A Delaware Perspective on Northstar v. Schwab and Its Implications
October 22, 2015
Publication| Corporate Trust & Agency Services
Northstar Fin. Advisors, Inc. v. Schwab Invs., No. 11-17187 (9th Cir. filed Sept. 14, 2011), has generated considerable apprehension in the mutual fund industry, particularly with respect to its discussion relating to the ability of mutual fund shareholders to bring direct actions against fund board members and investment advisors. With the U.S. Supreme Court’s recent denial of a petition for writ of certiorari, it appears that the holdings of Northstar will persist. Though Northstar did not directly involve questions of Delaware law (the court was mainly analyzing Massachusetts law), the court’s opinion contained sweeping language and citations to Delaware case law. What follows are a few observations and considerations from a Delaware law perspective.
We generally share the view of many commentators that certain of the holdings in Northstar (though not all) depart from long-standing precedent and the expectations of the mutual fund industry and, as a result, have created confusion and uncertainty. In our view, significant aspects of the Northstar court’s treatment of derivative/direct actions in particular seem at odds with Delaware law. Though Delaware law was not at issue in the case, the Northstar court cited a Delaware Supreme Court case, Tooley v. Donaldson, Lufkin, & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), in support of its holdings. While Tooley is good law in the context of Delaware corporations, that case did not involve a Delaware statutory trust or a mutual fund. Tooley has been cited by two recent Delaware Chancery Court cases in connection with an analysis of direct/derivative actions involving mutual funds organized as Delaware statutory trusts: Hartsel v. Vanguard Group Inc., No. 5394-VCP, 2011 Del. Ch. LEXIS 89 (Del. Ch. June 15, 2011), and Protas v. Cavanagh, No. 6555-VCG, 2012 Del. Ch. LEXIS 88 (Del. Ch. May 4, 2012). Neither case was cited or discussed in Northstar, and, in our view, neither case lends support to the premises or analysis applied in Northstar.
A detailed discussion of the Hartsel and Protas cases can be found in an article in the August 2012 The Investment Lawyer entitled “Delaware Statutory Trusts and Shareholder Derivative Actions: Recent Delaware Cases Provide First Rulings on the Law,” written by members of our firm. Both the Hartsel and the Protas courts dismissed direct claims by mutual fund shareholders by finding them derivative and, in so doing, provide little support, at least in Delaware, to the Northstar court’s declaration that the distinction between direct and derivative claims “has little meaning in the context of mutual funds.” The Hartsel court in particular rejected arguments that the unique structure of mutual funds would necessitate a departure from traditional rules governing the determination of what constitutes a direct or a derivative claim. In addition, the Hartsel court rejected an argument advanced by the Northstar court that “diminution of share value” was a basis for considering a claim direct as opposed to derivative. Lastly, given that the U.S. Court of Appeals for the Ninth Circuit sits in California, we note that the Hartsel court rejected the holding of a California federal court on the same issue, stating that “as a decision from a California federal court, it is not binding on this Court.”
As funds organized in Delaware as statutory trusts consider what options may be available to address the uncertainties created by Northstar, we suggest at a minimum that funds and their counsel consider the following items (each of which may be possible to achieve without a shareholder vote depending on the terms of a particular fund’s governing documents):
- Exclusive Forum Selection Clauses: We reiterate our advice from 2013 that funds consider the advisability of adopting Delaware exclusive forum provisions (see Impact of Delaware Forum-Selection Ruling on Investment Companies, July 2013 at www.rlf.com). Among other benefits, these provisions help ensure that a Delaware court is called upon to apply Delaware law. We believe this provides both a fund and its shareholders greater certainty against the risk of the misapplication of Delaware law. While it is routine to include such provisions in newly created Delaware statutory trusts operating as investment companies, many older funds’ governing instruments do not contain such a provision.
- Updating Outdated Governing Instrument Terms: In reaching its conclusions the Northstar court considered the terms of the governing instrument of the Massachusetts business trust involved in that case. Though some commentators have speculated that different governing instrument terms may not have changed the outcome in Northstar, we think it nonetheless advisable for funds to review their governing instruments to determine if their terms reflect current state of the art provisions relating to, among other things, derivative actions, shareholder rights and fiduciary duties. Given the primacy of the principle of freedom of contract as a public policy goal of the Delaware Statutory Trust Act, statutory trusts often have the ability to update and change their governing instruments to take into account changing court guidance and market practice. This may be of particular importance for older fund complexes whose documents may no longer reflect state of the art provisions.