Second Circuit rules securities fraud claim of mutual fund shareholders relating to affiliated transfer agent arrangements may proceed, but upholds dismissal of breach of fiduciary duty claim

Abstract

Purpose

The purpose of this paper is to explain a February 2010 US Second Circuit Court decision in Operating Local 649 Annuity Trust Fund v. Smith Barney Fund Management LLC that supported fund investor plaintiffs who alleged that fund advisors accepted undisclosed compensation from a transfer agent to the funds, but affirmed a district court dismissal of a shareholder claim alleging breach of fiduciary duty under Section 36(b) of the Investment Company Act of 1940.

Design/methodology/approach

The paper explains the background to the Second Circuit Court decision, including the advisors' hiring of a transfer agent, the advisors' creation of their own shareholder affiliate, the advisors' alleged concealing from shareholders of critical aspects of the new transfer agent affiliate's subcontracting arrangements with original transfer agent, and the earlier District Court decision.

Findings

The Court's opinion emphasized the fiduciary duty and disclosure obligations of investment advisers to mutual funds, noting that CAM, acting through SBFM, owed a “duty of ‘uncompromising fidelity’ and ‘undivided loyalty’ to Funds' shareholders.” The Court agreed with the district court that Section 36(b) does not permit the plaintiffs to seek damages that “inure to their own benefit and not to the Funds'”. As a result, the Court affirmed the District Court's holding that the Section 36(b) claim must be brought derivatively.

Practical implications

This case is a reminder that when proposing to provide a service “in‐house” a fund adviser should have a solid business rationale for doing so and should engage in a full dialogue with the fund's board regarding the proposal. Failure to disclose material information regarding such an arrangement could be significant in the context of a Section 36(b) claim, as well as a claim under the Securities Act of 1933 or the Securities Exchange Act of 1934.

Originality/value

The paper provides practical guidance from experienced financial services lawyers.

Citation

Dodds, W.K. and Vargo, B.S. (2010), "Second Circuit rules securities fraud claim of mutual fund shareholders relating to affiliated transfer agent arrangements may proceed, but upholds dismissal of breach of fiduciary duty claim", Journal of Investment Compliance, Vol. 11 No. 4, pp. 56-58. https://doi.org/10.1108/15285811011098992