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Second Circuit Emphasizes Fund Adviser's Fiduciary Duty

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  • Baker, John
    The U.S. Court of Appeals for the Second Circuit has ruled that shareholders of a family of mutual funds properly stated a claim under Rule 10b-5 against the
    Message 1 of 1 , Feb 16, 2010
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      The U.S. Court of Appeals for the Second Circuit has ruled that shareholders of a family of mutual funds properly stated a claim under Rule 10b-5 against the fund advisers for secretly accepting compensation from a service provider to the funds. Operating Local 649 Annuity Trust Fund v. Smith Barney Fund Management, Docket No. 07-5125-cv (2d Cir. Feb. 16, 2010). The district court had dismissed the claim, ruling that the alleged disclosure failures were immaterial because the funds disclosed the total fees paid by the funds. The Second Circuit opinion strongly emphasizes the fiduciary duty and disclosure obligations owed by fund advisers and their affiliates, and it effectively provides a roadmap for plaintiffs against advisers that fail to meet those obligations.

      The facts underlying the claim came to light in 2005, when the Securities and Exchange Commission announced a settled administrative proceeding against the fund advisers. Smith Barney Fund Management, Release Nos. 34-51761, IA-2390 (May 31, 2005). The fund advisers' corporate parent recommended, and the funds implemented, a new arrangement under which an advisory affiliate became the funds' transfer agent. The affiliate then hired the funds' former third-party transfer agent to continue to provide most transfer agency services, at a substantial profit to the advisory affiliate. The advisers allegedly concealed from the funds' directors and shareholders that the third-party transfer agent would have provided the same services much more cheaply and had also entered into a secret side letter to provide millions of dollars in additional revenue to various advisory affiliates. The advisers agreed in the SEC administrative proceeding to disgorgement, interest, and civil money penalties in an aggregate of approximately $208 million.

      The Second Circuit, in a unanimous opinion by Judge Barrington Parker, ruled that the plaintiffs properly alleged material misrepresentations, writing that, "First and foremost, what the Fund investors could not divine from the disclosures was that they were at the mercy of a faithless fiduciary." The advisers' corporate parent owed a duty of uncompromising fidelity and undivided loyalty to the funds' shareholders, the court said, and "Any 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." The court also ruled that the funds' prospectus disclosure was incorrect because it included the fees to the affiliated transfer agent as "Other Expenses," when in reality they included kickbacks.

      The court also ruled that the plaintiffs had adequately alleged loss causation. The plaintiffs alleged that the defendants' misrepresentations caused investors to make and maintain investment in funds that were subject to excessive fees and expenses, and that the periodic deduction of those fees and expenses reduced the value of the investments over time. The court ruled that this met the legal requirement that the plaintiffs show not only that had they known the truth they would not have acted but also that they suffered actual economic loss. The court noted the existence of the SEC-ordered restitution but said it would be premature to rule, on a motion to dismiss, that the SEC's ordered restitution fully compensates shareholders.

      The court did, however, affirm the district court's dismissal of the plaintiffs' claim under Section 36(b) of the Investment Company Act of 1940 for an alleged breach of fiduciary duty with respect to advisory compensation. The district court dismissed this claim because it was brought directly by the shareholders, rather than derivatively on behalf of the funds. The Second Circuit agreed that, to the extent plaintiffs seek damages that inure to their own benefit and not to the funds', that result is not permitted by Section 36(b).

      The Second Circuit opinion is available online at


      For the SEC's 2005 administrative proceeding, see


      John M. Baker <JMB@...>
      Stradley Ronon Stevens & Young, LLP http://www.stradley.com
      1250 Connecticut Avenue, NW, Suite 500
      Washington, DC 20036
      202.822.0140 fax
      FundLaw Listowner http://groups.yahoo.com/group/fundlaw
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