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Trust Fund Class Action Precluded by SLUSA, Dismissed with Prejudice

In Daniels v. Morgan Asset Mgmt., Inc., the United States Court of Appeals for the Sixth Circuit affirmed the ruling of the District Court for the Western District of Tennessee, dismissing with prejudice a class action brought by a group of trust funds and Fred C. Daniels (collectively, “Plaintiffs”) against Morgan Asset Management, Inc. (“Morgan”) for breach of contract and negligence.  No. 10–6335, 2012 WL 3799150 (6th Cir. Aug. 31, 2012).

This case involved two Investment Advisory Services Agreements (the “agreements”) between Plaintiffs and Morgan, which obligated Morgan to provide investment services. The agreements stated that Morgan would, “with ordinary skill and diligence,” recommend assets to purchase or sell from Daniels’ trusts and custodial accounts. Plaintiffs alleged that Morgan breached its contractual duty when it made and continued to hold investments in mutual funds on behalf of Plaintiffs, rather than discontinuing and liquidating them as would allegedly have been appropriate. The funds in question were illiquid securities backed primarily by mortgages, which led to greater losses and a slower rebound after the market collapsed in 2007 and 2008. 

The complaint alleged that Regions Financial, an investment and banking company, had a corporate structure that made it both operator of the mutual funds in question and the corporate owner of Morgan. This interweaved ownership created a conflict of interest that made it impossible for Morgan to exercise independent judgment in determining whether the mutual funds in question should have been purchased or retained. As a result of the conduct, Plaintiffs alleged that the Regions Morgan Keegan Entity Defendants “are liable for breaching the 2003 and 2007 Contracts and that all Defendants are liable for negligence.” 

The Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) provides that state-law ‘covered’ class actions alleging untruth or manipulation in connection with the purchase or sale of a ‘covered’ security may not be maintained in any state or federal court.  The district court viewed the complaint as one sounding in misrepresentations, including misrepresentations of “how investments would be determined” and omissions of “an undisclosed conflict of interest that required Defendants to invest assets of the trusts and custodial accounts in the RMK Funds." As a result, the court held that SLUSA precluded Plaintiffs’ claims, and dismissed them.

On appeal, the court acknowledged circuits have been split on what role the untrue statement or omission of material fact must play in the complaint to find SLUSA preclusion. The Sixth Circuit’s rule, the “literalist approach,” looked to whether the complaint contained any reference to the untrue statement or omission. As the court reasoned: 

This Circuit has held that "[SLUSA] does not ask whether the complaint makes 'material' or 'dependent' allegations of misrepresentation in connection with buying or selling securities. It asks whether the complaint includes these types of allegations, pure and simple." This approach has been referred to as the "literalist approach," and authorizes a more expansive reading of SLUSA's reach than other circuits have adopted. Other approaches include distinguishing inessential factual allegations from those critical to a claim's success, and dismissing a complaint that contains prohibited allegations without prejudice to allow amendment  (citations omitted).

Nor did it matter that the allegations of misrepresentations were not material to the underlying claims.  “[T]he literalist approach of our circuit makes it clear that the inquiry is only whether the complaint includes these type of allegations, not whether they are material elements of a claim.”

In analyzing Plaintiffs’ complaint, the court looked to the substance of the complaint – that Morgan misrepresented how investments would be determined and omitted the material conflict of interest. It held that this constituted grounds for SLUSA preclusion under the literalist approach. Plaintiffs attempted to avoid SLUSA by expressly disclaiming the preclusionary language in its complaint, but the court found that the disclaimer was ineffective to elude SLUSA’s provisions.

The court denied Plaintiffs’ Motion for Permission to File Second Amended Complaint, reasoning that a more specific allegation would be futile because it would only more specifically allege the prohibited types of allegations, reinforcing the SLUSA preclusion of the complaint alleging untruth or manipulation. The court affirmed the district court’s dismissal with prejudice of Plaintiffs’ claims as precluded under SLUSA.

The primary materials for this case may be found on the DU Corporate Governance website.

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