Northstar Financial Advisors, Inc. v. Schwab Investments

Citations: 807 F. Supp. 2d 871; 2011 U.S. Dist. LEXIS 87208; 2011 WL 3443496Docket: Case 08-CV-04119 LHK

Court: District Court, N.D. California; August 8, 2011; Federal District Court

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Northstar Financial Advisors, Inc. filed a class action lawsuit against Schwab Investments and several trustees, alleging that the Schwab Total Bond Market Fund improperly deviated from its investment objectives. Northstar claims that the Fund invested in high-risk non-U.S. agency collateralized mortgage obligations (CMOs) and exceeded a 25% investment concentration in U.S. agency and non-agency mortgage-backed securities, both of which were not consistent with the Fund's goal to track the Lehman Brothers U.S. Aggregate Bond Index. These deviations allegedly resulted in significant financial losses for the Fund and its shareholders, evidenced by a negative total return of 4.80% during a specified period compared to a positive return of 7.85% for the Index. Northstar has asserted claims for violation of Section 13(a) of the Investment Company Act of 1940, breach of fiduciary duty, breach of contract, and breach of the covenant of good faith and fair dealing. Defendants' motion to dismiss the Third Amended Complaint was granted by the court, following prior rulings that acknowledged an implied private right of action under Section 13(a) of the ICA.

Judge Illston granted Plaintiffs permission to amend their breach of fiduciary duty and breach of contract claims, leading to the filing of a First Amended Complaint (FAC) on March 2, 2009. Subsequently, defendants appealed Judge Illston's ruling that allowed a private right of action under Section 13(a) of the Investment Company Act (ICA) and obtained a stay of the case from April 27, 2009, to August 13, 2010. During this period, the case was reassigned to different judges. On August 13, 2010, the Ninth Circuit reversed the earlier ruling, stating that no private right of action exists under Section 13(a). Following this, Northstar filed a Second Amended Complaint (SAC) on September 28, 2010, removing the Section 13(a) claim and naming Schwab Investments, its Trustees, and Charles Schwab Investment Management as defendants. The SAC alleged breaches of fiduciary duty and contract, among other claims.

On March 2, 2011, the Court dismissed the SAC, determining that the claims were precluded by the Securities Litigation Uniform Standards Act of 1998 (SLUSA) because they involved misrepresentations related to the purchase or sale of the Fund's shares. However, the fiduciary duty claim was not precluded under the Delaware carve-out, as it was brought under Massachusetts law. The Court also found that Northstar had not sufficiently alleged a breach of contract, leading to the dismissal of that claim and the related good faith claim with prejudice. The fiduciary duty claim and the third-party beneficiary claim were dismissed with leave to amend. Northstar subsequently filed a Third Amended Complaint (TAC) on March 28, 2011, identifying two classes of potential plaintiffs: a "Pre-Breach" class and a "Breach Class," based on their purchase and holding of Fund shares during specified periods.

Classes are categorized between August 31 and September 1, 2007, as Northstar claims August 31, 2007, marks the end of the fiscal year prior to the Fund's initial deviation from its fundamental investment policy aimed at tracking the Lehman Index using indexing strategies. Northstar asserts that the Fund returned to its required policy around February 27, 2009. The complaint includes five causes of action for each of the two classes, totaling ten claims: (1) and (6) breach of fiduciary duty against the Trustees and the Trust; (2) and (7) breach of fiduciary duty against the Investment Advisor; (3) and (8) aiding and abetting breach of fiduciary duty against the Trustees; (4) and (9) aiding and abetting breach of fiduciary duty against the Investment Advisor; (5) and (10) breach of contract as a third-party beneficiary of the Investment Advisory Agreement against the Investment Advisor. 

During oral arguments, it was noted that some Schwab defendants settled claims, including Section 13(a) claims from the SEC concerning the Fund's management, and any recovery from fiduciary breach claims would be offset by amounts recovered through the SEC enforcement action. Northstar's claims are characterized as "alter egos" of the Section 13(a) claims. Under Federal Rule of Civil Procedure 12(b)(6), a complaint must be dismissed if it fails to present a plausible claim for relief. The plaintiff must provide sufficient factual allegations, not merely speculative assertions, to demonstrate that the defendant acted unlawfully. The court assumes the truth of the plaintiff's allegations and draws reasonable inferences in their favor, but does not accept conclusory or unreasonable inferences as true. The court must allow amendment unless it is clear that the deficiencies cannot be remedied. 

Northstar contends that the Trustees owe fiduciary duties to Fund investors as a matter of law, while other defendants owe such duties as a matter of fact. However, the court finds that Northstar has not adequately alleged a direct breach of fiduciary duty to investors and that these claims should be derivative. Northstar's cited cases, Fogelin v. Nordblom and In re Great N. Iron Ore Properties, are referenced in support of the ability for Fund investors to sue directly for fiduciary breaches.

The 1969 Amendment required two-thirds approval from each class of shareholders for any amendments altering their rights. However, the 1972 Amendment, executed by the Trustees, reduced the liquidation value of preferred shares and increased the majority required for future amendments. The preferred shareholders, all grandchildren of trustee Nordblom, opposed this ratification. The Massachusetts Supreme Court ruled against the ratification, stating it violated the 1969 Amendment by benefiting only Nordblom while prejudicing the preferred shareholders. The court emphasized the fiduciary duty of trustees to treat all beneficiaries equitably, rejecting the notion that trustees of Massachusetts Business Trusts owe direct fiduciary duties to all beneficiaries. It acknowledged that the fiduciary duty in Fogelin arose from the family trust context and the unequal treatment of shareholders. Citing the Ninth Circuit, it stated that direct claims for breach of fiduciary duty may arise when a beneficiary suffers distinct harm compared to others. The decisions in Fogelin and Great N. Iron Ore both highlighted a fiduciary obligation to avoid favoring one class of shareholders over another. The summary indicates that while a trustee's actions may benefit the trust overall, they must not disadvantage any particular class of shareholders.

Defendants assert that, with one exception, case law regarding fiduciary duties of mutual fund trustees under Massachusetts law indicates that such duties are owed to the mutual fund itself, not directly to individual investors. In Stegall v. Ladner, the court ruled that the duty to maximize trust share value is owed to the trust rather than its beneficiaries, comparing the business trust to a corporation. Thus, while plaintiffs may benefit from the trustees' fiduciary duties, they can only enforce these duties derivatively, requiring the fund to act first. Similarly, in Hamilton v. Allen, the court denied direct claims from mutual fund investors for breach of fiduciary duty, citing the absence of a direct fiduciary relationship between corporate directors and shareholders. Northstar criticized this reliance on corporate law in light of the lack of precedents in trusts law. Forsythe v. Sun Life Financial also reinforced that claims are derivative when shareholder injuries stem from harm to the corporate entity. Several other district court decisions echo this reasoning, concluding that fiduciary duty breach claims affecting all investors equally do not establish direct duties to investors, thus categorizing the claims as derivative.

Northstar has not provided any case law supporting a direct breach of fiduciary duty claim against mutual fund trustees by trust beneficiaries. It argues that its claims are direct, disputing the notion that seeking damages from a reduction in trust share values indicates a derivative claim. Citing Branch v. Ernst & Young, Northstar emphasizes that the distinction between direct and derivative claims lies in the source of the right rather than the nature of the damages or the identity of the harmed party. In Branch, the court ruled that a bank investor's claims were direct because the bank did not suffer injury from misrepresentations that benefited it. The court highlighted that derivative claims arise only when the shareholder's injury is merely a proportionate share of the corporate entity’s injury.

Northstar asserts that the putative class suffered harm due to changes in the Fund's investment objective without proper shareholder vote, but the court finds this does not establish direct claims, despite support from the Ninth Circuit's Lapidus decision regarding shareholder voting rights. However, Northstar has yet to plead a contract with the Trust, negating claims based on contractual rights. Northstar's additional arguments, such as varying degrees of shareholder injury and the nature of trust property ownership, do not hold up against precedents established in Hamilton and Forsythe, which recognized that trusts could experience direct injury from value diminutions. Thus, the court concludes that Northstar's claims are derivative rather than direct.

Claims against mutual fund trustees are classified as derivative, as established in previous decisions. Northstar contends that allowing defendants to profit from their own wrongs is inequitable; however, this does not negate the existence of a derivative claim on behalf of the Trust. Any recovery would ultimately benefit the Trust's beneficiaries. Northstar alleges that defendants breached their fiduciary duty by not adhering to the Fund's investment objectives and the 25% concentration policy, leading to a failure in tracking the Index, which resulted in a decrease in share value for all shareholders. Consequently, the Court determines that Northstar's fiduciary duty claims must be asserted derivatively, following Massachusetts law, which mandates a written demand before filing a derivative suit, with no exceptions for demand futility. Northstar's failure to meet this requirement leads to the dismissal of these claims with prejudice. The Court also refrains from addressing other arguments regarding the timeliness of the fiduciary duty claims or whether Northstar adequately pled a factual basis for a fiduciary duty. 

Furthermore, Northstar's claims for aiding and abetting breaches of fiduciary duty are contingent upon the existence of an underlying breach, which the Court has determined to be derivative as well; thus, these claims are also dismissed with prejudice. Lastly, Northstar asserts claims for breach of the Investment Advisor Agreement, alleging that Fund investors are third-party beneficiaries entitled to enforce the agreement, which mandates that the Investment Advisor manage the Fund in accordance with its fundamental objectives and policies.

Northstar outlines multiple provisions of the Investment Advisory Agreement (IAA) that required the Investment Advisor to oversee operations of the Schwab Funds, provide economic analysis, maintain a continuous investment program, decide on securities transactions, assist with operations, and comply with SEC regulations and the Investment Company Act of 1940. Northstar claims the Investment Advisor breached the IAA by not aligning the Fund's asset investment strategy with its stated policy of tracking an index and by exceeding the 25% threshold for investments in a particular industry. The language cited by Northstar originates from proxy statements rather than the IAA itself.

Under California law, for a third party to enforce a contract, it must be clearly intended to benefit them. A contract made for a third party's express benefit can be enforced before it is rescinded, and the third party does not need to be individually named. The term 'expressly' excludes those incidentally benefited from enforcement. Northstar argues that, although the IAA does not mention Fund investors, they are beneficial owners and thus part of a class that benefits from the contract. However, the legal distinction between the Fund and its investors complicates this claim. The court must assess whether Northstar has adequately demonstrated that investors are entitled to enforce the IAA despite not being expressly mentioned. Northstar references a California appellate decision where an excess insurance provider was recognized as a third-party beneficiary in a contract, indicating a precedent for such claims under specific circumstances.

Cambridge's responsibilities included limiting workers' compensation claims, which would benefit National Union by reducing its excess insurance payouts. Cambridge was also mandated to administer claims for National Union if they exceeded $250,000. Northstar argues that the benefit to investors under the Investment Advisory Agreement (IAA) is similarly non-incidental, as the value of the Fund's shares directly correlates to the Investment Advisor's decisions. Citing *Escalante v. Minn. Life Ins. Co.*, the text illustrates that a plaintiff can be a third-party beneficiary if a contract explicitly states a benefit to them, as seen when a lender failed to forward life insurance payments. The court concluded that the plaintiff benefited directly from the arrangement, which facilitated payments. Additionally, in *Tuttle v. Sky Bell Asset Mgmt. LLC*, partners were considered third-party beneficiaries of an auditor agreement due to explicit provisions to send audit reports to them. However, agreements in the cited cases differ from the IAA because they explicitly mentioned the third parties or classes benefiting from the contract, while the IAA lacks such clear intent. The court emphasized that a party must demonstrate that the contracting parties intended to confer a benefit upon them specifically, not merely that they would receive some benefit from contract performance.

In Jones v. Aetna Cas. and Sur. Co., the court ruled that a plaintiff, who leased property for a restaurant and was to benefit from insurance coverage obtained by the lessor, was not a third-party beneficiary of the insurance agreement because the contract did not expressly mention him or indicate an intention to benefit him. Northstar sought to extend third-party beneficiary rights beyond established legal precedents, but none of the cited cases supported enforcement of contracts that did not identify the third party. Although a previous case indicated that third parties need not be named to enforce a contract, the facts showed that those parties were part of a specified class in the contract. The court reiterated that merely being incidentally benefited by a contract does not confer enforcement rights; intent to benefit must be clear. In the case at hand, the Investment Advisory Agreement (IAA) did not explicitly mention Fund investors, and references to the Fund did not imply a class of beneficiaries. The court found that any benefit to Fund investors from the IAA was incidental and that allowing them to claim third-party beneficiary status would be overly broad. The court ultimately concluded that Fund investors are not third-party beneficiaries of the IAA.

Claims made by Northstar are dismissed with prejudice, meaning they cannot be brought again. The court orders the Clerk to close the file. Notably, Northstar had standing to bring these claims due to an assignment from an investor who held shares in the Fund as of August 31, 2007. The court references previous orders to clarify its reasoning. 

The court finds that Northstar's cited cases, including Loring v. United States and Levesque v. Ojala, do not support its arguments regarding fiduciary duties, as they relate to different legal principles. The court emphasizes that generally, corporate directors do not owe fiduciary duties directly to shareholders; instead, these duties are owed to the corporation itself, which impacts the nature of claims that can be brought. 

Although Northstar references Strigliabotti v. Franklin Resources, Inc. as a precedent for direct claims of fiduciary duty by mutual fund shareholders against trustees, the court notes that this case has not been widely followed and is less persuasive compared to the authorities it discusses. 

Additionally, while Northstar mentions a related case concerning voting rights and California's Unfair Competition Law, it fails to establish a similar interpretation of fiduciary duty breach claims under Massachusetts law. Finally, the court dismisses Northstar's claim for enforcement as a third-party beneficiary, citing a case that does not support Northstar’s position.