Securities Law - Section 10b-5 and Investment Company Act

An important § 10b-5 case was decided by the Second Circuit on February 16, 2010. Operating Local 649 Annuity Trust Fund and certain individuals as class plaintiffs vs. Smith Barney, LLC et al., (Second Circuit, Docket No. 07-5125-cv). The main plaintiff, Local 649, purchased shares in 105 mutual funds sponsored and managed by affiliates of Citigroup. Plaintiffs claimed violations of § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 and breaches of fiduciary duty in violation of § 36(b) of the Investment Company Act of 1940. The affiliates of Citigroup included Smith Barney, Citigroup Global Markets (CGMI) and Citigroup Asset Management (CAM).
The main question was, did Smith Barney negotiate a contract for transfer services that saddled the Funds with excessive fees, a portion of which were for kickbacks to Smith Barney?

An outside contractor, First Data, had provided transfer agent services for the Funds. These services included calculating daily asset values, share prices and commissions, distributing proxies and certain accounting functions. CAM disclosed the total fees paid in Fund Prospectuses. At some point, it was decided to renegotiate the contract with First Data. CAM organized a new subsidiary CTB which contracted with the Funds to provide transfer agent services and then CTB contacted with First Data to provide most of the same services at a much lower rate. That negotiation resulted in a subcontract with First Data in a “side letter.” CTB charged the funds more in transfer agent fees than it paid First Data. It kept the money, which would later be argued belonged to the Funds.

The important aspects were concealed from the Funds’ Board of Directors. The Board was told that the goal of the new contract with CTB was to reduce fees and promote future growth.

CAM concealed its scheme from investors. The fees were disclosed in Funds prospectuses but CAM did not disclose that the transfer agent, CTB, would perform only minimal functions, but would pocket the difference between what it charged the Funds
and what it paid for its data.

A whistleblower reported to the SEC about CAM’s failure to disclose the arrangement to the Funds’ Board. Three months later CAM issued supplements to the Funds’ Prospectus disclosing the existence of the side letter and disclosing that CAM had not informed the Funds’ Board at the time of the transfer agent contract. The SEC investigated the violations of the Investment Company Act. According to the SEC the effect was to provide CTB with pre-tax revenues of approximately $100 million, offset by expenses of $10.5 million and to funnel to CAM $17 million in additional revenue. The SEC settled with Smith Barney and CTB who agreed to pay $200 million in fines and to disclose the process generated by the scheme. Various lawsuits were filed after the public disclosure of the SEC action and settlement. They were consolidated into the subject case. The District Court granted defendants’ motion to dismiss the Complaint, holding that the mischaracterization of the fees paid to CTB as transfer agent fees was not a false material representation under § 10(b).

The District Court also dismissed Local 649’s § 36(b) claims on the grounds that such a claim can only be brought derivatively. The Second Circuit said that the District Court dismissed Local 649 § 10(b) claims because it concluded that when an advisor discloses a total amount of fees paid by a fund for various services neither the fees allocation nor the transfer agent profit margin is material and that the amount of fees is relevant to the price of value and finding that an investor who knows the amount of fees the Funds pays can, when deciding to invest, compare the fees to those of its competitors. Because the total amount of fees was disclosed, plaintiffs were in possession of all material information and that “it is the amount of fees, not their allocation or a transfer agent’s transfer profit margin that is relevant to the price and value of the Funds.”

The Second Circuit pointed out that although a statement may be literally true, if susceptible to another interpretation by a reasonable investor, it may properly be considered a material misrepresentation. The determining factor is that for a fact to be considered material, there is substantial likelihood that a reasonable investor would consider it important in deciding whether to buy or sell shares.
Plaintiffs argued that the defendants’ misrepresented the services that CTB performed because investors were not told that CTB was limited to operating a small call center, that First Data would provide the majority of the services or that First Data would charge only a fraction the fees that would be drained from the Funds. Accordingly, the Court held that CAM’s misrepresentations were material and that a substantial likelihood existed that a reasonable investor would view them as significant alterations of the total mix of information available. The Court also stated that CAM acting through investment advisor Smith Barney owed a duty of uncompromising fidelity and undivided loyalty to the Funds’ shareholders. The Defendants had an obligation to negotiate the best possible arrangement for the funds. In addition, they were obligated to disclose candidly to shareholders the material features of the arrangements they crafted. The Defendants’ misrepresentations were material because there was a substantial likelihood that a reasonable investor would consider it important that its fiduciary was in essence receiving kickbacks.

The Court concluded that the dismissal by the District Court of Local 649’s Section 36(b) claim under the Investment Company Act was proper. Such a claim must be plead derivatively on behalf of the funds with damages going to the Funds rather than directly to the shareholders.

The dismissals of Local 649’s claims under 10(b) and Rule 10b-5 were vacated and remanded while the ruling by the District Court of Local 649’s claims under § 36(b) were affirmed.

Special Notes

1. There are clear similarities between the Local 629 case and Judge Easterbrook’s decision in Jones et al v Harris Associates, L.P., 527 F.3d 629 (May, 2008) described in the Clinton Firm Blog dated September 24, 2009. In the Jones case, Judge Easterbrook said courts should not second guess the setting of fees. The U.S. Supreme Court has granted certiorari in the Jones case. If the Supreme Court affirms the Jones case it, on application, may order a remand of the Second Circuit case for reconsideration of the Local 629 case.

2. It is also interesting that the SEC paid serious attention to the whistleblower in the Local 649 case, but failed in the Madoff case to follow up with careful analyses.