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Ulferts v. Franklin Resources

April 24, 2008


The opinion of the court was delivered by: William J. Martini, U.S.D.J.


Plaintiff-a shareholder of several mutual funds-has sued Defendants-the funds' manager and distributor and their parent corporation-for violations of section 10(b) of the Securities Exchange Act of 1934 and section 12(a)(2) of the Securities Act of 1933. Plaintiff alleges that Defendants violated the Act by failing to disclose "shelf-space" arrangements with the funds' brokers. Under these arrangements, Plaintiff alleges that Defendants provided brokers with financial incentives to sell their mutual funds. Plaintiff further alleges that under these arrangements, he paid brokerage fees that he believed the funds used to purchase value-adding research and brokerage services but that in reality the funds used to finance these shelf-space arrangements.

Defendants now move under Federal Rule of Civil Procedure 12(b)(6) to dismiss Plaintiff's claims. They put forth several arguments to justify dismissal, including that Defendants had no obligation to disclose the shelf-space arrangements. The Court agrees and holds that Plaintiff's complaint fails to state a cognizable claim for relief. Accordingly, Defendants' motion is GRANTED, and Plaintiff's complaint is DISMISSED WITH PREJUDICE.


This suit is one of a growing number of actions stemming from the mutual fund industry's use of "shelf-space" arrangements. To understand the factual underpinnings of Plaintiff's claims, it is first necessary to understand the basic workings of mutual funds and shelf-space agreements.

A. Mutual Funds and Shelf Space Agreements

A mutual fund is a company created to allow individuals to invest in a range of financial products. See generally John P. Freeman, The Mutual Fund Distribution Expense Mess, 32 J. CORP. L. 739 (2006). Its assets consist of one or more investment portfolios, which may include stocks, bonds, or other securities. Ownership of a mutual fund is divided by shares, like a corporation, although its shareholders are more often referred to and thought of as investors. Also like a corporation, a mutual fund has a board of directors, which is supposed to represent and protect the interests of its shareholders.

Unlike corporations, however, which are run by their employees under the supervision of the board of directors, mutual funds are run by outside organizations. These outside organizations, called investment advisors, conduct the mutual fund's operations, such as selection of its investments. Usually, investment advisers are separate corporations, with their own shareholders and boards of directors.

This outsourcing of management creates a conflict of interest for the investment advisor. On one hand, the investment advisor is beholden to its own shareholders. On the other hand, the investment advisor is hired by the fund to serve the interests of its shareholders.

This conflict comes into focus upon consideration of the typical contract between a mutual fund and its investment adviser. The contract, under which the investment adviser promises its services to the mutual fund, typically provides for a fee in return to the investment adviser that is calculated as a percentage of the fund's net assets. Thus, investment advisers have an incentive to sell more shares of the fund, regardless of the return on the investments for the fund's existing shareholders.

This conflict of interest has spawned a recent wave of controversy over the mutual fund industry. Investment advisers, eager to sell more shares of their mutual funds to investors, are alleged to have devised methods of incentivizing securities brokers to prefer selling certain funds over other funds. These methods are generally referred to as "shelf-space" arrangements, analogous to the financial incentives that producers of consumer goods provide to retailers to obtain premium shelf space for products.

There are many opaque financial arrangements between investment advisers and brokers that can function as shelf-space arrangements, two of which are relevant here. First, the investment adviser, who selects investments for the fund's portfolio, may channel the trading necessary to obtain these investments to certain brokers, a practice called "directed brokerage." These brokers will receive the brokerage fees associated with the trades. In turn, the brokers will push certain mutual funds on their clients. Under these directed brokerages, funds may be utilizing brokers to trade their securities who do not guarantee the best market rate.

Second, investment advisers may pay brokers both brokerage commissions and research fees in one lump sum, a practice referred to as a "soft-dollar" payment. Given that the value of such brokerage and research fees together may be difficult to objectively value, soft-dollar payments allow investment advisers to pay brokers inflated fees and commissions, with the understanding that the soft dollars are purchasing not only trading and research, but also shelf space.

These shelf-space arrangements create at least one harm relevant here. As the funds' net assets grow, so do the fees that shareholders must pay investment advisers. Investment advisers can then pass some of these fees on to brokers, who will in turn continue to steer more investors toward purchasing the mutual funds. The mutual funds continue to increase in size, and the brokers and investment advisers will collect higher ...

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