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Northstar Financial Advisors, Inc. v. Schwab Investments

United States Court of Appeals, Ninth Circuit

September 14, 2018

Northstar Financial Advisors, Inc., on behalf of itself and all others similarly situated, Plaintiff-Appellant,
v.
Schwab Investments; Mariann Byerwaler; Donald F. Dorward; William A. Hasler; Robert G. Holmes; Gerald B. Smith; Donald R. Stephens; Michael W. Wilsey; Charles R. Schwab; Randall W. Merk; Joseph H. Wender; John F. Cogan; Charles Schwab Investment Management, Inc., Defendants-Appellees.

          Argued and Submitted October 11, 2017 San Francisco, California

          Appeal from the United States District Court for the Northern District No. 5:08-cv-04119-LHK of California Lucy H. Koh, District Judge, Presiding

          Robert C. Finkel (argued), Wolf Popper LLP, New York, New York; Joseph J. Tabacco Jr. and Christopher T. Heffelfinger, Berman DeValerio, San Francisco, California; Marc J. Gross, Greenbaum Rowe Smith & Davis LLP, Roseland, New Jersey; for Plaintiff-Appellant.

          Matthew L. Larrabee (argued), Joshua D.N. Hess, and Brian C. Raphel, Dechert LLP, San Francisco, California; Richard A. Schirtzer, Karin A. Kramer, and Arthur M. Roberts, Quinn Emanuel Urquhart & Sullivan LLP, San Francisco, California; for Defendants-Appellees.

          Before: Sidney R. Thomas, Chief Judge, and Milan D. Smith, Jr. and Kathleen M. O'Malley, [*] Circuit Judges.

         SUMMARY [**]

         Securities

         The panel (1) affirmed the district court's dismissal of class claims brought under state law as precluded by the Securities Litigation Uniform Standards Act and (2) reversed the dismissal with prejudice and remanded to give plaintiff the opportunity to amend its complaint.

         The panel held that SLUSA bars a plaintiff class from bringing (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. The central question is whether the complaint describes conduct by the defendant that would be actionable under the 1933 or 1934 Securities Acts. The court must determine whether (1) the complaint's description of a defendant's conduct involves conduct specified in SLUSA, and (2) the alleged conduct will be part of the proofs in support of the state cause of action. While a defendant's conduct need not be an element of the state cause of action, the conduct still must be a fact on which the proof of that state cause of action depends.

         The complaint made allegations about the Schwab Total Bond Market Fund. In 1997, shareholders approved proposals requiring the Fund managers to seek to track a bond index and to invest no more than 25% of the Fund's total assets in any one industry. During the "Pre-Breach Period," the Fund's investments performed in a manner substantially consistent with the index. During the subsequent "Breach Period," the Fund deviated from its fundamental investment policies.

         The panel held that the Pre-Breach class claims depended on allegations of misrepresentations or omissions and were therefore barred by SLUSA. It was this conduct to which plaintiff would point to prove its breach of contract and breach of fiduciary duty claims. The panel held that Breach class's claims similarly depended on allegations of misrepresentations and were barred by SLUSA.

         The panel concluded that neither the Pre-Breach nor the Breach class claims were saved by the Delaware carve-out, which provides that class claims that would otherwise be barred by SLUSA are not subject to dismissal if (1) they are based upon the statutory or common law of the state in which the issuer of the securities is organized, and (2) they constitute "permissible actions" defined by SLUSA. The panel concluded that the claims were based on the law of Massachusetts, the state in which defendant was organized, but the claims were not "permissible actions."

         The panel affirmed the district court's dismissal of all of the class claims, but it held that the district court erred in dismissing the claims with prejudice. The panel remanded to give plaintiff the opportunity to amend its complaint.

         Concurring in part and dissenting in part, Chief Judge Thomas wrote that he dissented from the portion of the opinion addressing the Pre-Breach claims. He wrote that those claims fell comfortably within the category of state law claims outside the ambit of SLUSA because proving them would not require proof of a misrepresentation or omission of material fact.

          OPINION

          O'MALLEY, Circuit Judge.

         In this appeal, we consider whether the Securities Litigation Uniform Standards Act ("SLUSA") precludes class claims brought under state law by Northstar Financial Advisors, Inc. ("Northstar") against Schwab Investments, Charles Schwab Investment Management, Inc., and the trustees of the Schwab Trust (collectively, "defendants"). We conclude that SLUSA precludes all of Northstar's claims, and that the district court therefore correctly dismissed them. The district court erred, however, in dismissing the claims with prejudice. We therefore affirm in part, reverse in part, and remand.[1]

         I

         A

         Northstar is a registered investment advisory and financial planning firm that manages accounts on behalf of investors. During the relevant time period, Northstar traded through Charles Schwab's Institutional Advisor Platform, where it purchased shares in the Schwab Total Bond Market Fund ("Fund") for its clients. The Schwab Trust ("Trust") is a Massachusetts Business Trust having assets held by a group of trustees ("Trustees") who manage and supervise the Fund's operations for the benefit of its shareholders, the Trust's beneficiaries. Charles Schwab Investment Management, Inc. ("Schwab Advisor"), an investment advisory firm affiliated with the Trust, has acted as the manager of, and investment advisor to, the Trust in accordance with a June 1994 Investment Advisory Agreement ("IAA"). The Schwab Advisor oversees the day-to-day operations of the Fund, including selection of investments.

         Northstar's core allegations have remained the same across its five complaints. In a July 1997 Proxy Statement ("1997 Proxy Statement"), the Trustees sought a shareholder vote on two proposals relevant to this appeal. Proposal No. 2 would amend the Fund's fundamental investment objective to track the investment results of the Lehman Brothers Aggregate Bond Index ("Index"). Proposal No. 3 would change the Fund's "fundamental investment policies and investment restrictions" regarding the concentration of investments to incorporate the SEC's interpretation of "concentration" from the Investment Company Act of 1940 ("ICA"), which was and is 25% of the available assets in a fund. A majority of Fund shareholders voted to approve the proposals. As a result, the Trust was obligated to "seek to track" the Index and to invest no more than 25% of the Fund's total assets in any one industry.

         From August 1997 through August 2007-which Northstar refers to as the "Pre-Breach period"-the Fund's investments performed in a manner substantially consistent with the Index. During this period, the Fund continuously offered its shares to the public pursuant to annual prospectuses, which affirmed to potential and current shareholders that the Trust was following the fundamental investment objectives set forth in the 1997 Proxy Statement.

         From August 2007 until February 2009-which Northstar refers to as the "Breach period"-the Trust continued to represent in Fund prospectuses and other public filings that the Fund would be managed conservatively and passively, and would be invested in the same securities as the Index, pursuant to its fundamental investment objective. In or about September 2007, however, the Trust caused the Fund to deviate from its fundamental investment policies by investing in collateralized mortgage obligations that were not part of the Index, and by concentrating more than 25% of the Fund's total assets in mortgage-backed securities and collateralized mortgage obligations. The Fund deviated from its fundamental investment policies until about the end of February 2009. Fund shareholders suffered financial injury due to the Fund's deviation, as the Fund underperformed the Index during this time.

         B

         This case has a lengthy procedural history that includes the dismissal of successive amended complaints for failures to state claims. In June 2015, Northstar filed its Fourth Amended Complaint. In that complaint, Northstar asserted claims on behalf of Fund shareholders who purchased shares during the Breach period ("Breach class"), as well as those who purchased shares during the Pre-Breach period but held them during the Breach period ("Pre-Breach class"). The complaint alleges fourteen causes of action: seven pertaining to the Pre-Breach class, and seven pertaining to the Breach class. With respect to each class, Northstar alleged breach of fiduciary duties against both the Trust and the Trustees; breach of fiduciary duty against the Schwab Advisor; aiding and abetting breach of fiduciary duty against the Trustees and the Schwab Advisor; breach of contract as third-party beneficiary to the IAA against the Schwab Advisor; breach of contract against the Trust; and breach of the covenant of good faith and fair dealing against the Schwab Advisor and the Trustees. Northstar alleged that its claims, if barred by SLUSA, are nonetheless preserved by the "Delaware carve-out."

         The district court granted in part and denied in part the defendants' motion to dismiss. Northstar Fin. Advisors Inc. v. Schwab Invs., 135 F. Supp. 3d 1059 (N.D. Cal. 2015). In particular, the court granted the motion to dismiss, with prejudice, Northstar's claims for breach of contract and breach of the covenant of good faith and fair dealing, concluding that SLUSA barred those claims and that they did not fall within the Delaware carve-out. The district court also granted the motion to dismiss, with prejudice, Northstar's breach of fiduciary duty claims "insofar as these claims pertain to an alleged breach of fiduciary duty by the Trust." Id. at 1089. The district court reasoned that any such duties were owed by the Trustees, rather than by the Trust itself. The district court further granted the motion to dismiss, with prejudice, Northstar's third-party beneficiary claims, breach of contract claims, and breach of the covenant of good faith and fair dealing claims, concluding that SLUSA also barred those claims and that they did not fall within the Delaware carve-out. Id. at 1080–89.

         The district court denied the motion to dismiss the remaining claims, however, which alleged breaches of fiduciary duties by the Trustees and the Schwab Advisor, and aiding and abetting such breaches. Id. at 1077–80. The district court reasoned that the defendants could not assert a SLUSA defense to these claims in a Rule 12(b)(6) motion, but that they could raise such a defense by filing a motion for judgment on the pleadings. Id. at 1071. The defendants subsequently moved for judgment on the pleadings, arguing that the breach of fiduciary duty and aiding and abetting claims were barred by SLUSA, and the district court granted the motion. Northstar Fin. Advisors Inc. v. Schwab Invs., No. 08-CV-04119-LHK, 2016 WL 706018 (N.D. Cal. Feb. 23, 2016). This appeal timely followed.

         II

         A

         We review de novo a district court's order granting a motion to dismiss, Proctor v. Vishay Intertechnology Inc., 584 F.3d 1208, 1218 (9th Cir. 2009), as well as a grant of a motion for judgment on the pleadings, Harris v. Cty. of Orange, 682 F.3d 1126, 1131 (9th Cir. 2012). In evaluating Northstar's claims, we "accept factual allegations in the complaint as true and construe the pleadings in the light most favorable to ...


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