January 03, 2014 Articles

The Ambiguity of the Investment Company Act Section 36(b)

The language has been called "a lesson in the art of studied ambiguity in drafting of statutes"

By Matthew Bowie

The language of Investment Company Act section 36(b), 15 U.S.C. § 80a-35(b), has been called “a lesson in the art of studied ambiguity in drafting of statutes.” Fogel v. Chestnutt, 668 F.2d 100, 112 (2d Cir. 1981) (quotations omitted). Nowhere is this more true, perhaps, than in section 36(b)’s marked absence of textual clues concerning the requirements private plaintiffs must meet to bring derivative claims for violations of the provision’s terms.

Compounding this problem is the fact that section 36(b) claims are not governed by Federal Rule of Civil Procedure 23.1, which establishes, for most other derivative claims, who may sue and how they may do so. Courts have necessarily filled this void. This article discusses the development of this authority and explores how the law governing section 36(b) suits might be further developed in the years to come. In particular, it describes a recent Third Circuit case establishing that section 36(b) claims—because of their derivative nature—may be maintained only by plaintiffs who continue to own securities during the case, and it explains why courts should establish a separate rule barring section 36(b) claims for conduct predating the time when the plaintiff became a security holder.

Derivative Suits under Section 36(b)
Section 36(b) imposes a fiduciary duty on investment advisers of investment companies concerning their receipt of compensation from the company or its security holders. It also provides that “[a]n action may be brought . . . by a security holder of such registered investment company on behalf of such company, against such investment adviser. . . .” This express private right of action is derivative in the sense that it is brought “on behalf of” a mutual fund, and any recovery inures to the benefit of that fund. The derivative section 36(b) cause of action is unique, however, in the sense that—unlike ordinary corporate derivative claims—a section 36(b) claim cannot be brought by the fund itself.

Inapplicability of Rule 23.1 to Section 36(b) Claims
The Supreme Court considered this idiosyncrasy significant in determining that Rule 23.1 is inapplicable to claims under section 36(b). Daily Income Fund, Inc. v. Fox, 464 U.S. 523, 542 (1984). Rule 23.1 imposes conditions on plaintiffs seeking to bring most derivative claims. Among other things, Rule 23.1 requires that derivative plaintiffs must plead any demands made upon company directors to sue (the “demand requirement”) and requires that shareholders plead that they held their shares at the time of the transaction giving rise to their claim (the “contemporaneous ownership requirement”). The rule also establishes that derivative plaintiffs must fairly and adequately represent the interests of the company’s other shareholders, from which courts have inferred a requirement that these plaintiffs must continuously own the company’s shares throughout the pendency of their case (the “continuous ownership requirement”). Lewis v. Chiles, 719 F.2d 1044, 1047 n.1 (9th Cir. 1983) (Rule 23.1 “provision that a ‘derivative action may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interests of the shareholders . . .’ has served as an anchor for the concept that ownership must extend throughout the life of the litigation”). Rule 23.1, however, applies only to shareholder claims “to enforce a right that the corporation . . . may properly assert but has failed to enforce.” Because a fund cannot assert a section 36(b) claim, the Supreme Court reasoned that Rule 23.1 does not apply to suits under this provision. Daily Income Fund, 464 U.S. at 542.

The Third Circuit’s Santomenno Decision
The Daily Income Fund holding does not mean that all of the derivative suit procedural requirements anchored in Rule 23.1 are inapplicable to section 36(b) claims; it only means that these restrictions—if they are to apply—must be imposed by an authority other than Rule 23.1. For instance, the Third Circuit recently determined that section 36(b) plaintiffs are subject to the continuous ownership requirement even though Rule 23.1, which is commonly considered to impose this requirement on federal derivative claims, does not apply to suits under section 36(b). Santomenno ex rel. John Hancock Trust v. John Hancock Life Ins. Co. (U.S.A.), 677 F.3d 178, 184–85 (3d Cir. 2012). Plaintiffs in this case held fund securities when the original complaint was filed but lost security holder status during the suit. The defendants argued the plaintiffs lacked standing under Article III of the Constitution because any recovery obtained as a result of a favorable decision would inure to the benefit of the fund. This recovery, the defendants observed, would benefit current security holders—who would experience a pro rata increase in the value of their securities—but would be of no benefit at all to former security holders such as the plaintiffs. The defendants argued that the plaintiffs were left without a stake in the outcome of the litigation and that their section 36(b) claim thus did not constitute the type of case or controversy that federal courts may adjudicate under Article III.

The plaintiffs countered that the continuous ownership requirement is derived from Rule 23.1, that Daily Income Fund held that this rule was inapplicable to section 36(b) claims, and that they consequently had standing to maintain their claims despite no longer holding securities in the relevant funds. The Third Circuit rejected the plaintiffs’ arguments, ruling that section 36(b) plaintiffs lose statutory standing if they fail to continuously own fund securities during a suit. Such a requirement exists, the court reasoned, because derivative suits, by their nature, may be brought only by current investors with a real interest in obtaining a recovery that would increase the value of their shares.

Underpinnings of the Santomenno Decision
The Santomenno decision is noteworthy in that it represents a rare circuit court decision expounding on the nature of security holder derivative standing. Given that most derivative suits are governed by Rule 23.1, most litigation concerning the proper parties to prosecute these claims focuses on the plaintiffs’ compliance with the terms of the rule. Faced with a challenge to the standing of derivative plaintiffs suing under a statutory provision not governed by this rule, however, the Santomenno court needed to explore this issue at a more fundamental level.

In requiring section 36(b) security holder plaintiffs to maintain a stake in the outcome of a case, the Third Circuit recognized that standing analyses in the context of derivative lawsuits must assess more than whether the entity is the proper party to sue and must also determine whether the security holders themselves may properly invoke the power of a federal court to decide their case. Article III standing authority has long contained a requirement for plaintiffs to maintain a stake in a suit’s outcome. Baker v. Carr, 369 U.S. 186, 204 (1962). The Supreme Court has described this “personal stake” requirement and the more specific three-part test for standing as “flip sides of the same coin.” Sprint Commc’ns Co. v. APCC Servs., 554 U.S. 269, 288 (2008). The three-part Article III standing test assesses whether (1) a plaintiff has suffered an injury in fact, (2) fairly traceable to conduct of the defendant, (3) that is likely to be redressed by a favorable decision. The continuous ownership requirement imposed on section 36(b) plaintiffs in Santomenno is consistent with these principles of Article III standing. The requirement flows logically from the recognition that claims by former fund security holders cannot meet the redressability element of Article III standing because injuries they may have suffered cannot be redressed through a judicial award to the fund.

However, the Santomenno court did not need to address directly whether Congress could constitutionally allow a former security holder to maintain a derivative section 36(b) action. Instead, the constitutional need to ensure that plaintiffs possessed a personal stake in the outcome of a case prompted the court to read section 36(b) itself as requiring continuous ownership. The court thereby appears to have followed the canon of statutory construction counseling in favor of interpreting statutory provisions, where possible, so as to avoid serious constitutional problems.

Applicability of the Contemporaneous Ownership Requirement to Section 36(b) Suits
In Santomenno, the Third Circuit illustrated how a requirement commonly understood to be anchored in Rule 23.1 can apply to section 36(b) even though Rule 23.1 itself does not. Rule 23.1 also imposes a contemporaneous ownership requirement, which bars derivative suits by plaintiffs for conduct prior to the date of their investment. It remains fairly unsettled whether this requirement applies to suits under section 36(b). In the absence of such a requirement, a person might purchase shares of a mutual fund at a price already reduced by excessive advisory fees and then sue under section 36(b) to recover these excessive fees on behalf of the fund, thereby obtaining a windfall increase in the value of his or her holdings. Older district court decisions found such suits were barred by Rule 23.1’s contemporaneous ownership requirement. See, e.g., Jerozal v. Cash Reserve Mgmt., Inc., No. 81 Civ. 1569, 1982 WL 1363, at *7 (S.D.N.Y. Aug. 10, 1982); Markowitz v. Brody, 90 F.R.D. 542, 554 (S.D.N.Y. 1981). The one district court that appears to have addressed this question since Daily Income Fund, however, found that section 36(b) plaintiffs can sue for excessive fees charged before they invested because the terms of section 36(b) do not require contemporaneous ownership and because Rule 23.1 does not apply to suits under section 36(b). In re Mut. Fund Inv. Litig., 519 F. Supp. 2d 580, 590–91 (D. Md. 2007). Courts analyzing this question in the future, however, might follow the approach taken by the Santomenno court and conclude that contemporaneous ownership is a requirement flowing from section 36(b)’s derivative nature even if section 36(b)’s terms do not clearly impose such a rule.

Considerations of Article III standing seem to lie just beneath the surface in the analysis of whether section 36(b) requires contemporaneous ownership, as illustrated by the Santomenno decision. Specifically, it stands to reason that a section 36(b) plaintiff would need to have suffered some decline in the value of his or her holdings from the excessive fees he or she contests to satisfy Article III’s injury in fact prong. Undoubtedly, a plaintiff unaffected by fees charged before his or her investment could vindicate the rights of the fund and other security holders harmed by these fees by successfully prosecuting a section 36(b) suit. But this alone would seem insufficient to satisfy the requirements for constitutional standing because “[t]he Art. III judicial power exists only to redress . . . injury to the complaining party, even though the court’s judgment may benefit others collaterally.” Warth v. Seldin, 422 U.S. 490, 499 (1975).

To be sure, the case law on security holder derivative standing is sufficiently underdeveloped that it is not free from doubt whether Congress could constitutionally authorize a security holder to sue derivatively for harm to his or her fund dating from a period before he or she invested. Seemingly cutting against the need for contemporaneous ownership, for instance, are cases interpreting section 16(b) of the Securities Exchange Act of 1934—a provision authorizing a security holder to sue, on behalf of a corporation, to recover profits from short swing trading earned by certain corporate insiders. Several courts have found that section 16(b) derivative claims are not governed by Rule 23.1 and that there is therefore no bar against plaintiffs suing derivatively under section 16(b) to recover profits obtained by corporate insiders prior to the date on which the plaintiffs obtained their holdings. See Gollust v. Mendell, 501 U.S. 115, 123 (1991) (describing cases holding section 16(b) claims do not require contemporaneous ownership, citing Dottenheim v. Murchison, 227 F.2d 737, 738–40 (5th Cir. 1955), and Blau v. Mission Corp., 212 F.2d 77, 79 (2d Cir. 1954)). However, section 16(b) case law permitting suits by non-contemporaneously owning security holders developed before the modern test emphasizing injury in fact as a sine qua non of Article III standing. Timothy C. Hodits, “The Fatal Flaw of Standing: A Proposal for an Article I Tribunal for Environmental Claims,” 84 Wash. U. L. Rev. 1907, 1911 (2006) (“[Supreme] Court moved . . . to an ‘injury-in-fact test’” for Article III standing in “years from the early 1960s until about 1975”). Current Article III implications associated with derivative suits by non-contemporaneously owning security holders, therefore, may not have been directly addressed in the context of this section 16(b) litigation.

For the purposes of determining whether contemporaneous ownership is a requirement for section 36(b) suits, however, it is ultimately unnecessary to determine conclusively whether analogies to section 16(b) are apt or even to explore the outer reaches of Article III standing in the context of derivative claims. It is enough to recognize that there are serious constitutional questions with construing section 36(b) to allow suits by security holders for fees charged before they invested. So long as the text of section 36(b) can support a different reading, established rules of statutory construction counsel in favor of courts adopting this alternative interpretation to avoid having to opine on the difficult constitutional questions raised by such suits. Edward J. DeBartolo Corp. v. Fla. Gulf Coast Bldg. & Const. Trades Council, 485 U.S. 568, 575 (1988) (“[W]here an otherwise acceptable construction of a statute would raise serious constitutional problems, the Court will construe the statute to avoid such problems unless such construction is plainly contrary to the intent of Congress.”). Even if it is not the most natural reading of section 36(b), the language of this provision, conferring a private right of action to a fund “security holder,” can reasonably be read to refer to a person who held securities at the time that the fund’s adviser charged the contested fees, just as the Santomenno court read the provision as requiring a plaintiff to hold his or her securities throughout the pendency of the suit.

Suits under section 36(b), unrestrained by the requirements of Rule 23.1, can offer fascinating studies on the fundamental nature of federal derivative claims. The Santomenno case is certainly one such example because the decision looked beyond the most natural reading of section 36(b)’s text in recognizing that that derivative suits, by their very nature, may be maintained only by plaintiffs meeting certain requirements. Article III standing case law points strongly toward the conclusion that derivative plaintiffs must own securities in the entity on behalf of which they sue at the time of the harm that gives rise to the suit. In the years to come, then, courts may draw upon the approach taken by the Santomenno court in concluding that a section 36(b) contemporaneous ownership requirement flows logically from this provision’s derivative nature, in recognition of the looming issue of Article III standing.