In this appeal we consider the adequacy of a brokerage firm's disclosures to its clients. Appellants claim that they were injured when the broker switched their money market "sweep" account to a new fund without fully disclosing that the firm was benefitting from the transfer. The Court of Chancery dismissed the Amended Complaint, finding that the prospectus and notification letter "strongly implied" the nature of the broker's interest, and holding that the disclosures were adequate as a matter of law. We disagree. The implications to be drawn from the disclosures are not obvious and, even if they were, implications rarely suffice as substitutes for express statements of fact. The Court of Chancery erred in deciding this mixed question of fact and law without an evidentiary record. Accordingly, appellants' state law claims must be reinstated.
I. Factual and Procedural Background
Patrick and Leatha O'Malley maintain an account with Everen Securities, Inc., a full services brokerage firm. Before November 1996, one of the services Everen provided was money market sweep accounts managed by Zurich Kemper Investments, Inc. Everen linked the customers' brokerage accounts to the sweep accounts, and any cash in the brokerage accounts periodically was "swept" into the designated Kemper fund. As a result, the customers were assured that their money was earning interest when not invested in securities.
Everen's choice of money market funds for its sweep accounts changed after it, and related companies, entered into a joint venture agreement (the "JVA") with Mentor Investment Group, Inc. and its affiliates (collectively "Mentor") to manage certain Mentor funds. Under the JVA, in exchange for a 20.2% interest in the venture, Everen agreed to transfer its clients' sweep accounts to money market funds managed by Mentor. Everen's interest in the venture could increase to as much as 50% depending on the extent to which Everen's customers invested in Mentor funds.
By letter dated September 23, 1996, Everen notified its customers that, unless instructed to the contrary, it would switch their sweep accounts to funds managed by Mentor on November 1, 1996. Everen sent a prospectus for the Mentor money market funds with the so-called "negative response" letter. Neither document explained how Everen acquired its interest in the venture, and the O'Malleys did not object to the switch.
The O'Malleys allege that they would not have approved the switch had they known that Everen was using the transfer of its customers' assets to acquire its 20.2% interest in the venture. The Amended Complaint alleges that Everen and its directors breached their fiduciary duties of disclosure and loyalty by acting
A. Federal Preemption
Before considering the O'Malleys' state law claims, we must address the question of federal preemption. Under the Supremacy Clause of the United States Constitution,
The Securities Exchange Act of 1934
For support, appellees primarily rely on Guice v. Charles Schwab & Co.,
We find no conflict preemption here because full disclosure of Everen's interest in the Mentor funds would not interfere with the purpose or effectiveness of the NASD rule allowing negative response letters. The NASD rule addresses a problem in obtaining customer authorizations. Brokers generally must obtain written authorization from their clients before making discretionary transfers.
B. Fiduciary Duty Claims
The relationship between a customer and stock broker is that of principal and agent.
In this case, the O'Malleys gave their agent relatively little discretionary authority, but the choice of sweep account funds was an investment decision that Everen made for its customers. As such, it is a decision for which Everen is accountable under fiduciary standards. The O'Malleys allege that Everen and its directors breached their duty of loyalty by switching the sweep account funds for Everen's benefit. They allege that their failure to object to the switch does not constitute consent because they were not told how Everen acquired its interest in the venture with Mentor. This lack of information also forms the basis for the O'Malleys' claim that Everen and its directors breached their fiduciary duty of disclosure. The O'Malleys' remaining claims, against Mentor and affiliates, are for aiding and abetting Everen's alleged breaches of fiduciary duty.
Each of these claims directly or indirectly turns on the adequacy of Everen's disclosures
The Court of Chancery found that this language adequately discloses the nature of Everen's interest in the Mentor venture since it explains that Everen's ownership will increase if its clients increase their investment in Mentor. In other words, Everen will benefit from bringing its customers to Mentor. The prospectus does not discuss what Everen contributed in exchange for its initial 20.2% share in the venture, but the Court of Chancery apparently found that omission to be immaterial because the equity-for-customers arrangement was strongly implied.
It is settled law in the corporate context that directors must disclose all material facts when seeking stockholder action,
We adopt this standard, which is consistent with the "full disclosure" mandated for agents, to evaluate the O'Malleys' disclosure claims.
The omitted information, in this case, is the fact that Everen paid for its interest in the venture by agreeing to transfer its clients' accounts to Mentor funds. The significance of that omission depends, in part, on the information that was disclosed — that Everen had a 20.2% interest in the venture at the outset and that Everen's interest would increase with any increase in the amounts that Everen's customers invested in Mentor funds. The question is whether reasonable investors, knowing that Everen stood to profit from the switch in sweep account funds, would consider it important to know what Everen exchanged for its initial share in the venture. If they would, the remaining question is whether something less than a direct statement of the material facts satisfies a broker's fiduciary duties to its customers.
On the first question, we are satisfied that the claim withstands a motion to dismiss. The determination of materiality is a mixed question of fact and law that generally can not be resolved on the pleadings.
Assuming for present purposes that the information about Everen's investment in Mentor is material, the remaining question is whether anything less than express statements of fact will satisfy the fiduciary duty of full disclosure. The Court of Chancery found that, from the information that was disclosed, a reasonable investor could not miss the point that Everen was using its customer base to participate in the venture with Mentor. We think 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 relating to the transaction at issue. While there may be cases where the disclosures are adequate because the undisclosed information inescapably follows from the disclosed facts, this is not such a case. The disclosures about Everen's interest in Mentor leave open at least two reasonable possibilities as to how Everen acquired its interest — by investing its own money or by transferring its clients' money. Under these circumstances, the information about how Everen acquired its interest in Mentor cannot be deemed to have been disclosed. Accordingly, the O'Malley's disclosure claim must be reinstated.
Our decision on the disclosure claim controls all the remaining state law claims. The duty of loyalty claim was dismissed on the theory that the O'Malleys consented to the switch in sweep accounts after full disclosure. If their consent was invalid because it was based on inadequate disclosures, their duty of loyalty claim remains. Similarly, the aiding and abetting claims were dismissed because there were no underlying breach of fiduciary duty claims. With the restoration of the breach of fiduciary duty claims, the aiding and abetting claims also must be reinstated.
Based on the foregoing, the decision of the Court of Chancery dismissing the state law claims for breach of fiduciary duty and aiding and abetting breaches of fiduciary duty is reversed and the matter is remanded for further action in accordance with this opinion. Jurisdiction is not retained.