DELAWARE SUPREME COURT RESTORES BREACH OF FIDUCIARY CLAIM AGAINST A BROKER-DEALER ALLEGING INADEQUATE DISCLOSURE OF A CHANGE IN THE MONEY MARKET FUND USED FOR SWEEP ACCOUNTS

* See O'Malley et al. v. Boris, Del., No. 59 (December 8, 1999). [11523] January 5, 2000 TO: COMPLIANCE ADVISORY COMMITTEE No. 1-00 SEC RULES MEMBERS No. 2-00 RE: DELAWARE SUPREME COURT RESTORES BREACH OF FIDUCIARY CLAIM AGAINST A BROKER-DEALER ALLEGING INADEQUATE DISCLOSURE OF A CHANGE IN THE MONEY MARKET FUND USED FOR SWEEP ACCOUNTS ______________________________________________________________________________ The Delaware Supreme Court recently restored a class-action claim brought under state law relating to whether a broker-dealer violated its fiduciary duty to its clients by failing to provide full disclosure regarding a change in the money market fund used in its sweep arrangement.* Plaintiffs' Allegations According to the court's decision, in September 1996, the broker-dealer notified its money market sweep account clients through a negative response letter that, unless it was instructed to the contrary, effective November 1st the clients' accounts would be swept into a different money market fund. A copy of the new fund's prospectus was included with the negative response letters. While the plaintiffs did not oppose this change, when they subsequently discovered that the broker-dealer had entered into a joint venture agreement with the money market fund, under which the broker-dealer would acquire a 20.2% interest in the venture in return for using the fund as the sweep vehicle, the plaintiffs sued alleging, in part, breach of fiduciary duty. In particular, the plaintiffs alleged that the broker-dealer breached its fiduciary duties of disclosure and loyalty by switching the sweep account funds for the benefit of the broker-dealer and by failing to provide the affected clients adequate disclosure of the joint venture between the broker-dealer and the money market fund. The lower court dismissed the plaintiffs' complaint finding that the prospectus and notification letter "strongly implied" the nature of the broker-dealer's interest and holding that the disclosures were adequate as a matter of law; the plaintiffs appealed the dismissal. Defendants' Response On appeal, the defendants argued (1) that the plaintiffs' state fiduciary claim was federally preempted inasmuch as the NASD regulates the use and content of negative response letters by broker- dealers (i.e., NASD Rule 2510(d)(2)) and (2) they had provided adequate disclosure. The defendants noted that the money market fund's prospectus, which had accompanied the negative response letters, had disclosed that the broker-dealer would acquire 20% of the fund and might acquire additional shares in the fund "depending principally on the amount of assets in investment companies sponsored by the [fund] attributable to clients of [the broker-dealer]." The Court's Holding The court disagreed with the defendants' argument that the plaintiffs' state law claim alleging breach of fiduciary duty was preempted by federal law. In particular, the court concluded that there was no direct conflict between the NASD's rules governing negative response letters and the broker-dealer's fiduciary duty under state law because "full disclosure [of the broker-dealer's interest in the money market funds] would not interfere with the purpose or effectiveness of the NASD rule allowing negative response letters." The court then addressed the defendants' argument that they had provided adequate disclosure of the broker-dealer's ownership interest in the fund company. It noted that the lower court had found, based on the prospectus disclosure, that a reasonable investor "could not miss the point that [the broker- dealer] was using its customer base to participate in the venture [with the money market fund]." However, in the view of the Delaware Supreme Court, this prospectus disclosure left open at least two reasonable possibilities as to how the broker-dealer acquired its initial 20% interest in the fund company -- "by investing its own money or by transferring its clients' money." The court noted that "full disclosure requires more than strong inferences. Investors should not be required to correctly 'read between the lines' to learn all of the material facts to the transaction at issue." The court found that "under these circumstances, the information about how the broker-dealer acquired its interest . . . cannot be deemed to have been disclosed." Based on this, and the fact that a reasonable shareholder might have found the information significant "not only to the choice of sweep accounts, but also to the investor's choice of brokers," the court restored the plaintiffs' breach of fiduciary duty claims and remanded the case for further action in accordance with the opinion. A copy of the court's decision is attached. Tamara K. Reed Associate Counsel Attachment Note: Not all recipients receive the attachment. To obtain a copy of the attachment referred to in this Memo, please call the ICI Library at (202) 326-8304, and ask for attachment number 11523. ICI Members may retrieve this Memo and its attachment from ICINet (http://members.ici.org).