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The Investment Lawyer Covering Legal and Regulatory Issues of Asset Management

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The Investment Lawyer Covering Legal and Regulatory Issues of Asset Management The Investment Lawyer Covering Legal and Regulatory Issues of Asset Management VOL. 24, NO. 5 • MAY 2017 Fiduciary Duties of Directors of Registered Investment Companies By Ellen R. Drought and Pamela M. Krill I. Introduction II. Fiduciary Duties of Fund Th e standards of conduct applicable to invest- Directors under State Law ment professionals under federal law have been A. Duty of Care, Duty of Loyalty under scrutiny in recent years. Th e Dodd-Frank and the Business Judgment Rule Wall Street Reform and Consumer Protection Act Th e concept of fi duciary dates back to the Latin of 2010 empowered the Securities and Exchange word fi dere, which means “to trust.”1 Th e word is Commission (SEC) to review the eff ectiveness of also closely associated with the word fi des (faith).2 existing legal and regulatory standards of care for Because funds are organized under state law, direc- brokers, dealers, and investment advisers and to tors of funds, like directors of any company, are sub- adopt a uniform fi duciary standard for broker- ject to fi duciary duties arising from applicable state dealers. Last year, the Department of Labor laws and general common law fi duciary principles.3 adopted a fi duciary rule under the Employee Most state statutes dealing with the fi duciary duties Retirement Income Security Act (ERISA) for of directors are relatively vague, with no specifi c broker-dealers and others who provide advice guidance provided regarding the scope of directors’ to retirement investors. While the standards of responsibilities. As a result, the development of spe- care under the Investment Advisers Act of 1940, cifi c standards has been left to the courts. Th e obli- the Securities Exchange Act of 1934, and ERISA have gations of directors as developed in case law can be been much debated, the fi duciary duties applicable grouped into two broad categories: the duty of care to directors and trustees (directors) of registered and the duty of loyalty. investment companies (funds) under state law and In general, the duty of care requires directors to the Investment Company Act of 1940 (1940 Act or act in good faith, in a manner the director reason- Act) have remained largely the same. Although the ably believes to be in the best interests of the fund standard of care has not changed, fund directors and its shareholders, and with the degree of care have seen increased responsibilities in light of SEC which an ordinarily prudent person in a like posi- rulemaking, enforcement actions, and shareholder tion would exercise under similar circumstances.4 litigation. In this article, we will examine the fi du- Under this duty, directors must inform themselves ciary duties of fund directors under state and fed- with all material information reasonably available to eral law as well as risk mitigation considerations. them prior to making a business decision. Th is can Copyright © 2017 by CCH Incorporated. All Rights Reserved. 2 THE INVESTMENT LAWYER be done by attending directors’ meetings, requesting judgment rule will not be applied where directors pertinent information, and then carefully evaluating have violated their duty of loyalty. Likewise, the the information provided.5 Depending on the mat- rule will not be applied in situations where direc- ter being acted upon, such information may include, tors have abdicated their responsibility to act on the among other things, materials relating to fund per- basis of their informed business judgment. Th is lat- formance, compliance reports, and any interests of ter situation has been likened to acting with gross affi liated persons in the action. In certain circum- negligence.11 stances, the 1940 Act requires the board to request information relevant to its decision making.6 In B. Delaware Statutory Trusts discharging their duty of care, directors are typically For funds organized as Delaware statutory entitled to rely on the fund’s records and on infor- trusts, the Delaware Statutory Trust Act (DSTA), mation, reports, and records prepared by or under like many other state corporate statutes, does not the direction of the fund’s investment adviser, coun- defi ne the fi duciary duties of trustees. But, unlike sel, public accountants, or other persons as to mat- other state corporate statutes, the DSTA provides ters that the directors reasonably believe to be within that unless the governing instrument provides oth- such person’s expertise. However, directors’ reliance erwise, the laws of the state pertaining to common on such data must be reasonable, which means they law trusts, including as they relate to the fi duciary must be attentive to detail, engaged, and, when nec- duties of common law trustees, apply.12 Because the essary, critical.7 Delaware default fi duciary standard for common Like the duty of care, the duty of loyalty also law trustees is a negligence standard,13 if the govern- requires directors to act in good faith and in a man- ing instrument is silent on this issue, a court could ner the director reasonably believes to be in the best refuse to apply the business judgment rule as being interests of the fund and its shareholders. In addi- incompatible with the common law standard. tion, the duty of loyalty prohibits directors from Fortunately, in August 2016, legislation went appropriating, for their own advantage, an opportu- into eff ect adding new Section 3806(l) to the DSTA, nity that rightly belongs to the fund and from oth- which provides that a trustee of a statutory trust erwise engaging in self-dealing.8 Th e duty of loyalty that is registered as an investment company under has been construed by some state courts to require the 1940 Act has the same fi duciary duties as direc- that directors be disinterested, so that they neither tors of a for-profi t corporation organized under the appear on both sides of a transaction nor expect to Delaware General Corporation Law, unless the gov- derive any personal benefi t from it, as well as inde- erning instrument provides otherwise. Th is amend- pendent, so that their decisions are based on the ment makes applicable to trustees of registered merits of the subject matter rather than extraneous investment companies organized under the DSTA considerations.9 the business judgment rule and its presumption In assessing the actions of directors, courts will that decision-makers act in good faith, on a fully- apply the business judgment rule, which is a rebut- informed basis and in the best interests of the orga- table presumption that insulates a director from nization for whom they act. liability for a business decision provided (1) the deci- sion is made in good faith, and (2) the director (a) C. Massachusetts Business Trusts does not have a personal interest in the subject mat- For funds organized as Massachusetts busi- ter of the decision, (b) is suffi ciently informed, and ness trusts, although there is no question that (c) reasonably believes the decision is in the best inter- the business judgment rule is available to protect ests of the fund and its shareholders.10 Th e business the decisions of trustees of such funds,14 a recent Copyright © 2017 by CCH Incorporated. All Rights Reserved. VOL. 24, NO. 5 • MAY 2017 3 federal district court decision has left trustees of anticipation of any litigation. Th e court further such funds nervous not about the business deci- noted that the fund paid legal counsel’s fees and that sions they make, but rather about the communica- legal advice concerning the fund was ultimately for tions they have with counsel in connection with the shareholders’ benefi t. Th erefore, the indepen- fulfi lling their duties to the funds and shareholders dent trustees and the defendants failed to show why they serve. the shareholder was not entitled to the documents In Kenny v. Pacifi c Investment Management he requested. Company, a shareholder of the PIMCO Total Return While an appeal of this decision is not likely,18 Fund, a series of a Massachusetts business trust, sued it is unclear whether the Kenny decision will apply the fund’s investment adviser and distributor for more broadly to funds organized under other state breaching their fi duciary duties by allegedly charging laws.19 Regardless of where the fund is organized, the fund excessive fees and failing to pass on econo- this case serves as an important reminder to all direc- mies of scale.15 As part of the lawsuit, the shareholder tors not to assume that their communications with issued subpoenas to the independent trustees, who counsel are privileged. were not parties, for documents pertaining to the case. Th e independent trustees provided some docu- III. Fiduciary Duties of Fund ments, but withheld over 200 documents containing Directors under the 1940 Act legal advice about the fund. Th e shareholder sought Th e fi duciary standard has been part of the a court order to compel the trustees to produce the 1940 Act since its adoption. During the Senate withheld documents. hearings in 1940, SEC Commissioner Robert E. Even though the parties agreed that the docu- Healy cited malpractice in the investment man- ments fell within the attorney-client privilege,16 agement industry, noting that “Too often sponsors the shareholder argued that the so-called “fi duciary and managers and insiders disregarded their basic exception” applied because the trustees were seeking fi duciary obligations to their investors.”20 As stated legal advice to guide the administration of the fund, by the SEC Staff in 1999, the 1940 Act “places and not legal advice for their own personal matters.17 substantial responsibilities on the independent Th e shareholder further argued that the attorney- directors of investment companies to protect the client privilege in this case belonged to the trust’s interests of fund shareholders by policing poten- benefi ciaries—that is, the shareholders—rather than tial confl icts of interest.
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