February 19, 2010

Investors scored a significant victory in a class action suit when an appeals court ruled against Citigroup Asset Management and two former executives for defrauding mutual fund shareholders over an agreement with its transfer agent.

Plaintiffs in the case claim that Citigroup Asset Management renegotiated its transfer agency fees with First Data Investor Services and then pocketed the substantial savings rather than passing them on to shareholders in CAM’s funds.

The U.S. Court of Appeals for the Second Circuit rejected a 2007 district court ruling that dismissed the plaintiffs’ claims of fraud under Rule 10b-5. The lower court found that “when an investment adviser discloses the total amount of fees paid by a fund for various services, neither the fees’ allocation nor the transfer agent’s profit margin is material,” according to Tuesday’s ruling. The Second Circuit disagreed, supporting the plaintiffs' contention that Citigroup Asset Management’s misrepresentations were, in fact, material.

The ruling could have substantial significance for fund advisors, legal experts say.

“The Second Circuit opinion strongly emphasizes the fiduciary duty and disclosure obligations owed by fund advisers and their affiliates, and it effectively provides a roadmap for plaintiffs against advisers that fail to meet those obligations,” writes John Baker, of counsel at Stradley Ronon Stevens & Young, in his FundLaw blog.

As a result, fund advisors may take greater care to ask whether they shopped hard enough to see what other providers are charging and how they are measuring the quality of service to make sure they are getting the best deal, industry sources say.

Operating Local 649 Annuity Trust Fund represented the plaintiffs, while the former executives, Thomas Jones, former chief of Citigroup Asset Management (CAM), and Lewis Daidone, former treasurer and chief officer of Smith Barney’s fund family, were named as defendants. Citigroup affiliates Smith Barney Fund Management and Citigroup Global Markets advised the funds and also were named as defendants.

The case resulted in an SEC suit, which Citigroup settled in 2005, agreeing to pay $208 million to the victims. Jones and Daidone refused to settle with the SEC, and in 2007 a federal judge dismissed the agency’s suit against the pair.

The class action case involved an agreement with CAM and outside contractor First Data Investor Services Group, which served as a transfer agent from 1994 to Sept. 30, 1999. In 1997 CAM commissioned Deloitte & Touche to learn if it could save money by taking over the transfer agent duties.

When Deloitte recommended that CAM create a subsidiary to take over as transfer agent, CAM rejected the recommendation and instead renegotiated its contract with First Data. What CAM proposed — that the funds pay the same transfer agent fees to First Data and have Smith Barney run a 14-person customer call center — concerned Deloitte.

“Deloitte expressed doubts to CAM as to the legality of the arrangement, questioning among other things, whether the anticipated savings belonged to the Funds as opposed to the investment adviser and whether the Fund Boards would ever approve such an arrangement,” the Second Circuit wrote in its decision. “At that point, CAM changed course and created a transfer agent subsidiary called Citicorp Trust Banks (CTB) which, in place of First Data, then contracted with the Funds to provide transfer agent services.”

CTB, in turn, contracted with First Data to provide essentially the same services it had been providing but at a greatly reduced price, the ruling stated. This effectively limited CTB’s transfer agent duties to operating a 15-person call center and led to allegations by the plaintiff that “CAM, through CTB, essentially pocketed money belonging to the Funds,” the ruling reads.

Through a “side letter” between CTB and First Data, CAM was guaranteed “millions of dollars in additional revenue, without providing commensurate benefit to the Funds,” the ruling reads. “Despite the fact that First Data substantially reduced the rate it charged for transfer agent services, and despite the fact that CTB’s circumscribed role was confined to operating the call center, CTB charged the Funds substantially more in transfer agent fees than it paid First Data,” the ruling states.

The plaintiffs additionally alleged that CAM hid a crucial part of the scheme from the Funds’ boards of directors, specifically when Daidone told the boards in 1999 about CTB, but not the details of the side letter. CAM also hid details in prospectuses that would have revealed the misrepresentation, plaintiffs alleged.

The Second Circuit poked holes in the district court’s ruling in favor of the defendants based on its belief that only the amount of fees is relevant to the price and value of the funds. As long as the investor is aware of what the fund pays in fees, they can make comparisons with competitors before deciding to invest, that district court ruled.

“Any rational mutual fund investor would be highly leery of dealing with a fiduciary such as CAM and its affiliates who, in violation of the law, lined their pockets at the expense of investors whose interests they were obligated to protect,” the Second Circuit ruled. “The district court’s analysis did not engage this reality.”

Tom Gorman, partner at Porter Wright Morris & Arthur, says that the case could significantly impact the industry. The essence of the claim is fraud centered on non-disclosure about the fee arrangements, Gorman writes in an e-mail response to questions.

“This is significant because it means that advisers will have to make sure not just to disclose the total fees charged but other components such as the fee kickbacks here,” Gorman writes. “In effect, this will probably limit these types of arrangements because the advisers probably will not want to make the disclosures.”

A spokesperson for Mayer Brown, one of the firms representing the defendants, declined to comment.