Managing Risks Posed to Mutual Fund Industry Participants by Increasing Litigation and Regulatory Enforcement Activity

Wall Street BullOver the last ten years, the far-reaching examination of the trading practices of the mutual fund industry, numerous enforcement actions by the SEC against prominent broker-dealers and fund complexes, and scores of civil lawsuits resulted in very significant costs to the mutual fund industry. Additionally, the enormous dislocations in the subprime mortgage industry and the ensuing global credit crisis caused market disruptions that led to trillions of dollars in lost investor wealth globally in a matter of months.  This substantially re-invigorated the SEC, which then pursued more than one hundred enforcement actions and settlements of credit crisis claims across all industries -- including the mutual fund industry - leading to the recovery of restitution payments and penalties that have to date totaled in excess of a billion dollars. 

The SEC is now more devoted than ever to examination and enforcement efforts directed at the mutual fund industry, specifically including the individual managers and officers of funds across the country.  The civil litigation against the fund industry arising from the credit crisis has been equally dramatic, with dozens of class actions alleging violations of federal and state securities laws, and shareholder derivative actions asserting breach of fiduciary duty and mismanagement claims against trustees and fund officers and managers.  In some instances, fund complexes also have been embroiled in hundreds of FINRA arbitrations initiated by individual investors alleging credit crisis related claims. 

Additionally, the United States Supreme Court also focused national attention on the mutual fund industry with two separate decisions, which together serve to highlight the current emphasis on the legal rights and obligations of mutual fund investors and industry participants.  First, in Jones v. Harris Assocs. L.P., 130 S. Ct. 1418 (2010), the Supreme Court removed what had been meaningful uncertainty about what the ultimate standard would be under Section 36(b) of the Investment Company Act governing the fiduciary duty of fund advisers in receiving advisory fees.  In adopting the Second Circuit's logic under Gartenberg v. Merrill Lynch, 694 F.2d 923 (2d Cir. 1982), the Supreme Court held that to be liable under Section 36(b), an adviser's fee must be unreasonably large to the point that it no longer bears a reasonable relationship to the services performed and could not have been the result of arms-length bargaining.  The following year, in Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011), the Court held that a mutual fund investment adviser did not "make" an allegedly misleading statement in a fund prospectus, for purposes of liability under Rule 10b-5 and Section 10b of the Securities Exchange Act, despite its role in preparing the prospectus.  Instead, the Court adopted a bright line rule that the "maker" of a statement under Rule 10b-5 is "the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it."  Accordingly, the Court held that the fund itself-and not the adviser-made the allegedly misleading statements because the fund controlled the statements at issue, as a separate legal entity subject to the authority of its own board of trustees. 

While observers may contend that both results were favorable to the industry and may have reduced the risks of some claims, more broadly the Supreme Court's rulings in these cases underscore the continuing industry scrutiny by regulators and class action lawyers alike.  As these decisions demonstrate, the legal rights and obligations of investors and industry participants will remain a prime subject for litigation and interpretation in the years to come.  Given the increased attention by regulators on the mutual fund industry and the current and expected future focus on the industry by the plaintiffs' bar, the importance of insurance for the industry has dramatically increased and promises to continue that trajectory.  Understanding the typical policies purchased by the industry to manage liability exposure has become more important and more complex. 

In the Mutual Fund Litigation and Insurance Practice Guide Matthew Larrabee, David Kotler, Timothy Burns and Eric Barber examine the legal risks faced by the mutual fund industry, the legal bases for potential liability of mutual fund industry participants, the key precedents from important regulatory enforcement actions and civil litigation against the industry, and the critical insurance products and approaches that are available to mitigate these risks. The Guide is available for purchase in print or ebook format (Mobipocket readers, including Amazon® Kindle® / Adobe Digital Editions, Apple® iPad®, SONY® Reader). 

Co authors:

Matthew LarrabeeTimothy BurnsDavid KotlerEric Barber

   Matthew Larrabee              Timothy Burns                 David Kotler                    Eric Barber

Lexis.com subscribers can access enhanced versions of the opinions cited in this article:

Jones v. Harris Assocs. L.P., 130 S. Ct. 1418 (2010)

Gartenberg v. Merrill Lynch, 694 F.2d 923 (2d Cir. 1982)

Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011)

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