The U.S. Court of Appeals for the 2nd Circuit, in Oxford University Bank v. Lansuppe Feeder LLC, held that Section 47(b) of the Investment Company Act of 1940 creates a private right of action to seek rescission of an unlawful contract. The opinion was necessitated by the plain text of the statute, which declares that contracts violating the ’40 Act are unenforceable and that courts must grant “rescission at the insistence of any party” unless doing so would be inequitable.
The decision carries implications for the mutual fund industry, as well as independent directors, but it should not come as much of a surprise. A look at the history of the courts’ interpretations of the statute is insightful.
While much has been made of the 2nd Circuit’s disagreement with a prior 3rd Circuit ruling, the broader history suggests that the Oxford decision represents the beginning of a course correction rather than a split among jurisdictions. Courts had assumed for decades that Section 47(b) created a private right of action, and only recently did some begin to doubt it. For example, as early as 1977, the 7th Circuit determined that Section 47(b) “contemplates civil suits for relief by way of rescission and for damages.” Then, in 1979, the Supreme Court held that an analogous section under the Investment Advisers Act creates a private right to rescission (the court reasoned that a statute declaring illegal contracts to be void must have been meant to be “litigated somewhere” by the parties). A decade later, the 1st Circuit aligned with the 7th Circuit when it assumed that Section 47(b) creates a private right of action, but dismissed the case on the merits.
In the mid 2000s, however, a handful of lower courts began to deviate, in part, because of an intervening Supreme Court opinion penned by ardent textualist Justice Scalia, which was generally regarded as having raised the bar for implying a right of action under federal law. In 2012, citing that Supreme Court decision, the 3rd Circuit became the first Court of Appeals to hold that Section 47(b) does not provide a private right of action. But, as the 2nd Circuit noted in Oxford, the 3rd Circuit “strangely” failed to consider the “strongest textual indication of Congressional intent to provide a right of action” – the statute’s language instructing courts not to deny rescission at the insistence of the parties. Thus, the 2nd Circuit joined the line of older cases finding that parties may avail themselves of the recession remedy expressly referenced by the statute.
In short, Oxford presents a sensible reading of a section of the ’40 Act that has been muddled by courts only in recent years. The take-away for independent directors is that advisors will continue to contest this issue in future litigation outside of the 2nd Circuit, but subsequent court decisions are likely to extend the line of precedent finding a private right of action.
What Are The Key Points for Directors?
A Remedy Available to Funds. Although commentary regarding Oxford has focused on the potential liability of advisors, directors and funds under Section 47(b), it is important to remember that the private right of action is, first and foremost, a powerful remedy available to funds. Directors should consider whether and how to utilize a fund’s legal rights in circumstances where service providers run afoul of the ’40 Act. Take, for example, the SEC’s June 2019 settlement with State Street, which suggests that the company violated the ’40 Act by overcharging its custody clients as much as $170 million. While directors should obviously seek to make funds whole in such circumstances (i.e. recover any losses with interest), the right to rescission may provide a further bargaining chip for directors to obtain retroactive or future fee reductions, enhancements in a provider’s service quality standards, or additional reporting.
Visibility Is Crucial. Oxford serves as a reminder of the importance of visibility into a fund’s contractual relationships with service providers. Directors may have significant visibility around a fund’s advisory contract thanks to Section 15(c) of the ’40 Act, and perhaps close to the same visibility with respect to a fund’s major service providers (e.g. administrators, accountants, custodians or transfer agents). However, directors may have less visibility into other relationships, especially those primarily managed by the advisor, such as contracts with sub-transfer agents, sub-administrators and financial intermediaries.
Directors must be diligent in obtaining information from advisors, and the counterparties themselves, regarding the nature of such contracts, as well as the conduct of counterparties under them. The latter may be challenging for the advisor to oversee and report in sufficient detail, but it is important because a counterparty’s conduct may implicate compliance with the ’40 Act (and the Section 47(b) right to rescission) even if the terms of the contract do not. Directors should consider whether the information they have regarding a contract extends beyond a description of its terms; includes timely and first-hand information from the counterparty itself and/or the advisor’s review of the counterparty’s conduct; and is sufficiently granular and reliable to permit directors to understand the facts on the ground.
Enhanced Focus on Directors. While directors are unlikely to be defendants to Section 47(b) claims (because they typically are not contractual counterparties), their conduct could be a focus of litigation if shareholders choose to advance claims against a counterparty in the form of a derivative action on behalf of a fund. Further, if the facts and circumstances in such cases suggest that the board failed to adequately oversee a counterparty’s conduct under a contract with the fund, shareholders may bring a parallel action against the directors alleging breach of fiduciary duty.
In sum, Oxford is a reminder that a fund (and its shareholders) do have a remedy for misconduct attributable to the fund’s counterparties. Directors should remain aware of the importance of fully understanding the fund’s contractual and financial arrangements with counterparties at the outset of the relationship and throughout the duration of the contract, and ensuring that the relationships fall well within the bounds of the ’40 Act.