Court Dismisses Shareholders’ Investment Company Act Claims Brought Against Advisers and Directors of Exchange-Traded Funds for Allegedly Excessive Fees Paid by the Funds in their Securities Lending Agreements

by Goodwin

A Tennessee federal court recently dismissed derivative claims brought under Sections 36(a), 36(b) and 47(b) of the Investment Company Act of 1940 (“ICA”) by shareholders in exchange-traded funds, against the funds’ investment adviser, the adviser’s affiliate, and the funds’ directors.  Plaintiffs alleged that the funds’ adviser and affiliate received excessive compensation from securities lending transactions executed on the funds’ behalf, and that the funds’ directors breached their fiduciary duties by allowing such transactions.

The fund’s adviser managed the funds’ investment activities and hired its affiliate, a national banking association, to perform securities lending services for the funds.  Specifically, the affiliate acted as an intermediary between the funds and those who wanted to borrow securities from the funds to generate revenue from short-selling transactions.  Use of the adviser’s affiliate for such a role is usually prohibited by ICA Section 17’s restrictions on related party transactions because of the inherent conflicts of interest, but here, the adviser’s affiliate obtained an exemptive order from the SEC permitting the relationship.  Plaintiffs alleged that the adviser’s and affiliate’s fees for these lending transactions – a total of 40% of the net revenue earned by the funds – were excessive compared to fees paid by funds that used unaffiliated lending agents for such transactions.

The court agreed with the defendants that the plaintiffs failed to state a claim under any of the ICA statutes at issue, for the following reasons.

Section 36(b)

The court acknowledged that the plaintiff shareholders had an express private right of action under ICA Section 36(b) to bring a claim on behalf of the funds alleging that the adviser and its affiliate received excessive compensation in breach of their fiduciary duties.  However, Section 36(b)(4) states that it shall not apply to compensation or payments made in connection with transactions subject to ICA Section 17 “or orders thereunder.”  Because the SEC had expressly granted the adviser and its affiliate’s predecessors an exemptive order under Section 17 for the transactions at issue, the court dismissed the Section 36(b) claim:  “[b]y the plain text of Section 36(b)(4), the SEC Exemption Order removes the transactions at issue from [the] scope of Section 36(b).”

Sections 47(b) and 36(a)

Section 47(b) of the ICA provides that a contract that is made, or whose performance involves, a violation of the ICA is unenforceable by either party.  Section 36(a) authorizes the SEC to bring an action to enforce breaches of fiduciary duty involving personal misconduct.  The court noted that unlike Section 36(b), neither Section 47(b) nor Section 36(a) expressly creates a private right of action for investors.

The court agreed with the reasoning in several other courts’ decisions declining to imply a private right of action under Section 47(b), and further noted that plaintiffs failed to demonstrate that they had an implied private right of action to enforce the alleged predicate violations under Sections 17(d), 17(e) and 36(a).  The court pointed out the absence of “rights-creating language” in those statutes, and stated that if Congress had intended to create a private right of action under Section 36(a), it would have expressly authorized private suits, as it did in subsection (b) of the very same statute.

The court dismissed the claims without prejudice and gave plaintiffs until September 17, 2013 to file a motion for leave to amend their complaint.

Laborers’ Local 265 Pension Fund v. iShares Trust, Case No. 3:13-cv-00046 (M.D. Tenn. Aug. 28, 2013).

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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