northstar financial considerations for directors · 2017-02-02 · in the context of mutual...
TRANSCRIPT
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ROPES & GRAY LLP
Northstar Financial Considerations for Directors Bryan Chegwidden, John Donovan & Robert Skinner
Mutual Fund Directors Forum July 30, 2015
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ROPES & GRAY
Northstar – Overview
• Northstar Financial Advisors Inc., v. Schwab Investments (“Northstar”) (March 2015)
• 9th Circuit Upheld 3 Novel State Law Claims Advanced by Mutual Fund Shareholders
• Claim: Fund Did Not Follow “Fundamental” Investment Policies
• Ruling: Class Action Permitted to Proceed – As breach of the “contract” represented by the Fund’s proxy
statement and prospectus – As a class action, rather than derivatively on behalf of the Fund – As “third-party beneficiaries” of the advisory contract
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ROPES & GRAY
Northstar – Overview
• Northstar Threatens to: – “De-federalize” claims by mutual fund shareholders – Create new state law causes of action not previously
recognized – Supplant directors as gatekeepers of a fund’s claims
• As binding precedent, could make 9th Circuit a magnet for shareholder litigation.
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ROPES & GRAY
Northstar – Overview
• Today’s Purpose: – Understand Northstar and its implications – Discuss possible steps to mitigate 9th Circuit risk
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ROPES & GRAY
Northstar – Factual Background
• Schwab Total Bond Market Fund – Intended to track “performance” of Lehman Aggregate Bond Index – Actively managed; not an index fund
• Fund Invested in Non-Agency CMO’s – Riskier than agency-issued mortgage-backed securities in Index – Over concentrated in mortgage backed securities
• Claim: Investments Deviated from a “Fundamental” Objective and Policy Without Shareholder Approval
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ROPES & GRAY
Northstar – Legal Claims
• Initial Claim – Adviser violated Section 13(a) of the 1940 Act – Forbids changes in fundamental policies without shareholder
vote – Claim dismissed
• Section 13(a) not privately enforceable
• Plaintiffs Then Reversed Course – Eliminated All Federal Claims – Three State Law Theories
• Breach of contract against the Fund • Breach of fiduciary duty against the trustees and the adviser • Breach of the investment advisory agreement between the Fund and the
adviser
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ROPES & GRAY
Northstar – Background
• District Court dismissed • 9th Circuit reversed in March 2015
– Let all 3 state law claims proceed
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ROPES & GRAY
Northstar – Breach of Contract
• Per the 9th Circuit: – Sending a “proxy statement and [adopting] two fundamental
investment policies after the shareholders voted to approve them, and the annual representations by the Fund that it would follow these policies are sufficient to form a contract between the shareholders . . . and the Fund.”
• Opinion also refers to the contract existing between the shareholders and the Trustees
– Policies were reflected in the Fund’s prospectus – Therefore, all purchasers were “contractually” entitled to have the
portfolio managed in accordance with the policies
• First and only ruling that a mutual fund’s mandatory federal securities disclosure can form a binding contract under state law 52008924_3.pptx
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ROPES & GRAY
Northstar – Breach of Fiduciary Duty
• Per 9th Circuit: – Shareholders could also pursue claims that the
trustees and adviser breached fiduciary duties by managing the portfolio in breach of a fundamental objective and policy
– That claim could be pursued “directly” by shareholders as a “class”
– Claim not “derivative” – where directors retain authority to “halt suits that are meritless or contrary to the corporation’s interest.”
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ROPES & GRAY
Northstar – Breach of Fiduciary Duty
• Per 9th Circuit: – “Derivative” vs. “Direct” distinction “has little meaning
in the context of mutual funds.” – The declaration of trust says assets are held for the
“benefit of the holders” – Since fund’s purpose is to increase NAV, benefits of
management flow to holders, not fund – Benefits to fund from derivative recovery unfair
because shareholder population changes
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ROPES & GRAY
Northstar – Breach of Fiduciary Duty
• Per 9th Circuit: – Procedural protections of derivative actions of little
value since mutual funds “are essentially puppets of the investment adviser.”
– ’40 Act definition of “independent” is “fairly loose” – “Any so-called independent directors would obviously
have to be satisfactory to the dominating stockholders who are in a position to continue to elect a responsive board.”
– Thus wrong to think “independent” directors would actually control fund litigation
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ROPES & GRAY
Northstar – Third-Party Beneficiary of IAA
• Per 9th Circuit: – Shareholders claim that adviser violated “fundamental
policy” was a claim that it breached the investment advisory agreement (“IAA”)
– Shareholders claimed to be third-party beneficiaries of that contract, entitled to enforce it directly
– The complaint adequately alleged that the parties to the IAA “intended” that it be enforceable by shareholders
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ROPES & GRAY
Northstar – Implications
• “De-federalizes” claims by mutual fund shareholders • Permits new theories previously not recognized • By permitting “direct,” not “derivative” suits under state
law: – Removes directors from gatekeeper role – Extinguishes procedural protections of derivative suits – Eliminates burden of federal pleading requirements
• Imagine state law suits for: – Statements in Annual and Semi-Annual Reports, Prospectuses, Proxy
Statements and other disclosures – Mismanagement of the portfolio – Excessive fees
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ROPES & GRAY
Northstar – Implications
• Most likely: – District courts in 9th Circuit (California, Oregon,
Washington, Arizona, Alaska, Montana, Idaho, Nevada, Hawaii) likely will consider Northstar binding precedent
– 9th Circuit could be litigation magnet – One suit already
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ROPES & GRAY
Possible Steps
• Aim: Minimize risk of being forced to litigate in 9th Circuit
• Won’t prevent actions in 9th Circuit • Rather, coerce plaintiffs to sue elsewhere or provide
basis for transfer to more favorable forum without Northstar precedent
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ROPES & GRAY
#1 Forum Selection
• Bylaw Forum Selection Provision – Bylaws typically can be amended by majority vote of the fund
board, without shareholder approval. – Bylaws could require litigation against, relating to, or on behalf of
the fund – including claims against trustees/directors and officers – to be brought in specified court
• E.g.: Fund complex headquarters • State where funds are organized (often Massachusetts, Delaware or
Maryland)
– If claim is brought elsewhere, defendants could enforce bylaws to dismiss or transfer case to specified jurisdiction
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ROPES & GRAY
#1 Forum Selection (cont.)
• While no guarantee a court would enforce forum selection, precedent is highly favorable: – U.S. Supreme Court: Forum selection provision
specifically enforceable. Atlantic Marine (2013) – Delaware: June 2015 legislation validating such
bylaw measures
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ROPES & GRAY
#2 Fee Shifting
• Add Fee Shifting Measure to Forum Selection Bylaw – Require plaintiff to pay costs of defendants’ successful motion to
dismiss or transfer a case brought outside selected forum – More aggressive than “mere” forum selection bylaw, but risk of
fee shift could coerce compliance – More complicated to uphold
• Delaware’s new statute precludes fee shifting on intracorporate claims
– Argument is this is not an “intracorporate” claim fee shift, only one to enforce forum selection
• Other states’ laws are undeveloped
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ROPES & GRAY
#3 New Language for Advisory Agreements
• No Third-Party Beneficiaries – IAA in Northstar was silent as to whether it was intended to
benefit third parties. – Parties’ intent should be dispositive on questions of contractual
interpretation. – Contractual language disclaiming third party beneficiaries could
be helpful
• Add forum selection provision to IAA • Require any claims arising from or relating to
performance under the IAA be brought in specified court
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ROPES & GRAY
#4 Mandatory Arbitration
• Mandatory Arbitration Provisions with a Class Action Waiver – Supreme Court: Contracts compelling disputes to be
arbitrated and waiving the right to bring claims as class actions are enforceable. American Express (2013).
– Since Northstar emphasizes “contractual” rights of shareholders, bylaw provision could eliminate class claims
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ROPES & GRAY
#5 Define Direct and Derivative Claims
• Define Direct vs. Derivative Claims – Northstar effectively eliminates distinction – Bylaw could define the types of claims shareholders
can bring directly, or must pursue derivatively • Takes distinction away from courts • Such a provision might specify that all claims must be
brought derivatively, except for a narrowly defined set of direct shareholder claims
– E.g.: right to be paid a declared dividend
• No guarantee of enforceability in view of Northstar reasoning • But no meaningful downside
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ROPES & GRAY
Additional Considerations
• Fund shareholders and proxy advisory firms may react negatively – Two major proxy advisory firms reject exclusive venue proposals for
publicly traded operating companies. – May be particularly troublesome for closed-end funds that hold annual
meetings – Proxy advisory firms could recommend withholding votes for the re-
election of directors/trustees
• Possible adverse publicity to a fund complex as being “anti-shareholder.”
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ROPES & GRAY
Additional Considerations
• Given the Northstar court’s treatment of the prospectus as a source of contractual obligations, clear disclosure in the fund’s prospectus of the bylaw provisions and advisory contract provisions selected by a fund’s board may be helpful in seeking to bind shareholder-plaintiffs to the selected provisions’ requirements in any litigation.
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ROPES & GRAY
Additional Considerations
• Same results obtainable through amendments to charter or declaration of trust
• Normally requires shareholder vote • Shareholder approval likely decreases risk that provision
is not enforced
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ROPES & GRAY
Questions and Comments
Bryan Chegwidden [email protected] (212) 497 3636 (New York) John D. Donovan [email protected] (617) 951 7566 (Boston) Robert A. Skinner [email protected] (617) 951 7560 (Boston)
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