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9th Cir. Revives Investor Lawsuit Against Schwab

(CN) - Charles Schwab may be liable for over-investing its Total Bond Index Fund in mortgage-backed securities, allegedly costing investors millions during the 2008 financial crisis, a divided 9th Circuit ruled.

In a class action, Northstar Financial Advisors says Schwab Investments breached its contract with investors, as well as its fiduciary duties, by overinvesting its Schwab Total Bond Index Fund in mortgage-back securities.

These risky assets accounted for more than 25 percent of the fund's assets, Northstar claims. When the value of mortgage-backed securities collapsed in September 2008, bringing on financial crisis, this allocation caused the fund to severely lag in its self-proclaimed "fundamental" investment objective of tracking its benchmark, the Lehman Brothers U.S. Aggregate Bond Index, the plaintiff says.

From September 2007 to February 2009, Schwab's bond fund lost 4.80 percent, while Lehman Brothers' index posted a positive return of 7.85 percent, costing Schwab investors tens of millions of dollars.

The 9th Circuit ruled Monday that Northstar had standing to sue Schwab even if it did not own shares in the fund itself, because a client assigned his rights to the investment advisory firm in a supplemental, post-complaint pleading.

Schwab disclosed in registration statements filed with the Securities and Exchange Commission that tracking its benchmark was "fundamental," and could not be change without the approval of a majority of the securities-holders.

Therefore, "until the fundamental investment objectives were amended by the shareholder vote, the investors had a contractual right to have the Fund managed in accordance with those objectives," said U.S. District Judge Edward Korman, a federal judge from New York sitting by designation.

He added that "the mere fact that Congress has chosen to ensure that investors are fully informed of the fundamental investment objectives of mutual funds hardly provides a license to ignore the objectives, enshrined by shareholder approval, which a mutual fund has obligated itself to pursue. Nor does it alter the fact that the purchase of those shares constitutes an acceptance of the offer by the investor."

U.S. Circuit Judge Carlos Bea dissented from the panel's opinion, writing that the complaint should be dismissed because Northstar itself did not own any shares in the Schwab fund, and suffered no injury of its own.

"If all an uninjured party need do to get around pesky Article III standing requirements is to file a complaint, then ask for liberal leave to supplement under Fed. R. Civ. P. 15(d) to allege after-acquired rights of those who were timely injured, the long-standing general rule which requires injury in-fact at commencement of the action for standing to exist quickly would lose all force," Bea wrote. "Today the majority green-lights those who would race to the courthouse and bend Federal Rules of Civil Procedure and Article III standing requirements to gain an edge over other claimants who are not as fleet of foot."

But in the majority opinion, Korman said that "the dissent does not dispute, nor can it, that the assignee of a cause of action stands in the shoes of the assignor, and unquestionably has the same standing to file a complaint that the assignor could have filed."

Therefore, the majority found it unnecessary to require Northstar to file an entirely new complaint - rather than a supplemental pleading - to confer standing once it had been assigned a client's rights.

"A rule that would turn on the label attached to a pleading is difficult for us to accept," Korman said.

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