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Northstar Financial Advisors, Inc v. Schwab Investments; and Mariann

March 1, 2011


The opinion of the court was delivered by: Lucy H. Koh United States District Judge

For the Northern District of California United States District Court


The Court heard oral argument on defendants' Motion to Dismiss the Second Amended Complaint (Motion) in this matter on January 13, 2011. For the reasons set forth below, the Motion is GRANTED IN PART and DENIED IN PART. Plaintiffs are given leave to amend as 25 specified in this Order. 26

I. Introduction and Procedural History

On August 28, 2008, Plaintiff Northstar Financial Advisors, Inc. (Northstar) filed this class action lawsuit on behalf of all persons who owned shares of the Schwab Total Bond Market Fund (the Fund) at any time from August 31, 2007 to the present. Compl. (Dkt. No. 1) ¶ 1. Northstar is 2 a registered investment advisory and financial planning firm serving both institutional and 3 individual clients. Id. ¶ 9. Northstar manages both discretionary and non-discretionary accounts 4 on behalf of investors in its role as an investment advisor. Id. Northstar traded through Charles Schwab's Institutional Advisor Platform, and purchased shares in the Fund for its clients. Id. ¶¶ 6

Northstar alleged that defendants deviated from the Fund's investment objective to track the Lehman Brothers U.S. Aggregate Bond Index (the Index) in two ways. First, Northstar alleged 9 that the Fund deviated from this objective by investing in high risk non-U.S. agency collateralized 10 mortgage obligations (CMOs) that were not part of the Lehman Index and were substantially more risky than the U.S. agency securities and other instruments that comprised the Index. Id. ¶ 3.

United States District Court For the Northern District of California

Second, Northstar alleged that the Fund deviated from its investment objectives which prohibited 13 any concentration of investments greater than 25% in any industry by investing more than 25% of 14 its total assets in U.S. agency and non-agency mortgage-backed securities and CMOs. Id. ¶ 4. 15

Fund and its shareholders to tens of millions of dollars in losses due to a sustained decline in the 17 value of non-agency mortgage-backed securities. The Funds' deviation from its stated investment 18 objective caused it to incur a negative total return of 1.09% for the period September 4, 2007 19 through August 27, 2008, compared to a positive return of 5.92% for the Index over that period. 20

Based on these allegations, Northstar asserted the following claims: (1) Violation of Section 13(a) of the Investment Company Act of 1940 (ICA); (2) Breach of Fiduciary Duty; (3) Breach of Contract; and (4) Breach of Covenant of Good Faith and Fair Dealing. Defendants moved to 24 dismiss the first complaint. See First MTD (Dkt. No. 33). Judge Illston, to whom this case was 25 previously assigned, granted in part and denied in part defendants' motion. See Feb. 19, 2009 26

First, Judge Illston found that Northstar, as lead plaintiff, had no standing to sue regarding 28 securities it had not itself invested in, but that an assignment of claim from one of its client Northstar alleged that defendants' deviation from the Fund's investment objective exposed the 16 Id. ¶ 5. 21 Order (Dkt. No. 74). 27

investors "would . . . cure this deficiency." Feb. 19, 2009 Order at 4. Northstar had submitted 2 such an assignment, dated December 8, 2008, to the Court in support of its opposition to the First 3

Northstar could state a claim on its own behalf. Id. Judge Illston also found that there was an 5 implied private right of action under Section 13(a) of the ICA, and that Plaintiffs had stated a 6 claim for violation of shareholders' voting rights under this section. Feb. 19, 2009 Order at 7, 9-7

MTD. See Finkel Decl. (Dkt. No. 39) at Ex. F. Judge Illston also granted leave to amend so that 4

12. Regarding the asserted state law causes of action, Judge Illston granted Plaintiffs leave to 8 amend their breach of fiduciary duty and breach of contract claims. Regarding the breach of 9 fiduciary duty claim, Judge Illston did not decide whether Massachusetts or California law would 10 apply to determine whether the defendants owed investors a duty, but that the defendant's admission that "some person or entity" owed a duty to the fund's investors supported granting

Plaintiffs leave to amend. Judge Illston ordered the Plaintiffs to "carefully examine whether each 13 of the defendants named in this claim can in fact be named in such a claim, and under which 14 state's law such a claim is properly brought." She further held that "[a]fter review of the amended 15 complaint, defendants may renew their motion to dismiss this claim." Feb. 19, 2009 Order at 14-16

15. Judge Illston likewise concluded that it was unclear whether or not Plaintiffs could state a 17 breach of contract claim based on Proxy statements and prospectuses relating to the Fund. 18

Plaintiffs were given leave to amend to "add more specific allegations regarding the language 19 plaintiff relies on to allege the formation of a contract, as well as each defendants' involvement." 20

Id. at 15. Finally, Judge Illston found that the Plaintiffs had stated a claim for breach of the 21 covenant of good faith and fair dealing. Id. at 15-16. 22

23 defendants sought and were granted leave to appeal Judge Illston's Order finding a private right of 24 action under the ICA § 13(a), and a stay of this action pending the appeal. See Dkt. No. 108. 25

Thus, the case was stayed from April 27, 2009 through August 13, 2010 while the appeal was 26 pending. In the interim, the case was reassigned, first to Judge Seeborg, and then to the 27 undersigned. See Dkt. Nos. 115, 117. On August 13, 2010, the Ninth Circuit reversed Judge 28

On March 2, 2009, Plaintiffs filed a First Amended Complaint (FAC). On March 5, 2009, Illston's Order, holding that there is no private right of action under Section 13(a). Northstar Fin. 2

In light of this, Plaintiffs filed a Second Amended Complaint (SAC) removing their Section 13(a) claim on September 28, 2010. The SAC named Schwab Investments (the Trust), its 5

Trustees*fn1 , and Charles Schwab Investment Management, Inc. (the Investment Advisor) as 6 defendants. According to the SAC, the Trust is an investment trust organized under 7

The Trust is managed by the Trustees. SAC ¶ 19. Pursuant to a contractual agreement between 9 the Trust and the Investment Advisor, the Investment Advisor serves as the investment manager 10 for the Fund. SAC ¶ 23, 154. The SAC alleges claims based on breach of fiduciary duty (against

Advisors, Inc. v. Schwab Invs., 615 F.3d 1106, 1122 (9th Cir. 2010). 3

Massachusetts law, and "consists of a series of mutual funds, including the Fund." SAC ¶ 16. 8

all defendants), breach of contract (against the Trust), breach of the covenant of good faith and fair dealing (against the Trust and the Investment Advisor), and a claim for third party beneficiary 13 status to the agreement between the Trust and the Investment Advisor (against the Investment 14

II. Legal Standard 16

17 it fails to state a claim upon which relief can be granted. To survive a motion to dismiss, the 18 plaintiff must allege "enough facts to state a claim to relief that is plausible on its face." Bell Atl. 19 Corp. v. Twombly, 550 U.S. 544, 570 (2007). This "facial plausibility" standard requires the 20 plaintiff to allege facts that add up to "more than a sheer possibility that a defendant has acted 21 unlawfully." Ashcroft v. Iqbal, 129 S. Ct. 1937, 1949 (2009). In deciding whether the plaintiff has 22 stated a claim, the Court must assume the plaintiff's allegations are true and draw all reasonable 23 inferences in the plaintiff's favor. Usher v. City of Los Angeles, 828 F.2d 556, 561 (9th Cir. 1987). 24

However, the court is not required to accept as true "allegations that are merely conclusory, 25 unwarranted deductions of fact, or unreasonable inferences." In re Gilead Scis. Sec. Litig., 536 26

Advisor). 15

Under Federal Rule of Civil Procedure 12(b)(6), a district court must dismiss a complaint if

F.3d 1049, 1055 (9th Cir. 2008). Leave to amend must be granted unless it is clear that the 27 complaint's deficiencies cannot be cured by amendment. Lucas v. Dep't. of Corr., 66 F.3d 245, 2 248 (9th Cir. 1995).

a. Standing

Defendants argue that all of Plaintiffs' claims must be dismissed for lack of standing.

Defendants argue that because standing must be determined at the time a complaint is filed, and 7 because Northstar did not obtain an assignment of claims until several months after the original 8 complaint was filed, the assignment cannot cure Northstar's original lack of standing.*fn2 Plaintiffs 9 respond that Judge Illston's dismissal considered the assignment of claim that Plaintiffs now rely 10 upon, held that this assignment would "cure this [standing] deficiency," and gave the Plaintiffs 13 finding that a lack of standing at the outset of the case was not curable via a later assignment of 14 claim. In re SLM Corp. Sec. Litig., 258 F.R.D. 112, 115 (S.D.N.Y. 2009). However, in In re SLM, 15 the Southern District of New York was determining lead plaintiff status, not dismissing a claim. 16

Id. In this context, the court found that because it had appointed a lead plaintiff who was later 17 determined to lack standing, the better course was to appoint a new lead plaintiff who clearly 18 possessed standing at the outset of the action rather than approving the original lead plaintiff's 19 post-filing assignment of claim. The court noted that "[e]ven if [it] held that the assignment was 20 sufficient to cure the lack of standing, the Court of Appeals could hold otherwise. That uncertainty 21 requires this Court to proceed with caution. Accordingly, this Court declines to approve the 22 assignment of claims by Westchester Capital's two client funds." Notably, in the In re SLM 23 opinion, the court read Judge Illston's prior opinion in the instant case to "allow[] [Northstar] to 24 cure its lack of standing by obtaining an assignment after the court granted the defendants' motion 25 to dismiss." In re SLM, 258 F.R.D. at 115. 26 27

III. Application 4

leave to file an amended complaint to cure the standing problem. Feb. 19, 2009 Order at 4.

At the hearing on this Motion, defendants focused on a Southern District of New York case 2 considered at the outset of the litigation, but do not address how a court should treat a post-filing 3 assignment of claim. See, e.g., Perry v. Arlington Heights, 186 F.3d 826, 830 (7th Cir. 1999) 4

(dismissing claim regarding impounding of motor vehicles because plaintiff did not allege that he 5 owned a vehicle and therefore had not been injured at the time of filing; plaintiff's post-filing 6 purchase of a vehicle could not cure the standing problem). In their Reply brief, defendants focus 7 on United States for the Use and Benefit of Wulff v. CMA, Inc., 890 F.2d 1070, 1074-75 (9th Cir. 8

Many of the other cases defendants rely upon simply recite the rule that standing is

1989), a Ninth Circuit case dismissing claims for lack of standing. Wulff is distinguishable, 9 however. In Wulff, the assignment of claim occurred after the statute of limitations had run, and 10 there was no relation back to the originally-asserted claims. Id. Accordingly, the decision in Wulff

turned on the statute of limitations and the relation-back issues, not on whether a post-filing assignment of claim might save a claim that was otherwise timely asserted. 13

14 executed; instead, defendants argue that because this assignment occurred after the complaint was 15 filed, it "came too late" to affect Plaintiffs' standing. Mot. at 10. According to this argument, if 16

Northstar had dismissed its original complaint without prejudice and filed a new complaint relying 17 on the assignment of claim, rather than filing an amended complaint, there would be no standing 18 problem now. In that case, standing would have existed at the time the new case was filed. This 19 argument elevates form over substance. Particularly in light of Judge Illston's previous holding 20 that the assignment would cure the Plaintiffs' lack of standing, and direction to the Plaintiffs to file 21 an amended complaint based on the assignment, it would be unfair to Plaintiffs to punish them for 22 relying on the Court's specific instructions. Accordingly, the Court finds that in this particular 23 circumstance, Judge Illston's order will be construed as granting Plaintiffs leave to file a 24 supplemental pleading under Federal Rule of Civil Procedure 15(d). 25

Although there is no published Ninth Circuit authority on this point, courts in other circuits 26 have found that parties may cure standing deficiencies through supplemental pleadings. See Perry, 27 180 F.R.D. at 337 ("a supplemental complaint may correct deficiencies such as lack of standing.");

Defendants do not dispute that Plaintiffs' assignment conferred standing when it was

Travelers Ins. Co. v. 633 Third Assoc., 973 F.2d 82, 87-88 (2d Cir. 1992) (granting plaintiff leave to file a supplemental pleading incorporating events occurring after the complaint was filed in 2 order to establish standing); Decorative Ctr. of Houston v. Direct Response Publs., Inc., 264 F. 3 Supp. 2d 535, 544 n.22 (S.D. Tex. 2003). Accordingly, the Court concludes that Plaintiffs' FAC, 4 filed on March 2, 2009, constituted a supplemental pleading approved by Judge Illston's February 5 19, 2009 Order under Rule 15(d). This supplemental pleading established Plaintiffs' standing to 6 sue based on the asserted assignment of claim. Therefore, defendants' Motion to Dismiss based on 7 a lack of standing is DENIED. 8

b. SLUSA Preclusion

Defendants argue that Plaintiffs' claims are precluded by the Securities Litigation Uniform

Standards Act of 1998 (SLUSA). 15 U.S.C. § 77p. SLUSA was enacted to prevent a "shift from 11 Securities Litigation Reform Act of 1995 (PSLRA). Merrill Lynch v. Dabit, 547 U.S. 71, 82 13

Federal to State courts" of lawsuits asserting secu

rities law violations in the wake of the Private (2006) (internal citation omitted). In order to avoid the PSLRA's requirements, plaintiffs began 14 asserting what were essentially federal securities law claims as state law causes of action in state 15 court. Id. Congress sought to end this practice by amending the Securities Acts of 1933 and 1934 16 through SLUSA. 17

SLUSA prohibits class actions brought on behalf of more than 50 people ("covered class 18 actions"), if the action is based on state law and alleges (a) a misrepresentation or omission of a 19 material fact in connection with the purchase or sale of covered security; or (b) that the defendant 20 used or employed any manipulative or deceptive device or contrivance in connection with the 21 purchase or sale of a covered security. 15 U.S.C. §§ 77p, 78bb; Proctor v. Vishay Intertechnology 22 Inc., 584 F.3d 1208, 1221-22 (9th Cir. 2009). The complaint need not allege scienter, reliance, or 23 loss causation in order for SLUSA preclusion to apply. See Anderson v. Merrill Lynch Pierce 24 Fenner & Smith, Inc., 521 F.3d 1278, 1285-87 (10th Cir. 2008). In addition, the precluded state 25 law claims need not contain a "specific element" of misrepresentation in order to be precluded by 26

SLUSA. Proctor, 584 F.3d at 1222, n.13. Plaintiffs concede that this is a "covered class action," 27 that their claims are based on state law, and that the Fund's shares are covered securities under 28

SLUSA. Plaintiffs dispute the final two elements of SLUSA preclusion: first, that the SAC alleges misrepresentations or omissions of material fact, and second, that any such misstatements or 2 omissions are alleged to have been made "in connection with" the purchase or sale of the Fund's 3 shares. 4

6 defendants. First, Plaintiffs list a number of Registration Statements and Prospectuses in which 7

Lehman Brothers] bond index 'through the use of an indexing strategy. . . .'" SAC ¶¶ 49 -- 79. 9

2007 and 2008. Id. According to Plaintiffs, these statements of Fund policy attracted many 11

i. Misrepresentations

A careful review of the SAC shows that Plaintiffs allege a number of misrepresentations by

Schwab represented that the Fund would pursue a "fundamental indexing strategy 'to track' [the 8

Plaintiffs allege that defendants repeated these statements in 1997, 1998, 2003, 2004, 2005, 2006, 10

investors to the Fund: "[t]he Index Fund's conversion to an indexing strategy was a great success 12 for Schwab, as net assets increased from $24 million as of August 31, 1997 to approximately $1.5 13 billion as of August 31, 2007." SAC ¶ 80. Then, in the section of the SAC titled "The Fund 14

Substantially Deviates From Its Stated Investment Objective," Plaintiffs allege that the Fund began 15 to deviate from its promises to use an indexing strategy to ...

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