A federal district court in Tennessee dismissed a case brought by two union pension funds claiming that securities lending fees paid by an ETF to its adviser’s affiliate violated  the adviser’s fiduciary duty under Section 36(b) of the Investment Company Act of 1940 (“1940 Act”).

The defendants argued that the SEC issued an order exempting the adviser from the prohibitions of Section 17(a) of the 1940 Act, and thus payments to an affiliated securities lending agent were appropriate.

The SEC’s order required the ETFs to follow specific procedures to ensure that fees paid to the securities lending agent were fair and reasonable in light of the usual and customary charges imposed by others for services of the same nature and quality.

Section 36(b) of the 1940 Act “imposes a fiduciary duty on investment advisors with respect to compensation and grants shareholders an express private right of action to seek relief from breaches of fiduciary duty resulting in excessive compensation.”  Like many sections of the 1940 Act, however, Section 36(b) includes exceptions to the general rule.  One such exception, Section 36(b)(4), provides that Section 36(b) “shall not apply to compensation or payments made in connection with transactions subject to [Section 17 of the 1940 Act], or rules, regulations, or orders thereunder.”

The court said that, because the SEC had expressly granted the ETFs an exemptive order under Section 17(b) of the 1940 Act, “[b]y the plain text of Section 36(b)(4), the […] Order removes the transaction at issue from scope of Section 36(b).”  In addition, the court noted that “Section 36(b)(4) of the [1940] Act makes it clear that rights and remedies under section 17 and section 36(b) are intended to be mutually exclusive.”

The court also quickly dismissed the plaintiffs’ claims under Section 47(b) and Section 36(a) of the 1940 Act, finding no private right of action under either section.

The court dismissed the case without prejudice, and the plaintiffs have until September 17, 2013, to file a motion for leave to amend the complaint.  Given the very clear language used by the court, however, it may be unlikely that the plaintiffs will be able to resurrect the Section 36(b) claim with new facts.  It remains to be seen if the plaintiffs can develop a new, and actionable, theory.