Following a series of much-publicized demand letters served in 2009 upon the trustees of three mutual fund complexes (Franklin Templeton, Eaton Vance and OppenheimerFunds), derivative lawsuits were filed last year by the Milberg firm against the funds’ trustees and distributors. The complaints allege nearly identical facts and assert the same causes of action under the Investment Company Act of 1940 (“1940 Act”) for purported underlying violations of the Investment Advisers Act of 1940 (“Advisers Act”).  

Last June, the court presiding over the Franklin/Templeton action granted defendants’ motion to dismiss on the ground that plaintiff had not stated a viable claim under Section 47(b) of the 1940 Act.1 In March, the court presiding over the Eaton Vance action also rejected plaintiff’s Section 47(b) claim.2 And, on June 6, 2011, Judge Sand of the United States District Court for the Southern District of New York issued an opinion in which he dismissed the Section 47(b) claims plaintiff had brought derivatively on behalf of two OppenheimerFunds mutual funds.3 This update provides the background of these lawsuits and analyzes this third dismissal of this breed of Section 47(b) claim.  

Background of the Lawsuits

Rule 12b-1 under the 1940 Act permits a fund to use its assets to support fund distribution, provided that such payments are made in accordance with a written plan that meets certain requirements specified in the Rule (a “Rule 12b-1 Plan”). Pursuant to its Rule 12b-1 Plan, a fund generally makes these payments, known as Rule 12-1 Fees, to its distributor in support of distribution and certain specified shareholder services, and the distributor in turn pays these Rule 12b-1 Fees to broker-dealers that sell fund shares.

NASD Rule 2830(d)4 limits the amount of Rule 12b-1 Fees that may be paid to broker-dealers to a certain percentage of the annual net assets of the fund. Thus, Rule 12b-1, in conjunction with NASD Rule 2830, contemplates Rule 12b-1 Fees as being “asset-based,” i.e., based on a percentage of assets.

However, according to plaintiffs in these derivative actions, because Rule 12b-1 Fees are asset-based compensation paid to broker-dealers, the broker-dealers that receive the Rule 12b-1 Fees must register as investment advisers under the Advisers Act. While the Advisers Act regulates persons that give investment advice, a broker-dealer is exempt from Advisers Act regulation if the investment advice he provides “is solely incidental to the conduct of his business as a broker or dealer and [he] receives no special compensation therefor . . . .”5 In their lawsuits, plaintiffs alleged that Rule 12b-1 Fees are de facto “special compensation” because they are “asset-based” rather than transactional commissions, meaning that the broker-dealers that receive them cannot qualify for the Advisers Act broker-dealer exemption. Thus, according to plaintiffs, any broker-dealer that receives Rule 12b-1 Fees without being registered as an investment adviser under the Advisers Act is in violation of the Act.

Plaintiffs further claimed that by paying Rule 12b-1 Fees to broker-dealers that are not registered under the Advisers Act, the funds and their distributors violated Section 36(a) of the 1940 Act and Rule 38a-1 thereunder. Plaintiffs therefore contended that, because of the alleged violation of Section 36(a) and Rule 38a-1, they could sue derivatively to obtain contract rescission under Section 47(b) of the 1940 Act, which permits either party to seek rescission of a contract “that is made, or whose performance involves, a violation of [the 1940 Act], or of any rule, regulation, or order thereunder . . . .” Perhaps more significantly, plaintiffs demanded restitution of all Rule 12b-1 fees paid by the Funds.

The OppenheimerFunds Decision

The OppenheimerFunds decision refutes the core premise that plaintiffs in each of these derivative actions alleged as a basis to hold the funds’ trustees and distributors responsible under the 1940 Act for a purported violation of the Advisers Act by brokerdealers. Specifically, the OppenheimerFunds court reached the following important conclusions:  

  • First, Section 47(b) does not create a private right of action.6 In reaching this conclusion, the court relied on the Supreme Court’s Alexander v. Sandoval decision,7 which “strictly limited the ability of federal courts to imply private rights of action in federal statutes.”8 Specifically, the OppenheimerFunds court ruled that the 1940 Act contains express private rights of action “only for specific, narrowly defined offenses,”9 and Section 47(b) does not expand that small number of available private rights of action by permitting private plaintiffs to obtain remedies for breaches of 1940 Act provisions that do not themselves contain a private right of action.10 Thus, to obtain relief pursuant to Section 47(b), a plaintiff “must assert a predicate violation of a substantive provision of the [1940 Act] which itself has a private right of action.”11  
  • Second, Section 36(a) of the 1940 Act cannot supply the predicate for a claim pursuant to Section 47(b) because Section 36(a) does not itself provide for a private right of action.12 Rather, Section 36(a) authorizes only the SEC to bring certain actions for breaches of fiduciary duty involving personal misconduct.13
  • Third, the OppenheimerFunds court held that, even if a private right of action under Section 36(a) of the 1940 Act could be implied, liability under that section would not extend to the allegations of Advisers Act violations that underlie plaintiff’s Section 47(b) claim.14 Indeed, as the court further recognized, nothing in the 1940 Act indicates that a litigant should be able to invoke Section 36(a) as basis to bring claims pursuant to multiple securities statutes, and even Sectio 47(b) explicitly limits its remedy to violations o the 1940 Act
  • Fourth, Rule 38a-1—the other provision on which plaintiff relied as a basis for his Section 47(b) claim—does not contain a private right of action, and thus, cannot serve as the predicate for Section 47(b) relief.16

Conclusion

The OppenheimerFunds decision, following upon the Franklin/Templeton and Eaton Vance decisions before it, puts a seal on the unanimous rejection of the plaintiffs’ bar’s efforts to upset the settled practice of payment of Rule 12b-1 Fees for distribution-related activities. We will continue to report on developments in this important series of cases.