A two-judge panel of the U.S. Court of Appeals for the Second Circuit (the “Court”) on Febru-ary 16, 2010 vacated the dismissal of a putative class action securities fraud claim brought by shareholders of the Smith Barney family of funds (the “Funds”) under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and remanded the case to the district court. The Court also affirmed the district court’s dismissal of the shareholders’ claim alleging breach of fiduciary duty under Section 36(b) of the Investment Company Act of 1940. The shareholders brought the action against Smith Barney Fund Management, LLC (“SBFM”) and Citigroup Global Markets, Inc. (“CGMI”), the Funds’ advisers, for accepting undisclosed compensa-tion from a transfer agent to the Funds.1 The district court had dismissed the securities fraud claim, holding that the alleged disclosure failures were immaterial because the Funds disclosed the total fees paid by the Funds, and the Section 36(b) claim, holding that the claim could only be brought derivatively on behalf of the Funds.2
Both SBFM and CGMI were part of Citigroup Asset Management (“CAM”). From 1994 to 1999, First Data Investors Services Group (“FDIS”), an outside contractor, served as transfer agent to the Funds. In 1999, after conducting a formal study of the transfer agent functions, CAM decided to create a transfer agent affiliate (the “Affiliated Transfer Agent”) and contract with the Affiliated Transfer Agent to provide transfer agent services. The Affili-ated Transfer Agent then subcontracted FDIS to continue providing most of the transfer agency services it had previously provided but at a substantially lower rate. Based on this arrangement, the Affiliated Transfer Agent’s actual role as transfer agent to the Funds was limited. Plaintiffs alleged that CAM concealed critical aspects of this arrangement from the Funds’ board of directors and shareholders, including that the third-party transfer agent would have provided the same services at a lower rate and that the Affiliated Transfer Agent entered into a “side letter” with FDIS which allegedly guaranteed CAM “millions of dollars in additional revenue, without providing commensurate benefit to the Funds.”3
In 2005, the U.S. Securities and Exchange Commission (“SEC”) investigated SBFM and CGMI for violations of the Investment Advisers Act of 1940 by “failing to disclose to the Funds’ boards that [FDIS] had offered to do the same work for substantially less and by failing to disclose the contents of the [s]ide [l]etter to the Funds’ boards.”4 In May 2005, the SEC settled with SBFM and CGMI, who agreed to disgorgement, interest, and civil money penalties in an aggregate amount of approximately $208 million. Based on these allegations, shareholders filed a series of civil suits in district court which were ultimately consolidated into a class action suit.
The Court held that the plaintiffs adequately alleged that SBFM and CGMI made material misrepresentations necessary to support a securities fraud claim and that the plaintiffs sufficiently alleged loss causation. However, the Court found that plaintiffs were required to seek damages derivatively on the Funds’ behalf with regard to the alleged breaches of fiduciary duty. The Court noted that the district court had dismissed the Section 10(b) claims because the district court concluded that if an investment adviser discloses the total amount of fees paid by a fund to a service provider, neither the fees’ allocation nor the service provider’s profit margin are material.5 However, the Court disagreed with the district court and ruled that the plaintiffs properly alleged material misrepresentations, stating that, “[f]irst and foremost, what the Fund investors could not divine from the disclosures was that they were at the mercy of a faithless fiduciary.”6
The Court’s opinion emphasized the fiduciary duty and disclosure obligations of investment advisers to mutual funds, noting that CAM, acting through SBFM, owed a “duty of ‘uncompromising fidelity’ and ‘undivided loyalty’ to Funds’ shareholders.”7 Highlighting the materiality of the misrepresentations, the Court stated that “[a]ny rational mutual fund investor would be highly leery of dealing with a fiduciary such as CAM and its affiliates who, in violation of the law, lined their pockets at the expense of investors whose interests they were obligated to protect. The district court’s analysis did not engage this reality.”8 The Court also analyzed the SEC disclosure rules and held that the Funds’ prospectus disclosure incorrectly included fees to the Affiliated Transfer Agent as “Other Expenses,” when in essence the advisors were receiving kickbacks.9
The Court also found that the plaintiffs had adequately alleged loss causation. The plaintiffs alleged that the defendants’ misrepresentations “caused investors to make and maintain investments in Funds that were subject to excessive fees and expenses, and that the periodic deduction of those fees and expenses reduced the value of their investments over time.”10 Based on these findings, the Court vacated the district court’s judgment with respect to the Section 10(b) and Rule 10b-5 claims, which were remanded to the district court.
The Court did affirm the district court’s dismissal of the plaintiffs’ claim alleging breach of fiduciary duty with respect to advisory compensation under Section 36(b) of the Investment Company Act of 1940. The district court held that the breach of fiduciary duty claims must be brought derivatively on behalf of the Funds. The Court agreed with the district court that Section 36(b) does not permit the plaintiffs to seek damages that “inure to their own benefit and not to the Funds’.”11 As a result, the Court affirmed the district court’s holding that the Section 36(b) claim must be brought derivatively.
Filed in the wake of a large regulatory settlement, Operating Local 649 involved egregious alleged facts and unusual circumstances. The Court’s decision does not purport to break new legal ground and should not change existing jurisprudence with respect to Rule 10b-5 and loss causation. However, defense counsel should be prepared to address this decision in connection with a motion to dismiss a securities fraud claim, particularly one involving an alleged breach of fiduciary duty as the basis for a putative duty to disclose.
It should be noted that, while the Court upheld the dismissal of the Section 36(b) claim, it did so on the ground that a Section 36(b) claim may be brought directly by a fund shareholder only for the benefit of the fund.
This case is a reminder that when proposing to provide a service “in-house” a fund adviser should have a solid business rationale for doing so and should engage in a full dialogue with the fund’s board regarding the pro-posal. Failure to disclose material information regarding such an arrangement could be significant in the context of a Section 36(b) claim, 12 as well as a claim under the Securities Act of 1933 or the Securities Exchange Act of 1934.