Corporations – Investment Company Act of 1940

Mitchell Scott Ostwald's Securities Legal Blogs

Licensed for 29 years

Attorney in Sacramento, CA

Private party may not bring action for violation of Section 13(a) of Investment Company Act of 1940.

A California Court of Appeal reversed the lower court’s decision in NORTHSTAR FINANCIAL ADVISORS, INC v. SCHWAB INVESTMENTS.  The district court held that Congress intended private enforcement of §13(a) of the Investment Company Act, which “prohibits investment companies from changing certain investment policies in their registration statements without first obtaining shareholder approval.”  The appellate court reversed this decision, declaring that there was nothing in that section “as originally enacted or as subsequently amended either creates a private cause of action or recognizes one exists.”  They found that no private citizen could bring an action against an investment company for violations of the Act because sole enforcement rights were granted to the SEC.

Background Info

The original Investment Company Act of 1940 was, among other things, designed to regulate corporate securities by requiring registration with the SEC and imposing specific reporting requirements. Subsection (a) states (15 U.S.C. §80a-13(a)):

(a)   No registered investment company shall, unless authorized by the vote of a majority of its outstanding voting securities –

(1)   change its sub-classification as defined in section 80a-5(a)(1) and (2) of this title or its sub-classification from a diversified to a non-diversified company;

(2)   borrow money, issue senior securities, underwrite securities issued by other persons, purchase or sell real estate or commodities or make loans to other persons, except in each case in accordance with the recitals of policy contained in its registration statement in respect thereto;

(3)   deviate from its policy in respect of concentration of investments in any particular industry or group of industries as recited in its registration statement, deviate from any investment policy which is changeable only if authorized by shareholder vote, or deviate from any policy recited in its registration statement pursuant to section 80a-8(b)(3) of this title; or

(4)   change the nature of its business so as to cease to be an investment company.

To ensure compliance with the ICA, Congress gave the SEC expansive authority to regulate violations of the Act.  15 U.S.C. §80a-42(a) states that the SEC:

May make such investigations as it deems necessary to determine whether any person has violated or is about to violate any provision of [the ICA] or of any rule, regulation, or order hereunder, or to determine whether any action in any court or any proceeding before the [SEC] shall be instituted under [the ICA] against a particular person or persons, or with respect to a particular transaction or transactions.

Congress made amendments to the Act in 1970, to “clarify that an investment company violates §13(a) whenever it deviates, without shareholder approval, from an investment policy that its registration statement says is changeable only by shareholder vote, even if the registration statement does not also identify the policy as ‘fundamental’.”

The amendments that are of chief concern in this case, however, were ratified in 2007, in response to the crisis in Darfur, Sudan.  Congress imposed economic sanctions on various Sudanese officials and companies as a result of their involvement with the genocide.  These sanctions prohibited US companies from doing business with the subject companies and vice versa. Congress then enacted the Sudan Accountability and Divestment Act of 2007, to help the government and asset fund managers divest from certain businesses in Sudan.  This Act added a new subsection to §13 [(c)] of the ICA by placing limitations on the actions allowed against “an investment company to challenge the company’s divestment from the securities of the companies conducting the affected business operations in Sudan.”  It stated (15 U.S.C. § 80a-13(c)):

(c)   Limitation on actions

  1. In general

Notwithstanding any other provision of Federal or State law, no person may bring any civil, criminal, or administrative action against any registered investment company, or any employee, officer, director, or investment adviser thereof, based solely upon the investment company divesting from, or avoiding investing in, securities issued by persons that the investment company determines, using credible information that is available to the public, conduct or have direct investments in business operations in Sudan described in section 3(d) of the Sudan Accountability and Divestment Act of 2007.

  1. Applicability
    1. Actions for breaches of fiduciary duties

Paragraph (1) does not prevent a person from bringing an action based on a breach of fiduciary duty owed to that person with respect to a divestment or noninvestment decision, other than as described in paragraph (1).

  1. Disclosures

Paragraph (1) shall not apply to a registered investment company, or any employee, officer, director or investment adviser thereof, unless the investment company makes disclosures in accordance with regulations prescribed by the Commission

  1. Person defined

For purposes of this subsection the term ‘person’ includes the Federal Government and any State or political subdivision of a State

This essentially provided a ‘safe harbor’ clause for these investment companies.

In July 2010, Congress enacted the Comprehensive Iran Sanctions, Accountability, and Divestment Act of 2010.  This Act further amended §13(c)(1) by adding a safe harbor clause for those investment companies divesting from certain companies in Iran.  It also amended §13(c)(2)(a) to say:

Nothing in §13(c)(1) shall be construed to create, imply, diminish, change or affect in any way whether or not a private right of action exists under §13(a) or any other provision of the ICA.

The Act’s Conference Report specified that this amendment was “designed to clarify that Congress did not intend, in the SADA, to imply the creation of a new private right of action under the ICA.”

This Litigation

This case involves “claims by investors that a large American investment trust operating a series of mutual funds unlawfully deviated from the investment policies set forth in its registration statement, to the detriment of the fund’s shareholders and in violation of §13(a) of the ICA.” 

In 1997, defendant/appellant Schwab Investments converted a long-term government bond fund into the Schwab Total Bond Market Fund, which was to be a fixed-income mutual fund that would track the Lehman Brothers U.S. Aggregate Bond Index.  The Fund stated its investment objective as “to attempt to provide a high level of current income consistent with preservation of capital by seeking to track the investment results (of the Lehman Index) through the use of an indexing strategy.”  The Fund also disclosed that this policy was “fundamental, which means that it may be changed only by vote of a majority of the Fund’s shareholders.”

In August 2008, plaintiff/appellee Northstar Financial Advisors, Inc. filed a suit against Charles Schwab & Schwab Investments for violations of ICA §13(a), on behalf of their clients that owned shares of the Fund.  Plaintiff alleged that Schwab deviated from the Fund’s fundamental investment policies and that these deviations “exposed the Fund and its shareholders to tens of millions of dollars in losses stemming from a sustained decline in the value of non-agency mortgage-backed securities.”

Schwab filed a motion to dismiss for “failure to state a claim under ICA §13(a), asserting there is no private right of action to enforce that section’s terms.”   The district court denied this motion, holding that “Congress recognized a private right to enforce §13(a) when it enacted §13(c).  The court, however, recognized that the issue of whether there exists an implied private right is not free from doubt, so it certified its opinion for interlocutory appeal, which the appellate court accepted.

The appellate court found that Northstar did not meet the burden of demonstrating that such a private right of action exists.  They analyzed first the language and then the structure of the Act itself.  As for language, they looked for the presence of any “‘rights-creating language’ that might imply Congress intended to confer upon shareholders the right to sue an investment company for violating the statute’s requirements.”  They then looked to see if Congress “designated a method of enforcement other than through private lawsuits, because ‘the express provision of one method of enforcing a substantive rule suggests that Congress intended to preclude others’.”  In the end, the court found that the language did not imply a private right to enforce the Act.

When they turned to the structure of the statute, they found again that it did not indicate that Congress intended to imply a private right of action.  Because Congress delegated authority to the SEC, the court found, it suggested that they intended to preclude other methods of enforcement.

Northstar also argued that the amendments to the Act created an implied private right.  As for the 1970 amendments, the appellate court found that “by clarifying when a change of policy violates §13(a), Congress did not thereby indicate an intent to recognize a private remedy for such a violation.” 

Northstar’s stronger allegation (and the one that the district court accepted) was that by enacting the SADA in 2007 and adding §13(c) to the ICA, Congress recognized a preexisting private right of action.  However, the appellate court found that Congress’ use of the word ‘person’ did not imply recognition of a private right of action to enforce. 

The court’s view of the 2010 amendment followed a similar pattern.  Because they had already decided that there was no private right before this recent amendment, they found that it “expressly stated that §13(c) does not create of affect the existence of a private right of action under §13(a). 

In conclusion, the appellate court reversed the district court’s opinion, and found that there is no implied private right of enforcement for the ICA; the authority remains exclusively with the SEC.

Quotes and information gathered from The Daily Recorder, Vol. 103, No. 157, August 16, 2010 Daily Appellate Report, Part II.

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