United States: Federal Court Decision Highlights Uncertainty over Mutual Fund Derivative Litigation Under Massachusetts Law

Originally published in The Journal of Index Investing

Like any issuer of securities, mutual funds are subject to various types of lawsuits brought on behalf of shareholders, seeking recovery for underperformance, the allocation of fees, or other types of perceived losses to investors. The potential monetary damages, legal costs, and administrative burdens imposed by such lawsuits have meaningful implications for the advisors and trustees of mutual funds, and others involved in mutual fund management. This article explains recent developments in a common type of shareholder lawsuit under Massachusetts law, known as a "derivative" claim. Because many U.S. mutual funds are organized as Massachusetts business trusts, and shareholder derivative suits are governed by state law,1 a unique Massachusetts statute— enacted in 2004 and still largely open to interpretation by state and federal courts—raises important considerations for anyone working to minimize or respond to shareholder lawsuits in the mutual fund industry.

What are Derivative Suits, and Why are They Relevant?

Derivative suits are a unique type of legal claim available to shareholders: rather than directly suing a company for perceived wrongs visited upon them as shareholders, plaintiffs seek in a derivative claim to stand in the shoes of the corporate entity, and to pursue rights that belong to the entity itself. In the mutual fund context, such claims are often brought by shareholders on behalf of funds against fund advisors, their affiliates, and sometimes fund trustees or directors.2

A derivative claim represents an exception to the cardinal rule of corporate law that the board of directors—not individual shareholders—ultimately has the power to manage all business and affairs of a corporate entity, including whether to pursue a lawsuit on its behalf.3 As a result, state corporate law has traditionally imposed stringent procedural requirements upon the shareholder who seeks to sue on the corporate entity's behalf, requiring a shareholder plaintiff first to demand in writing that the board act on his claim, in order "to ensure that all available means to obtain relief through the corporation itself are exhausted."4 In response to such a demand, the board could choose to pursue the litigation on behalf of the corporate entity, reject the demand, or settle on some intermediate remedy to address the concerns raised by the shareholder. Where the board declined to initiate litigation, the shareholder could pursue the corporate claim, but only if he was able show that the board's rejection of the demand was not made in good faith, or through a reasonable exercise of its business judgment.

Because a derivative lawsuit pursues claims on behalf of the corporation or trust, rather than the shareholders themselves, any recovery goes to the corporate entity, and not to the individual plaintiffs. Even so, individual plaintiffs and their attorneys are at times allowed to collect a fee for pursuing a successful derivative suit. In the mutual fund context, the prospect of such a fee creates an incentive for plaintiffs' attorneys to pursue derivative suits in the wake of a fund's underperformance, as an alternative to a class action brought on behalf of shareholders themselves. Derivative demands are becoming increasingly common, as recent court decisions have dramatically narrowed the causes of actions for which shareholders are deemed to have a direct right of action brought against mutual funds under federal securities laws, such as the Investment Company Act of 1940 (the "ICA"). But the ICA can still be implicated in a derivative suit brought by a shareholder on behalf of a mutual fund—in recent years, such cases have sought recovery for a broad range of grievances, including theories du jour pertaining to market timing, revenue sharing, and investments in mortgage-related assets, among others. As a result, Massachusetts law pertaining to the initiation of a derivative suit has broad implications for mutual funds organized as Massachusetts business trusts.

In 2004, the Massachusetts legislature enacted a statute, entitled the Massachusetts Business Corporations Act ("MBCA"), which provided sweeping changes to the Massachusetts law governing shareholder derivative suits—including provisions that are unique among the law of all 50 states.5 The U.S. Court of Appeals for the Second Circuit, based in New York, recently took the unusual step of referring an unsettled question of Massachusetts law directly to the state's highest court, regarding a relatively narrow question under the MBCA (in a derivative case pursued against the trustees and directors of a Citigroup-affiliated trust comprised of six mutual funds).6 While the MBCA is six years old, there have been relatively few court cases interpreting its sometimes novel provisions, and the Second Circuit's action underscores that a number of questions pertaining to derivative claims under Massachusetts law remain unresolved, with implications in any derivative suit involving a Massachusetts corporation or business trust, wherever the case might be filed.7 We discuss below some of the more significant of these open questions, as well as the strategic considerations they pose for mutual fund advisors and trustees faced with derivative demands and suits.8

Universal Demand Requirement and its Implications

Massachusetts case law, like that of most states, historically allowed certain derivative cases to go forward without a demand on the board in situations where a majority of the directors were unable to act in the best interests of the corporation due to a conf lict of interest, such as a personal stake in the underlying transaction, or wrongful conduct that rendered the directors themselves the targets of the proposed litigation. Consequently, two separate types of derivative cases arose under the common law regime: the first, where a demand was made and rejected, known as "demand refused" cases; and the second, where demand would be an unnecessary idle ceremony due to the directors' disabling conf licts, or "demand excused" cases. Further, a shareholder plaintiff who had in fact made a demand was deemed to have conceded that demand was not excused, thereby forcing him to select one of two separate and alternative paths at the outset of his efforts to address the perceived corporate harm—even before filing a formal complaint.

Where a shareholder first demanded that the board pursue certain corporate action for purposes of addressing his protest, and the demand was eventually refused, an ensuing lawsuit would focus on whether the directors' potential rejection of his demand was made in good faith and was the product of a reasonable investigation. Should the shareholder instead file suit without pursuing the "intra-corporate alternative dispute resolution" encouraged by the demand requirement, he would have to convincingly advance a different argument: that a majority of the board had a pre-existing conf lict of interest that would render useless his prospective demand.9

The new MBCA, by contrast, requires demand in all cases. It thereby dispenses with both a shareholder's ability to proceed with litigation without first seeking relief through the board, and the traditional rule that making a demand on the board waived the shareholder's ability to argue that the board was incapable of independently evaluating it. In every derivative case brought under the new statute, a shareholder plaintiff can argue both that the board suffered from a disabling conf lict of interest that prevented it from fairly considering his demand, and that the board's decision was not a reasonable application of its business judgment.

Initially, by requiring that all prospective shareholder plaintiffs make a demand on a corporation's board of directors before pursuing a derivative suit, the MBCA is likely to increase the number of pre-suit shareholder demands made upon Massachusetts corporations and business trusts. Further, because a plaintiff can both make a demand, and challenge the board's ability to assess his request disinterestedly, a board of directors responding to a litigation demand should anticipate potential challenges both to the independence of the directors who will be evaluating the demand with respect to the relevant transaction or conduct, and to the procedural reasonableness of their investigation into the demand, in contrast to the previous "either or" regime.10

From the time a demand is received, through the company's investigation and the directors' decision regarding the demand, a mutual fund's board of directors will be well served to assess both the independence of each individual director, and the adequacy of the investigation, so as to protect the company against both types of challenges in any ensuing litigation. Directing outside counsel to interview or submit questionnaires to the directors, and documenting the results, is one possible approach to assessing independence and maintaining a useful record. If the company has doubts about the independence of a majority of its directors, it will need to consider whether to delegate control over the response to the shareholder demand to a committee of independent directors, as provided for in the statute.

Procedure and Standard for Dismissal

If a shareholder whose demand on the board is rejected later decides to pursue a derivative lawsuit, the individual defendants (typically the fund advisors, their affiliates, and fund trustees) will often seek to avoid the burden of litigating a shareholder derivative suit by filing a motion to dismiss the claim at the outset. In derivative suits, motions to dismiss generally challenge whether the plaintiff has met the procedural prerequisites pertaining to the demand requirement, and establishing that the demand was rejected in good faith by independent directors after a reasonable investigation. But the new MBCA overhauled the procedure for a motion to dismiss, with meaningful implications for the steps a board should take in assessing a derivative demand.

In contrast to traditional motions to dismiss, where the defendants simply challenge the sufficiency of the plaintiff 's allegations on their face, the MBCA requires that a defendant corporation seeking to dismiss a derivative suit submit a "written filing with the court setting forth facts to show 1) whether a majority of the board of directors was independent at the time of the determination by the independent directors and 2) that the independent directors made the determination in good faith after conducting a reasonable inquiry upon which their conclusions are based."11 If the corporation's written filing meets this standard, the court is required to dismiss the action unless the shareholder plaintiff "has alleged with particularity facts rebutting the corporation's filing in [the] complaint or an amended complaint or in a written filing with the court."12

In some ways, the MBCA's unique dismissal procedure confers a benefit on the corporation seeking dismissal of a derivative complaint. It has an opportunity unique in civil litigation to present its version of the facts when moving to dismiss—typically without providing the other side an opportunity to request documents and take depositions through discovery—and the court is required to accept those facts unless they are specifically rebutted by the plaintiffs. This standard ref lects the deference shown to corporate boards under the traditional business judgment rule. Unlike a traditional motion to dismiss, where the defendant is required to treat the plaintiff 's allegations as if they are true and to only challenge the legal relevance of the facts alleged in the complaint, under the MBCA, the corporation gets to tell its side of the story, with a presumption in favor of its decision that the potential corporate claims were not in the corporation's best interest.

But the new dismissal procedure also presents potential disadvantages and areas of concern for the corporate defendants. Where a simple and plainly deficient derivative complaint could be dismissed based on its facial deficiencies under the old rules, the new statute requires the directors to disclose facts explaining the basis of their decision, making the dismissal procedure more burdensome in some instances, and requiring more detailed public disclosure of board determinations than might otherwise be necessary. The potential for protracting an otherwise meritless case could increase, as the corporate entity will be required to provide a factual account that the plaintiffs will inevitably seek to construe in their own favor, or to challenge as inadequate by contriving purported investigatory omissions. In addition to accessing this otherwise unavailable information, the statute also affords the plaintiffs an opportunity to amend their complaint or submit their own factual statement, creating a broader factual record than would be relevant in a traditional motion to dismiss.

Given the present lack of precedent interpreting exactly how the facts raised by derivative plaintiffs might rebut the corporation's factual submission, the prospect for inconsistent and unpredictable standards of interpretation by individual trial judges may add uncertainty for a corporation seeking to respond appropriately to derivative claims. Because corporations currently have little guidance on what qualifies as an adequate factual showing under the statute, they may have reason to create and maintain a documentary record from the investigation into the demand that can later be used in support of their written submission, though competing considerations about potential drawbacks of an extensive written record should also be evaluated.

The Shifting Burdens in an MBCA Motion to Dismiss

The showing that the corporation must make to obtain dismissal under the MBCA varies significantly depending on whether a majority of its directors are deemed independent, affecting in turn the level of detail that the company will want to submit in its motion to dismiss. Specifically, if a majority of the directors are independent, it is the plaintiff 's burden to plead and prove that the decision to reject the demand was not made in good faith, or was not the product of "a reasonable inquiry upon which [the directors'] conclusions [were] based." In this scenario, while the corporation still must make a factual showing in support of its motion to dismiss, the court's focus is necessarily on the sufficiency of the facts pled or otherwise offered by the plaintiffs.

By contrast, where a majority of the directors are not independent, it is the corporation's burden to establish that the decision was made in good faith and based upon a reasonable inquiry. Presumably such cases—now rare in the mutual fund context—will usually involve demand responses delegated to a committee comprised of independent directors, created specifically to make a binding determination regarding the demand, because a board lacking a majority of independent directors is not qualified to reject a demand under the statute.

These varying burdens of proof create a markedly different dismissal process in the initial stages of a derivative lawsuit, depending on whether or not a majority of the directors are deemed independent. Where a majority of the directors are independent, even though the corporation must offer an initial factual statement regarding its rejection of the demand, it is the plaintiff 's burden to plead or otherwise provide facts undermining the board's determination, and to do so under the traditional heightened pleading standard. These substantial procedural obstacles on derivative plaintiffs ref lect the protections of the business judgment rule, under which the actions of independent directors are presumed to have been made in the corporation's best interest. While the corporation's motion for dismissal under the MBCA in this context must still be accompanied by its own statement of facts, the company's argument and the court's inquiry should ultimately focus on the adequacy of the plaintiff 's pleadings, akin to a traditional motion to dismiss.

The burden on corporate defendants is more substantial in instances where a majority of the directors are not independent. These cases require the defendants to establish that the rejection of the demand by a committee of independent directors was reasonable and principled, in a motion similar to a traditional motion for summary judgment, where the defendants must make an uncontested factual showing to defeat the plaintiff 's claims. As part of such a motion, the corporation may be required to provide a detailed factual explanation regarding its investigation into the potential claims raised in the demand, and the reasons why it decided not to pursue them. Thus, a non-independent board not only has to satisfy the less deferential "reasonable and principled" standard, but is also required to provide more factual details regarding the merits of its decision in support of its motion to dismiss the case.

Discovery

The MBCA provides a presumption against allowing the plaintiffs to take any discovery from the officer or director defendants, or from the corporate entity itself, while the corporation's motion to dismiss is pending. But there is a vaguely defined exception to this rule, which allows the court to order "specified discovery" "after a hearing and for good cause shown," even while the motion to dismiss is unresolved.

Neither the statute, the commentary, nor the case law interpreting the MBCA provides any explanation as to what constitutes "good cause" that would justify discovery. The statute's presumption against discovery is consistent with pre-MBCA court decisions that allowed for stays of discovery in derivative cases to effectuate the business judgment rule by protecting the board's domain over corporate business affairs from shareholder intrusions, until the viability of a shareholder's derivative claims had been tested by a motion to dismiss. Prior to the MBCA, courts generally allowed discovery to proceed prior to a ruling on the corporation's motion to dismiss only in specific narrow circumstances, such as cases that involved requests for preliminary injunctive relief or concerns that relevant documents or data might not be available later, and where the motion to dismiss would only resolve part of the litigation.

The drafters of the MBCA likely had similarly narrow circumstances in mind when enacting the "good cause" exception to the statute's automatic stay of discovery, particularly in light of the general presumption that discovery be stayed as a matter of course. Because the statute does not explicitly define what constitutes "good cause" for discovery, however, derivative plaintiffs will inevitably argue that discovery is warranted in every MBCA case. Without clear guidance from the statute or court decisions interpreting it, corporate litigants will have to evaluate the risks of board materials and documents pertaining to the investigation of a derivative demand becoming discoverable, while also arguing that the statute incorporates prior case law, under which a derivative plaintiff was not allowed discovery to bolster his complaint.

Conclusion

Many of the novel provisions of the revised MBCA will have still-unsettled implications in derivative suits involving Massachusetts-incorporated mutual funds. Boards of directors can gain some guidance from the familiar and traditional approaches to responding to shareholder demands, although the new statute explicitly imposes some new, more specific requirements for responding to derivative claims. Mutual fund directors and their attorneys will be well served to pay attention to additional developments on the issues discussed herein, and other unanswered questions pertaining to the MBCA when they have reason to anticipate or respond to a derivative demand from shareholders.

Footnotes

1. See ING Principal Prot. Funds Derivative Litig., 369 F. Supp. 2d 163, 171 (D. Mass. 2005) (holding in a mutual fund derivative case that Massachusetts state law applies also to business trusts because "a business trust in practical effect is in many respects similar to a corporation."); Halebian v. Berv, 631 F. Supp. 2d 284, 291 (S.D.N.Y. 2007) ("Since CitiTrust is a Massachusetts business trust, the parties correctly conclude that Massachusetts substantive law governs this action."); see generally Kamen v. Kemper Fin. Servs., 500 U.S. 90, 108-109 (1991) ("[A] court that is entertaining a derivative action under [the 1940 Investment Company Act] must apply the demand futility exception as it is defined by the law of the State of incorporation.").

2. Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984).

3. Id.

4. Harhen v. Brown, 431 Mass. 838, 844, 730 N.E.2d 859, 865 (2000) (quoting Bartlett v. New York, N. H. & H. R. Co., 221 Mass. 530, 532, 109 N.E.2d 452, 453 (1915)).

5. The MBCA was codified as a new chapter 156D to the Massachusetts General Laws, consisting of 24 sections. Mass. Gen. Laws ch. 156D, §§ 1-24.

6. Halebian v. Berv, 590 F.3d 195, 207 (2d Cir., Dec. 29, 2009). The Massachusetts Supreme Judicial Court answered the certified question in an opinion issued August 23, 2010. Halebian v. Berv, 457 Mass. 620 (2010).

7. The certified question in Halebian pertained to the Massachusetts statute's time limits on when a derivative suit could be filed, and when the corporation could move to dismiss. The statute allows a motion to dismiss "after rejection of a demand," and does not let plaintiff file suit until 90 days after making a demand. In Halebian, the plaintiff filed suit before his demand was rejected, but after the expiration of the 90-day waiting period. The Second Circuit's certified question to the Massachusetts Supreme Judicial Court was whether the corporation could move to dismiss the claim under the statute without having previously rejected the plaintiff 's demand. 590 F.3d at 214. The Massachusetts Supreme Judicial Court ruled that such a motion was still appropriate in light of the board's control over corporate policy, including whether or not to pursue a lawsuit on the corporation's behalf. Halebian v. Berv, 457 Mass. 620, 625 (Mass. 2010).

8. See John D. Donovan, Jr., Shareholder Suits, Massachusetts Corporation Law and Practice, ch. 17 (Donald W. Glazer and Richard Southgate, ed.; Aspen Publishers (forthcoming revised edition)), for a broader discussion of derivative cases and other shareholder causes of action under Massachusetts law.

9. While the independence of the directors would remain relevant in a demand refusal case, it would be a sub-part of the broader inquiry regarding their decision to reject the demand.

10. The statute explicitly provides that a determination as to whether "the maintenance of the derivative proceeding is not in the best interests of the corporation ... shall be made by" either i) a majority of the independent directors, if they constitute a quorum; ii) a committee of two or more independent directors appointed by a majority vote of the independent directors; iii) the holders of the majority of outstanding shares, excluding shares controlled by individuals with a beneficial financial interest in the underlying act or omission or the relatives of such individuals, or iv) a panel of one or more independent persons appointed by the court, on motion of the corporation. Thus, where a quorum of the board is comprised of independent directors, a majority of those independent directors can make the determination on their own. Where the independent directors do not constitute a quorum, they can refer the demand to a committee of independent directors, selected by a majority of the full group of independent directors, request that the court appoint a panel to assess the demand on the corporation's behalf, or submit the demand to a shareholder vote.

11. Mass. Gen. Laws ch. 156D, §7.44(d). The Comments to the new MBCA explain that Section 7.44 "is patterned on but does not strictly follow" the Revised Model Business Corporation Act. The Model Act does not require the defendant to prepare a factual filing, and the new MBCA's requirement that a defendant corporation file a factual statement in conjunction with its motion to dismiss appears to be unique among the states that have enacted some version of the model act.

12. Id.

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