Securities Enforcement Alert Second Circuit Decision in “Shelf Space” Directors and Advisers


Securities Enforcement Alert

April 2007


Charles L. Eisen


[email protected]

Jeffrey B. Maletta


[email protected]

Nicholas G. Terris


[email protected]

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Second Circuit Decision in “Shelf Space”

Class Action Increases Protection for Fund

Directors and Advisers

In the past three years, the investment management industry has been subjected to more litigation than at any time in the preceding three decades. Not only has this litigation been frequent, it has often been based on allegations of complex-wide wrongdoing and has asserted equally sweeping fi nancial claims. In

Bellikoff et al. v. Eaton Vance Corp. et al.

, 05-6957

(March 15, 2007), the United States Court of Appeals for the Second Circuit issued two rulings that should provide some welcome relief for fund directors, advisers and distributors who recently have been beset by the wave of large-scale cases. First, the Second Circuit hammered the last nails in the coffi n of the implied private right of action under various sections of the

Investment Company Act of 1940 (“ICA”), in particular, claims for breach of fi duciary duty under Section 36(a). Second, the court confi rmed that the express private right of action under Section 36(b) of the ICA is a narrowly tailored remedy for receipt of excessive fees, not a “catch all” statute enabling plaintiffs to sue for a broad range of alleged wrongdoing.

K&L Gates represented Eaton Vance Corp. and its affi liates in this litigation.


represents the fi rst appellate opinion arising from the wave of substantially similar

“shelf space” securities class action cases fi led against mutual fund management fi rms and fund directors in federal courts across the country. The shelf space cases grew out of regulatory scrutiny of arrangements between mutual fund sponsors and brokers to increase the visibility of funds to the brokers’ customers. Beginning in the fall of 2003, the SEC and NASD instituted and simultaneously settled enforcement actions against a number of broker-dealers involving allegations that the brokerage fi rms had failed to disclose adequately potential confl icts of interest arising from payments the brokers requested and received from fund complexes to promote the sale of particular funds. Regulators also brought enforcement actions against certain mutual fund advisers and distributors involving allegations that they failed adequately to disclose confl icts of interest associated with their fund portfolio brokers policies and practices. The SEC and NASD have since overhauled the rules applicable to mutual fund preferred marketing arrangements.

Within weeks of the fi rst enforcement action, the securities class action bar began fi ling class action complaints against the advisers, distributors and directors of various mutual fund families in federal district courts from Massachusetts to California. Even organizations that, like Eaton Vance, had not been the subject of regulatory action were sued. The allegations in the


case were typical. Plaintiffs alleged that, during a purported

“class period” extending from January 30, 1999, to November 17, 2003, certain defendants made “revenue sharing” payments to brokers out of their own assets, caused the funds to pay commissions on fund portfolio transactions that were “excessive,” and paid distribution fees from the funds that were not in accordance with Rule 12b-1. Plaintiffs alleged various claims against defendants for breach of fi duciary duty and nondisclosure under Sections

34(b), 36(b), and 48(a) of the ICA as well as under state law, and demanded damages from the funds’ advisers, distributors and directors.

Securities Enforcement Alert

In a comprehensive opinion issued in July 2005,

United States District Judge John Koeltl dismissed all of plaintiffs’ claims and rejected their requests for a further opportunity to amend their complaint.

Plaintiffs appealed only the dismissal of their claims under the ICA.

The Court of Appeals affi rmed the district court in all respects. In its most sweeping ruling, it held that, despite numerous judicial decisions over nearly

30 years endorsing it, the broad and amorphous implied private right of action under ICA Section

36(a) (as well as similar implied private rights under

Section 34(b) and 48(a)) could not be squared with the Supreme Court’s recent rulings concerning implied private rights of action. Those decisions have emphasized that the right of a private plaintiff to sue for violation of a federal statute must fi nd support in the statutory text. In


, the Second Circuit found that the text of the ICA does not support private rights of action. The court focused on three factors: the provision in ICA Section 42 granting the SEC power to enforce the statute; the express creation of a specifi c private right of action in Section 36(b); and the absence of so-called “rights-creating” language in the ICA provisions cited by plaintiffs. In the Second

Circuit’s words, “[t]he analysis ends there, because the text and the structure of the ICA reveal no ambiguity about Congress’s intention to preclude private rights of action to enforce Section 34(b), 36(a), and 48(a).”

In a second important ruling, the Second Circuit also underscored that the express private right of action in Section 36(b) is a carefully drawn and limited remedy. The decision emphasizes that the statute imposes certain obligations with respect to the

receipt of compensation for services

and allows plaintiffs to sue only where an adviser or manager has charged a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered.

Thus, plaintiffs may not use Section 36(b) to assert a claim that defendants breached a fi duciary duty by paying “excessive” commissions on portfolio brokerage, even if defendants allegedly received an indirect benefi t, because third party brokers, and not defendants, were alleged to have actually received the commissions. Similarly, plaintiffs’ allegations concerning 12b-1 fees failed because plaintiffs did not allege that the fees received by defendants were disproportionate to the services rendered, but instead claimed that such fees were “improper.”

* * * * *

The shelf space cases are only one example of the recent practice of the plaintiffs’ bar to fi le numerous, essentially identical, cases attacking, often on a complex-wide basis, allegedly unlawful or improper practices, or excessive compensation. The plaintiffs in these cases have relied, as have plaintiffs in cases involving funds for years, on a mix of claims based on implied private rights of action under sections of the

ICA, as well as Section 36(b), and state law.

Bellikoff ’s

unequivocal holding that private rights of action cannot be implied under the ICA and its affi rmation of the limited nature of the express remedy of Section

36(b) add substantially to the protections for fund directors, advisers, and distributors from the type of sweeping, cookie-cutter suits that have recently beset members of the fund industry.

In this respect,


should be read in conjunction with other recent decisions. Last September, in

Amron v. Morgan Stanley Investment Advisors, Inc.


464 F.3d 338 (2006), the Second Circuit held that a complaint alleging violations of Section 36(b) must identify facts—not merely conclusory allegations

—that would support a fi nding that a management fee was excessive under the factors set in the seminal


decision. In February 2006, the Supreme

Court’s decision in

Merrill Lynch, Pierce, Fenner

& Smith v. Dabit

, 126 U.S. 1503 (2006), effectively ended “holders” class actions—cases brought under state law on behalf of shareholders allegedly injured by misrepresentations that caused them to continue to retain fund shares without knowledge of the defendants’ wrongful conduct. The elimination of potentially broad implied federal causes of action under the ICA and the restriction of the state law claims to traditional state corporate law remedies confi ne the plaintiffs’ bar to claims that are subject to more stringent pleading and procedural protections that should discourage the fi ling of speculative lawsuits and will facilitate the dismissal of those not well grounded in fact and supported by law.

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For information relating to the


litigation and/or other recent developments in litigation affecting investment companies, please contact one of the attorneys listed below who represented Eaton

Vance Corp., Eaton Vance Management, Boston

Management and Research, Eaton Vance Distributors,

Inc., and other defendants in the case.

Charles L. Eisen


[email protected]

Jeffrey B. Maletta


[email protected]

Nicholas G. Terris


[email protected]

Securities Enforcement Alert

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