Section 47(b) of the Investment Company Act of 1940 provides that contracts that violate or “whose performance involves, a violation of” the act are not enforceable by “either party.”
The majority of the business of mutual funds and other registered investment companies is conducted pursuant to investment management or other agreements with third parties. It potentially would be extremely disruptive if a fund’s shareholders could sue under Section 47(b) to void such fund contracts. Specifically, plaintiffs’ lawyers could bring troublesome lawsuits seeking to rescind one contract or another based on practically any alleged 1940 Act violation they could dream up.
Fortunately, holders of securities issued by a mutual fund (or other company registered under the 1940 Act) historically have not been considered “parties” to a contract with the fund. Therefore, except in the Second Circuit, courts generally have not permitted fund shareholders to maintain actions to rescind contracts under Section 47(b). Now, however, the U.S. Supreme Court is being asked to consider this question.
Several theories could support a shareholder's right, in some circumstances, to maintain actions under Section 47(b) to rescind a contract. These theories include:
- Because the courts of certain states have held that a fund’s bylaws or other basic documents constitute“contracts” between the fund and its shareholders, the shareholders also should be considered “parties” to such contracts within the meaning of Section 47(b).
- Shareholders who properly bring a derivative action to rescind a contract that a fund has entered into should be considered “parties” to the contract within the meaning of Section 47(b), because the fund clearly is a party, and the derivative action is asserting the fund’s rights as such.
- Shareholders should be considered third-party beneficiaries of certain contracts that a fund has entered into, in which case the shareholders also should be considered “parties” to the agreement within the meaning of Section 47(b), given the rights they have as beneficiaries.
To date, the Second Circuit is the only federal appellate court to have held that shareholders can maintain actions under Section 47(b), thus giving them a private right of action. This stance, however, conflicts with several other federal circuit courts that have denied such a right.
In a recent opinion, the Second Circuit reaffirmed its position by permitting an activist shareholder of closed-end funds (CEFs) to maintain an action under Section 47(b) to rescind certain board actions. The court treated the CEFs’ bylaws as contracts with their shareholders. The board actions aimed to prevent the activist shareholder from leveraging its stake in ways that disadvantaged other CEF shareholders, but the activist alleged these actions violated another provision of the 1940 Act. For more information about the battles between CEFs and such activist investors, please refer to “Gone With the Wind? Closed-End Funds Risk Extinction,” Expect Focus – Life, Annuity, and Retirement Solutions (September 2024).
The CEF defendants in this case have petitioned the U.S. Supreme Court for a writ of certiorari to resolve the conflict over whether a private right of action exists for Section 47(b). The Investment Company Institute and the Asset Management Group of the Securities Industry and Financial Markets Association have jointly filed an amicus brief supporting the petition, joined by a separate supporting brief from the U.S. Chamber of Commerce.
There are many strong arguments against affording fund shareholders a private right of action under Section 47(b). It is to be hoped, therefore, that the Supreme Court will grant certiorari and overrule the Second Circuit.
