Prior to the last decade, most litigation against funds (both open-and closed-end) and their advisers and directors involved claims of excessive fees pursuant to § 36(b) under the Investment Company Act of 1940 (ICA) and non-disclosure lawsuits under the Securities Act of 1933 (Securities Act). The collapse of the “dot com” bubble post-2001 left the mutual fund industry under stress, as assets under management for many managers had deflated materially. The aggressive quest for new assets to manage led some managers to adopt or expand marketing practices that became the focus of regulatory inquiries.
Beginning in 2003, the industry saw the beginning of several highly publicized regulatory investigations concerning market timing and improper revenue sharing arrangements. Scores of lawsuits were instigated against advisers, distributors, funds, and, in some cases, a fund’s independent directors. While independent directors were named defendants in prior lawsuits—for example, § 36(b) excessive fee lawsuits—the scope of litigation that followed 2003 was without precedent both in terms of the number of lawsuits and the number of those suits naming directors as defendants. Moreover, the lawsuits against fund directors coincided with an increase in suits against directors of companies outside of the fund industry. Both the number of lawsuits and the scope of litigation reflect the increased scrutiny to which the conduct of fund directors is subject.
With increased litigation came increased costs. Even if fund defendants prevail in a lawsuit, the expense of civil litigation is substantial. The number of law firms and industry experts with experience in representing funds, fund directors, and fund advisers in civil litigation, however, has remained limited. This expertise is reflected in the fees of these firms and experts. Moreover, in addition to the out-of-pocket expenses engendered by civil litigation, the involvement of independent directors in a lawsuit (as witnesses or as defendants) is stressful, time-consuming and, obviously, distracts the directors from focusing on board business.
This article explains what independent fund directors should know about fund litigation. The first half of the article beings by describing the most common types of claims against funds and the roles that independent directors typically play when these claims are brought by a plaintiff. The next section describes the differences between “direct actions” against a fund and derivative lawsuits brought on behalf of a fund. The differences are important because, among other reasons, independent directors have a particularly important role to play with respect to derivative lawsuits by investors on behalf of the fund. Specifically, as described in the following section, independent directors can form a special litigation committee with respect to a proposed lawsuit to recommend whether the fund should pursue the lawsuit or claim. If handled appropriately, a special litigation committee’s decision not to recommend that the proposed lawsuit or claim be pursued may deter a derivative lawsuit by investors or, if such a lawsuit is pursued, prove dispositive in dismissal of the derivative lawsuit.
The second half of the article describes the attorney-client privilege and when the privilege applies to protect the confidentiality of communications between an attorney and a client in the context of litigation against a fund. The next section discusses the common interest doctrine, which permits parties to a lawsuit to share privileged information without losing the confidentiality protection of the attorney- client privilege. Next, the articles moves on to the related topics of insurance and indemnification in the context of directors and fund litigation. The final section discusses payment of the settlement costs in fund litigation.
Common Types of Lawsuits and the Director’s Role
In this section, fund lawsuits are classified into four categories to simplify the presentation. Lawsuits against funds often involve multiple claims. For example, as discussed in this section, some of the revenue-sharing lawsuits included claims by the plaintiffs that the adviser violated § 36(b), and that the fund failed to disclose the revenue sharing in the fund’s registration statement. Similarly, disclosure lawsuits against funds often include a claim of fraudulent non-disclosure under the Securities Exchange Act of 1934’s (Exchange Act) Rule 10b-5.
Excessive Fee Litigation
Excessive fee lawsuits are normally commenced as a class action by fund investors although, technically, the nominal plaintiffs are suing on behalf of the fund against the adviser (or its affiliates) that allegedly received the excessive fees. The “modern era” for these types of lawsuits began in the 1980s, and involved attacks on the nascent money market fund industry, leading up to the Gartenberg decision. Following that decision and continuing to the present, no plaintiff in an excessive fee lawsuit has obtained a verdict against an investment adviser.
In the past decade, plaintiffs brought a new wave of lawsuits in the federal courts against fund advisers. One wave of suits were “pure” excessive fee complaints in which the plaintiffs claimed that an adviser received excessive advisory fees for fund management services in breach of the adviser’s fiduciary duty under § 36(b) of the ICA. Another wave of suits combined excessive fee allegations with other miscellaneous allegations relating to revenue sharing and other alleged misconduct.
Many of these lawsuits focused on comparisons between the fees paid by institutional investors for what were claimed to be the same advisory services. To this extent, these lawsuits were challenges to Gartenberg and its progeny because in Gartenberg, the federal appeals court rejected comparisons between retail fund advisory fees and institutional clients’ advisory fees. Most of these lawsuits were either dropped or dismissed. The most notable exception, of course, is Jones v. Harris Associates L.P, recently decided by the US Supreme Court. The Supreme Court’s Harris Associates opinion endorses the “traditional” analysis, based on Gartenberg and its progeny, on which boards have relied to guide them as to the appropriate factors to consider in their determinations under § 15(c) of the ICA whether to approve or to renew an adviser’s contract.
Use of the Gartenberg factors as an analytical framework for § 15(c) determinations had come under attack in recent years. Critics argued that application of the Gartenberg factors has not resulted in a § 15(c) process that effectively results in the lowest fees. Some courts have voiced similar concerns; in a recent decision dismissing the excessive fee litigation against one fund complex, the district court nonetheless observed:
Thus, although the directors were represented by counsel and were provided with detailed materials to which they and Defendants can point to and say, “see how thorough and careful we were,” the entire process seems less a true negotiation and more an elaborate exercise in checking off boxes and papering the fi le. Nonetheless, this is what controlling case law and [Securities and Exchange Commission] regulations demand, and is sufficient to immunize Defendants against section 36(b) liability so long as the fees charged are not grossly out of line with the range of fees charged in the industry.
The decision in Harris Associates presumably will reduce the exposure of fund advisers to § 36(b) claims, although it is reasonable to expect plaintiffs to test that proposition in new or pending actions. However, the naming of independent fund directors as defendants in excessive fee lawsuits should remain the exception because they do not receive the compensation that is at issue in most cases. Nevertheless, independent directors will continue to be critical witnesses in excessive fee lawsuits because § 36(b) expressly permits the court to give the fund board’s decision regarding the fees in question such weight as is appropriate under all the circumstances—most importantly the board’s § 15(c) determination. Indeed, in Harris Associates, the Supreme Court went out of its way to emphasize the importance of the board’s role in excessive fees cases and the deference that a court should give to the board’s determination if its § 15(c) process was robust. Naturally, then, the independent directors are in the best position to describe the § 15(c) process and the considerations that the directors included in reaching their challenged decision.
Independent directors and the funds they oversee will continue to see class action lawsuits in which investors contend that a fund’s registration statement contained material misstatements or failed to disclose material facts. Not surprisingly, such lawsuits occur when a fund’s net asset value (NAV) has decreased significantly. When such drops occur, it is likely that potential plaintiffs will scour the fund’s registration statement for any latent ambiguity or less-than-fulsome disclosure, especially when that disclosure is viewed in hindsight. Consider these examples:
- Several funds that had substantial exposure during the recent credit crisis to mortgage-backed securities, or derivative instruments related to these securities, are now defending class action disclosure lawsuits. At least one of the lawsuits was dismissed recently based, in part, on plaintiffs’ attempt to engage in a misstatement-by-hindsight analysis. In dismissing the complaint, the court noted: “[T]he accuracy of offering documents must be assessed in light of information available at the time they were published. . . . A backward-looking assessment of the infirmities of mortgage-related securities, therefore, cannot help plaintiffs’ case.”
- In the early 1990s, funds that had substantial losses arising from investments in collateralized mortgage obligations (CMOs) and other synthetic fixed-income instruments were the subject of disclosure class actions.
- After the technology bubble burst in 2000, various Merrill Lynch funds and Morgan Stanley funds were sued in class actions in which plaintiffs alleged that the funds had failed to disclose that they were investing in companies with which an affiliate of the fund’s adviser had an investment banking relationship.
- Until the practice was proscribed by the Securities and Exchange Commission (SEC) in 2004, it was common for a fund family to “take into account” the sale of fund shares by a broker as a factor when allocating fund brokerage, assuming the order was not solicited by the broker on that basis and that placement of the order was otherwise consistent with the adviser’s duty to seek best price and execution. Separately, fund managers also made cash payments, out of their own resources, to support the broker education process and encourage the sale of fund shares. These payments included expenditures made in response to broker demand for marketing support that came to be known as “shelf-space” (revenue sharing) payments (analogizing to practices in the retail grocery industry). Following a number of SEC enforcement actions against fund managers, beginning in 2004, class actions were filed against funds and investment advisers alleging that, without adequate disclosure, cash payments and directed brokerage had been used improperly to pay broker-dealers to recommend a particular family of funds to their customers. While most of the directed brokerage actions were dismissed, at least two of the actions that were filed as revenue sharing class actions were repleaded as excessive fee cases under § 36(b).
- Class action disclosure lawsuits also have resulted when certain fund practices have come to light, including market timing and the relative economics of B class shares.
The most-recent wave of litigation, involving funds that had substantial exposure during the recent credit crisis to mortgage-backed securities and related derivatives, is likely to lead to decisions that will elaborate further on the scope of disclosure obligations on a host of issues including the risk of derivatives, liquidity, valuation, internal controls, risk management, and the frequency of prospectus amendments. In addition, the courts will be assessing the viability of new theories of disclosure- related liability, such as whether there is a private right of action under § 13(a) of the ICA for claims that a fund’s portfolio has strayed from its disclosed investment policy.
In disclosure litigation, federal law expressly authorizes independent directors to be named individually as defendants, along with the fund and its executive officers. In fact, naming the independent directors as defendants is not uncommon and may have little to do with the underlying legal claims. Rather, naming independent directors as defendants is a strategy or tactic employed by plaintiffs’ counsel to enhance financial and psychological pressure to settle or to settle more favorably. In addition, naming independent directors may facilitate recovery under the applicable Directors and Officers (D&O) insurance policy.
A plaintiff can prevail in a disclosure lawsuit without showing that he relied on a registration statement’s misstatements or that there was fault on the part of any defendant with respect to the misstatements. Moreover, even a modest depreciation in a fund’s NAV can result in a lawsuit in which plaintiffs claim losses in the tens or hundreds of millions of dollars. Consequently, unless defendants can succeed in having a disclosure lawsuit dismissed at the pretrial stage, defendants will encounter a significant incentive to settle the lawsuit before trial.
All defendants, except the fund, may avoid liability through a “due diligence” defense by establishing that, after reasonable investigation, there was no reasonable ground to believe the registration statement contained a material misstatement. However, the burden is on the defendant to establish the defense and doing so prior to trial can be extremely difficult because of the inherent factual issues involved.
All defendants, including the fund, also may be able to avoid liability by establishing that the depreciation in the fund’s NAV was not caused by the misstatements in the fund’s prospectus identified by the plaintiff. Here, again, the burden is on the defendant to establish the defense.
In practical terms, because disclosure lawsuits are almost always settled before trial, the likelihood of personal liability for an independent director is remote. If the lawsuit is dismissed, then defendants owe nothing. In the case of a pretrial settlement, the settlement payment normally is paid by other defendants or insurance or a combination of the two sources.
Closed-End Fund Litigation
Closed-end funds face additional litigation challenges. Instead of seeking monetary damages for shareholders, most lawsuits involving closed-end funds are instigated to challenge decisions reached by the fund’s board in order to force the fund to become an open-end fund or to take some other action designed to mitigate a share price/NAV discount.
In general, shareholder proposals to force a closed-end fund to convert to an open-end structure have not succeeded. The corporation laws in most states require an amendment of the fund’s articles of incorporation to effect such a conversion. However, this type of amendment may be instigated only by a fund’s board. For these reasons, the SEC Staff permits closed-end funds to omit from their proxy materials mandatory (that is, binding on the directors) open-ending proposals.
Lawsuits involving closed-end funds typically are instigated by institutional investors that are “in the business” of attempting to cause a closed-end fund to open end. These lawsuits frequently name independent directors as defendants to challenge the board’s decision-making. However, the Business Judgment Rule protects directors by providing that directors will not be subject to liability for their decisions as long as their decisions were made in accordance with certain principles. These principles require that directors: (1) act in good faith, (2) be reasonably informed, and (3) reasonably believe that the actions that they take are in the best interests of the fund and its shareholders. Because closed-end fund lawsuits typically do not seek monetary judgments and because the Business Judgment Rule is available, the risk to closed-end fund directors of personal liability is remote.
The recent credit crunch froze the market for so-called auction rate preferred shares, through which closed-end funds derive additional capital to lever their investments. Consequently, various lawsuits were filed against closed-end funds that used this leverage technique and their directors. Plaintiffs in some of these suits allege misleading disclosure, while in other suits, plaintiffs allege breach of fiduciary duty. These cases are still pending, but the discussion, above, concerning disclosure-related suits and the Business Judgment Rule, respectively, should apply to these cases.
Finally, activist investors will sometimes commence proxy fights seeking to replace boards that do not adopt their proposals. Such proxy fights are often accompanied by litigation over the adequacy of proxy disclosures by one or both sides.
Regulatory Investigations and Enforcement Proceedings
The SEC and state regulators investigate and, where deemed appropriate, bring enforcement actions against funds and their advisers. Typically, the fund advisers or distributors are the entities investigated rather than the funds. Nevertheless, the funds may incur substantial defense costs arising from the regulatory investigations. Moreover, if an investigation results in a settlement with a regulator, private lawsuits may follow.
A fund’s adviser should apprise a board of any investigation that relates to the adviser’s management of the fund. This should include any charges or alleged deficiencies by a regulator that may concern a fund, regardless of whether the adviser contests the charges or allegations.
In addition, directors oversee a fund’s Rule 38a-1 compliance program as part of their overall oversight responsibilities. Rule 38a-1 also requires the fund’s CCO “no less frequently than annually,” to provide a written report including, among other things, any material compliance matters that occurred since the date of the last report. Directors are not expected to be compliance experts. That said, as part of their oversight responsibilities, Rule 38a-1 mandates that a fund’s board must approve the policies and procedures of the fund, the adviser and the principal service providers, based upon a determination that the procedures are reasonably designed to prevent violation of the federal securities laws.
Accordingly, if an investigation reveals that written policies either were not followed or were inadequate, resulting in the problems detected in the investigation, the directors’ oversight responsibilities would include overseeing the implementation of new policies and procedures to prevent a reoccurrence. To that end, directors may rely on the CCO, the adviser and their own independent legal counsel to assist them.
If the regulator brings a formal enforcement proceeding against the fund’s adviser, in some circumstances, the independent directors may have a role to play in protecting the fund’s shareholders and assisting the adviser “to get out ahead” of the enforcement proceeding. There are instances in which independent directors, with the adviser’s cooperation, may wish to form a special ad hoc committee (Special Committee) to determine if any harm was incurred by the fund(s) resulting from the alleged violations on the part of the adviser or its affiliates. To this end, the Special Committee can appoint independent counsel and employ independent experts to assist the Special Committee to identify and quantify any harm incurred by the funds. A useful point of reference is the use of independent director committees, discussed in the next section of this article, to investigate and determine whether the fund should instigate litigation against the adviser.
The findings of the Special Committee are not binding on the SEC. Moreover, the principal focus of a Special Committee’s investigation is to assess the alleged harm to the fund. Nevertheless, findings by the Special Committee, especially any quantification of harm to the funds that are reimbursed by the adviser along with other remedial measures, may facilitate a resolution of an SEC investigation and possible settlement. Moreover, the Special Committee’s findings may preclude a derivative lawsuit by investors or, if such a lawsuit is instigated, prove dispositive in dismissal of the lawsuit.
Direct Lawsuits v. Derivative Lawsuits
A direct lawsuit is one in which a shareholder sues in his or her personal capacity to enforce rights arising from his or her share ownership, typically for harm he or she suffered individually as opposed to any injury to the fund that fell upon all shareholders. The suit may be brought by a shareholder against the adviser, distributor, the fund, directors or officers of the fund or any other party who the shareholder believes contributed to their injury.
A derivative lawsuit is brought on behalf of the fund, rather than on behalf of individual shareholders or classes of shareholders, to enforce the rights of the fund that the fund allegedly has failed to enforce (that is, the suit is “derived” from the fund’s right). Derivative suits may require extra procedural steps on the part of the plaintiffs. To avoid the additional procedural requirements that apply to derivative suits, shareholders will often seek to characterize their suit as a direct action.
Direct suits generally pertain to shareholders’ structural, financial, liquidity, and voting rights. Disclosure actions are generally brought as direct actions. In contrast, derivative suits generally seek to enforce fiduciary duties owed to the fund or seek redress for alleged wrongs against the fund.
In a direct suit, if there are numerous plaintiffs with similar or identical claims, the suit may be structured as a class action. In a class action suit, a shareholder sues in his or her own capacity, as well as on behalf of other shareholders similarly situated. In effect, the members of a class have banded together through a representative to bring their individual direct actions in one large direct action. Cases may only proceed as class actions if they satisfy a number of procedural requirements intended to protect the interests of absent class members and achieve judicial efficiency.
Section 36(b), uniquely among the provisions of the ICA, explicitly permits shareholders to commence an action for the benefit of the fund against an investment adviser, an affiliated person of an investment adviser and the fund’s directors for a breach of fiduciary duty with respect to compensation or payments paid by a fund to the investment adviser or its affiliates. In addition to the express grant of a right of action under § 36(b), courts historically have also implied private direct rights of action from certain other provisions of the ICA, permitting shareholders to seek redress from alleged violations of those provisions. In recent years, however, federal courts have followed a seminal holding by the Supreme Court to deny most claims predicated on such “implied” direct private rights of action.
Separately, § 42 of the ICA provides that the SEC has authority to enforce all provisions of the ICA.
The Role of Special Litigation Committees in Derivative Actions
Derivative actions frequently allege a state-law claim of breach of fiduciary duty owed to the fund on the part of a fund’s directors or officers, such as failure to exercise due care or loyalty in the performance of one’s responsibilities. A challenge of a closed-end fund board’s decision not to reorganize the fund as an open-end fund is an example.
A derivative state-law claim of breach of fiduciary duty may be appended to a claim under the federal securities laws. This permits the plaintiffs to bring the claim in federal court, rather than in a state court and to pursue alternative theories of seeking recovery for the same or related alleged misconduct.
A demand letter, sent to the fund’s board, normally is a prerequisite to a shareholder bringing a derivative lawsuit. Recall that a derivative suit is brought by shareholders on behalf of the fund to enforce the rights of the fund that the fund allegedly has failed to enforce. A demand letter gives the fund board the opportunity to decide whether to pursue a claim directly or make a determination that the lawsuit should proceed. If the board determines not to pursue the claim outlined in the demand letter, then the aggrieved shareholders still may attempt to pursue a derivative suit, although overcoming the board’s decision is an additional obstacle.
Following a board’s receipt of a written demand letter that it pursue claims against persons alleged to have harmed the fund, a board may vote to create a special litigation committee (SLC) to investigate, review and analyze the facts and circumstances underlying both the demand letter and any related investigations. A fund’s independent directors may serve on a SLC if they are also deemed independent with respect to the claims being investigated. The SLC analyzes the veracity of the claims of the aggrieved shareholders and makes a reasonable business determination as to whether it is in the best interest of the fund that the proposed lawsuit should proceed.
The SLC must be independent, unbiased, and act in good faith. Moreover, such a committee must conduct a thorough and careful analysis regarding the claims. When seeking dismissal of a derivative action on the basis of an SLC’s determination, the SLC will have the burden of proving that these requirements have been met.
The standard of review of a SLC’s decision with respect to derivative suits varies by jurisdiction. In Massachusetts, for example, when a majority of the board is independent, the Business Judgment Rule presumptively applies, with the burden of proof falling on the plaintiffs to deprive the directors of the Business Judgment Rule’s protection. When a majority of the board is not independent, the Business Judgment Rule’s evidentiary presumption of validity does not apply, and a reasonable/principled review is employed, with the burden of proof falling on the fund.
Regardless of whether the majority of the board of a Massachusetts business trust is independent, the decision to reject a shareholder demand must be determined by:
(i) A majority vote of independent directors present at a meeting of the board of directors if the independent directors constitute a quorum; (ii) A majority vote of a committee consisting of two or more independent directors appointed by a majority vote of independent directors present at a meeting of the board of directors, whether or not the independent directors constituted a quorum; or (iii) The vote of the holders of a majority of the outstanding shares entitled to vote, not including shares owned by or voted under the control of a shareholder or related person who has or had a beneficial financial interest in the act or omission complained of or other interest therein that would reasonably be expected to exert an influence on that shareholder’s or related person’s judgment if called upon to vote in the determination.
If handled appropriately, an SLC’s decision not to recommend that the proposed lawsuit or claim be pursued may deter a derivative lawsuit by investors or, if such a lawsuit is pursued, prove dispositive in dismissal of the lawsuit.
Finally, it is important to note that the concept of independent directors under the ICA is not synonymous with independence for litigation purposes. Rather, whether a director is independent for derivative litigation purposes will be determined according to applicable state law.
Attorney-Client Privilege in Fund Litigation
What is the Privilege?
The attorney-client privilege is a legal rule of evidence that protects the confidentiality of communications between an attorney and a client. The privilege is one of the strongest privileges available under law. Generally, in a lawsuit, the attorney-client privilege entitles a party to withhold from production to the other party confidential communications that seek or reflect legal advice.
The attorney-client privilege requires at least four elements: (1) a communication; (2) with an attorney or his or her subordinate; (3) in confidence; (4) for the primary purpose of securing an opinion of law, legal services or assistance in a legal proceeding.
As a matter of procedure, the party invoking the attorney-client privilege bears the burden of persuasion. If disputed, the judge will determine whether a communication is privileged.
Availability of the Attorney-Client Privilege
The independent directors, interested directors, fund, Special Litigation Committee (SLC) or adviser may hire counsel to assist in fulfillment of their respective duties. If the requisite elements are met, the attorney-client privilege may be asserted by the independent directors, interested directors, fund, SLC or adviser to protect communications with their respective counsel. However, because one law firm may represent multiple parties, the ability to assert the attorney-client privilege may turn on the issue of who is the client with respect to a particular communication.
As a general matter, to the extent that any board materials or communications with one’s counsel meet the requisite four elements, the fund or board may assert the privilege against outsiders, including the adviser. Communications between the board and counsel to the adviser generally are not privileged unless, as described below, they are subject to the common interest/joint defense exception.
Members of a board of directors normally cannot assert privilege against each other. Nevertheless, a SLC, created to investigate, review and analyze the facts and circumstances surrounding a derivative demand letter, and its retained counsel have a privilege that may be asserted even against the board. A SLC may waive that privilege, however, by sharing privileged documents and legal advice with the full board, if the interests of the SLC and one or more members of the board (for example , management directors) are adverse.
For documents prepared by an adviser’s inside or outside counsel, where the adviser is the client and the documents were not produced to the board or any other third party, the adviser should be able to assert a claim of privilege against the board and against the SLC, as the adviser controls the privilege. The adviser may waive the privilege if the adviser shares the documents with an adverse party.
Although disclosure of a communication to third parties generally acts as a waiver of privilege, no case law suggests that storage of privileged documents with an affiliated third-party would sever any applicable privilege, provided the documents are kept confidential. This is important to funds because a fund usually maintains documents with its adviser or affiliates of the adviser.
Whether the attorney-client privilege may be asserted to protect draft Securities and Exchange Commission (SEC) filings varies by jurisdiction. Case law from the US Court of Appeals for the First Circuit, which includes Massachusetts, suggests that draft public filings may not be privileged against any party. Other jurisdictions, including Maryland, find privilege waived as to the entire draft document. Other courts consider the privilege waived only to those portions of draft documents actually disclosed. If there is a privilege as to the draft SEC filings, the SEC’s Standards of Professional Conduct for Attorneys suggests that the privilege can only be asserted by the board, rather than the adviser, since the filings are those of the fund.
Section 4 of the SEC’s Enforcement Manual directs the SEC Staff that it “should not ask a party to waive the attorney-client or work product privileges and is directed not to do so.” The Enforcement Manual states that “[t]he Enforcement Division’s central concern is whether the party has disclosed all relevant facts within the party’s knowledge that are responsive to the [S]taff ’s information requests, and not whether a party has elected to assert or waive a privilege.” The SEC will often take a party’s cooperation into account in resolving an investigation or determining what sanctions, if any, should apply. The withholding of information on the basis of legal privilege may affect the SEC’s judgment as to the extent of cooperation afforded.
Finally, the following are practical considerations for independent directors concerning the attorney-client privilege:
- 1. All parties should structure meetings and communications in a manner that is designed to maximize protection. For example, at a meeting with an attorney at which legal advice is requested and provided, persons who do not have a need to participate in the meeting ordinarily should not be present. This will prevent subsequent claims that the communication was not intended to be privileged or that the privilege was waived.
- 2. Minutes of meetings may lose their privileged status. For example, if an attorney notifies an adviser of a material compliance violation involving a fund, the adviser or the chief compliance officer will have an obligation to disclose that violation to the fund’s directors. The disclosure of the minutes to an adverse party, such as the SEC Staff during the course of a Staff investigation, may result in the waiver of privilege.
- 3. Because notes taken during a meeting may be discoverable, consider whether taking notes or retaining the notes is appropriate.
- 4. When appropriate, limit minutes of meetings held in executive session to topical descriptions.
- 5. Communications should be kept confidential. To satisfy one of the four basic elements required to establish the existence of the attorney-client privilege, clients should make reasonable attempts to keep communications confidential.
- 6. Independent directors should consider asking their counsel to retain independent experts to conduct investigations requested by the directors, and request that the reports be delivered to such counsel. Doing so may protect the reports themselves as confidential attorney work product if undertaken in contemplation of possible litigation, while the communication by counsel of the results of the investigation would remain privileged.
The Common Interest Doctrine and the Attorney-Client Privilege
The common interest doctrine, also known as the joint defense privilege, is a rule of evidence that permits parties to share privileged information without a waiver of confidentiality protections where they have common interests in defending against a pending or anticipated proceeding. The doctrine is an exception to the rule that no attorney-client privilege attaches to communications between a client and an attorney in the presence of a third person.
The recognition of, and the test for, the joint-defense privilege, as with all testimonial privileges, varies by jurisdiction. Under the most commonly accepted interpretation of the joint-defense privilege, in order for the privilege to apply, the party asserting the privilege must show that: (1) the communication was made in the course of a joint defense effort; (2) the statements were designed to further the effort; and (3) the privilege has not been waived.
In general, communications between a fund’s directors and the fund’s adviser where there is a common interest/joint defense, should be deemed to be privileged against third parties. In order for two clients to have a common interest in a matter, their interests arguably need not be identical. However, the requisite nature of the interest varies by jurisdiction. Certain jurisdictions require that the nature of the interest be “identical, not similar, and be legal, not solely commercial.” Other jurisdictions have a less strict approach and require that the interests be similar, not identical.
When the attorney-client privilege applies in a common-interest scenario, the privilege cannot be waived without the consent of all the parties, and the voluntary disclosure by one party does not waive the privilege with respect to other parties. If the parties sharing a common interest are subsequently engaged in litigation against one another, the privilege may no longer apply.
Not all communications between a fund’s directors and the adviser will be subject to protection under the common interest doctrine. Where the interests of the fund and those of the adviser diverge, such as with respect to adviser fees, communications involving their respective counsel likely will not be privileged.
Where applicable, independent directors should consult counsel regarding the advisability of entering into a joint defense agreement. While a joint defense agreement is not required to assert the privilege, an agreement may be evidence of the existence of confidential communications protected by the attorney-client privilege. More generally, independent directors should consult counsel to understand fully the requirements for asserting the common interest doctrine in the relevant jurisdiction.
Insurance and Indemnification
Funds normally purchase directors’ and officers’ liability insurance policies (commonly called D&O policies), which indemnify their directors and officers for claims made against them for their designated acts, errors or omissions. Funds also normally purchase “errors and omissions” insurance (commonly called E&O policies), which typically covers the fund for claims made against the fund for designated acts, errors or omissions by the fund or its representatives (for example, its directors and officers). Both forms of insurance protect against losses resulting from claims made against an insured for a wrongful act, including any actual or alleged error, misstatement, misleading statement, act, omission, neglect or breach of duty.
With their adviser and its affiliates, funds frequently acquire D&O polices and E&O policies on a joint basis due to the cost savings derived (greater coverage and/or savings on premiums). A joint policy, however, also gives rise to the risk that one or more insured parties will exhaust the coverage of the insurance. This risk exists because joint D&O/E&O policies provide for an “aggregate” amount of coverage, and each payment on the policy therefore reduces the amount available for other joint-insureds. Ordinarily, this is more of a concern for directors because claims against the adviser and/or the fund are more likely to exhaust the relevant coverage limits.
Boards can mitigate the problem of reaching the policy maximum by entering into an agreement with the other insured parties that allocates coverage if the maximum is reached. For example, the allocation agreement could provide for a minimum coverage for each insured and, thereafter, the independent directors and the funds shall be indemnified fully before the adviser or its affiliates are permitted to recover any additional amount. Some D&O policies have separate or additional coverage for independent directors that will be available even if other coverage is not available due to exhaustion or exclusions.
Generally, the scope of coverage is a matter of negotiation and, of course, the premiums to be charged. Common issues for negotiation include, but are not limited to, exclusions from coverage, the definition of “claim” and the definition of “loss.”
D&O policies and E&O policies contain certain exclusions from coverage. D&O policies and E&O policies typically contain an exclusion for improper profit or fraudulent or dishonest conduct. Importantly for directors, pursuant to Rule 17d-1(d)(7) under the Investment Company Act of 1940 (ICA), joint D&O/E&O polices may “not exclude coverage for bona fide claims made against any director who is not an interested person of the investment company, or against the investment company if it is a co-defendant in the claim with the disinterested director, by another person insured under the joint liability insurance policy.”
A threshold issue in determining coverage is what constitutes a covered “claim.” Some D&O policies define claim broadly to include formal lawsuits and administrative proceedings, as well as investigations. Under these policies, insurers may request that an insured person demonstrate that it is the target of an investigation and has not merely received a general request for information. On the other hand, some D&O policies define claim to mean a written demand seeking monetary damages, which insurers interpret not to include investigations, or place dollar limits on claims for investigation costs.
While D&O policies typically cover “loss” resulting from certain claims against an insured, the definition of loss varies by policy. A D&O policy may exclude fines or penalties from the definition of loss. In addition, D&O policies ordinarily have retention provisions (similar to a deductible), limiting the coverage to amounts above a certain amount that the insureds must pay first.
D&O policies are generally “claims-made” policies, meaning that claims must be made during the policy period unless, and to the extent, an “extended reporting period” applies. An insured may pay an additional premium for the extended reporting period, which generally allows the insured to extend the policy period for some period of time. However, the act for which the insured person seeks coverage must have taken place during the original policy period.
D&O policies ordinarily state that an insured person shall not admit liability, consent to any judgment, agree to any settlement or make any settlement offer without the insurer’s written consent. Because certain D&O policies are not clear as to whether the insurer is required to advance attorneys’ fees and costs, litigation and disputes have arisen regarding the requirement to advance the fees and expenses. D&O policies may require the insured person to obtain the insurer’s consent prior to incurring “defense costs,” the definition of which will vary by policy. On the other hand, D&O policies may limit defense costs to “reasonable” defense costs and require the cooperation, but not consent, of the parties. D&O policies generally provide that the insurer may not unreasonably withhold consent.
A D&O policy may not afford coverage to all persons associated with a mutual fund complex. Coverage disputes may arise as to how to allocate defense costs, settlements or judgments among the parties. D&O policies typically require that the parties agree to use their best efforts to determine a fair and proper allocation of all amounts to be allocated.
Depending on applicable state law and the fund’s governing documents, indemnification may allow directors to be reimbursed from fund assets for liabilities (including legal expenses) incurred by them as defendants and witnesses in fund-related civil litigation. As with D&O insurance, indemnification typically allows directors to receive advances to cover their legal and associated expenses.
Under state indemnification statutes, funds are typically required to indemnify directors in certain circumstances, and are permitted to indemnify fund directors in other circumstances. While there are variations by state, state laws commonly provide, for a director who has been fully exonerated, mandatory indemnification of the director for legal fees and expenses the director incurred. State law also commonly permits, but does not require, a corporation or business trust to include provisions in its organic documents of organization, which provide for director indemnification of defense costs and of amounts paid in judgment or settlement, provided the director acted in good faith. State law may provide one or more procedures for a fund to make a determination regarding whether director indemnity is proper. On the other hand, state law commonly does not permit a director to be indemnified for costs arising from conduct that involves bad faith, willful malfeasance, or reckless disregard of duty or that resulted from active or deliberate dishonesty or improper personal benefit or, in a criminal proceeding, when the director knew or had reasonable basis to know that his conduct was unlawful.
Provisions in fund governing documents typically grant directors the broadest indemnification rights available under applicable law. Directors’ indemnification rights are constrained by, among other things, the securities laws and SEC Staff interpretations. Section 17(h) of the ICA prohibits indemnification of a fund director where the director engaged in disabling conduct, which includes willful malfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of office. Courts and the SEC have also generally taken the position that indemnification against liabilities under the Securities Act of 1933 is contrary to public policy and, therefore, unenforceable. In addition, the SEC has placed limits on the circumstances under which a fund may advance an officer or director’s defense costs. Section 17(i) of the ICA similarly prohibits indemnification of a fund adviser where the adviser engaged in disabling conduct, which includes willful malfeasance, bad faith, gross negligence or reckless disregard of the adviser’s duties under a fund advisory contract.
Payment of Settlement Costs
Due to a number of factors, such as the cost of litigation or the desire to avoid a protracted legal battle, the majority of fund lawsuits that are not dismissed are resolved by a settlement. Generally, when a settlement is reached, it will be submitted for approval to the court in which the lawsuit is pending. Any settlement or compromise in a class action or shareholder derivative action settlement requires court approval.
Procedures for a proposed settlement, voluntary dismissal or compromise in a class action include the following: (i) the court must direct notice in a reasonable manner to all class members who would be bound by the proposal; (ii) if the proposal would bind class members, as is ordinarily the case, the court may approve it only after a hearing and on finding that it is fair, reasonable and adequate; (iii) the parties seeking approval must file a statement identifying any agreement made in connection with the proposal; (iv) if the class action was previously certified, the court may refuse to approve a settlement unless it affords a new opportunity to request exclusion to individual class members who had an earlier opportunity to request exclusion but did not do so; and (v) any class member may object to the proposal if it requires court approval, the objection may be withdrawn only with the court’s approval. Notice of the settlement, voluntary dismissal or compromise in a shareholder derivative action “must be given to shareholders or members in the manner that the court orders.”
Some, if not all, of a director’s costs associated with a settlement will typically be covered by insurance and/or indemnification. The extent of coverage will vary based on a number of factors, such as the director’s actions, the facts of the specific situation or the provisions of the relevant D&O policy. Because D&O policies typically require the consent of the insurance provider prior to entering into a settlement, it is important to communicate all details of and issues related to a settlement with the insurance provider. In addition, because insurance policies may exclude coverage for fines and penalties, an insured person will want to consider carefully how to structure any settlement to ensure that any monetary payments fall within the D&O policy’s definition of loss.
If insurance coverage is exhausted or unavailable, the SEC’s guidance is to the effect that any arrangement providing for the sharing of settlement costs, including litigation expenses, between a fund and an affiliate constitutes a joint transaction within the meaning of Rule 17d-1 under the ICA. Thus, in various no-action letter requests, the SEC Staff declined to provide relief to permit funds to share settlement and litigation expenses with an affiliate and indicated that the applicants must obtain exemptive relief. Accordingly, funds and their affiliates have obtained such exemptive relief.
With respect to regulatory actions, certain additional considerations regarding settlements are relevant. Importantly, the SEC will not enter into any settlement involving a fine or penalty in which the fine or penalty is paid by insurance or other form of indemnity. Typically, in regulatory actions, if the court approves the settlement, it issues a consent or decree, which is “to be construed for enforcement purposes basically as a contract.”
Beginning in 2003, the industry saw the beginning of several highly publicized regulatory investigations concerning market timing and improper revenue sharing arrangements. Scores of lawsuits were instigated against advisers, distributors, funds, and, in some cases, a fund’s independent directors. While independent directors were named defendants in prior lawsuits, the scope of litigation that followed 2003 was without precedent in terms of the number of lawsuits and the number of those suits naming directors as defendants. This article describes what funds’ independent directors should know about fund litigation and how that litigation can affect them.