OPINION AND ORDER
LEISURE, District Judge:
This proposed class action arises out of plaintiffs' purchase of shares in TCW/DW North American Government Income Trust (the "Fund"). Plaintiffs claim that through various registration statements, prospectuses, sales materials, annual and semiannual reports, as well as oral statements of brokers and representatives of defendant Dean Witter Reynolds, Inc. ("DWR"), all defendants misrepresented the risks inherent in the Fund, in violation of Sections 11 and 12(2) and of the Securities Act of 1933 (the "Securities Act"). See 15 U.S.C. §§ 77k and 771(2). In addition, plaintiffs assert that all defendants except the Fund, by virtue of these misrepresentations, violated § 15 of the Securities Act. See 15 U.S.C. § 77o. Finally, Count IV of the Consolidated Class Action Complaint (the "Complaint") alleges that three of the eleven named defendants breached their fiduciary duty by charging excessive management and advisement fees in violation of § 36(b) of the Investment Company Act of 1940 (the "ICA"). See 15 U.S.C. § 80a-35(b). Pursuant to Fed. R. Civ. P. 12(b)(6), defendants move to dismiss the complaint for failure to state a claim upon which relief can be granted. For the reasons stated below, defendants' motion is denied.
Plaintiffs, individuals who purchased shares of the Fund during the class period of between July 31, 1992, the closing date of the initial offering of shares, and December 29, 1994, bring this proposed class action on behalf of themselves and all others who purchased shares in the Fund during the class period. Defendant the Fund is an "open-end," non-diversified management investment company (i.e. mutual fund) registered pursuant to the Investment Company Act of 1940. See 15 U.S.C. § 80a-8(a). According to the complaint, other defendants are: (1) DWR, a securities broker-dealer and the principal underwriter and distributor for the initial offering of the Fund; (2) Dean Witter Distributors, Inc. ("DW Distributors"), which succeeded DWR in January 1993 as principal underwriter and distributor for the continuous offering of the Fund's shares; (3) Dean Witter Intercapital, Inc., a wholly owned subsidiary of DWR, and the Manager of the Fund from January 1993 until January 1, 1994; (4) Dean Witter Services Company, Inc. ("DW Services"), a wholly owned subsidiary of Dean Witter Intercapital, which it succeeded on January 1, 1994 as Manager of the Fund; (5) TCW Funds Management, Inc. ("TCW Funds"), a California corporation which served at all relevant times as the Fund's Investment Adviser; and (6) individual defendants who were all officers and/or trustees of the Fund.
As an open-end mutual fund, the Fund conducts a continuous offering of shares, made pursuant to registration statements and prospectuses which are amended periodically. The initial prospectus was filed with the Securities and Exchange Commission on June 2, 1992, and was amended without material change two times during the class period, first on January 8, 1993, later on December 9, 1993.
The Fund's prospectus (the "prospectus"), which purported to set forth all the information an investor should know before deciding to invest, stated that "the investment objective of the Fund is to earn a high level of current income while maintaining relatively low volatility of principal." Affidavit of Richard A. Rosen, Esq., in Support of Defendants' Motion to Dismiss Ex. A at 2.
According to the prospectus, the Fund intended to achieve its investment objective by investing in fixed-income securities, the value of which "generally increase during periods of declining interest rates and decrease during periods of increasing interest rates." Id. at 6. Under normal circumstances, at least 65% of the total assets of the Fund were to be invested in investment grade fixed-income securities issued or guaranteed by the United States, Canadian, or Mexico governments. It was expected that "under normal circumstances, the market value dollar weighted average life . . . of the Fund's portfolio securities will be no greater than three years." Id. Disclosure of the expected short average life of the securities in the Fund was worthy of inclusion in the prospectus because of the fact that fluctuations in the values of fixed income securities "has historically been smaller for short term securities than for securities with longer maturities." Id.
A substantial portion of the 65% of the total assets of the Fund invested in investment grade fixed income securities was to be invested in United States and Canadian mortgage-backed securities. Mortgage-backed securities "are securities that directly or indirectly represent a participation in, or are secured by and payable from, mortgage loans secured by real property." Id. at 9. While the value of mortgage-backed securities, like that of traditional debt securities, typically increases when interest rates fall and decreases when interest rates rise, they are different from traditional debt securities in several ways, including the notable exception that the principle of the mortgages underlying the securities may be prepaid at any time. See id. at 13. Normally, "prepayments on fixed rate mortgage loans will increase during a period of falling interest rates and decrease during a period of rising interest rates." Id. at 14.
Mortgage-backed securities have become increasingly complicated financial products, and now include among their number several mortgage derivative securities. One such product, which the Fund heavily invested in, is the collateralized mortgage obligation ("CMO"). CMOs are "debt obligations collateralized by mortgage loans or mortgage pass-through securities." Id. at 10. The average life of mortgage derivative securities, such as CMOs, is determined by "using mathematical models that incorporate prepayment assumptions and other factors that involve estimates of future economic and market conditions." See Affidavit of Robert C. Finkel, Esq., in Opposition to Defendants' Motion to Dismiss Ex. A at 13.
As stated in the prospectus, to compensate for the services and facilities furnished to the Fund and for expenses of the Fund assumed by the Manager, the Fund pays the Manager DW Services a monthly fee calculated daily by applying the annual rate of 0.39% to the Fund's net assets. See Rosen Aff. Ex. A at 5. In addition, as compensation for its investment advisory services, the Funds pays the Adviser TCW Funds a monthly fee calculated daily by applying an annual rate of 0.26% to the Fund's net assets. Finally, pursuant to a Plan of Distribution, the Fund pays the distributor DW Distributors for its services a monthly fee calculated daily by applying the annual rate of 0.75% to the Fund's net assets.
I. General Standard for a Rule 12(b)(6) Motion to Dismiss
In deciding defendants' Rule 12(b)(6) motion to dismiss, the Court accepts as true the material facts alleged in the complaint and draws all reasonable inferences in plaintiffs' favor. See Kaluczky v. City of White Plains, 57 F.3d 202, 206 (2d Cir. 1995) (citing Hill v. City of New York, 45 F.3d 653, 657 (2d Cir. 1995)). A motion to dismiss must be denied "unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Scheuer v. Rhodes, 416 U.S. 232, 236, 40 L. Ed. 2d 90, 94 S. Ct. 1683 (1974) (citing Conley v. Gibson, 355 U.S. 41, 45-46, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957)). Merely because recovery appears remote and unlikely on the face of a complaint is not reason for dismissal, because "'"the issue is not whether a plaintiff will ultimately prevail but whether the claimant is entitled to offer evidence to support the claims."'" Bernheim v. Litt, 79 F.3d 318, 321 (2d Cir. 1996) (quoting Villager Pond, Inc. v. Town of Darien, 56 F.3d 375, 378 (2d Cir. 1995) (quoting Scheuer, 416 U.S. at 236)).
II. The 1933 Act Claims
Counts I and II of plaintiffs' complaint contain their substantive claims under the Securities Act. Count I is brought pursuant to section 11 of the Securities Act. Section 11 states that if "any part of the registration statement . . . contain[s] an untrue statement of a material fact or omit[s] to state a material fact . . . necessary to make the statements therein not misleading," then any person acquiring such security may sue, among others, underwriters of the security, officers of the issuer, or signers of the registration statement. 15 U.S.C. § 77k(a). Count II alleges violations of section 12(2) of the Securities Act. Section 12(2) prohibits any person from offering or selling a security "by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements . . . not misleading." 15 U.S.C. § 771(2).
"[A] complaint may not properly be dismissed pursuant to Rule 12(b)(6) . . . on the ground that the alleged misstatements or omissions are not material unless they are so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of their importance." Goldman v. Belden, 754 F.2d 1059, 1067 (2d Cir. 1985) (Kearse, J.). In TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 48 L. Ed. 2d 757, 96 S. Ct. 2126 (1976), the Supreme Court held that an omitted fact is material if there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." Id. at 449.
As one of several allegations in their complaint,
plaintiffs assert that the prospectus failed to alert investors of the "maturity extension risk" inherit in the Fund's portfolio of securities, a large portion of which consists of mortgage derivative securities. A prospectus filed with the SEC and distributed to shareholders after the end of the class period stated that the Fund's investment in mortgage derivative securities subjected the Fund to extension risk, and stated that "extension risk is the possibility that rising interest rates may cause prepayments to occur at a slower than expected rate." Finkel Aff. Ex. A. at 13.
Most precisely in their reply papers supporting this motion, defendants argue that, without using the specific language "maturity extension risk" or "extension risk," the prospectus disclosed the nature, causes and consequences of such risk, and that therefore the failure of the prospectus to include plaintiffs chosen language should not impede the Court in granting the instant motion. It is true that the prospectus in several places stated that rising interest rates may cause prepayments to occur at a slower than expected rate, and the Court therefore agrees with defendants that the failure to use the term extension risk in explaining this idea is not a material omission. The Court, however, disagrees with defendants' assertion that the consequences of extension risk were disclosed in the prospectus, and finds that this omission is not so "obviously unimportant to a reasonable investor that reasonable minds could not differ as to the question of [its] importance." Goldman, 754 F.2d at 1067. The important idea to understand in considering extension risk is not that the prepayments may occur at a slower rate during periods of rising interest rates, but rather is the consequence of this statement, which the prospectus filed after the class period clearly articulates:
This particular risk may effectively change a security which was considered short or intermediate-term at the time of purchase into a long-term security. Long-term securities generally fluctuate more widely in response to changes in interest rates than short or intermediate-term securities.
Finkel Aff. Ex. A at 13.
The prospectus disclosed that the principal underlying mortgage-backed securities may be prepaid at any time, that the prepayment rate generally decreases as interest rates rise, and that rising interest rates generally decrease the value of mortgage-backed securities. In addition, the prospectus disclosed that derivative mortgage securities may be extremely sensitive to changes in the interest rates. None of these disclosures, however, would indicate to a reasonable investor that a fund which expected to maintain a portfolio of securities with a short average life would in fact, during times of rapidly rising interest rates, have a portfolio of securities with a much higher average life. Thus, while these disclosures, understood together, clearly and accurately depict the type of risk borne by the Fund, they do not accurately depict the extent of the risk.
It is true that the Fund did not, and could not, guarantee that the average life of the portfolio securities would be three years, because, as noted above, average life is determined by mathematical models which incorporate prepayment assumptions and other factors that involve estimates of future economic and market conditions. However, once one considers that the expected average life is determined by mathematical models, it appears that the models could also project the effect, at least in general terms, of an increase in interest rates on the average life of the portfolio securities.
The prospectus in this case did not do this, but rather simply stated that under normal circumstances the average life of the portfolio securities would be three years. By not explaining what normal and/or abnormal circumstances were, or what caused them, the prospectus did not make clear that lower than estimated prepayment rates would alter the expected average life of the securities, and therefore did not disclose the risk of the possibility that an increase in interest rates would not only likely decrease the value of the Fund's securities, but would also increase the inherent volatility of the Fund by effective converting short term debt instruments into long term debt instruments.
Defendants are correct in arguing that the prospectus bespoke caution concerning the negative effect on a fixed-income based fund of a rise in interest rates. See I. Meyer Pincus & Assoc., P.C. v. Oppenheimer & Co., Inc., 936 F.2d 759, 763 (2d Cir. 1991) (court affirms dismissal of complaint where statements in prospectus clearly bespeak caution). However, this risk is common to all fixed-income securities. The risk which the prospectus did not describe is one that is apparently limited to derivative mortgage securities -- that a rapid rise in interest rates can dramatically alter the projected average life of the securities, thus revealing a Fund with greater inherent volatility than a reasonable shareholder could have expected. But cf. Jackson Nat. Life Ins. v. Merrill Lynch & Co., 32 F.3d 697, 703 (2d Cir. 1994) (where prospectus warned of the very contingency complained of in plaintiff's complaint, prospectus bespoke caution).
Plaintiffs also point to sales materials in asserting that defendants failed to disclose the extension risk inherent in the Fund. Defendants cite to the decision of the Court of Appeals for the Second Circuit in Brown v. E.F. Hutton Group, Inc., 991 F.2d 1020, 1031-32 (2d Cir. 1993), as authority in this Circuit for the proposition that investors may not rely upon investment information provided by the sellers if the information is contradicted by the prospectus. While there is language in Brown which appears to support defendants' position, at least with respect to oral statements, other language in the opinion appears to indicate that reliance upon representations outside of the prospectus may be permissible even where the other representations are contradicted by the prospectus. See id. at 1032 & n.4. Moreover, having found in this case that the consequences of extension risk were not adequately disclosed, the sales materials offered as proof of material misrepresentations are not contradicted by the prospectus, and therefore were justifiably relied upon by plaintiffs. Therefore, the Court cannot find that plaintiffs citation in their class action complaint to sales materials which state that the Fund is comprised of "government-guaranteed securities with an average life of three years or less," Complaint P 66, and which state that a "fixed income portfolio with a shorter average life is generally more stable when interest rates move," id., are statements that are so "obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of their importance." Goldman, 754 F.2d at 1067. Thus, the sales material statements are not immaterial as a matter of law.
Defendants' motion to dismiss plaintiffs' consolidated class action causes of action pursuant to §§ 11, 12(2), and 15 of the Securities Act is denied.
II. The ICA Claim
Count IV of plaintiffs' complaint, brought pursuant to § 36(b) of the ICA, see 15 U.S.C. 80a-35(b), alleges that defendants breached their fiduciary duty by charging the Fund excessive fees to compensate the Manager, the Adviser, and the Distributor. At the time relevant for the purposes of this claim, the Manager of the Fund was DW Services, the Adviser was TCW Funds, and the Distributor was DW Distributors.
"The standard to apply in determining whether compensation for managing a mutual fund violates the fiduciary duty imposed by section 36(b) is 'whether the fee schedule represents a charge within the range of what would have been negotiated at arm's-length in the light of all the surrounding circumstances.'" Krinsk v. Fund Asset Management, Inc., 875 F.2d 404, 409 (2d Cir. 1989) (quoting Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923, 928 (2d Cir. 1982), cert. denied, 461 U.S. 906, 76 L. Ed. 2d 808, 103 S. Ct. 1877 (1983)). To violate § 36(b), "'the adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered.'" Id. (quoting Gartenberg, 694 F.2d at 928). The Krinsk Court, citing Gartenberg, stated that numerous factors are to be considered in determining whether or not the standard has been met, including: (1) the nature and quality of services provided to fund shareholders; (2) whether the fund benefited from economies of scale; (3) the adviser fees charged by the funds in comparison to other funds; and (4) the independence and conscientiousness of the trustees. Id. In assessing the nature and quality of services provided, the performance of a fund may be considered. See Krinsk at 409. In addition, in determining whether the fund benefitted from economies of scale, the overall cost to the manager or adviser of providing services may be considered. See Gartenberg, 694 F.2d at 927.
Plaintiffs allege that DW Services' management fee was excessive considering: (1) the actual out of pocket expenses incurred by defendants in managing the Fund; (2) management fees charged to comparable funds; (3) the lack of independence of certain trustees of the Fund; and (4) the economies of scale that should have resulted in DW Services management of other funds.
See Complaint 11 34, 35, 40, 176. If plaintiffs can provide evidence to support these factual allegations, a claim for breach of fiduciary duty pursuant to § 36(b) of the ICA will be made, and therefore dismissal is inappropriate.
Similarly, plaintiffs allege that TCW Funds' adviser fees were excessive considering: (1) the poor performance of the Fund; (2) advisement fees charged compared to other funds; (3) economies of scale; and (4) lack of independence of certain trustees. Likewise, if plaintiffs can provide evidence to support these allegations, a claim that TCW Funds breached its fiduciary duty pursuant to § 36(b) would be made, and therefore dismissal is inappropriate.
Finally, plaintiffs allege that DW Distributors' distributor fees were excessive because DW Distributors allegedly ceased actively promoting investment in the Fund during the relevant time period, and the number of shares dropped dramatically during that time period. See Complaint P 169.
Because this factual allegation, if true, goes to the nature and quality of the services provided by DW Distributor, they may support a § 36(b) claim. See Krinsk, 875 F.2d at 409. In sum, consideration of the factual allegations regarding DW Services, TCW Funds, and DW Distributor in plaintiffs' complaint, requires the Court to deny defendants' motion to dismiss the fourth count of the complaint.
For the reasons stated above, defendants' motion to dismiss the complaint pursuant to Fed. R. Civ. P. 12(b)(6) is HEREBY DENIED. The parties are directed to appear at a pre-trial conference in Courtroom 18B at 500 Pearl Street on June 14, 1996 at 3:00 p.m.
New York, New York
May 8, 1996
Peter K. Leisure