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Northstar Financial Advisors, Inc., On Behalf of Itself and All Others Similarly Situated v. Schwab Investments; and Mariann Byerwalter

March 2, 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 24 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

2 action lawsuit on behalf of all persons who owned shares of the Schwab Total Bond Market Fund 3

(the Fund) at any time from August 31, 2007 to the present. Compl. (Dkt. No. 1) ¶ 1. Northstar is 4 a registered investment advisory and financial planning firm serving both institutional and 5 individual clients. Id. ¶ 9. Northstar manages both discretionary and non-discretionary accounts 6 on behalf of investors in its role as an investment advisor. Id. Northstar traded through Charles 7

On August 28, 2008, Plaintiff Northstar Financial Advisors, Inc. (Northstar) filed this class

Schwab's Institutional Advisor Platform, and purchased shares in the Fund for its clients. Id. ¶¶ 8

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 that the Fund deviated from this objective by investing in high risk non-U.S. agency collateralized 12 mortgage obligations (CMOs) that were not part of the Lehman Index and were substantially more 13 risky than the U.S. agency securities and other instruments that comprised the Index. Id. ¶ 3. 14

Second, Northstar alleged that the Fund deviated from its investment objectives which prohibited 15 any concentration of investments greater than 25% in any industry by investing more than 25% of 16 its total assets in U.S. agency and non-agency mortgage-backed securities and CMOs. Id. ¶ 4. 17

Fund and its shareholders to tens of millions of dollars in losses due to a sustained decline in the 19 value of non-agency mortgage-backed securities. The Funds' deviation from its stated investment 20 objective caused it to incur a negative total return of 1.09% for the period September 4, 2007 21 through August 27, 2008, compared to a positive return of 5.92% for the Index over that period. 22

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 26 dismiss the first complaint. See First MTD (Dkt. No. 33). Judge Illston, to whom this case was 27 28

Northstar alleged that defendants' deviation from the Fund's investment objective exposed the 18 Id. ¶ 5. 23 previously assigned, granted in part and denied in part defendants' motion. See Feb. 19, 2009 2

Order (Dkt. No. 74). 3

4 securities it had not itself invested in, but that an assignment of claim from one of its client 5 investors "would . . . cure this deficiency." Feb. 19, 2009 Order at 4. Northstar had submitted 6 such an assignment, dated December 8, 2008, to the Court in support of its opposition to the First 7

Northstar could state a claim on its own behalf. Id. Judge Illston also found that there was an 9 implied private right of action under Section 13(a) of the ICA, and that Plaintiffs had stated a 10 claim for violation of shareholders' voting rights under this section. Feb. 19, 2009 Order at 7, 9-

First, Judge Illston found that Northstar, as lead plaintiff, had no standing to sue regarding

MTD. See Finkel Decl. (Dkt. No. 39) at Ex. F. Judge Illston also granted leave to amend so that 8

12. Regarding the asserted state law causes of action, Judge Illston granted Plaintiffs leave to 12 amend their breach of fiduciary duty and breach of contract claims. Regarding the breach of 13 fiduciary duty claim, Judge Illston did not decide whether Massachusetts or California law would 14 apply to determine whether the defendants owed investors a duty, but that the defendant's 15 admission that "some person or entity" owed a duty to the fund's investors supported granting 16

Plaintiffs leave to amend. Judge Illston ordered the Plaintiffs to "carefully examine whether each 17 of the defendants named in this claim can in fact be named in such a claim, and under which 18 state's law such a claim is properly brought." She further held that "[a]fter review of the amended 19 complaint, defendants may renew their motion to dismiss this claim." Feb. 19, 2009 Order at 14-20

15. Judge Illston likewise concluded that it was unclear whether or not Plaintiffs could state a 21 breach of contract claim based on Proxy statements and prospectuses relating to the Fund. 22

Plaintiffs were given leave to amend to "add more specific allegations regarding the language 23 plaintiff relies on to allege the formation of a contract, as well as each defendants' involvement." 24

Id. at 15. Finally, Judge Illston found that the Plaintiffs had stated a claim for breach of the 25 covenant of good faith and fair dealing. Id. at 15-16. 26

27 defendants sought and were granted leave to appeal Judge Illston's Order finding a private right of 28

On March 2, 2009, Plaintiffs filed a First Amended Complaint (FAC). On March 5, 2009, action under the ICA § 13(a), and a stay of this action pending the appeal. See Dkt. No. 108. 2

Thus, the case was stayed from April 27, 2009 through August 13, 2010 while the appeal was 3 pending. In the interim, the case was reassigned, first to Judge Seeborg, and then to the 4 undersigned. See Dkt. Nos. 115, 117. On August 13, 2010, the Ninth Circuit reversed Judge 5

Illston's Order, holding that there is no private right of action under Section 13(a). Northstar Fin. 6

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 9

Advisors, Inc. v. Schwab Invs., 615 F.3d 1106, 1122 (9th Cir. 2010). 7

Trustees*fn1 , and Charles Schwab Investment Management, Inc. (the Investment Advisor) as 10 defendants. According to the SAC, the Trust is an investment trust organized under

The Trust is managed by the Trustees. SAC ¶ 19. Pursuant to a contractual agreement between 13 the Trust and the Investment Advisor, the Investment Advisor serves as the investment manager 14 for the Fund. SAC ¶ 23, 154. The SAC alleges claims based on breach of fiduciary duty (against 15 all defendants), breach of contract (against the Trust), breach of the covenant of good faith and 16 fair dealing (against the Trust and the Investment Advisor), and a claim for third party beneficiary 17 status to the agreement between the Trust and the Investment Advisor (against the Investment 18

II. Legal Standard 20

21 it fails to state a claim upon which relief can be granted. To survive a motion to dismiss, the 22 plaintiff must allege "enough facts to state a claim to relief that is plausible on its face." Bell Atl. 23

Corp. v. Twombly, 550 U.S. 544, 570 (2007). This "facial plausibility" standard requires the 24 plaintiff to allege facts that add up to "more than a sheer possibility that a defendant has acted 25 unlawfully." Ashcroft v. Iqbal, 129 S. Ct. 1937, 1949 (2009). In deciding whether the plaintiff has 26

Donald R. Stephens, Michael W. Wilsey, Charles R. Schwab, Randall W. Merk, Joseph H. Wender and John F. Cogan Massachusetts law, and "consists of a series of mutual funds, including the Fund." SAC ¶ 16. 12

Advisor). 19

Under Federal Rule of Civil Procedure 12(b)(6), a district court must dismiss a complaint if stated a claim, the Court must assume the plaintiff's allegations are true and draw all reasonable 2 inferences in the plaintiff's favor. Usher v. City of Los Angeles, 828 F.2d 556, 561 (9th Cir. 1987). 3

However, the court is not required to accept as true "allegations that are merely conclusory, 4 unwarranted deductions of fact, or unreasonable inferences." In re Gilead Scis. Sec. Litig., 536 5 F.3d 1049, 1055 (9th Cir. 2008). Leave to amend must be granted unless it is clear that the 6 complaint's deficiencies cannot be cured by amendment. Lucas v. Dep't. of Corr., 66 F.3d 245, 7

III. Application 9

248 (9th Cir. 1995). 8

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 12 because Northstar did not obtain an assignment of claims until several months after the original 13 complaint was filed, the assignment cannot cure Northstar's original lack of standing.*fn2 Plaintiffs 14 respond that Judge Illston's dismissal considered the assignment of claim that Plaintiffs now rely 15 upon, held that this assignment would "cure this [standing] deficiency," and gave the Plaintiffs 16 leave to file an amended complaint to cure the standing problem. Feb. 19, 2009 Order at 4. 17

18 finding that a lack of standing at the outset of the case was not curable via a later assignment of 19 claim. In re SLM Corp. Sec. Litig., 258 F.R.D. 112, 115 (S.D.N.Y. 2009). However, in In re SLM, 20 the Southern District of New York was determining lead plaintiff status, not dismissing a claim. 21

Id. In this context, the court found that because it had appointed a lead plaintiff who was later 22 determined to lack standing, the better course was to appoint a new lead plaintiff who clearly 23 possessed standing at the outset of the action rather than approving the original lead plaintiff's 24 post-filing assignment of claim. The court noted that "[e]ven if [it] held that the assignment was 25 sufficient to cure the lack of standing, the Court of Appeals could hold otherwise. That uncertainty 26

Plaintiffs confirmed at the hearing on this Motion that the asserted claims are all assigned investor claims, and therefore depend on the December 8, 2008 assignment of claim.

At the hearing on this Motion, defendants focused on a Southern District of New York case

requires this Court to proceed with caution. Accordingly, this Court declines to approve the 2 assignment of claims by Westchester Capital's two client funds." Notably, in the In re SLM 3 opinion, the court read Judge Illston's prior opinion in the instant case to "allow[] [Northstar] to 4 cure its lack of standing by obtaining an assignment after the court granted the defendants' motion 5 to dismiss." In re SLM, 258 F.R.D. at 115. 6

7 considered at the outset of the litigation, but do not address how a court should treat a post-filing 8 assignment of claim. See, e.g., Perry v. Arlington Heights, 186 F.3d 826, 830 (7th Cir. 1999) 9

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

(dismissing claim regarding impounding of motor vehicles because plaintiff did not allege that he 10 owned a vehicle and therefore had not been injured at the time of filing; plaintiff's post-filing purchase of a vehicle could not cure the standing problem). In their Reply brief, defendants focus 12 on United States for the Use and Benefit of Wulff v. CMA, Inc., 890 F.2d 1070, 1074-75 (9th Cir. 13 1989), a Ninth Circuit case dismissing claims for lack of standing. Wulff is distinguishable, 14 however. In Wulff, the assignment of claim occurred after the statute of limitations had run, and 15 there was no relation back to the originally-asserted claims. Id. Accordingly, the decision in Wulff 16 turned on the statute of limitations and the relation-back issues, not on whether a post-filing 17 assignment of claim might save a claim that was otherwise timely asserted. 18

19 executed; instead, defendants argue that because this assignment occurred after the complaint was 20 filed, it "came too late" to affect Plaintiffs' standing. Mot. at 10. According to this argument, if 21

Northstar had dismissed its original complaint without prejudice and filed a new complaint relying 22 on the assignment of claim, rather than filing an amended complaint, there would be no standing 23 problem now. In that case, standing would have existed at the time the new case was filed. This 24 argument elevates form over substance. Particularly in light of Judge Illston's previous holding 25 that the assignment would cure the Plaintiffs' lack of standing, and direction to the Plaintiffs to file 26 an amended complaint based on the assignment, it would be unfair to Plaintiffs to punish them for 27 relying on the Court's specific instructions. Accordingly, the Court finds that in this particular 28

Defendants do not dispute that Plaintiffs' assignment conferred standing when it was circumstance, Judge Illston's order will be construed as granting Plaintiffs leave to file a 2 supplemental pleading under Federal Rule of Civil Procedure 15(d). 3

4 have found that parties may cure standing deficiencies through supplemental pleadings. See Perry, 5

180 F.R.D. at 337 ("a supplemental complaint may correct deficiencies such as lack of standing."); 6

Travelers Ins. Co. v. 633 Third Assoc., 973 F.2d 82, 87-88 (2d Cir. 1992) (granting plaintiff leave 7 to file a supplemental pleading incorporating events occurring after the complaint was filed in 8 order to establish standing); Decorative Ctr. of Houston v. Direct Response Publs., Inc., 264 F. 9

Although there is no published Ninth Circuit authority on this point, courts in other circuits

Supp. 2d 535, 544 n.22 (S.D. Tex. 2003). Accordingly, the Court concludes that Plaintiffs' FAC, 10 filed on March 2, 2009, constituted a supplemental pleading approved by Judge Illston's February

19, 2009 Order under Rule 15(d). This supplemental pleading established Plaintiffs' standing to 12 sue based on the asserted assignment of claim. Therefore, defendants' Motion to Dismiss based on 13 a lack of standing is DENIED. 14

Federal to State courts" of lawsuits asserting securities law violations in the wake of the Private 18

Securities Litigation Reform Act of 1995 (PSLRA). Merrill Lynch, Pierce, Fenner & Smith, Inc. v. 19

Dabit, 547 U.S. 71, 82 (2006) (internal citation omitted). In order to avoid the PSLRA's 20 requirements, plaintiffs began asserting what were essentially federal securities law claims as state 21 law causes of action in state court. Id. Congress sought to end this practice by amending the 22

SLUSA prohibits class actions brought on behalf of more than 50 people ("covered class

24 actions"), if the action is based on state law and alleges (a) a misrepresentation or omission of a 25 material fact in connection with the purchase or sale of covered security; or (b) that the defendant 26 used or employed any manipulative or deceptive device or contrivance in connection with the 27 purchase or sale of a covered security. 15 U.S.C. §§ 77p, 78bb; Proctor v. Vishay Intertechnology 28

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 17

Securities Acts of 1933 and 1934 through SLUSA. 23 Inc., 584 F.3d 1208, 1221-22 (9th Cir. 2009). The complaint need not allege scienter, reliance, or 2 loss causation in order for SLUSA ...

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