SAN JOSE, Calif. (CN) – Charles Schwab owed investors a fiduciary duty not to deviate from a set investment plan, a federal judge has ruled.
Northstar Financial Advisors, Inc. filed a putative class action against Schwab in 2008, alleging the company broke away from financial objectives tied to the Schwab Total Bond Market Fund by investing too heavily in risky mortgage-backed securities that accounted for more than 25 percent of the fund’s assets.
The original plan involved tracking the Lehman Brothers U.S. Aggregate Bond Index, and the deviation from that objective allegedly cost shareholders tens of millions of dollars when the housing bubble burst – an affect triggered by relaxed industry standards that led to bad loans made to homeowners who could not pay them back.
The fund suffered a total negative return of 4.80 percent as a result, according to Northstar, which notes the Lehman Index enjoyed a positive 7.85 percent return for the same class period between September 2007 and February 2009.
U.S. District Judge Susan Illston initially found that Northstar did not have standing to bring claims against Schwab because the company only purchases shares for its clients, not for itself.
She granted with prejudice Schwab’s motion to dismiss Northstar’s third amended complaint in August 2011
The Ninth Circuit ruled in March 2015, however, that Northstar had standing to sue Schwab even if it did not own shares of 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 changed 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,” U.S. District Judge Edward Korman, a federal judge from New York sitting by designation, wrote for the circuit.
Schwab filed a motion to dismiss Northstar’s fifth amended complaint in June 2015, and U.S. District Judge Lucy Koh in San Jose granted the motion with prejudice on six of Northstar’s 14 claims.
She threw out Northstar’s claims for breach of contract as third party beneficiary against the advisor, breach of contract against the trust, breach of covenant of good faith and fair dealing against the advisor and trustees, breach of contract as third party beneficiary against the advisor, and breach of covenant of good faith and fair dealing against the advisor and trustees.
Koh, however, preserved Northstar’s claims for fiduciary duty against the Schwab defendants.
“The advisor did not operate at arm’s length,” she wrote in a 42-page order. “Instead, the advisor worked under the supervision of the trustees on behalf of the shareholders. As such, the advisor ultimately owed the shareholder certain fiduciary duties.”
Northstar also fulfilled the requirements for its aiding and abetting claims, Koh said.
“The [complaint] and exhibits suggest that the trustees and the advisor are to have a close working relationship,” she explained. “Schwab investments’ 1997 proxy statement states, for instance, that the trustees and the advisor worked together in proposing new investment objectives for the fund.”
She added that the statement, and others like it, “suggests that, if a breach did in fact occur, one defendant knew what the other defendant was doing, and may have helped facilitate the breach at issue.”
Koh noted that “the court’s decision does not foreclose defendants from challenging Northstar’s aiding and abetting claims at a later stage. It is possible, for instance, that defendants will be able to show that the trustees did not actively participate in the advisor’s breach of the advisor’s fiduciary duties to Northstar,” she wrote.
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