Financial Services Quarterly Report - First Quarter 2016: Northstar Decision on Remand: U.S. District Court Holds SLUSA Precludes State Law Claims Alleging Deviation from Mutual Fund’s Investment Objective

by Dechert LLP

In a complete victory for Defendants, on February 23, 2016, a federal district court dismissed with prejudice the final remaining claims in Northstar Financial Advisors, Inc. v. Schwab Investments et. al.,1 which had been ongoing for nearly eight years. In her ruling, Judge Lucy H. Koh of the U.S. District Court for the Northern District of California extended her prior grant of a motion to dismiss other claims on the grounds that they were precluded under the Securities Litigation Uniform Standards Act of 1998 (SLUSA), which forbids shareholders from filing state law claims based on alleged misrepresentations or omissions involving covered securities.

Judge Koh held, in her prior ruling on October 5, 2015, that SLUSA precluded Plaintiff’s breach of contract, breach of covenant, and third-party beneficiary claims based upon allegations that the Schwab Total Bond Fund (Fund) had deviated from its investment objective. In so holding, the district court dramatically narrowed the potential impact of a prior opinion from the Ninth Circuit in the same case, which held that mutual fund shareholders may have state law contractual rights to enforce fundamental investment objectives approved by shareholders and set forth in fund prospectuses.2 Judge Koh, however, initially left breach of fiduciary duty claims against the adviser and the Fund’s trustees in the case on procedural grounds – the Judge solicited a motion for judgment on the pleadings, which Defendants (represented by Dechert after the Ninth Circuit opinion3) submitted and the court granted, under the same rationale as her October 5th Order. In practice, the reasoning behind the court’s broad ruling in both dismissal orders should compel the dismissal of most similar state law claims premised on an alleged violation of a mutual fund’s fundamental investment objectives.

This article summarizes the pertinent rulings in Northstar that may be applicable in other contexts.

Brief History of the Case

Plaintiff alleged that the shareholders of the Fund approved a change to the Fund’s fundamental investment objectives in 1997. Plaintiff further alleged that the Fund had deviated from those objectives beginning in August 2007, and that such deviation caused harm to any shareholder who bought or held shares from 2007 through 2009. After certain claims were dismissed by early rulings in the case, Plaintiff ultimately asserted breach of contract, breach of covenant, breach of fiduciary duty, third-party beneficiary, and aiding and abetting claims against: Schwab Investments (the trust of which the Fund was a part); the Fund’s trustees; and the Fund’s adviser, Charles Schwab Investment Management, Inc. (CSIM).

In 2011, in relevant part, the district court dismissed all of the claims with prejudice, on the grounds that: the Fund’s proxy statements and disclosures did not form a contract; the fiduciary breach claims must be asserted derivatively; and Plaintiff could not claim to be a third-party beneficiary of the advisory agreement between the Fund and CSIM. On appeal, the Ninth Circuit reversed – and reached the unprecedented conclusion that when a mutual fund holds a shareholder vote to approve a change to certain fundamental investment objectives and the shareholders approve such change, the shareholders could thereby acquire contract rights to enforce those new objectives. The Ninth Circuit also held that Plaintiff could bring its fiduciary breach claims directly against the trustees, in broad language that suggests that any fiduciary breach claim involving a mutual fund could be brought directly. Finally, the court determined that mutual fund shareholders could be third-party beneficiaries of fund advisory contracts and sue directly for breach of those agreements. This sweeping ruling was a dramatic departure from pre-existing law, and the ruling has already spawned copy-cat lawsuits that parrot the allegations in Northstar.

Despite finding that contract and fiduciary breach claims could be asserted, the Ninth Circuit remanded the case and directed the district court to determine if any of Plaintiff’s claims were precluded by SLUSA.

The October 2015 and February 2016 District Court Opinions

The district court’s October 5th order clarifies that a shareholder cannot buy or hold shares in reliance on certain stated investment objectives and then later allege, under state law causes of action, that those statements were not true at the time of reliance. Such claims are classic securities fraud claims and, under SLUSA, must be asserted as such in federal court or not at all.

Although Plaintiff was offered five opportunities to draft its complaint, the district court on remand was not swayed by Plaintiff’s attempts to delete explicit references to specific “misrepresentations” or “omissions.” The district court concluded that such attempts amounted to nothing more than “artful wordsmithing” that did not detract from the fact that Plaintiff had alleged “a misrepresentation in the most classic sense.” Judge Koh indicated that when a plaintiff claims that a mutual fund or its adviser represented it “would do one thing, but ended up doing another” then that claim “implicates the very sort of misrepresentations and omissions that fall within SLUSA’s reach.”

The district court was also not swayed by Plaintiff’s reliance on the sole statutory exception to SLUSA, known as the “Delaware carve-out” (Carve-Out). As an initial matter, the Carve-Out applies only to claims brought under the laws of the state of incorporation of a company or mutual fund. Further, even under that circumstance, the Carve-Out only applies to narrowly prescribed “permissive actions.” The first such action includes cases involving a misrepresentation in connection with the sale or purchase of securities exclusively to and/or from current shareholders. The second category includes claims involving a misrepresentation in connection with a significant corporate event (including mergers, tender offers, and shareholder votes). Importantly, the district court rejected the argument that an allegation that a shareholder vote should have occurred, but did not, would be sufficient to invoke the Carve-Out. Instead, it concluded that Plaintiffs must be able to point to a specific vote that was purportedly influenced by the alleged misrepresentation or else the Carve-Out does not apply. Under this ruling, the Carve-Out should never save any claim that shareholders should have been afforded an opportunity to vote before a fund allegedly deviated from its investment objectives.

On the motion for judgment on the pleadings respecting the remaining fiduciary breach claims, Judge Koh once again reaffirmed her prior holdings dismissing the breach of contract and third-party beneficiary claims – finding that the same rationale extended to the fiduciary breach claims. Like the previously dismissed claims, the court found that the gravamen of the fiduciary breach claims was also for a misrepresentation “in the classic sense”: the Fund allegedly said it would “do one thing, but ended up doing another.”


The combination of the district court’s rulings on SLUSA and the Carve-Out provide a roadmap for the dismissal of virtually any state law claims, filed in the wake of the Ninth Circuit’s decision, alleging that a mutual fund has deviated from its investment objectives.


1) 08-CV-04119.

2) Northstar Financial Advisors, Inc. v. Schwab Investments et. al., 779 F.3d 1036, 1054 (9th Cir. 2015).

3) While Dechert represented Defendants in connection with this matter upon remand, all factual statements herein are based solely on publicly available information.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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