It is well recognized that only investors have standing to sue a mutual fund on behalf of a class of investors and that a fiduciary duty claim accusing fund trustees of mismanagement is the property of the fund, and not of the investors. Yet the Ninth Circuit recently allowed an end run around both of these clear principles. First, the Circuit affirmed amendment of a class action complaint to reflect that an investment advisor, which did not own shares in the fund at the time it filed suit, could be assigned the right of action—and standing—from an actual investor in the interim. Second, the Circuit, eliding years of distinction between derivative and direct claims in the mutual fund context, reversed dismissal of a breach of fiduciary duty claim against the fund’s trustees.

Northstar Financial Advisors, Inc. (“Northstar”), an investment advisor and financial planning firm, sued on behalf of a class of investors in a mutual fund that was organized as a Massachusetts business trust. Northstar alleged that the defendants—the trust (a group of mutual funds that included the fund at issue), the trustees, and the fund’s investment advisor (all Charles Schwab entities)—failed to adhere to the fund’s investment objectives of tracking a particular index and not over-concentrating in a particular industry. Northstar asserted claims under the Investment Company Act of 1940, as well as Massachusetts common law claims for breach of fiduciary duty and breach of contract.

At the time of filing suit, Northstar did not own any of the mutual fund’s shares. The U.S. District Court for the Northern District of California granted a motion to dismiss for lack of standing, inviting Northstar to acquire standing from an actual investor. Three months later, Northstar found such a shareholder, acquired the cause of action from that shareholder, and was granted leave to amend.

Defendants later won a motion to dismiss the third amended complaint, with prejudice. The district court held, without discussion, that “Northstar had standing to assert these claims through an assignment from an individual investor who owned shares of the Fund . . . .” In dismissing the complaint, the district court held, among other things, that because the trustees owed fiduciary duties to the fund and not to the investors, a breach of fiduciary duty claim must be brought, if at all, by the fund. The court explained: “Northstar has failed to cite a single case finding a direct claim for breach of fiduciary duty against mutual fund trustees by trust beneficiaries.”

Northstar appealed the dismissals of its causes of action to the Ninth Circuit. In Northstar v. Schwab, decided on April 28, 2015, that court affirmed that Northstar had standing and reversed the district court’s dismissal of each of Northstar’s claims.

As to standing, the Ninth Circuit reasoned that Federal Rule of Civil Procedure 15(d) encompassed correcting defects of standing. According to the Ninth Circuit’s majority opinion, a non-shareholder may file a lawsuit, without initially having standing, and later supplement its complaint after it acquires a claim from a shareholder with standing. The implications of this decision are significant, not least among them that a financial advisor can race to a courthouse, sue on behalf of a class of investors, and obtain or even purchase standing later. The court wrote that any such race, presumably for a plaintiff to become class representative, would be tempered by the standards for appointing class counsel under Federal Rule of Civil Procedure 23(g).

Judge Carlos Bea dissented, explaining that the majority opinion went against the established principle that standing is determined as of the date of filing the initial complaint, not based on events that unfold after the filing of the complaint. There is no exception to the requirement of standing based on earlier court error, the dissent wrote, with the error being that the district court had no jurisdiction to grant Northstar leave to amend its initial complaint at the time that it did. The dissent stated: “Today the majority green-lights those who would race to the courthouse and bend Federal Rule of Civil Procedure and Article III standing requirements to gain an edge over other claimants who are not as fleet of foot.”

As to the fiduciary duty claim, the Ninth Circuit’s majority opinion determined that Northstar could pursue a direct action. The Ninth Circuit offered three premises for this conclusion.

First, the Court found that the trust documents themselves supported a direct action since they stated that the trustees will hold assets in trust “for the pro rata benefit of the holders.” Yet this fact would merely support an argument allowing investors to sue under contract, not under common law breach of fiduciary duty directly against the trustees. In relying on the trust documents, the Circuit flipped the district court’s phrasing around, writing: “We are not aware of any Massachusetts case that holds that agreements of this kind cannot be enforced directly by the beneficiaries of a trust.” (emphasis added).

Second, the court cited an axiom from a single Massachusetts judicial opinion and language from certain secondary sources that together explained that trustees owe fiduciary duties to trust beneficiaries generally. From this broad language, the court concluded that fund investors therefore must be able to sue trustees of a mutual fund that is organized as a trust for traditionally “derivative” claims, namely those that impact the fund as a whole rather than an individual investor.

Third, the court asserted, with no citation, that the “distinction between direct and derivative actions has little meaning in the context of mutual funds.” The court reasoned that because a mutual fund’s sole objective is to increase net asset value, any decrease in the mutual fund’s share price resulting from failing to comply with investment objectives flows directly and immediately to shareholders. In the Ninth Circuit’s view, this stands in contrast to a corporation, which “engages in a business, e.g., the buying and selling of widgets, in which the accretion of share price is generally the by-product of business success.” By interposing this “business” activity—contrasted with a mutual fund’s mere “acquiring investment instruments for the purpose of increasing net asset value”—corporations retain a distinction between derivative and direct lawsuits while mutual funds lose it, in the view of the Ninth Circuit.

It is not clear what impact the Ninth Circuit’s opinion will have on fiduciary duty litigation in the mutual fund context. Because the fund at issue was an investment trust organized under Massachusetts law, it is possible that the Ninth Circuit’s interpretation of Massachusetts law may be of limited reach. Nonetheless, those who advise and defend mutual funds should row carefully in the wake of Northstar.