Northstar Fin. Advisors Inc. v. Schwab Invs.

Citation779 F.3d 1036
Decision Date09 March 2015
Docket NumberNo. 11–17187.,11–17187.
PartiesNORTHSTAR FINANCIAL ADVISORS INC., on behalf of itself and all others similarly situated, Plaintiff–Appellant, v. SCHWAB INVESTMENTS ; Mariann Byerwalter, Donald F. Dorward, William A. Hasler, Robert G. Holmes, Gerald B. Smith, Donald R. Stephens, Michael W. Wilsey, Charles R. Schwab, Randall W. Merk, Joseph H. Wender and John F. Cogan, as Trustees of Schwab Investments ; and Charles Schwab Investment Management, Inc., Defendants–Appellees.
CourtUnited States Courts of Appeals. United States Court of Appeals (9th Circuit)

Robert C. Finkel (argued), Wolf Popper LLP, New York, N.Y.; Joseph J. Tabacco, Jr., Christopher T. Heffelinger, and Anthony D. Phillips, Berman DeValerio, San Francisco, CA; Marc J. Gross, Greenbaum Rowe Smith & Davis LLP, Roseland, NJ, for PlaintiffAppellant.

Karin Kramer and Arthur M. Roberts, Quinn Emanuel Urquhart & Sullivan, LLP, San Francisco, CA; Richard Schirtzer (argued), Susan R. Estrich, and B. Dylan Proctor, Quinn Emanuel Urquhart & Sullivan, LLP, Los Angeles, CA, for DefendantsAppellees.

Before: RICHARD R. CLIFTON and CARLOS T. BEA, Circuit Judges, and EDWARD R. KORMAN, Senior District Judge.**

OPINION

KORMAN, District Judge:

The Investment Company Act (“ICA”) establishes a comprehensive federal regulatory framework applicable to mutual funds. See 15 U.S.C. § 80a–1 et seq. More specifically, it provides that a mutual fund's registration statement must recite all investment policies that can be changed only by shareholder vote. 15 U.S.C. § 80a–8(b). Deviation from policies so designated violates § 13(a) of the ICA. 15 U.S.C. § 80a–13(a)(3). This appeal arises out of a class action on behalf of investors who allege that the managers of the Schwab Total Bond Market Fund (“Fund”) failed to adhere to two of the Fund's fundamental investment objectives; namely, that it seek to track a particular index and that it not over-concentrate its investments in any one industry. These objectives, which could only be changed by a vote of the shareholders, were adopted by a shareholder vote and subsequently incorporated in the Fund's registration statement and prospectuses.

On a previous interlocutory appeal, we rejected the argument that this conduct gave rise to an implied private right to enforce § 13(a) of the ICA. Northstar Fin. Advisors, Inc. v. Schwab Invs., 615 F.3d 1106 (9th Cir.2010). On this appeal from an order granting a motion to dismiss a Third Amended Complaint, the principal issues are whether the investors have stated valid causes of action for breach of contract, breach of fiduciary duty, and breach of an agreement to which the investors claim to be third-party beneficiaries.

BACKGROUND

Schwab Investments (“Schwab Trust”) is an investment trust organized under Massachusetts law. Such a trust, which is often referred to generically as a “Massachusetts trust,” even when not created under Massachusetts law, is an unincorporated business organization created by an instrument of trust by which property is to be held and managed by trustees for the benefit of persons who are or become the holders of the beneficial interests in the trust estate. See Hecht v. Malley, 265 U.S. 144, 146–47, 44 S.Ct. 462, 68 L.Ed. 949 (1924).1 Thus, the Schwab Trust's Agreement and Declaration of Trust states that “the Trustees hereby declare that they will hold all cash, securities and other assets, which they may from time to time acquire in any manner as Trustees hereunder IN TRUST to manage and dispose of the same ... for the pro rata benefit of the holders from time to time of Shares in this Trust.” Schwab Investments, Registration Statement (Form N–1A), Agreement and Declaration of Trust 1 (Ex. 1) (Dec. 29, 1997) [hereinafter “Agreement and Declaration of Trust”]. Such a “trust today is a preferred form of organization for mutual funds and asset securitization.” Dukeminier, Sitkoff & Lindgren, Wills, Trusts, and Estates 556.

One of the significant features that distinguishes a Massachusetts trust from the ordinary or private trust “lies in the manner in which the trust relationship is created; investors in a business trust enter into a voluntary, consensual, and contractual relationship, whereas the beneficiaries of a traditional private trust take their interests by gift from the donor or settlor.” Herbert B. Chermside, Jr., Modern Status of the Massachusetts or Business Trust, 88 A.L.R.3d 704, 720 (1978) ; see also Berry v. McCourt, 1 Ohio App.2d 172, 204 N.E.2d 235, 240 (1965) (“By an underlying contract, or in the provisions of a business trust instrument, or both, the parties agree on the operations of the venture.”). Thus, the Agreement and Declaration of Trust at issue here states at the very outset that it was made “by the Trustees hereunder, and by the holders of shares of beneficial interest to be issued hereunder.” Agreement and Declaration of Trust 1. Moreover, it continues that [e]very Shareholder by virtue of having become a Shareholder shall be held to have expressly assented and agreed to the terms hereof and to have become a party hereto.” Agreement and Declaration of Trust 4.

Because this case involves the relationship between investors and a mutual fund, the trust which created the fund and the investment adviser which manages the fund, it is helpful to have a clear understanding of the relationships among these parties. We begin with a useful, if oversimplified, description of a mutual fund:

T, an investment professional, approaches A, B, C, and others like them and agrees to pool certain of their assets in a common fund to be managed by T. A, B, C, and the other investors each receive tradable shares in the fund in an amount proportional to their investment. By structuring their collective investment in this way, A, B, C, and the others are able to take advantage of economies of scale, obtain professional portfolio management, and achieve a more diversified portfolio than each could have individually. In managing the portfolio, T is subject to a fiduciary obligation to A, B, C, and the other investors in the fund.

Dukeminier, Sitkoff & Lindgren, Wills, Trusts, and Estates 556.

This simple description does not adequately discuss perhaps the most important party to this arrangement, namely, the investment adviser, whose “main role is to supervise and manage the fund's assets, including handling the fund's portfolio transactions.” Clifford E. Kirsch, An Introduction to Mutual Funds, in Mutual Fund Regulation § 1:2.2 (Clifford E. Kirsch ed., 2d ed.2005). The investment adviser is not a mere employee, contractor, or consultant. Instead, it is “more often than not also the creator, sponsor, and promoter of the mutual fund.” Charles E. Rounds, Jr. & Charles E. Rounds, III, Loring and Rounds: A Trustee's Handbook 955–56 (2012 ed.); see also Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 93, 111 S.Ct. 1711, 114 L.Ed.2d 152 (1991) (Mutual funds “typically are organized and underwritten by the same firm that serves as the company's ‘investment adviser.’); Daily Income Fund, Inc. v. Fox, 464 U.S. 523, 536, 104 S.Ct. 831, 78 L.Ed.2d 645 (1984) (Mutual funds are “typically created and managed by a pre-existing external organization known as an investment adviser.” (citing Burks v. Lasker, 441 U.S. 471, 481, 99 S.Ct. 1831, 60 L.Ed.2d 404 (1979) )).

Thus, while [i]n theory, the [trust] is able to choose any adviser it deems appropriate to invest the fund's portfolio, based on the adviser's investing style, track record and fees,” in practice, the investment adviser picked to manage the portfolio is most often self-selected and unlikely to be removed. John Shipman, So Who Owns Your Mutual Fund?, Wall St. J., May 5, 2003, at R1, available at http://online.wsj.com/news/articles/SB10520796 9873142900. Because “a typical fund is organized by its investment adviser which provides it with almost all management services ..., a mutual fund cannot, as a practical matter sever its relationship with the adviser.” Burks, 441 U.S. at 481, 99 S.Ct. 1831 (quoting S.Rep. No. 91–184, at 5 (1969), reprinted in 1970 U.S.C.C.A.N. 4897, 4901).

Consistent with this description of the structure of a mutual fund and its relationship with its investment adviser, the Schwab Trust selected Charles Schwab Investment Management, Inc. (Schwab Advisor) as its investment adviser. Indeed, Charles R. Schwab is alleged to have been chairman and trustee of the Schwab Trust and a member of the board of the Schwab Advisor. Third Am. Compl. ¶ 38. The latter is a subsidiary of the Charles Schwab Corporation, of which Mr. Schwab has served as “CEO at various times, including from 2004 through October 2008.” Third Am. Compl. ¶ 36. Moreover, the complaint alleges that all [d]efendants and their affiliates held themselves out as one Schwab entity[.] Third Am. Compl. ¶ 167.

The mutual fund at issue here, one of several operated by the Schwab Trust, is the Schwab Total Bond Market Fund. Reflecting the terms of a proxy statement proposed by the Schwab Trust in 1997, and subsequently adopted by the shareholders by majority vote, the prospectuses that the Fund issued during the relevant period stated that the Fund was “designed to offer high current income by tracking the performance of the Lehman Brothers [U.S.] Aggregate Bond Index [ (“Lehman Index”) ] and was “intended for investors seeking to fill the fixed income component of their asset allocation plan.” Specifically, the Lehman Index included “investment-grade government, corporate, mortgage-, commercial mortgage- and asset-backed bonds that [were] denominated in U.S. dollars and ha [d] maturities longer than one year.” Northstar Fin. Advisors, Inc. v. Schwab Invs., 609 F.Supp.2d 938, 945 (N.D.Cal.2009).2 Nevertheless, the Fund is not itself an index fund and, according to the Fund's prospectus, it was “not required to invest any percentage of its assets in the securities...

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