Opinion ID: 2784749
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Heading Rank: 1

Heading: facts

Text: Schwab Investments (“Schwab Trust”) is an investment trust organized under Massachusetts law. Such a trust, which is often referred to generically as a “Massachusetts trust,” even when not created under Massachusetts law, is an unincorporated business organization created by an instrument of trust by which property is to be held and managed by trustees for the benefit of persons who are or become the holders of the beneficial interests in the trust estate. See Hecht v. Malley, 265 U.S. 144, 146–47 (1924).1 Thus, the Schwab Trust’s Agreement and Declaration of Trust states that “the Trustees hereby declare that they will hold all cash, securities and other assets, which they may from time to time acquire in any manner as Trustees hereunder IN TRUST to manage and dispose of the same . . . for the pro rata benefit of the holders from time to time of Shares in this Trust.” Schwab Investments, Registration Statement (Form N-1A), Agreement and Declaration of Trust 1 (Ex. 1) (Dec. 29, 1997) [hereinafter “Agreement and Declaration of Trust”]. Such a “trust today is a preferred form of organization for mutual funds and asset securitization.” Dukeminier, Sitkoff & Lindgren, Wills, Trusts, and Estates 556. 1 “Unlike the corporation of the late 1800s and early 1900s, the common law business trust was only lightly regulated, so entrepreneurs used the business trust to escape the comparatively much heavier regulation of the corporate form. Using the business trust for this purpose was so pronounced in Massachusetts, where corporate ownership of real estate was prohibited, that the term Massachusetts trust became synonymous with business trust.” Jesse Dukeminier, Robert H. Sitkoff & James Lindgren, Wills, Trusts, and Estates 555–56 (8th ed. 2009). NORTHSTAR FIN. ADVISORS V. SCHWAB INV. 7 One of the significant features that distinguishes a Massachusetts trust from the ordinary or private trust “lies in the manner in which the trust relationship is created; investors in a business trust enter into a voluntary, consensual, and contractual relationship, whereas the beneficiaries of a traditional private trust take their interests by gift from the donor or settlor.” Herbert B. Chermside, Jr., Modern Status of the Massachusetts or Business Trust, 88 A.L.R.3d 704, 720 (1978); see also Berry v. McCourt, 204 N.E.2d 235, 240 (Ohio Ct. App. 1965) (“By an underlying contract, or in the provisions of a business trust instrument, or both, the parties agree on the operations of the venture.”). Thus, the Agreement and Declaration of Trust at issue here states at the very outset that it was made “by the Trustees hereunder, and by the holders of shares of beneficial interest to be issued hereunder.” Agreement and Declaration of Trust 1. Moreover, it continues that “[e]very Shareholder by virtue of having become a Shareholder shall be held to have expressly assented and agreed to the terms hereof and to have become a party hereto.” Agreement and Declaration of Trust 4. Because this case involves the relationship between investors and a mutual fund, the trust which created the fund and the investment adviser which manages the fund, it is helpful to have a clear understanding of the relationships among these parties. We begin with a useful, if oversimplified, description of a mutual fund: T, an investment professional, approaches A, B, C, and others like them and agrees to pool certain of their assets in a common fund to be managed by T. A, B, C, and the other investors each receive tradable shares in the fund in an amount proportional to their 8 NORTHSTAR FIN. ADVISORS V. SCHWAB INV. investment. By structuring their collective investment in this way, A, B, C, and the others are able to take advantage of economies of scale, obtain professional portfolio management, and achieve a more diversified portfolio than each could have individually. In managing the portfolio, T is subject to a fiduciary obligation to A, B, C, and the other investors in the fund. Dukeminier, Sitkoff & Lindgren, Wills, Trusts, and Estates 556. This simple description does not adequately discuss perhaps the most important party to this arrangement, namely, the investment adviser, whose “main role is to supervise and manage the fund’s assets, including handling the fund’s portfolio transactions.” Clifford E. Kirsch, An Introduction to Mutual Funds, in Mutual Fund Regulation § 1:2.2 (Clifford E. Kirsch ed., 2d ed. 2005). The investment adviser is not a mere employee, contractor, or consultant. Instead, it is “more often than not also the creator, sponsor, and promoter of the mutual fund.” Charles E. Rounds, Jr. & Charles E. Rounds, III, Loring and Rounds: A Trustee’s Handbook 955–56 (2012 ed.); see also Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 93 (1991) (Mutual funds “typically are organized and underwritten by the same firm that serves as the company’s ‘investment adviser.’”); Daily Income Fund, Inc. v. Fox, 464 U.S. 523, 536 (1984) (Mutual funds are “typically created and managed by a pre-existing external organization known as an investment adviser.” (citing Burks v. Lasker, 441 U.S. 471, 481 (1979))). NORTHSTAR FIN. ADVISORS V. SCHWAB INV. 9 Thus, while “[i]n theory, the [trust] is able to choose any adviser it deems appropriate to invest the fund’s portfolio, based on the adviser’s investing style, track record and fees,” in practice, the investment adviser picked to manage the portfolio is most often self-selected and unlikely to be removed. John Shipman, So Who Owns Your Mutual Fund?, Wall St. J., May 5, 2003, at R1, available at http://online.wsj.com/news/articles/SB105207969873142900. Because “a typical fund is organized by its investment adviser which provides it with almost all management services . . . , a mutual fund cannot, as a practical matter sever its relationship with the adviser.” Burks, 441 U.S. at 481 (quoting S. Rep. No. 91-184, at 5 (1969), reprinted in 1970 U.S.C.C.A.N. 4897, 4901). Consistent with this description of the structure of a mutual fund and its relationship with its investment adviser, the Schwab Trust selected Charles Schwab Investment Management, Inc. (“Schwab Advisor”) as its investment adviser. Indeed, Charles R. Schwab is alleged to have been chairman and trustee of the Schwab Trust and a member of the board of the Schwab Advisor. Third Am. Compl. ¶ 38. The latter is a subsidiary of the Charles Schwab Corporation, of which Mr. Schwab has served as “CEO at various times, including from 2004 through October 2008.” Third Am. Compl. ¶ 36. Moreover, the complaint alleges that all “[d]efendants and their affiliates held themselves out as one Schwab entity[.]” Third Am. Compl. ¶ 167. The mutual fund at issue here, one of several operated by the Schwab Trust, is the Schwab Total Bond Market Fund. Reflecting the terms of a proxy statement proposed by the Schwab Trust in 1997, and subsequently adopted by the shareholders by majority vote, the prospectuses that the Fund 10 NORTHSTAR FIN. ADVISORS V. SCHWAB INV. issued during the relevant period stated that the Fund was “designed to offer high current income by tracking the performance of the Lehman Brothers [U.S.] Aggregate Bond Index [(“Lehman Index”)]” and was “intended for investors seeking to fill the fixed income component of their asset allocation plan.” Specifically, the Lehman Index included “investment-grade government, corporate, mortgage-, commercial mortgage- and asset-backed bonds that [were] denominated in U.S. dollars and ha[d] maturities longer than one year.” Northstar Fin. Advisors, Inc. v. Schwab Invs., 609 F. Supp. 2d 938, 945 (N.D. Cal. 2009).2 Nevertheless, the Fund is not itself an index fund and, according to the Fund’s prospectus, it was “not required to invest any percentage of its assets in the securities represented in the [Lehman] Index.” Decl. of Kevin Calia in Support of Motion to Dismiss Second Amended Class Action Complaint, Ex. A at 14, Nov. 10, 2010. The Fund disclosed in its registration statement, and reiterated in prospectuses issued thereafter, that its policy of tracking the Lehman Index was “fundamental,” which means that it “cannot be changed without approval of the holders of a majority of the outstanding voting securities (as defined in the [ICA]).” Schwab Investments, Registration Statement 5, 14 (Form N-1A) (Jan. 16, 1998), Prospectus 10 (Form N-1A, Part A) (Nov. 1, 1997, as amended Jan. 15, 1998); see also 2 The former Lehman Index is now known as the Barclays U.S. Aggregate Bond Index. It currently “comprises a total of 8,286 bonds and is worth nearly $17 trillion.” Carolyn Cui, Barclays Agg Had Modest Origin, Wall St. J., Apr. 2, 2013, http://online.wsj.com/article/ SB10001424127887324883604578398880679949670.html. “[A]bout $663 billion of institutional assets is invested in 270 U.S. core fixedincome portfolios, 75% of which are benchmarked against the Barclays Agg Index.” Id. NORTHSTAR FIN. ADVISORS V. SCHWAB INV. 11 Michael Glazer, Prospectus Disclosure and Delivery Requirements, in Mutual Fund Regulation § 4:3.6 (Clifford E. Kirsch ed., 2d ed. 2005). The Fund was also precluded from investing twenty-five percent or more of the Fund’s total assets in any one industry, unless necessary to track the Lehman Index. Schwab Investments, Registration Statement 41 (Form N-1A) (Jan. 16, 1998), Statement of Additional Information 11 (Form N-1A, Part B) (Nov. 1, 1997, as amended Jan. 15, 1998). Northstar Financial Advisors, Inc. (“Northstar”) is a registered investment advisery and financial planning firm that manages discretionary and non-discretionary accounts on behalf of investors and had over 200,000 shares of the Fund under its management. In August 2008, Northstar filed this shareholder class action against the defendants, alleging that they deviated from the Fund’s fundamental investment policies and exposed the Fund and its shareholders to tens of millions of dollars in losses. Northstar has identified two classes of potential plaintiffs: (1) a “Pre-Breach” class, consisting of those who purchased shares of the Fund on or prior to August 31, 2007, and who continued to hold their shares as of August 31, 2007, and (2) a “Breach” class, consisting of those who purchased shares of the Fund during the period September 1, 2007 through February 27, 2009. Northstar alleges that August 31, 2007 was the last day of the fiscal year preceding the one during which the Fund first began deviating from its required fundamental investment policies, and that on February 27, 2009, the Fund reverted back to the required policies. This case has a lengthy and complicated procedural history that includes the dismissal of successive amended 12 NORTHSTAR FIN. ADVISORS V. SCHWAB INV. complaints for failure to state a cognizable cause of action. Specifically, the Third Amended Complaint, which is based on the Fund’s unauthorized deviation from its fundamental investment objectives, alleges five causes of action on behalf of each of the two identified classes, for a total of ten claims: breach of fiduciary duty against the Trustees3 (counts one and six); breach of fiduciary duty against Schwab Advisor (counts two and seven); aiding and abetting breach of fiduciary duty against the Trustees (counts three and eight); aiding and abetting breach of fiduciary duty against Schwab Advisor (counts four and nine); breach of the Investment Advisory and Administration Agreement (“IAA”) between Schwab Trust and Schwab Advisor. The last cause of action is based on the allegations that the investors are third-party beneficiaries of the IAA. The Third Amended Complaint also incorporates by reference a breach of contract cause of action against the Schwab Trust that was alleged in the Second Amended Complaint, but dismissed with prejudice on an earlier motion to dismiss. The incorporation by reference was included to preserve Northstar’s right to appeal from the dismissal of this cause of action with prejudice.