Schwab faces uphill battle in court over fund losses

Schwab faces uphill battle in court over fund losses
Charles Schwab & Co. Inc. is likely to lose this week when a California federal judge hears a motion appealing a ruling in a class action that, if left standing, would give mutual fund investors a new line of attack against underperforming funds, fund industry attorneys said.
JAN 06, 2012
Charles Schwab & Co. Inc. is likely to lose this week when a California federal judge hears a motion appealing a ruling in a class action that, if left standing, would give mutual fund investors a new line of attack against underperforming funds, fund industry attorneys said. The original ruling, handed down Feb. 19 by Judge Susan Illston of the U.S. District Court of the Northern District of California in San Francisco, said that investors have the right to sue an investment company under the Investment Company Act of 1940 for deviating from the fund's stated investment objectives. "I'd say it's precedent-setting," Sean M. Murphy, a litigation partner at Milbank Tweed Hadley & McCloy LLP of New York, said about the ruling, in which investors are suing Schwab over losses they suffered in the Schwab Total Bond Fund. The case is the first to find a right to sue an investment company under the 1940 Act since 2002 when the 2nd U.S. Circuit Court of Appeals in New York ruled that the act didn't give investors the express right to sue investment companies. The Supreme Court ruled in 2001 that acts of Congress need to have such language if suits alleging violations of the acts are to go forward. But that doesn't mean that units of Schwab associated with the Total Bond Fund are going to succeed in getting the judge to revisit her own decision. Schwab filed a motion March 26 asking Ms. Illston to allow an appeal, and a hearing is set for Friday. She is unlikely to revisit the decision, especially since the 9th District is a busy one, said a fund attorney, who asked that neither he nor his firm be identified, as Schwab is a client. Attorneys for Schwab referred questions to David Weiskopf, a spokesman for the company, who declined to comment. The attorney for Northstar Financial Advisors Inc., the lead plaintiff, wouldn't comment on how he thinks the judge will rule. The advisory firm, which is based in North Caldwell, N.J., has more than $30 million in assets under management, according to federal filings. "What courts do sometimes is that they do justice," was all Robert C. Finkel, a partner with Wolf Popper LLC of New York, would say. In the case of Northstar v. Schwab, however, justice is complicated. Northstar alleges that the Schwab Total Bond Fund was allowed to deviate from its investment strategy in violation of the Investment Company Act. According to the fund's documents, it tracks the performance of the Lehman Brothers U.S. Aggregate Bond Index. The suit, however, alleges that the fund improperly invested in mortgage-backed securities that were riskier than those in the index. The fund also invested more than 25% of its assets in mortgage-backed securities despite its own policy prohibiting it from investing more than 25% in any single industry, the suit claims. The fund's deviations from its stated investment objectives caused it to lose 1.09% from Sept. 4, 2007, to Aug. 27, compared with a gain of 5.29% for the index, according to the suit. Ms. Illston found that the allegations were sufficient to survive a motion to dismiss. Her decision has fund attorneys worried. "In refusing to dismiss a class action case alleging a fund harmed investors by investing in high-risk mortgage-backed securities, some plaintiffs may claim that the court has opened a new front in the plaintiff's bar's efforts to capitalize on the subprime crisis through investor class actions," said a client alert released this month by Paul Hastings Janofsky & Walker LLP of Los Angeles. More lawsuits are almost a certainty, according to a March alert from Milbank Tweed Hadley & McCloy. "Historically, when courts found [or suggested] that the securities laws provide a potential cause of action, the class action plaintiff's bar has tried to stretch the limits of those findings," the alert said.

LIMITED DAMAGE

Attempting to stretch Ms. Illston's ruling, however, may prove especially difficult. The ruling is very narrow, applying only to Section 13(a) of the Investment Company Act, which says a fund can't deviate from its stated investment objectives without a vote of its shareholders. "We don't see it spreading to other sections of the Investment Company Act," Mr. Murphy said. Furthermore, it isn't clear if other courts would adopt Ms. Illston's reasoning, he said. Rulings by judges in U.S. District Courts do not hold precedent in other jurisdictions. Ms. Illston reasoned that investors could sue under the section of the Investment Company Act in question because it was amended by Congress as part of the Sudan Accountability and Divestment Act of 2007 to restrict the rights to bring actions against a fund or an adviser for divesting from securities issued by those conducting operations in Sudan. "If there were no private right of action under Section 13(a), there would be no need to restrict the actions that could be filed under Section 13," Ms. Illston wrote in her opinion. The judge's reasoning, however, is awkward at best, said one fund attorney, who asked not to be identified, because he has cases pending before her. It doesn't mesh with what the Supreme Court has said is required to bring a suit under an act of Congress — that there be language specifically in the act allowing for suits to go forward, he said. Mr. Finkel, however, holds a different view. "I do think that Schwab is using this perhaps as a way to end a lot of potential litigation, because they want to be able to deviate from a fundamental investment policy without holding themselves responsible to their investors," he said. "They are looking for a loophole in the law." Whether such a loophole exists will most likely be decided by another court. "Regardless of the result [of Schwab's appeal], this issue is likely to be revisited by a court in the 9th District or another court in the not-too-distant future," said James Cavoli, a partner in Milbank Tweed Hadley & McCloy.

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