In the past few months, several derivative suits against mutual fund issuers of auction rate securities (ARS) have hit the courts. These include lawsuits filed in Illinois (Safier, et al. v. Nuveen Asset Management, et al., No. 10CH32166 (Cook County Cir. Ct.)), New York (Curbow, et al. v. Blackrock Advisors, LLC, et al., No. 651104/2010 (N.Y. Sup. Ct.)), and Massachusetts (Summers v. John Hancock Advisors, LLC, No. 10-3430A (Suffolk Super. Ct.)). Nuveen mutual funds in particular were the largest issuer of ARS. The Illinois and New York suits were brought by the same plaintiffs’ firm – Barroway Topaz Kessler Meltzer & Check, LLP.
These suits are very similar in substance. The defendants are closed-end funds that issued ARS to create leverage for the fund. In February 2008, the dutch auctions that set the interest rates for ARS suddenly began to fail at an overwhelming rate, and the market for ARS collapsed. The market value of these securities was thus severely impaired. Nevertheless, these defendant funds voluntarily redeemed their outstanding ARS at their full “liquidation value” (i.e., the amount of capital initially contributed).
Since the collapse of the ARS market, regulatory and enforcement authorities have accused broker-dealers of misconduct in touting the liquidity of these securities as equivalent to cash. The plaintiffs in these suits – common shareholders in the funds – take the opposite tack. They complain that the funds were not obligated to redeem the ARS at their liquidation value because the funds’ prospectuses did put the ARS holders on notice that liquidity was not guaranteed. Thus, plaintiffs say, the holders of the ARS – the preferred shareholders – got an unnecessarily good deal, at the expense of the common shareholders.
Plaintiffs allege that the investment advisers to the funds gave preferred shareholders this unwarranted deal in order to maintain their business relationships. Plaintiffs say the advisers also sought to mitigate the write-down they would need to take on the ARS in their own portfolios.
As we mentioned, these suits were filed derivatively on behalf of the funds. In other words, they claim that the funds’ advisers breached their duties of care and loyalty to the funds and seek redress on behalf of the funds themselves. As a pre-requisite to the filing of a derivative claim, a plaintiff must first “demand” that the trustees of the fund address his claims. The trustees usually then create an independent committee to examine the claim and determine if pursuing it is in the best interests of the fund. In virtually all cases, the answer is “no,” and the derivative plaintiff files suit.
Once the suit is filed, the trustees move to dismiss the complaint. The basis for this motion is that pursuant to the business judgment rule, the decision by the trustees not to pursue the claim on behalf of the fund must be respected. To survive the motion to dismiss, the derivative plaintiff has a steep hill to climb. He must demonstrate that the independent committee was somehow not, in fact, independent, or that the committee’s inquiry was unreasonable, or that its conclusions lacked a reasonable basis. In the absence of exceptional circumstances, courts will defer to the sound judgment of the independent directors or trustees, under the “business judgment rule.”
Thus, the staying power of these ARS-related suits will turn on the funds’ handling of the plaintiffs’ demands. In Safier, the Demand Committee rejected plaintiffs’ demand, but plaintiffs allege that the Committee failed to provide requested documents and information to support their conclusion. In Curbow, the Demand Review Committee had not yet reached a conclusion, but plaintiffs argued that the Committee acted improperly in refusing to halt the redemptions while the review was ongoing.
In Summers, the Supreme Judicial Court’s recent decision of Halebian v. Berv, 931 N.E.2d 986 (Mass. 2010) should have a significant effect on the outcome. By statute in Massachusetts, if the trustees or board accepts the derivative demand, the derivative plaintiff may only sue if the board rejects the demand or fails to act within 90 days. The business judgment rule is also codified in the Massachusetts statute. The statute provides that a “derivative proceeding commenced after rejection of the demand shall be dismissed” if the board’s decision passes muster under the business judgment rule.
In Halebian, the plaintiff had filed suit after 90 days of inaction, and the board then rejected the demand only after the suit was filed. The plaintiffs argued that the business judgment rule should not apply, because the proceeding was properly commenced before, not “after,” the rejection. SJC found that such a literal application of the phrase “after rejection of the demand” was illogical and conflicted with the purpose of the statute. Rather, courts must apply the business judgment rule in all cases, even where the trustees or board failed to act within 90 days.
In Summers, the plaintiffs allege that the trustees of the John Hancock mutual fund failed to act on their demand within 90 days. Nevertheless, under Halebian, the trustees will be entitled to the protection of the business judgment rule. Accordingly, we expect that a motion to dismiss will likely be successful.
In summary, the consequences from the collapse of the ARS market in February 2008 continue. Ultimately, we believe that the business judgment rule should permit closed end mutual funds to get past this wave of litigation. Nevertheless, we should not be surprised if the financial losses suffered by ARS holders lead to even more novel types of lawsuits later this year.