A federal judge dismissed a suit claiming brokers are investment advisers because they receive marketing fees. But the decision is likely to be appealed. So what's at stake? A reversal in the decision could cost fund companies billions -- and force brokers to dually register.
Mutual fund companies won a victory yesterday when a judge dismissed a case that could have forced funds to pay back years worth of 12(b)-1 fees — and created yet another pressure on broker-dealers to register as investment advisers.
In Bradley C. Smith v. OppenheimerFunds Distributor Inc., the plaintiffs alleged that brokers are being paid for investment advice by receiving 12(b)-1 payments, and thus need to be registered as investment advisers.
Specifically, the plaintiffs argued that since 12(b)-1 payments are asset-based fees, they are technically “special compensation” under the 1940 Investment Advisers Act.
The case was heard before Judge Leonard B. Sand in the U.S. District Court in the Southern District of New York.
“The case alleged that by paying 12(b)-1 fees to broker-dealers who were not registered as investment advisers, the funds and the fund trustees breached the fiduciary standard,” said William K. Dodds, chair of the securities litigation practice at Dechert LLP and the lead attorney on the case representing OppenheimerFunds.
In his decision, Mr. Sand dismissed the suit, stating that the plaintiffs didn't have “private rights to action,” under the statutes they cited. In other words, as private investors, the plaintiffs didn't have the right to sue the funds on behalf of shareholders based on the sections of the Investment Advisers Act they invoked in their argument.
This was the last of three cases brought by Milberg LLP against fund companies on this issue. The firm had also filed suit against Eaton Vance Distributors Inc. and Franklin Templeton Distributors Inc. Both cases were dismissed but the decisions have been appealed.
Mr. Dodds expects the plaintiffs to appeal the OppenheimerFunds decision too. Xenia Kobylarz, a spokeswoman at Milberg, declined to comment.
Since Judge Sand did not rule on the merits of the case, it's possible the litigants might still come away with a victory in court. In fact, if any of the decisions are reversed, it could make all fund companies that pay 12(b)-1 fees vulnerable to similar lawsuits and force them to pay back billions of dollars in 12(b)-1 fees, Mr. Dodds said.
“A different outcome on any of these cases [could] encourage similar litigation,” Mr. Dodds said. “It not only would represent a tremendous financial burden on funds, but it also would undermine the entire 12(b)-1 system and in some respects make mutual funds the watchdog for broker-dealers.”
A victory for plaintiffs could also put another pressure on broker-dealers to dually register as investment advisers, even through brokers were not defendants in these cases, Mr. Dodds said.
The court decision come as the Securities and Exchange Commission is looking to establish a universal fiduciary standard for all brokers as well as revamp 12(b)-1 fees.
While a change in 12(b)-1 fees won't affect the cases currently on appeal, it could affect the potential of future lawsuits, Mr. Dodds said. “Depending on what happens with 12(b)-1,” he said, “it could affect whether there is a basis for a case going forward.”
