Regulatory Update: Recent Judicial Decisions Bring Changes to Financial Services Industry
A pair of recent judicial decisions threatens to alter the legal landscape for financial services professionals. The Supreme Court’s decision in Perez v. Mortgage Bankers Association diminishes companies’ ability to take part in the regulatory rulemaking process. And Northstar Financial Advisory Services v. Schwab Investments, decided by the Ninth Circuit Court of Appeals, arguably creates new obligations and liability for mutual fund directors and trustees. Below is a brief overview of these decisions.
I. Perez v. Mortgage Bankers Association
The Supreme Court’s decision in Perez v. Mortgage Bankers Association failed to garner much attention, but it has far-reaching implications for entities regulated by federal agencies. For nearly the last twenty years, regulated companies have often had a degree of input in the way federal agencies interpret administrative rules and regulations. Perez changes that.
The Administrative Procedure Act (“the APA”) requires administrative agencies to use what is known as notice-and-comment rulemaking when promulgating regulations. These procedures invite the public to participate in the deliberative process by commenting on proposed rules. Agencies then respond to public comments. This back-and-forth often influences the content of administrative rules, sometimes significantly.
But under the APA, so-called interpretive rules are not subject to notice-and-comment rulemaking. These rules—which comprise agencies’ official interpretations of their rules and regulations—are given great deference by courts and thus effectively bind regulated entities to the same extent as the regulations themselves. Federal agencies operate under thousands of these interpretive rules, none of which are necessarily open to public comment.
By exempting interpretive rules from the notice-and-comment requirements, the APA allows federal agencies to change their settled interpretations of administrative rules without public input. Recognizing the potential uncertainty this creates for the regulated community, the Court of Appeals for the D.C. Circuit held in 1997 that agencies could revise their existing interpretations of regulations only after going through the notice-and-comment process. Given the volume of administrative-law matters handled by the D.C. Circuit, this rule—called the Paralyzed Veteran doctrine after the case in which it was announced—affected the way many agencies revised their interpretive rules.
It took the Supreme Court roughly eighteen years to consider the Paralyzed Veteran doctrine, but when it finally did, it unanimously dispensed with the doctrine. The decision, Perez v. Mortgage Bankers Association, involved an about-face from the Department of Labor with respect to whether mortgage-loan officers should be considered exempt administrative employees under the relevant labor regulations. The Mortgage Bankers Association sued the Department of Labor, claiming the latter was required to use the notice-and-comment process before revising its interpretation of who constitutes exempt employees. The Supreme Court sided with the Department of Labor, and in so doing soundly repudiated the Paralyzed Veteran doctrine. It reasoned that the plain language of the APA resolved the issue by expressly and unequivocally exempting interpretive rules from the notice-and-comment process.
The Court’s decision to retire the Paralyzed Veteran doctrine is a game-changer. Administrative agencies are now indisputably free to amend existing interpretive rules without taking proposed revisions through the notice-and-comment process. One should not expect agencies to voluntarily continue with this often lengthy and costly process. But this does not mean regulated entities must passively accept an agency’s amendment to a well-settled policy interpretation. The Court in Perez was clear that agencies must provide “substantial justification” for new interpretations of widely relied-upon policies. Thus, the Perez decision does not quell the debate over the propriety of an agencies’ revision to an interpretive rule; it just moves that debate into the courtroom. Those in the regulated community should plan accordingly.
II. Northstar Financial Advisory Services v. Schwab Investments
The Ninth Circuit’s decision in Northstar Financial Advisory Services v. Schwab Investments is a curious one in many ways. The court is equivocal on some of its most important points, making it hard to predict the decision’s impact. Yet the decision is nonetheless an important one, since it can be read to create additional risk to mutual fund trustees and directors, and because it casts doubt on the validity of what many thought to be established procedures for shareholders to raise and redress the alleged mismanagement of fund assets.
In Northstar, the plaintiff alleged that a Schwab fund did not adhere to its investment strategies. According to the complaint, the fund invested 37% of one of its assets in collateralized mortgage obligations during the credit and mortgage crisis. Northstar Financial Advisors, which had invested its clients’ money in the fund, claimed these investments violated “two fundamental investment objectives” described in the fund’s registration statements and prospectuses: first, to track the performance of Lehman Brothers U.S. Aggregate Bond Index, and second, to not invest 25% or more of the fund’s total assets in any one industry. Northstar brought a federal class action against Schwab, its trustees, and its investment adviser, alleging claims for breach of contract and breaches of fiduciary duties.
The district court dismissed the lawsuit, but the Ninth Circuit revived Northstar’s claims in a 2–1 decision. In a lengthy and sweeping opinion, the Ninth Circuit challenged what many thought were established principles of fund governance. Three aspects of the majority’s decision are particularly important.
A. Statements in Proxy Materials and Prospectuses May Form a Binding Contract
The Ninth Circuit revived Northstar’s breach of contract claim on the theory that statements in the fund’s proxy statements and subsequent SEC filings created contractual obligations between the fund and its shareholders. In 1997, shareholders approved a proxy statement that outlined the fund’s investment objectives. The proxy statement specified that the fund would track the Lehman Brothers index and would not invest more than 25% of its assets in a given industry unless doing so was necessary to track the index. Subsequent fund prospectuses stated that the policy of tracking the Lehman Brothers index was “fundamental” and could not be changed without shareholder approval.
The Ninth Circuit concluded that representations in the proxy statement and annual prospectuses were sufficient to create a contract between the fund and its shareholders: “The Fund offered the shareholders the right to invest on [terms described in the proxy statements or a prospectus], and the shareholders accepted by so investing. The consideration for the contract was the shareholders’ investment, or continued investment, in the Fund, and the parties’ object was lawful.”
B. Directors May Owe Fiduciary Duties Directly to Shareholders Rather Than the Trust as a Whole.
The Ninth Circuit also revived Northstar’s claims against the fund trustees for breaches of fiduciary duty. Schwab had argued that Northstar could not bring the claims directly against its trustees but must instead bring them derivatively on behalf of the fund itself. The Ninth Circuit rejected this argument in a sweeping, 3000-plus-word analysis whose alternative rationales make it hard to pinpoint concrete takeaways.
In essence, the court offered three alterative justifications for reviving the breach of fiduciary duty claims. The first was that the fund, as a series of a Massachusetts business trust, was subject to Massachusetts law, and the court saw no reason to assume Massachusetts had altered the general legal principle that beneficiaries of a trust—here, the shareholders—could enforce a trustee’s fiduciary obligations directly against the trustees themselves. Alternatively, the court reasoned that it makes little sense to require investors to bring actions derivatively on behalf of a fund because any decrease in the fund’s share price flows directly to the shareholders—meaning that any injury to the fund is indistinguishable from an injury to the investors themselves. Finally, the court explained that it was sound policy to allow shareholders to bring their claims directly. Derivative actions exist to allow boards of directors to exercise their business judgment to act in the best interest of the company. But fund boards are “essentially puppets of the investment adviser”—or so the court reasoned—and so there is little reason to defer to their business judgment.
C. Investors May Bring Third-Party Contract Claims for Violations of an Advisory Agreement
Finally, the court revived Northstar’s claim for a breach of the advisor agreement between the fund and its investment advisor. That agreement contained a choice-of-law provision that specified California law as the governing law. And under California law, a third party may bring a breach of contract claim whenever a party to the contract knows the contract was made for the express benefit of the third person. The court concluded that Northstar had plausibly alleged that an investment advisor would understand that a fund was established for the benefit of the shareholders. Accordingly, it allowed Northstar to maintain claims against the investment advisor as a third-party beneficiary to the advisory contract.
The decision in Northstar is hardly a model of clarity. In fact, in many ways, the decision raises more questions than it answers. Those questions will have to be resolved by other courts in the months and years to come.
Perhaps the most critical of these questions concerns whether the state-law claims at issue in Northstar—claims for breach of fiduciary duty and breach of contract—are preempted by federal law. The mutual fund industry is regulated by a web of federal laws, including the Securities Litigation Uniform Standards Act. These federal laws may well prevent plaintiffs from bringing the kinds of state-law claims at issue in Northstar. The court in Northstar acknowledged as much, but declined to resolve the issue, leaving it instead for the trial court to consider. Until that issue is resolved, fund boards can expect an array of battles over both the propriety of these state-law claims and the proper judicial forum for claims involving the alleged mismanagement of funds.
It also remains to be seen what will come of some of the more controversial aspects of the court’s opinion in Northstar. The opinion openly questions what were thought to be several established precepts of mutual fund governance. For instance, the court suggested that fund directors owe fiduciary duties directly to shareholders rather than to the funds themselves. It also suggested that the distinction between direct and derivate actions is inapposite in mutual fund litigation, and that fund directors were mere “puppets” of investment advisors. But none of these suggestions were themselves necessary to the court’s ultimate decision to revive the claims for breach of fiduciary duty. Accordingly, later courts are not bound by these suggestions. As a result, the scope of a fund director’s duties remain unclear following Northstar, providing little guidance to trustees and directors about the scope of their obligations.