On February 16, 2010, the Second Circuit Court of Appeals issued its ruling in Operating Local 649 v. Smith Barney Fund Management LLC. The case arose following a 2005 SEC settlement with Smith Barney Fund Management LLC and Citigroup Global Markets, Inc., both subsidiaries of Citigroup Asset Management (collectively “CAM”), related to alleged violations by CAM of the Advisers Act for inducing the Smith Barney Family of Funds to enter into a transfer agency contract with an affiliate of CAM that resulted in high expenses to the Funds and undisclosed profits to CAM. Based on the findings of the SEC, various Fund investors filed civil suits seeking damages from CAM for violations of Section 10(b) and Rule 10b-5 of the 1934 Act and Section 36(b) of the 1940 Act. The district court dismissed the suit, holding that: (1) the mischaracterization of the fees paid to the affiliated transfer agent as transfer agent fees was not a false material misrepresentation under Section 10(b); and (2) the Section 36(b) claim could only be brought derivatively on behalf of the Funds and not directly by the plaintiffs. The plaintiffs appealed these judgments and the Second Circuit then vacated the dismissal of the Section 10(b) claims and affirmed the dismissal of the Section 36(b) claim.
With respect to the Section 10(b) claims, on appeal, the plaintiffs argued that the judgment of the district court should be reversed because CAM materially misrepresented the services performed by the affiliated transfer agent by not disclosing that: (1) the affiliated transfer agent would only operate a small call center; (2) the affiliated transfer agent would subcontract the majority of transfer agent services to an unaffiliated party; and (3) the unaffiliated party would charge substantially less for transfer agent fees than what the Funds would pay to the affiliated transfer agent. In addition, the plaintiffs contended that CAM, in the Funds’ prospectuses, miscategorized the transfer agent fees that the affiliated transfer agent received as “other expenses” when they should have been categorized as “management fees.” The Second Circuit agreed with the plaintiffs that CAM’s misrepresentations were material due to (A) the SEC’s prospectus and proxy disclosure rules which focus on the importance of fee disclosure to investors and the proper categorization of fees and (B) the fiduciary duty with respect to management fees imposed by Section 36(b). The Second Circuit stated, “Few facts would likely constitute more important ingredients in investors’ ‘total mix’ of information than the fact that, in violation of [SEC] disclosure requirements the expenses categorized as transfer agent fees were not transfer agent fees at all and included kickbacks to [the affiliated transfer agent] and ultimately, CAM.” The Second Circuit further stated, “In light of the importance the SEC attaches to the proper categorization of fees generally, and the importance Congress has attached to management fees in particular, we hold that [CAM’s] misrepresentations were material because there exists a substantial likelihood that a reasonable investor would consider it important that her fiduciary was, in essence, receiving kickbacks.”
With respect to the Section 36(b) claim, on appeal, the plaintiffs argued that the judgment of the district court should be reversed because the U.S. Supreme Court previously held that the federal procedure rule covering “derivative” actions does not apply to Section 36(b) claims and, therefore, if a Section 36(b) claim is not “derivative” within the meaning of the rule, it can be brought as a direct claim by shareholders. The Second Circuit disagreed, stating that the plaintiffs’ reading of the precedent was too narrow. The Court went on to examine the history of such precedent, noting the end result is that 36(b) claims are brought directly by shareholders to recover damages derivatively for a fund. The Second Circuit stated, “To the extent [the plaintiff] seeks damages that inure to its own benefit and not to the Funds’, that result is not permitted by Section 36(b).”