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GREEN v. FUND ASSET MANAGEMENT

June 5, 2001

JACK GREEN, INDIVIDUALLY AND AS TRUSTEE, LAWRENCE P. BELDEN, TRUSTEE, AND STANLEY SIMON, TRUSTEE, PLAINTIFFS,
v.
FUND ASSET MANAGEMENT, L.P., MERRILL LYNCH ASSET MANAGEMENT, L.P., MERRILL LYNCH & CO., INC., MERRILL LYNCH, PIERCE, FENNER & SMITH INC., PRINCETON SERVICES, INC., ARTHUR ZEIKEL, TERRY K. GLENN, MUNIENHANCED FUND, INC., MUNIVEST FUND II, INC., MUNIYIELD FUND, INC., MUNIYIELD INSURED FUND, INC., MUNIYIELD INSURED FUND II, INC., MUNIYIELD QUALITY FUND, INC., AND MUNIYIELD QUALITY FUND II, INC., DEFENDANTS.



The opinion of the court was delivered by: Dickinson R. Debevoise, Senior District Judge

    OPINION

This matter is before the court on defendants' motions for summary judgment and on plaintiffs' cross-motion for partial summary judgment on liability. For the reasons that follow, the plaintiffs' cross-motion shall be denied, the defendants' motions for summary judgment shall be granted, and the case shall be dismissed.

Factual Background and Procedural History

Plaintiffs commenced this action by filing their original complaint on June 21, 1996 in the United States District Court for the District of Massachusetts. On July 18, 1997, the action was transferred to this court. In their original complaint, plaintiffs lodged against the defendants federal statutory claims under sections 8(e), 34(b), 36(a), and 36(b) of the Investment Company Act of 1940 (the "ICA"), and state common-law claims for breach of fiduciary duty and deceit. On February 23, 1998, on defendants' motion, plaintiffs' claims under sections 8(e), 34(b), and 36(a) of the ICA were dismissed, leaving only their claim under section 36(b) of the ICA. See Green v. Fund Asset Mgmt., L.P., 19 F. Supp.2d 227 (D.N.J. 1998) ("Green"). In the wake of this disposition, plaintiffs filed an amended complaint, without leave of court, on March 31, 1998.*fn1

On June 14, 1999, on defendants' motion for judgment on the pleadings, plaintiffs' state-law claims were dismissed on the ground that they were preempted by section 36(b) of the ICA. See Green v. Fund Asset Mgmt., L.P., 53 F. Supp.2d 723 (D.N.J. 1999). On March 16, 2001, this judgment was reversed; the state-law claims were reinstated, and the matter was remanded for further proceedings. See Green v. Fund Asset Mgmt., L.P., 245 F.3d 214 (3rd Cir. 2001).

Defendants have now moved for summary judgment on plaintiffs' remaining federal claim under section 36(b) of the ICA, 15 U.S.C. § 80a-35(b) (1940, as amended). Plaintiffs have filed a cross-motion on this claim for partial summary judgment on liability. The state-law claims are not the subject of the instant motions.

As the factual background and procedural history of this case are set forth in Green, only those undisputed facts and disputed factual allegations necessary to disposition of these motions shall be recited here. All recitations of fact are undisputed unless otherwise noted.

Purpose and Operation of the Funds

Plaintiffs own common stock in the seven defendant non-diversified, closed-end management investment companies (the "funds"). The funds are non-diversified in that their investment assets consist largely, if not entirely, of "obligations issued by or on behalf of states, territories and possessions of the United States and their political subdivisions, agencies or instrumentalities paying interest which, in the opinion of bond counsel to the issuer, is exempt from federal income taxes ("municipal bonds")." Prospectus, MuniVest Fund II, Inc., 3/19/93, Exhibit B to Declaration of Sean M. Murphy in Support of Defendants' Motions for Summary Judgment, at 10 (initial capitals changed to lowercase).*fn2 The funds are closed-end in that they do not redeem their securities at the option of their shareholders, and do not engage in continuous stock offerings. Prospectus at 9. The funds are registered under the ICA. Ibid. Each fund's goal is providing "shareholders with as high a level of current income exempt from federal income taxes as is consistent with its investment policies and prudent investment management." Id. at 10; accord Am. Compl. ¶ 31, at 9.

An essential feature of the funds' operation is leverage. Ordinarily, the term "leveraged" is used to describe investments made with a given amount of capital and a given amount (often a larger amount) of borrowed funds. See Black's Law Dictionary 906 (6th ed. 1990). However, leverage is also used to describe "[t]he effect on common stockholders of the requirements to pay bond interest and preferred stock dividends before payment of common stock dividends," ibid., and it is in this connection that the term is used to describe the funds' operation.

Common stockholders in the funds have provided the main corpus of capital with which the funds have purchased long-term municipal bonds for their portfolios. In lieu of borrowing funds at standard market interest rates, ranging typically from six to eight percent (6% - 8%), in order to purchase additional municipal bonds, the funds have issued shares of preferred stock that pay, on a monthly basis, dividends at rates equal to short-term interest rates, ranging typically from two and one-half to four percent (2 1/2%-4%). Investors are willing to purchase preferred stock paying such low dividend rates chiefly because the funds' asset portfolios consist in the main of municipal bonds exempt from federal income taxation, and so the preferred stock dividends are also exempt from federal income taxation. Defs.' Statement Undisputed Material Facts ¶ 34, at 8.*fn3 The funds have used the proceeds from their issues of preferred stock, purchased by investors, to purchase additional municipal bonds.*fn4

The use of leverage furthers the funds' stated goal of providing investors with income exempt from federal income taxation. Under normal market conditions, securities with longer maturities, such as these long-term municipal bonds, produce higher yields than do short-term securities, such as the preferred stock. The spread between the dividend rates payable on the preferred stock and the coupon rates on the long-term municipal bonds provides common shareholders with a higher yield than they would have realized had the funds not been leveraged with issues of preferred stock. Prospectus, Ex. B. to Murphy Decl., at 17.

As the funds have made abundantly clear to potential investors, leverage, like investment itself, has its risks. The funds are non-diversified: the vast majority of the funds' assets consists of large positions taken in the municipal bonds of a small number of issuers. See Prospectus at 12 (explaining non-diversified status under the ICA and the Internal Revenue Code). The municipal bonds are long-term, fixed-coupon instruments; accordingly, they pay interest periodically to investors at a fixed percentage of the principal amount, and then yield the principal upon maturity. For this reason, if long-term interest rates rise above the municipal bonds' fixed-coupon rates, the market value of the bonds decreases, and the bonds trade at a discount. When this happens, the impact of the reduction in the bonds' market value is felt more acutely by the common shareholders than if the funds held a smaller dollar amount in bonds or if the funds' asset portfolios were more diversified. Prospectus at 17, 18. This results in a corresponding reduction in the net asset value, with a likely reduction in market value, of the common stock. Id. at 18.

If short-term interest rates rise more steeply than do long-term interest rates, the positive yield curve created by the spread between short-term and long-term rates flattens; if short-term rates exceed long-term rates, the yield curve becomes inverted. In this case, this means that as short-term interest rates rise relative to long-term interest rates, the dividend rate paid on the outstanding shares of preferred stock increases, while the fixed-coupon rate on the bonds remains the same. As the yield curve flattens, the benefit of leverage reflected in the return to common shareholders is reduced. Ibid. If short-term rates exceed long-term rates — if the dividend rate paid on the preferred stock exceeds the fixed-coupon rate on the bonds — then the inverted yield curve results in a lower rate of return to the common shareholders than if the funds had not been leveraged. Ibid.

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