Plaintiff-Appellant Operating Local 649 Annuity Trust Fund appeals from a judgment of the United States District Court for the Southern District of New York (Pauley, J.), dismissing claims brought under§ 10(b) of the Securities Exchange Act of 1934, Rule 10b-5 and § 36(b) of the Investment Company Act of 1940. See Fed. R. Civ. P 12(b)(6). The judgment is VACATED and REMANDED in part and AFFIRMED in part.
The opinion of the court was delivered by: Barrington D. Parker, Circuit Judge
Before: B.D. PARKER, Circuit Judge,*fn1 and HAIGHT, District Judge.*fn2
Plaintiff-appellant Operating Local 649 Annuity Trust Fund ("Local 649") appeals from a judgment of the United States District Court for the Southern District of New York (Pauley, J.) dismissing claims alleging securities fraud in violation of § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, and breaches of fiduciary duty in violation of § 36(b) of the Investment Company Act of 1940. See 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5; 15 U.S.C. § 80a-35(b).*fn3
The claims were asserted in a class action brought on behalf of investors, including Local 649, the lead plaintiff, who purchased shares in the 105 mutual funds that are part of the Smith Barney Family of Funds ("Funds") between September 11, 2000 and May 31, 2005.
Various affiliates of Citigroup sponsored and managed the Funds. Smith Barney Asset Management, LLC ("Smith Barney") and Citigroup Global Markets, Inc. ("Global Markets" or "CGMI") served as investment advisers. Both Smith Barney and Global Markets were part of Citigroup Asset Management ("CAM"), a business unit of Citigroup that provides investment advisory and management services to Citigroup-sponsored funds. During the Class Period, Thomas Jones served as the Chief Executive Officer of CAM, while Lewis Daidone served as its Senior Vice President.
According to Local 649's complaint, whose allegations we accept for the purposes of this appeal, Smith Barney negotiated a contract for transfer agent services that saddled the Funds with excessive, misleadingly disclosed fees, a significant portion of which were, in essence, kicked back to a Smith Barney affiliate. Specifically, the scheme unfolded as follows: From 1994 through September 30, 1999, an outside contractor, First Data Investor Services Group ("First Data"), provided transfer agent services for the Funds. Transfer agents do a number of things. They process transactions in Funds shares, calculate daily net asset values, compute sales charges and commissions, distribute proxy and other materials, operate customer service centers and perform various accounting functions. As is customary, CAM paid First Data's transfer agent fees using Fund assets, an expense that CAM publicly disclosed, in accordance with Securities and Exchange Commission ("SEC") rules, under the heading "Other Expenses."
In 1997, CAM initiated a formal study of the transfer agent function in anticipation of the expiration of the existing contracts between the Funds and First Data. To assist with the study, CAM retained Deloitte & Touche Consulting ("Deloitte"). Looking to save money, CAM asked Deloitte to research and report on whether CAM could take over the transfer agent functions, rather than continue to contract with an outside agency such as First Data. Ultimately, Deloitte proposed that CAM create a subsidiary that would provide transfer agent services to the Funds using technology purchased from a First Data competitor.
CAM rejected Deloitte's recommendation. Instead, it renegotiated the terms of its contract with First Data. CAM proposed that the Funds continue to pay the same transfer agent*fn4 fees to First Data, with the exception that Smith Barney would assume the limited function of running a 14-person customer service call center at minimal cost. First Data would receive the same fees as before, but would rebate a substantial portion of the fee to Smith Barney.
Deloitte expressed doubts to CAM as to the legality of the arrangement, questioning, among other things, whether the anticipated savings belonged to the Funds as opposed to the investment adviser and whether the Fund Boards would ever approve such an arrangement. At that point, CAM changed course and created a transfer agent subsidiary called Citicorp Trust Banks ("CTB") which, in place of First Data, then contracted with the Funds to provide transfer agent services. At the same time, CTB contracted with First Data to provide most of the same transfer agent services it had previously provided but at a much lower rate. Because of this subcontract, CTB's role as a transfer agent was a circumscribed one; the company operated a 15-person call center. CTB memorialized its subcontract with First Data in a "side letter." The side letter allegedly guaranteed CAM millions of dollars in additional revenue, without providing commensurate benefit to the Funds. Despite the fact that First Data substantially reduced the rate it charged for transfer agent services, and despite the fact that CTB's circumscribed role was confined to operating the call center, CTB charged the Funds substantially more in transfer agent fees than it paid First Data. Thus, according to Local 649, CAM, through CTB, essentially pocketed money belonging to the Funds.
Local 649 further alleges that CAM concealed critical aspects of its scheme from the Funds' boards of directors, which were responsible for approving the investment adviser's fee. During presentations to the Funds' boards between March and June 1999, Senior Vice President Daidone recommended that the boards enter into the proposed contract with CTB but failed to inform the boards about the details of the side letter. These presentations were accompanied by a memorandum, authored by Daidone, which represented that the goals of the new contract with CTB were to reduce fees and promote future growth. Daidone's efforts to persuade the Funds' boards to adopt the contract with CTB proved successful. Each of the boards approved his recommendation.
According to Local 649, CAM then concealed its scheme from investors. On May 26, 2000, a Smith Barney affiliate issued a prospectus, updating them about the state of the Funds and subsequently issued an amended prospectus on September 11, 2000, the first day of the Class Period. That amended prospectus and prospectuses that followed on April 24, 2001, March 29, 2002 and June 24, 2002 all disclosed, with varying levels of detail, the existence of the contract between the Funds and CTB. These prospectuses also disclosed the subcontract between CTB and First Data. CAM did not initially disclose in these prospectuses, however, that First Data continued to perform the same services it had previously performed at a substantially reduced rate. Nor did CAM disclose that the nominal transfer agent, CTB, would perform only minimal functions but would then pocket the difference between what it charged the Funds and what it paid First Data.
In September 2003, a whistleblower reported to the SEC about CAM's failure adequately to disclose the arrangement to the Fund Boards. Three months later, CAM issued written supplements to the Fund prospectuses disclosing the existence of the side letter, and disclosing that CAM had not informed the Funds' boards of the side letter at the time that they approved the transfer agent contracts.
In 2005, the SEC investigated Smith Barney and CGMI for violations of the Investment Advisers Act of 1940 alleging that they induced the Funds to enter into a contract that resulted in unnecessarily high expenses to the Funds and undisclosed profits to CAM. Specifically, according to the SEC, the cumulative effect of the scheme was to provide CTB with pretax revenues of approximately $100 million off set by total operating expenses of $10.5 million and to funnel to CAM and its affiliates approximately $17 million in additional revenue based on "revenue guarantee" arrangements in the side letter. In May 2005, the SEC settled with Smith Barney and CGMI, who agreed to pay more than $200 million in fines and disgorge the profits generated by the scheme. Based on these allegations, investors filed a series of civil suits in the Southern District of New York seeking damages for defendants' violations of, among other provisions, § 10(b) of the Securities Exchange Act of 1934, Rule 10b-5, and § 36(b) of the Investment Company Act of 1940. These suits were subsequently consolidated with Local 649 serving as lead plaintiff and filing the Amended Complaint that is the subject of this appeal.
In September 2007 the District Court granted Defendants' motion to dismiss the Complaint, holding that the mischaracterization of the fees paid to CTB as transfer agent fees was not a false material representation under § 10(b). The district court also dismissed Local 649's § 36(b) claims on the ground that they could only be brought derivatively on behalf of the Funds. The court granted Local 649 leave to replead its § 36(b) claims as derivative, rather than direct ...