A Ninth Circuit decision may have a significant impact on institutional trustees. The U.S. Court of Appeals held that the general rule that prohibits class actions concerning misrepresentations of material fact in the purchase or sale of a security and the alleged use of a manipulative device in connection with the purchase or sale of a security does not apply to actions against a trustee by the beneficiaries of an irrevocable trust.
The Ninth Circuit’s ruling in Banks v. Northern Trust, et al.[1] may alert institutional trustees that may have thought themselves immune from class action lawsuits relating to the purchase or sale of securities on behalf of a trust. In the past, these types of actions have only been brought individually. Institutional trustees have always used caution in their representations concerning the purchase or sale of securities, and the prospect of significant liability in class actions has not been a concern. But a Ninth Circuit panel held that this general rule doesn’t apply to claims brought against a trustee by beneficiaries of an irrevocable trust. As a result, large institutional trustees that provide investment products should be aware of a class action like the one in this case.
Summary
In an appeal from the U.S. District Court for the Central District of California, a Ninth Circuit panel reversed the district court’s dismissal, as barred by the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) of a putative class action brought against Northern Trust for violations of state law involving breaches of fiduciary duty by a trustee.
While the SLUSA deprives a federal court of jurisdiction to hear certain state-law class actions, the panel held that the Act did not preclude plaintiffs’ imprudent investment claims. Specifically, the panel held that SLUSA’s “in connection” requirement didn’t preclude claims brought by an irrevocable trust beneficiary with no control over the trustee who claims imprudent investments by the trustee.
Background
Lindie Banks was the beneficiary of the irrevocable Lindstrom Trust, created under California law. As trustee, Northern Trust Corporation (“Northern”) had sole discretion in managing trust assets, and Banks couldn’t participate in, direct, or be involved in those decisions. Banks and her daughter Erica LeBlanc sought to represent a class of plaintiffs and appealed from the dismissal of their putative class action lawsuit against Northern for violations of state law involving of fiduciary duty by a trustee. According to the Complaint, Northern invested the trust’s assets in its own affiliated “Funds Portfolio,” instead of considering better investments outside its own financial umbrella. As a result, Plaintiffs alleged that the trust suffered poor returns—a result that wouldn’t have occurred if Northern prioritized the interests of the trust beneficiaries (and not merely its own). Banks argued that favoring these inferior affiliated funds — rather than better-performing non-Northern funds — benefitted Northern, which violated its duties of prudent investment and loyalty to Banks.
The Complaint also alleged that Northern, as part of an “undisclosed internal decision to create a new profit center,” charged improper and excessive fees for “routine preparation of fiduciary tax returns” and failed to maintain records to justify these expenses. These new fees, which previously were “part of the base fee and a fundamental duty for a trustee,” allegedly breached Northern’s duty of prudent administration.
The Ninth Circuit Decision
Circuit Judge John B. Owens wrote the opinion for the panel that included Circuit Judge Jacqueline H. Nguyen and District Judge John Antoon II, United States District Judge for the Middle District of Florida, sitting by designation. The Ninth Circuit held that the SLUSA does not preclude Banks’ imprudent investment claims.
The judge explained that the SLUSA deprives a federal court of jurisdiction to hear: (1) a covered class action (2) based on state law claims (3) alleging that the defendants made a misrepresentation or omission or employed any manipulative or deceptive device (4) in connection with the purchase or sale of (5) a covered security.”[2]
Owens went on to opine that when applying SLUSA to a complaint, courts must “look to the substance of the allegations” to ensure that “artful pleading” does not “remove[] the covered words . . . but leave[] in the covered concepts.”[3]
The “In Connection With” Requirement
The Court recognized that the action hinged primarily on the “in connection with” requirement.[4] Judge Owens noted that, even assuming Banks adequately alleged that Northern made a misrepresentation or omission or employed a manipulative device or contrivance, the panel had to decide if Northern’s alleged activity was in connection with the purchase or sale of a covered security.
The Ninth Circuit panel explained that the Supreme Court has discussed the SLUSA and its “in connection with” requirement on two occasions. In Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit [5], Judge Owens said that the Supreme Court stressed that the “in connection with” requirement should be interpreted broadly, as “[a] narrow reading of the statute would undercut the effectiveness of the [PSLRA] and thus run contrary to SLUSA’s stated purpose,” which is to prevent state-law class actions from end-running the PSLRA.[6] The Court explained that “it is enough that the fraud alleged ‘coincide’ with a securities transaction — whether by the plaintiff or by someone else” – to meet the “in connection with” requirement.[7]
Judge Owens next noted that in Chadbourne & Parke LLP v. Troice [8], the Supreme Court held that the SLUSA didn’t preclude the claims because the statute required “misrepresentations that are material to the purchase or sale of a covered security.”[9] As to materiality, the Court addressed the “in connection with” requirement, which demands “a connection…where the misrepresentation makes a significant difference to someone’s decision to purchase or to sell a covered security.”[10]
The Supreme Court also held that, under SLUSA, “[a] fraudulent misrepresentation or omission is not made ‘in connection with’ . . . a ‘purchase or sale of a covered security'” unless that fraudulent conduct “is material to a decision by one or more individuals (other than the fraudster) to buy or sell a ‘covered security.’”[11] The Court stressed that “the ‘someone’ making that decision to purchase or sell must be a party other than the fraudster… If the only party who decides to buy or sell a covered security as a result of a lie is the liar, that is not a ‘connection’ that matters.”[12]
Judge Owens stressed that the Supreme Court was careful to state that Troice did not overrule Dabit, noting:
[I]n Dabit, we held that [SLUSA] precluded a suit where the plaintiffs alleged a “fraudulent manipulation of stock prices” that was material to and “‘coincide[d]’ [**9] with” third-party securities transactions, while also inducing the plaintiffs to “hold their stocks long beyond the point when, had the truth been known, they would have sold.” We do not here modify Dabit. [13]
Nevertheless, the Court distinguished Dabit and other cases because they involved a victim who took, tried to take, or maintained an ownership position in the statutorily relevant securities via “purchases” or “sales” induced by the fraud.[14] The Court pointed out that “[e]very one of these cases . . . concerned a false statement (or the like) that was material to another individual’s decision to purchase or sell a statutorily defined security.”[15]
The Application of Dabit and Troice to the Banks Action
Judge Owens and the Ninth Circuit panel noted that Banks presented a question of first impression in the circuit: whether allegations concerning a trustee’s imprudent investments constitute activity “in connection with” the purchase or sale of securities when those allegations are brought by the beneficiaries of an irrevocable trust.
Banks contended that any false statements or deceptive activity by Northern couldn’t have been material to a beneficiary’s individual decision to purchase or sell a covered security because a beneficiary who’s not also a trustee of an irrevocable trust can’t make an individual decision to purchase or sell securities for the trust, and Banks had no control over Northern’s decision to do so.
Applying Troice to the dispute in Banks, the Ninth Circuit panel held that, unlike an agent-principal relationship, beneficiaries who are not also trustees of an irrevocable trust can’t direct Northern’s actions as the trustee. Therefore, the Court held, even if Northern engaged in fraudulent conduct, that conduct didn’t alter the fact that its beneficiaries were unable to purchase or sell covered securities.
Northern argued that this difference between an agent and a trustee is a meaningless one. But if Northern were acting as an agent — similar to a stockbroker — Northern’s statements and allegedly deceptive conduct could meet SLUSA’s “in connection with” requirement because Banks (and other beneficiaries) could have relied on Northern’s statements to induce the purchase of the affiliated funds. Conversely, if Northern was in fact acting as a trustee, and if Banks did not have control over investment of trust assets, Northern’s deceptive or manipulative conduct resulted only in Northern — and no other party — purchasing affiliated funds. As Troice specifically notes, the SLUSA does not preclude cases where “the only party who decides to buy or sell a covered security as a result of a lie is the liar” because “that is not a ‘connection’ that matters.[16]
But the Ninth Circuit held that there was ample support for its conclusion that preclusion turns on the distinction between a trustee and an agent. An agent acts for and on behalf of his principal and subject to his control,” while a “trustee acts for the benefit of the beneficiaries of the trust; he is an agent only if he agrees to hold title for the benefit and subject to the control of another, the Court said citing the Restatement 2d, Agency § 14B and the Restatement 2d, Trusts § 8.
Northern argued that the level of control between an agent and a trustee doesn’t matter because a principal can give full control to an agent — just like a trustee has full control of a trust. However, Judge Owens and the panel disagreed, stating that Northern overlooked the fact that the principal controls and directs the agent, who the principal likely has chosen. But in the irrevocable trust context, a principal can revoke control from an agent in the course of their relationship. In the irrevocable trust context, by contrast, unless otherwise specified in the trust instrument, a beneficiary cannot alter the powers of a trustee or remove the trustee without petitioning a court of law.
In this case, the Complaint didn’t allege that beneficiaries made any investment decision based on Northern’s conduct or statements but that Banks had no control over how Northern invested the trust’s assets because Banks was only the beneficiary of an irrevocable trust. The Complaint also alleged that Northern conducted all the relevant purchases of covered securities without direction from Banks or other beneficiaries. As a result, Troice‘s discussion of the SLUSA’s “in connection with” requirement was directly on point, Judge Owens wrote. The Complaint didn’t allege that Northern’s activities as trustee were “in connection with” any purchase or sale of covered securities by anyone other than Northern.
No “Game of Thrones” Final Season Treatment of Dabit
Judge Owens opined that Northern wanted the Court to read Dabit without considering its clarification in Troice. However, Owens said the panel would not “render Troice meaningless the way that Game of Thrones rendered the entire Night King storyline meaningless in its final season.”[17] The circuit judge held that Troice directly supported the panel’s conclusion that a trustee’s misconduct — over which a beneficiary of an irrevocable trust has no control — cannot constitute misconduct “in connection with” the sale of covered securities where “the only party who decides to buy or sell a covered security as a result of a lie is the [trustee].”[18]
Using the language in Troice, the panel noted:
[T]he trustee is both the buyer and the “fraudster”; because the trustee can deceive only itself with any alleged misconduct, its misconduct does not require SLUSA preclusion. Troice confirms that SLUSA’s “in connection with” requirement does not preclude claims brought by an irrevocable trust beneficiary — who has no control over the trustee — alleging imprudent investments by that trustee.[19]
Judge Owens found that in this case, the district court’s dismissal relied entirely on its conclusion that Northern was an agent of the trusts’ beneficiaries, which wasn’t supported by the moving papers and the Complaint. Owens and the panel went on to hold that “[n]ot only did the district court fail to consider Banks’ allegations that the beneficiaries lacked any control over the trustees — an allegation supported by caselaw and secondary sources — but courts generally determine the existence of an agency relationship at the summary judgment stage, not in determining a motion to dismiss.”[20]
Moreover, Owens found that the district court’s brief discussion of Troice did not acknowledge its holding that the “in connection with” requirement was not met if the fraudster alone bought or sold the covered securities. As such, Judge Owens and the panel held that the district court erred in concluding SLUSA precluded Banks’ imprudent investment claims.
Because the panel concluded Banks’ imprudent investment claims did not meet the “in connection with” requirement for SLUSA preclusion, the Ninth Circuit said it need not decide whether the claims met SLUSA’s fraudulent conduct requirement, i.e., whether Banks adequately alleged Northern (1) engaged in misrepresentation or omission of a material fact or (2) used or employed any manipulative or deceptive device or contrivance. The panel reversed and remanded all of Banks’ imprudent investment claims.
The SLUSA Also Did Not Preclude Banks’ Fee-Related Claims
The Complaint also alleged three claims related to management fees, asserting that Northern: (1) improperly charged tax-preparation fees, (2) failed to maintain records justifying those costs, and (3) overcharged fixed-fee trusts. The district court dismissed these claims as precluded by the SLUSA but failed to explain how the alleged activities were “in connection with” securities transactions. The Ninth Circuit panel said that “[t]he same concern that animates our holding as to the imprudent investment claims — that a trustee’s misconduct, without more, cannot constitute misconduct ‘in connection with’ the purchase or sale of covered securities — applies equally to Banks’ fee claims.”[21]
Northern argued that the fee claims should be precluded because they were “inextricably intertwined” with the investment claims. But Judge Owens and the panel held that “[n]ot only are the fee claims not precluded by SLUSA because of the ‘in connection with’ requirement, the fee claims also lack any plausible relationship to covered securities.”[22] Unlike the investment claims, the judge found that the fee claims didn’t allege conduct in relation to any securities transactions.
Judge Owens said that the district court’s order did not address these considerations or discuss the fee claims in any substantive manner, nor did it explain why the SLUSA would preclude these claims. The Ninth Circuit concluded that the district court erred in dismissing the tax-preparation and overcharging claims on SLUSA-preclusion grounds.
Conclusion
The dismissal of the putative class action alleging breach of fiduciary duty by the trustee was reversed, and the case was remanded because it wasn’t barred by SLUSA. The statute’s “in connection” requirement didn’t preclude claims brought by the irrevocable trust beneficiaries—who had no control over the trustee—alleging imprudent investments by that trustee.
Even if the trustee engaged in fraudulent conduct, the Ninth Circuit found that this conduct didn’t change the fact that the beneficiaries were unable to purchase or sell covered securities, and that the Troice decision’s discussion of the SLUSA’s “in connection with” requirement was directly on point. The SLUSA did not preclude the beneficiaries’ fee-related claims as they didn’t allege conduct in relation to any securities transactions.
[1] 929 F.3d 1046 (9th Cir. 2019).
[2] Banks, at 1050, citing Northstar Fin. Advisors, Inc. v. Schwab Invs., 904 F.3d 821, 828 (9th Cir. 2018). The panel noted that the SLUSA does not preclude a plaintiff from filing an individual (i.e., non-class action) state-law securities claim in state court.
[3] Id., citing Freeman Invs., L.P. v. Pac. Life Ins. Co., 704 F.3d 1110, 1115 (9th Cir. 2013) (second alteration in original) (quoting Segal v. Fifth Third Bank N.A., 581 F.3d 305, 311 (6th Cir. 2009)).
[4] Id. Northern’s attempt to differentiate between subsections A and B of SLUSA was unpersuasive, the panel said, because the “in connection with” requirement is an element of both.
[5] 547 U.S. 71, 126 S. Ct. 1503, 164 L. Ed. 2d 179 (2006).
[6] Id., citing Dabit at 86.
[7] Id., citing Dabit at 85.
[8] 571 U.S. 377, 134 S. Ct. 1058, 188 L. Ed. 2d 88 (2014).
[9] Id. at 387.
[10] Id., citing Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 36-40, 131 S. Ct. 1309, 179 L. Ed. 2d 398 (2011) (stating that a misrepresentation or omission is “material” if a reasonable investor would have considered the information significant when contemplating a statutorily relevant investment decision).
[11] Id. (emphasis added by the Court).
[12] Id., 388.
[13] Banks, at 1051, quoting Dabit at 387 (citations omitted).
[14] Troice, at 389.
[15] Id. at 393 (emphasis added) (internal quotation marks and alteration omitted).
[16] 571 U.S. at 388.
[17] Banks, at 1054.
[18] Troice, 571 U.S. at 388.
[19] Banks, at 1054. The Ninth Circuit limited its opinion to claims involving a trustee-beneficiary irrevocable trust relationship in which the trust instrument does not grant the beneficiary financial management trustee powers. The panel did not opine on how Troice may affect other state-law claims. Id., at 1054 n.6.
[20] Id.
[21] Banks, at 1055.
[22] Id.
