Independent mutual fund directors spooked by a Ninth Circuit Court of Appeals ruling last spring are exploring ways to minimize their vulnerability to shareholder lawsuits. The plaintiffs’ bar already has pounced on the precedent set by the appeals court in Northstar Financial Advisors Inc. v. Schwab Investments by amending a suit against PIMCO, and it is expected to continue looking for opportunities to sue boards and advisers.
The San Francisco-based Ninth Circuit in March reversed the district court’s dismissal of a class-action lawsuit filed in 2008 by Northstar Financial Advisors on behalf of investors in the Schwab Total Bond Market Fund. The suit named as defendants the Schwab units that acted as the fund’s adviser and its trust, as well as the directors overseeing the fund. The appeals court—in a 2-1 decision—allowed the plaintiff to proceed with the case, which claims breach of contract against the fund, breach of fiduciary duty against the adviser and the directors, and breach of contract against the adviser. As a result, the U.S. district court judges in the Ninth Circuit—which covers districts in nine western and northwestern states plus Guam and the Northern Mariana Islands—are bound by the decision.
For boards, the ruling means there is now precedent for them to be sued directly by shareholders for breach of fiduciary duty. Prior to the ruling, long-established precedent had prohibited this; such claims had to be asserted derivatively on behalf of a fund against the adviser. This process involves the shareholders sending a demand letter to the board, which gives the fund directors the opportunity to decide whether to pursue the claim themselves by setting up a special litigation committee to investigate, review and analyze the underlying circumstances or determine that the lawsuit should proceed in the courts. If the board decides not to pursue the claim at all, shareholders still can proceed but overcoming the board’s decision is an additional obstacle.
The precedent set in the Northstar case—which does not apply outside the Ninth Circuit—allows the plaintiffs’ bar to bypass this cumbersome and time-consuming process altogether and make claims directly against board members, advisers and funds. It is seen as a Holy Grail of sorts for the plaintiffs’ bar because it’s an easier, quicker way to attack their targets.
Amended PIMCO Suit
The plaintiffs’ bar already has seized an opportunity to try to benefit from the precedent set by the Ninth Circuit. In July, class-action plaintiffs filed an amended complaint regarding the PIMCO Total Return Fund that added the fund directors as defendants. The initial filing, a 10b-5 securities fraud claim, named only the adviser, the fund and the distributor as defendants.
In the amended Hampton v. Pacific Investment Management Company filing, the plaintiff makes claims of breach of contract and fiduciary duties similar to those in the Northstar case. “It’s the first inkling of fallout from Northstar,” David Smith, founder of litigation tracking service Fundfox, told Fund Board Views. He explained that the plaintiff was able to unilaterally amend the claim because PIMCO hadn’t yet replied to the original filing. “They completely changed the lawsuit,” he said. “This is very fast fallout. I have no doubt that plaintiffs’ firms are now investigating ways to file class actions against directors directly because they got a green light from the Ninth Circuit.”
In the amended filing, the plaintiff claims “the trustees caused the 15% cap on emerging market investments to be exceeded negligently, with bad faith, willfully, with gross negligence, and/or reckless disregard of their fiduciary duties.” Further, the suit claims “the trustees violated the covenant of good faith and fair dealing by investing more than 15% of the fund’s property in emerging markets without first securing the approval of a majority of the fund’s shareholders.”
Interested Chairman Brent Harris, interested director Douglas Hodge, independent directors Ronald Parker and Philip Cannon, and former independent directors Michael Hagan, Vern Curtis and William Popejoy are named as defendants along with Pacific Investment Management Company LLC and PIMCO Funds.
A PIMCO spokesman declined to comment, but a lawyer involved in the case told FBV that a briefing schedule has been ordered for a motion to dismiss. The defendants must respond to the complaint by Oct. 5. The plaintiff’s lawyers, Nicholas Porritt and Adam Apton at Levi & Korsinsky in Washington, D.C., did not respond to requests for comment.
The Ninth Circuit
Hope remains among fund industry participants that the Ninth Circuit ruling could be struck down. At the end of July, Schwab filed a petition for writ of certiori to the Supreme Court, asking that the justices review the case. The Investment Company Institute/Independent Directors Council, Mutual Fund Directors Forum and others have filed amicus briefs in support of Schwab’s call for review, arguing that the Ninth Circuit precedent is a bad one for the industry.
“In our amicus brief, we urge the Supreme Court to grant review of the Ninth Circuit’s erroneous Northstar Financial Advisors, Inc. v. Schwab Investments decision,” ICI/IDC said in a statement. “Among other troubling effects, this decision threatens to convert every mutual fund prospectus into a contract and permit any investor to pursue a state law action for breach of contract to enforce a prospectus’s terms.” ICI/IDC predicted increased litigation, compliance and operating costs that would be passed on to fund shareholders should the precedent stand.
In its brief, MFDF said the decision would discourage qualified professionals from serving on boards and would compromise fund governance “because the Ninth Circuit’s decision undermines the fundamental role fund directors play in the regulatory scheme of protecting shareholders’ interests.”
It is unclear when the Supreme Court will consider the cert or if the justices will act on it.
Minimizing Vulnerability
While the case continues to be hashed out in the courts, the precedent stands and is worrying mutual fund boards. There is some question as to how much directors should be concerned, but there is consensus on ways they can try to ease their minds and minimize their vulnerability.
The Ninth Circuit ruling, “in the hands of plaintiffs’ lawyers, could serve to undermine and eradicate [directors’] role as gatekeepers and arbiters of claims,” said Amy Roy, counsel in the securities litigation group at Ropes & Gray. “What we think a lot of directors and funds are doing is following this case very closely and taking steps to make themselves less susceptible to being sued in the Ninth Circuit,” she told FBV.
One step directors can take is to amend funds’ bylaws to include a forum selection clause that states that any action against trustees, funds and advisors must be litigated outside the Ninth Circuit, Roy said, noting the clause often would name the specific court in which cases can be brought. “We can expect plaintiffs’ lawyers to challenge the enforceability of such a clause, but there is very little downside risk and it puts parties on notice,” she said.
David Hearth, a partner in the corporate department of Paul Hastings, agreed there are increased risks to directors associated with the Ninth Circuit precedent and underscored that the plaintiffs’ bar would seek to exploit the ruling. Plaintiffs’ lawyers may believe that entangling the board will give them greater leverage, leading to more and quicker settlements, he told FBV.
“I have not seen any boards yet doing anything differently; they talk about things that could be done, some of which may or may not work,” Hearth said. “Directors can make extra efforts to review the fundamental investment policies of the funds they oversee [and] perform more careful analysis of how the fundamental investment policies are followed and applied.” This, he explained, will give them a higher level of comfort with their own due diligence. Directors also can build provisions into funds’ articles, trust instruments or bylaws to try to keep cases out of the Ninth Circuit, as Roy explained. Hearth said he anticipates that some fund groups will have added such provisions by the end of the year. “I don’t know how many ultimately will do it…[and] whether it’s enforceable; we like to think that they are, but there’s never a guarantee.”
Hearth said he has encouraged boards not to overreact to the Ninth Circuit ruling because of the distinct set of circumstances of the case. Unlike a 36(b) case, which can easily be brought if a plaintiff considers fees to be excessive, a case like Northstar requires both a perceived violation of the fundamental investment policy and losses. “This is not a case of general applicability,” he underscored.
Roy, however, is less optimistic. “We’ll wait to hear from the Supreme Court. …In the meantime, I think what we’re going to see is more shareholder litigation in the Ninth Circuit.”