United States: Initial Rulings On Motions To Dismiss, But No Ruling Yet On Impact Of Regulatory Settlements

In a pair of recent rulings in the multidistrict litigation ("MDL") proceedings related to alleged market timing and late trading activities in mutual funds, Judge Frederick Motz ruled on certain common issues raised in motions to dismiss filed by defendants in the cases relating to the Janus family of funds, dismissing some claims, while allowing others to proceed. In the putative class actions, Judge Motz dismissed all claims asserted by a putative class of fund investors under the Securities Act of 1933 ("1933 Act") and under various state law theories and certain claims brought under the Securities Exchange Act of 1934 ("1934 Act") and the Investment Company Act of 1940 ("ICA"). In re Mutual Funds Investment Litigation, No. 1:04-MD-15863-JFM, Docket No. 1386 (D. Md. Aug. 25, 2005) . In the derivative actions, Judge Motz dismissed all but one of the derivative claims brought under the ICA and the Investment Advisers Act of 1940 ("IAA") by a group of shareholders on behalf of the fund. In re Mutual Funds Investment Litigation, No. 1:04-MD-15863-JFM, Docket No. 1388 (D. Md. Aug. 25, 2005) . Judge Motz has not yet ruled on a more recent motion filed by defendants in the Janus cases seeking dismissal on the grounds that a fund set up to compensate investors as part of a regulatory settlement would exceed any possible damages that could be obtained in the civil actions, although he did comment generally on this issue.

Beginning in February 2004, the Judicial Panel on Multidistrict Litigation transferred to the District of Maryland hundreds of cases asserting claims relating to alleged market timing and late trading activities in shares of mutual funds. The cases include both securities claims and non-securities claims. Some of the cases were brought as putative class actions, while others were brought as derivative actions on behalf of the funds. Defendants include funds, investment advisors and affiliated companies, fund directors, broker-dealers, and traders. More than fifteen different mutual fund families are involved. The cases have been divided up among three judges, with each having responsibility for cases relating to a particular set of fund families. Following the filing of consolidated amended complaints in late 2004, defendants in the various fund family cases filed motions to dismiss.

On August 25, 2005, Judge Motz issued two opinions, one directed to the motion to dismiss in the Janus class actions and the other directed to the motion to dismiss in the Janus derivative action.

Judge Motz’s opinion in the class actions addressed numerous issues, ruling on some and saving others for another day:

• Rule 10b-5 "Holder" Standing: Defendants argued that because the class plaintiffs had alleged they held (rather than bought or sold) mutual fund shares during the class period, they lacked standing to bring a claim under Section 10(b) of the 1934 Act and Rule 10b-5, citing Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975) (only purchasers or sellers of securities may bring private action under Rule 10b-5). Judge Motz ultimately declined to rule on this issue, concluding that plaintiffs’ class allegations included purchasers as well as holders and that the holders were likely to have also qualified as purchasers by virtue of their participation in dividend reinvestment programs. He reiterated views expressed earlier, however, that applying the rule of Blue Chip Stamps in the context of allegations of market timing would "elevate rule over principle."

• Sufficiency of Allegations of Rule 10b-5 "Scheme": Judge Motz first found that the allegations of market timing were sufficient to constitute the sort of fraudulent scheme, artifice, or other deceitful practice necessary to the imposition of liability under Rule 10b-5, concluding that even though market timing is not illegal per se, where

Judge Motz rejected arguments that no alleged scheme should be found because market timing had been widely known within the mutual fund industry for years.

• Sufficiency of Allegations of Defendants’ Participation in Alleged Rule 10b-5 "Scheme": Because Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), precludes aider and abettor liability in private actions under Rule 10b-5, Judge Motz held that in order to be liable under Rule 10b-5, a defendant must have been either a "co-designer" of the scheme or have committed a manipulative or deceptive act in furtherance of the scheme; the mere fact a defendant had financed or cleared a transaction would be insufficient. Reviewing the allegations as to particular defendants, Judge Motz found that the class plaintiffs had adequately alleged the participation of (1) the trader defendants, who were alleged to have been the primary architects of and to have profited from the scheme and (2) two of the broker-dealer defendants, who were alleged not only to have profited from the market timing activities but also to have provided systems and equipment for the specific purpose of facilitating market timing and late trading. The court also rejected arguments by these broker-dealer defendants that the plaintiffs had not met their burden of pleading scienter under the Private Securities Litigation Reform Act of 1995 and Federal Rule of Civil Procedure 9(b). As to two other broker-dealer defendants, however, Judge Motz found that plaintiffs had not adequately alleged that such broker-dealers either orchestrated the alleged scheme or committed any deceptive or manipulative acts in furtherance of the alleged scheme.

• Reliance Under Affiliated Ute: The fund defendants (i.e., various defendants affiliated with the Janus funds) argued that the class plaintiffs had not alleged they actually relied upon the fund defendants’ failure to disclose the fact they permitted market timing and late trading activities. The court rejected this argument, agreeing with plaintiffs that where plaintiffs had alleged a claim that was "primarily" based on a failure to disclose material facts (as opposed to affirmative misrepresentations), they were entitled to a presumption of reliance under Affiliated Ute Citizens v. United States, 406 U.S. 128, 153-54 (1972).

• Reliance Under "Fraud on the Market" Theory: Judge Motz found it unnecessary to reach plaintiffs’ alternative argument that they were entitled to a presumption of reliance under a "fraud on the market" theory (i.e., reliance is presumed where a company’s shares are traded on an efficient market). Judge Motz expressed skepticism, however, about the argument:

• Damages Under 1933 Act Claims: With respect to plaintiffs’ claims against the fund defendants under Sections 11 and 12(a)(2) of the 1933 Act, Judge Motz found that the only measure of damages contemplated by these provisions of the 1933 Act is the difference between the price paid for a share and the price for which the shares were or could have been sold at the time suit was filed. Because plaintiffs had not alleged they or any other members of the putative class had sold their shares for an amount less than they had originally paid, and therefore had failed to allege the essential element of recoverable damages, Judge Motz dismissed the 1933 Act claims.

Both the class plaintiffs and the derivative plaintiffs had asserted claims against the fund defendants under Sections 34(b), 36(a), and 36(b) of the ICA while the derivative plaintiffs had additionally asserted claims under Section 47(b) of the ICA and Sections 214 and 215 of the IAA.

• ICA Section 36(b): Section 36(b) provides a cause of action for a breach of fiduciary duty with respect to compensation or payments by investment companies or their shareholders to investment advisers or their affiliated persons. Judge Motz held neither group of plaintiffs could base a Section 36(b) claim on alleged late trading and market timing activities generally; rather, they could only pursue a claim based on any excessive fees and expenses that resulted from the alleged scheme.

• Failure of Derivative Plaintiffs To Make Demand: Applying Delaware and Massachusetts law, Judge Motz found that plaintiffs’ failure to make demand upon the fund trustees before filing a derivative action required them to allege particularized facts creating a reasonable doubt as to whether (1) the trustees were disinterested and independent and (2) as of the time the complaint was failed, the trustees could have properly exercised their independent and disinterested business judgment in responding to a demand. See Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993). The derivative plaintiffs argued demand was excused based on their allegations that the fund trustees (1) were highly compensated members of the boards of multiple funds and (2) faced a substantial risk of liability. Judge Motz rejected the first argument on the basis of Delaware and Massachusetts statutory provisions that investment company trustees not deemed "interested" under the ICA are considered "independent and disinterested for all purposes." See Del. Code Ann. tit. 12, § 3801(h); Mass. Gen. Laws Ann. ch. 182, § 2B. Although Judge Motz accepted the legal predicate underlying the second argument, he found the plaintiff’s allegations insufficient to raise a reasonable doubt the fund trustees did, in fact, face a substantial likelihood of liability. Judge Motz noted plaintiffs had not alleged the fund trustees actually knew of the market timing and late trading activities occurring within the funds, but only that they should have discovered and acted to prevent those activities. As such, plaintiffs’ allegations established, at most, negligence on the part of the trustees and fell short of the intentional conduct, recklessness, or gross negligence required to hold them liable. Accordingly, Judge Motz dismissed all of the shareholder derivative claims with the exception of the claim asserted under Section 36(b) of the ICA, which he found did not require demand. See 15 U.S.C. § 80a-35(b). Notwithstanding his dismissal of most of the derivative claims, Judge Motz went on to discuss their viability.

• Implied Causes of Action Under ICA Sections 34(b) and 36(a) and IAA Section 214: Section 34(b) of the ICA prohibits material misstatements in registration statements and various other documents; ICA Section 36(a) permits the SEC to bring a breach of fiduciary duty action; and IAA Section 214 provides for district court jurisdiction for violations of that statute. None of these provisions expressly provides for a private right of action. Relying upon Alexander v. Sandoval, 532 U.S. 275, 286-87 (2001) (revising judicial approach to implied rights of action so as to make statutory intent determinative in assessing whether a statute creates an implied private right of action and/or provides a private remedy) and a number of post-Sandoval district court rulings, Judge Motz held no private right of action exists under any of these three provisions.

• ICA Section 47(b) and IAA Section 215: Section 47(b) of the ICA declares unenforceable any contract "made in, or whose performance involves," violation of the ICA. 15 U.S.C. § 80a-46(b). Judge Motz found the derivative plaintiffs had failed to state a claim under this provision because the alleged market timing and late trading activities were "entirely ‘collateral and tangential to’" the investment advisory contracts and the terms of the contracts themselves were not necessarily unlawful. Although Section 215 of the IAA employs very similar wording, see 15 U.S.C. § 80b-15(b) (voiding "every contract made in violation of any provision of this subchapter and every contract . . . the performance of which involves the violation of . . . any provision of this subchapter"), Judge Motz noted the IAA broadly prohibits an investment adviser from "engaging in any act, practice, or course of business which is fraudulent or deceptive" irrespective of whether such act is "in connection with the purchase or sale of any security." See id. § 80b-6. Relying upon this variation in statutory language and the holding in Laird v. Integrated Resources, Inc., 897 F.2d 826 (5th Cir. 1990), Judge Motz suggested that (but for the dismissal on the basis of the demand requirement) Section 215 might permit a claim for rescission of the contract and restitution of fees based on the adviser defendants’ alleged failure to disclose the conflicts under which they were operating as a result of late trading and market timing activities.

Finally, Judge Motz found the Securities Litigation Uniform Standards Act of 1998 ("SLUSA") preempted all of the assorted state law claims asserted in the class plaintiffs’ complaint. SLUSA completely preempts all class actions based upon the common or statutory law of any state which allege "(A) a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security; or (B) that the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security." 15 U.S.C. § 78bb(f)(1). Plaintiffs had argued their claims for breach of fiduciary duty/constructive fraud, aiding and abetting breach of fiduciary duty, and unjust enrichment were not preempted because they did not require proof of fraud or misrepresentations as a "necessary component." Judge Motz, however, held that preemption turned not on the essential legal elements of the various state law claims, but the nature of the facts alleged to give rise to those claims. Since the state law counts explicitly incorporated the allegations of fraud and misrepresentation asserted in connection with the federal claims, Judge Motz found the state law claims preempted. Judge Motz granted plaintiffs leave to file an amended pleading, but expressed "substantial doubt" any such claims could be viably asserted under the circumstances since the nondisclosure of market timing and/or late trading practices "lies at the heart of the alleged wrongs."

On July 11, 2005, several months after the initial motions to dismiss, the Janus defendants filed a separate motion to dismiss based on the fact that Janus Capital had paid $50 million into a fund to compensate investors for any legally cognizable injuries suffered due to market timing. In re Mutual Funds Investment Litigation, No. 1:04-MD-15863-JFM, Docket No. 1330 (D. Md. July 11, 2005) . The Janus defendants contend that in light of this development and the Independent Distribution Consultant’s conclusion that total losses sustained by Janus fund investors were under $22 million, no case or controversy remains and, therefore, the court lacks subject matter jurisdiction. Plaintiffs have made clear that they oppose the motion, but their opposition brief is not due until October 14, 2005, and the Janus reply brief is not due until November 4, 2005. The parties have requested a hearing date in late November or early December.

Although Judge Motz was not in a position to rule on the issue in the absence of completed briefing, he did make clear that he views the impact of amounts paid for restitution under regulatory settlements to be one that needs to be resolved soon:

The court’s future rulings on the effect of the compensation funds established in the regulatory settlements relating to the Janus funds and other fund families (assuming other fund family defendants file similar motions) may have implications for the collateral effects of settlements with securities regulators and the nature of future regulatory settlements and negotiations.

© 2005 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.