Courts have sought to simplify their approach to determining whether an action is derivative or direct — a determination that the Delaware Supreme Court has acknowledged “is sometimes difficult.” Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1036 (Del. 2004). Proper determination is critical in shareholder litigation; however, the Ninth Circuit's March 2015 decision in Northstar Financial Advisors Inc. v. Schwab Investments, 779 F.3d 1036 (9th Cir. 2015) allows direct lawsuits from shareholders in a case that seemed to be a straightforward example of a derivative claim. The Ninth Circuit further complicated the issue by trying to carve mutual funds out of the analysis entirely, suggesting that courts abandon the distinction between direct and derivative claims in lawsuits arising from investments in mutual funds because, according to the court, the claims of investor plaintiffs should be deemed direct claims in virtually all instances. This finding is likely to sow additional confusion and inconsistent application of the proper analysis in future investment company litigation.
In Northstar, investors in the Schwab Total Bond Market Fund asserted claims of breach of contract and breach of fiduciary duty against the fund's trustees and investment adviser. Those claims were based on allegations that the defendants violated the fund's "fundamental investment objectives" by investing too heavily in mortgage-backed securities. The plaintiffs also alleged that the offending investments generated significant losses and therefore directly injured the fund by diminishing the value of its assets. Because the plaintiffs asserted all their claims as direct claims on behalf of themselves and a putative class of fund investors, the defendants filed a motion to dismiss those claims, arguing that they were really derivative in nature, and plaintiffs therefore lacked standing to assert them directly. The district court granted the motion, but the Ninth Circuit reversed.
Because the fund is a mutual fund organized as a Massachusetts business trust, the Ninth Circuit in Northstar applied the "internal affairs doctrine" to find that Massachusetts law governed the standing question before it. However, in its application of Massachusetts law, the court made a common mistake in this context: Namely, it erroneously held that a plaintiff may adequately plead a direct claim by alleging the breach of a contractual right held by a plaintiff qua shareholder, even if the plaintiff's injury is derivative of the harm suffered by the company.
The court based its decision in large part on Lapidus v. Hecht, 232 F.3d 679 (9th Cir. 2000), a prior Ninth Circuit opinion that relied solely on...
