only allegedly harmed investors insofar as it deprived the fund of cost savings. Thus, the investors claims are, in fact, derivative of the fund’s own claims against the adviser. Despite the court’s invitation, plaintiffs declined to re-plead their claims as derivative claims, probably because of the substantial hurdles those claims would need to clear, such as the demand requirement.