The Second Circuit recently overturned the Southern District of New York’s dismissal of a claim under § 10(b) Securities Exchange Act of 1934 relating to management fees charged to a mutual fund in Operating Local 649 Annuity Trust Fund v. Smith Barney Fund Management LLC, 595 F.3d 86 (2d Cir. 2010). The court held that even though the total amount of the fees was disclosed, the allegation that a portion of the fees were “pocketed” by the defendant was sufficient to sustain the securities fraud claim.
According to the plaintiffs (representing a class of investors in the funds), the defendant re-negotiated the funds’ contract with the previous transfer agent, First Data Investor Services Group. Under the new arrangement, the funds contracted with a subsidiary of the defendants for transfer agent services. The subsidiary, in turn, subcontracted these services to First Data, which allegedly “continued to perform the same services it had previously performed at a substantially reduced rate.” The subsidiary, meanwhile, allegedly performed “only minimal functions” – a small call center – and “pocketed” the savings obtained under the re-negotiated contract with First Data. According to plaintiffs, the defendant disclosed the existence of the contracts and the total fees paid by the funds, but not the nature of the services provided by the subsidiary or First Data. The defendant thus allegedly concealed the fact that it was providing little of value to the funds while capturing the savings obtained under the new contract with First Data.
The Second Circuit held that these alleged misrepresentations could be “material” in that they altered the “total mix of information” relevant to an investor in deciding whether to invest, under the well-established Basic v. Levinson test. Specifically, the court found that the concealed facts were material in two respects. First, the facts would have revealed to investors that they were “at the mercy of a faithless fiduciary” seeking to reap profits for itself rather than for the funds, which would have affected their decision to invest with such a fiduciary. Second, the SEC requires that management fees be disclosed and categorized, and under the alleged facts, the defendant violated these rules by categorizing the “pocketed” fees as genuine transfer agent fees. As the SEC considers categorization of fees important enough to be required, such information must be material, reasoned the court.
The Second Circuit also held that plaintiffs had adequately pled “loss causation.” The court rejected the defendant’s argument that since the total amount of the fees was in fact disclosed, the alleged misrepresentations regarding the nature of those fees could not have caused a loss. In a brief analysis, the court found that plaintiffs “alleged that the defendants’ misrepresentations proximately resulted in the regular deduction of identifiable amounts that would not have been deducted had defendants conformed their conduct to what the law required.” The defendant also argued that any losses had been repaid to the funds under a settlement with the SEC, but the court found that the record was not sufficiently developed on this point.
The court upheld dismissal of the investors’ direct claim under Section 36(b) of the Investment Company Act, however. The court held that § 36(b) does not allow for a direct claim for damages by investors, only a derivative claim on behalf of the fund. Click here to review the decision.