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From Securities Regulation Daily, March 9, 2015

Schwab must face class action over departure from fund investment objectives

By Matthew Garza, J.D.

An investment adviser that sued Schwab Investments claiming that Schwab failed to adhere to a fund’s fundamental investment objectives found a receptive audience before a Ninth Circuit panel, which breathed new life into its class action against Schwab (Northstar Financial Advisors Inc. v. Schwab Investments, March 9, 2015, Korman, E.).

Background. Northstar Financial Advisors, which managed investor accounts and had over 200,000 shares of the Schwab Total Bond Market Fund under its management, represented a class of investors who claimed that Schwab failed to adhere to two of the fund’s stated investment objections, exposing it to tens of millions of dollars in losses. The fund adopted in 1997 the objective of tracking the Lehman Brothers Aggregate Bond Index, and although it was not itself an index fund, it specified in its registration statement that tracking the Lehman Brothers index was “fundamental” and could not be changed without the approval of holders of a majority of the outstanding voting securities. The fund was also precluded from concentrating more than 25 percent of its total assets in any one industry, unless it was necessary to track the Lehman Brothers index.

Standing. The court initially found that Northstar had standing to bring the suit, despite the fact that when it filed the complaint in August of 2008, it owned no shares of the fund. It subsequently obtained an assignment of claim from a client-shareholder upon the suggestion of the district court, which cured the standing deficiency. Judge Carlos Bea dissented from this holding, arguing that the district court originally lacked subject matter jurisdiction and it was not permissible to grant leave to cure the defect. The majority ruled that the lower court judge did not abuse her discretion in permitting Northstar to file a supplemental pleading after a post-complaint assignment from a party that clearly had standing.

Breach of contract. The court reversed the district court and found that Northstar had sufficiently established that a contract was formed between the investors and Schwab when a 1997 proxy proposal addressing the fund’s investment objectives was subsequently incorporated and disseminated in the fund’s registration statement and prospectuses. Anyone who purchased or held shares in the fund after that date was legally and contractually entitled to have his investment managed in accordance with the proxy proposals and subsequent SEC filings, unless shareholders voted to permit otherwise, held the court. The court was not persuaded by Schwab’s argument that SEC filings themselves cannot reflect contractual obligations that can be enforced in a breach of contract suit.

Breach of fiduciary duty. The court vacated the district court’s holding on a claim of breach of fiduciary duty and remanded to the court to further consider Northstar’s arguments that the fund’s trustees owned a fiduciary duty directly to Northstar’s investors, who were not required to bring the claims derivatively. “There may be scenarios where a mutual fund trustee can be sued only derivatively—for example, if he embezzles assets held by the fund, the injury may be first to the mutual fund and only secondarily to the investors in the fund.” But in this case the claims were about the failure to follow trading restrictions, “the very essence of business,” said the court, so a direct cause of action was supported.

The panel also reversed the district court’s dismissal of Northstar’s third-party beneficiary breach of contract claim, holding that the adviser sufficiently alleged that the investors were third-party beneficiaries of the Investment Advisory and Administration Agreement between Schwab Trust and Schwab Advisor.

This is case No. 11-17187.

Attorneys: Christopher T. Heffelfinger (Berman DeValerio) for Northstar Financial Advisors, Inc. Patrick Charles Doolittle (Quinn Emanuel Urquhart & Sullivan) for Schwab Investments.

Companies: Northstar Financial Advisors, Inc.; Schwab Investments.

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