Earlier this month, a district court in New York dismissed plaintiffs' claims in Smith v. Oppenheimer Funds Distributor, Inc., a case involving payments made to broker-dealers by the funds' distributor in accordance with the funds' 12b-1 plan. The dismissed case was one of a number of recent lawsuits challenging the ability of funds (and fund distributors) to pay asset-based compensation to broker-dealers with respect to their clients' ownership of fund shares. Put most simply, plaintiffs in these cases have alleged that, under the Investment Advisers Act of 1940 ("IAA"), only advisers may receive asset-based compensation. According to the plaintiffs, in contrast to advisers, broker-dealers are permitted to receive only transaction-based compensation - that is, commissions in returns for the sale of fund shares.
In this case, the plaintiffs did not sue the broker-dealers. Rather, they brought suit against the funds, the funds' distributor and the members of the funds' board. The plaintiffs alleged that by permitting the payment of asset-based compensation to broker-dealers pursuant to the funds 12b-1 plans, the defendants were violating their fiduciary duties under section 36(a) of the Investment Company Act of 1940 ("ICA") and their obligation under ICA Rule 38a-1 to ensure that the funds complied with the securities laws. They brought suit under section 47(b) of the ICA, which permits a court to rescind any contract that violates the ICA.
The court did not discuss the key issue in this case - whether, in receiving asset-based compensation, broker-dealers are violating the Advisers Act. Instead, the court concluded that the suit was not allowed under the ICA. Importantly, the court reaffirmed much existing law regarding the ability of fund shareholders to sue the funds in which they have invested, stating that:
- Apart from section 36(a), the ICA generally does not permit fund shareholders to directly sue a fund (or its related parties, such as its directors or distributor) for violations of other provisions of the Act.
- Section 47(b) does not permit plaintiffs to seek rescission of the advisory contract or distribution contract for violations of other provisions of the Act.
The court concluded that plaintiff's suit violated these fundamental premises, and thus dismissed it.
The court did suggest, however, that if the payment of asset-based fees to broker-dealers is illegal, "the ultimate fault would lie with the broker-dealers themselves, and Plaintiff may sue them for violating the IAA." The court further suggested that if plaintiffs were able to prove this point, "the contract voiding provision of the IAA ... remains available to Plaintiffs ... to void the selling agreement between [the funds' distributor] and the broker-dealers, rather than the agreement between the Funds and [their distributor] at issue in this case."
The court, however, declined to express a view on whether the payment of these fees did, in fact, violate the IAA, leaving that issue open for further analysis in a later case.
The full text of the court's memorandum opinion is avaialable here.