California case could pave the way for investor actions

Thanks to an obscure but potentially significant court case in California, investors soon may be able to file lawsuits against mutual fund companies without going through directors.

In a little-publicized ruling in November, the 9th U.S. Circuit Court of Appeals reversed a lower court’s ruling that a California couple did not have the legal standing to directly sue RS Investment Management of San Francisco in a class action.

“It’s a precedent-setting case,” says Richard M. Phillips, a securities lawyer at Kirkpatrick & Lockhart LLP in Washington. “It’s the first time, to my knowledge, that the courts have held that an injury to the fund is also a direct injury to shareholders – allowing them to sue as a class.”

Typically, disgruntled investors must convince the fund’s directors to file a suit. But since directors and fund companies are often cozy with each other, such lawsuits are practically unheard of.

In this case, the couple alleges that the company’s Contrarian Fund posted serious losses in part because it exceeded the percentage of assets that its prospectus stated could be devoted to short-selling stocks.

The case is unusual because it is a class action, which essentially allows the plaintiffs to bypass the fund’s directors. It also underscores the court’s determination to uphold the voting rights of fund shareholders.

The decision could lead to more investor lawsuits – especially in cases where the management company makes changes without shareholder approval that affect the fund performance.

“If this holding prevails among the different circuit courts, it will expose fund managers to a wider variety of suits than they would otherwise be exposed to,” Mr. Phillips says.

Burton Greenwald, a mutual fund consultant in Philadelphia, agrees. “This will turn on some ambulance chasers,” he says. “There are a bunch of lawyers around the country looking for a situation where they can make a case. They find the plaintiffs after they discover the violation.”

The reversal of the lower court’s decision comes at a dangerous time for mutual fund companies. Considering that the average domestic stock fund posted a loss of 0.021% last year, plenty of investors are eager for a reason to sue their managers in hopes of recovering at least some of their losses.

“People are less likely to get upset about an enormous bet that violates a prospectus if it pays off,” says Scott Cooley, an analyst for Morningstar Inc., the Chicago fund tracker.

The Court of Appeals’ decision is the latest twist in a story that began Feb. 27, 1997, when Cary and Denise Lapidus, a couple in Berkeley, Calif., decided to invest $75,000 in Robertson Stephens Contrarian, a mid-cap value fund managed by what was then Robertson Stephens Investment Management LP. Like all contrarian funds, Robertson Stephens was supposed to make its money by bucking the crowd.

Mr. and Mrs. Lapidus claim they chose the Robertson Stephens Contrarian partly because its prospectus limited to 25% the portion of its assets that it could use to sell short.

But on May 5, 1997, the fund amended its prospectus to allow its manager, Paul H. Stephens, to short as much as 40% of the assets. The change in investment strategy was made without shareholder approval, according to the suit. Whether such approval was required in that instance is likely to be a point of contention in the case.

Robertson Stephens Contrarian lost 29.5% in 1997, a year in which up to 35% of its assets were allegedly held in short positions.

The Lapiduses sold their shares in the fund in September 1997 for $65,439.46, a loss of $9,560.54, or 13% of their original investment. Soon after, they filed for a class action, claiming the fund had altered its prospectus without shareholder approval.

Also named in the suit were Mr. Stephens and G. Randall Hecht, RS Investments’ chief investment officer.

Because the Lapiduses had sued the management company directly instead of asking the fund’s directors to do so, a federal district court dismissed that suit in May 1999.

RS Investment Management declined to comment on the now-revived suit. So did the Securities and Exchange Commission, which often investigates such matters.

But Joseph J. Tabacco Jr., a lawyer for the Lapiduses, says that, at the very least, the suit should discourage fund companies from making significant changes to investment strategy without first seeking shareholder approval.

“This is not a situation where the investors are saying, `Gee … it went down, and we are unhappy,”‘ he says. “It’s a situation where a mutual fund changed the rules improperly and then, as a result of those changes, lost a lot of money.”

Mr. Tabacco, a partner at the San Francisco law firm Berman Devalerio Pease & Tabacco, does not expect a flood of copycat lawsuits as a result of the pending litigation. “I don’t think the vast majority of mutual funds would willy-nilly violate the voting rights of the constituents,” he says. “But if they do, there is now a remedy.”

Pamela Wilson, a mutual fund lawyer at Boston’s Hale & Dorr, also cast doubts on whether the appellate court decision will have as far reaching an impact as some might expect. That’s because the 9th Circuit, she says, is known for controversial rulings.

“They are perceived as being more liberal and consumer friendly than the other circuits,” she says. “The other circuits might not necessarily choose to follow the 9th Circuit.”

Either way, the Lapiduses have a long road ahead. The next step, according to lawyers involved, is to collect mounds of information with which to build the case. There’s also the task of identifying shareholders eligible to take part in the suit.

“We don’t know exactly how many people will be involved,” Mr. Tabacco says. “At the time, the [Robertson Stephens] Contrarian fund was quite popular, so I would think there would be thousands of people affected by this.”