Opinion
01 Civ. 8986 (HB).
January 3, 2005
OPINION ORDER
Pursuant to the Second Circuit's mandate, Nat. Investor Servs. Corp. v. Integrated Fund Servs., Inc., 85 Fed. Appx. 779 (2d Cir. 2004) (Summary Order), I write here, in accordance with the Circuit's direction, to supplement the record and expand upon one aspect of my prior holding in the Memorandum and Order issued following a bench trial in the above-captioned matter, TD Waterhouse Investor Servs., Inc. v. Integrated Fund Servs., No. 01 Civ. 8986, 2003 WL 42013 (S.D.N.Y. Jan. 3, 2003). For the reasons set forth herein and following an evidentiary hearing held on December 10, 2004, I adhere to my prior ruling that TD Waterhouse Investor Services, Inc.'s ("TDWIS") breach of contract claim fails because its actions in the underlying matter constituted an intervening cause that forecloses recovery.
Although Westlaw indicates that this Opinion was issued on January 6, 2003, in reality, the Slip Opinion was signed and dated January 3, 2003.
I. PRIOR PROCEEDINGS
A more detailed recitation of the facts, parties, and history of this litigation are set out in this Court's two prior Opinions, TD Waterhouse Investor Servs., Inc. v. Integrated Fund Servs., No. 01 Civ. 8986, 2002 WL 441123 (S.D.N.Y. March 31, 2002); TD Waterhouse Investor Servs., Inc. v. Integrated Fund Servs., No. 01 Civ. 8986, 2003 WL 42013 (S.D.N.Y. Jan. 3, 2003), as well as the Second Circuit Mandate, Nat. Investor Servs. Corp. v. Integrated Fund Servs., Inc., 85 Fed. Appx. 779 (2d Cir. 2004) (Summary Order).
Plaintiffs TDWIS, the shareholder servicer and administrator for TD Waterhouse Family of Funds, Inc. ("the Fund"), and National Investor Services, Corp. ("NISC"), the Fund's transfer agent, initiated this suit to recover damages for alleged breach of contract, breach of the duty of care, and breach of fiduciary duty claims against Integrated Fund Services, Inc. ("Integrated"), a company with whom TDWIS contracted to perform certain accounting and pricing services for the Fund. These claims arose out of Integrated's failure to accurately record the Fund's purchase of two bonds and resultant revenue stream from June 1998 through November 1999, which represented a total of approximately $3.8 million in under-accrued and undistributed income. As a result of the inaccurately reported income, TDWIS and NISC (collectively, "the plaintiffs") — who had a practice of waiving the administrative fees to which they were entitled so the Fund would perform competitively in the market — waived approximately $1.5 million in fees because they believed the Fund was under-performing when, in fact, Integrated had not accurately reported its performance. Eventually, as will be discussed in greater detail below, TDWIS decided not to recoup the waived fees from the Fund and instead issued a one-time distribution to shareholders. After Integrated refused to reimburse plaintiffs, TDWIS and NISC initiated this lawsuit.
On March 21, 2002, this Court granted in part and denied in part Integrated's motion for partial dismissal and dismissed all of NISC's claims. Shortly thereafter, this Court granted TDWIS' motion for leave to replead, and TDWIS filed an amended complaint, which resulted in the reinstatement of NISC's breach of the indemnification clause of the contract between TDWIS and Integrated. Following a bench trial and the submission of post-trial briefs, this Court issued a Memorandum and Order on January 3, 2003, in which this Court held that the plaintiffs failed to prove their claims. TD Waterhouse Investor Servs., Inc., 2003 WL 42013. With respect to TDWIS' breach of contract claim arising out of Integrated's alleged failure to accurately calculate and report the Fund's portfolio — the only claim at issue here — this Court ruled that this claim suffered from a causal defect that prevented the recovery of either general or consequential damages. Id. at *9, 10. This ruling was based on the Court's view that TDWIS' decisions with respect to the fees — first to waive them and later not to recoup them — were voluntary business decisions that were made independently of Integrated's accounting error. Id. at *7, 8, 9. Moreover, this Court held that the waived fees were not within the contemplation of the parties, another pre-requisite to the recovery of consequential damages. Id. at *10.
TDWIS filed a timely appeal, which it limited to the dismissal of its breach of contract claim discussed above with respect to the fiscal year 1999. The Second Circuit affirmed in part and reversed in part. Nat. Investor Servs. Corp., 85 Fed. Appx. 779. The Second Circuit agreed that the damages sought here were "not the natural result of the breach," and thus not recoverable as general damages. Id. at 781. However, the Second Circuit disagreed with respect to consequential damages and ruled that these damages were indeed within the contemplation of the parties and TDWIS' waiver of the fees was not an intervening cause. Id. The Second Circuit was unable to review this Court's decision that TDWIS' failure to recoup the fees after it discovered Integrated's error was an intervening cause because it needed additional factual findings and a clarification of this Court's ruling on this score. Id. at 782. Specifically, the Second Circuit ordered this Court supplement the record with respect to: (1) the structure and governance of TDWIS and the Fund and the relationship between the entities; (2) whether TDWIS has a contractual right or other legal basis to recoup the waived fees directly from the Fund; and (3) the manner by which the decision not to recoup the fees was made and whether the Funds' auditors and/or independent directors were involved in that decision. As set out in United States v. Jacobson, 15 F.3d 19, 21-22 (2d Cir. 1994), the Circuit panel retains jurisdiction over any claims that may arise from this Court's supplemental findings and clarification of its earlier ruling.
To assist this Court with its task on remand, the parties submitted a Joint Submission of Agreed Statements of Fact ("JSASF") and each side submitted proposed supplemental findings of fact. Upon review, it became evident that these submissions were inadequate to answer the questions posed by the Circuit and therefore this Court held an evidentiary hearing on December 10, 2004. The discussion that follows sets out the findings of fact and conclusions of law for which this case was remanded based upon the existing record, the parties' submissions, and the recent evidentiary hearing.
II. FINDINGS OF FACT
A. Structure of the Fund and Related Entities
All of this information is as of the timeframe in question, i.e., June 1998 through December 1999, the time during which Integrated made its accounting error, that error was discovered, the shareholder distribution was made, and the Fund's Board ratified that decision.
The Fund is "an open-end, diversified management investment company known as a money market mutual fund." (JSASF ¶ 4.) The Fund is a Maryland corporation and is an investor company registered under the Investment Company Act of 1940. (12/10/04 Hearing Transcript ("Hr. Tr.") at 12:6-14.) In 1998 and 1999, the Fund had three money market portfolios, one of which, the Money Market Portfolio, maintained a stable net asset value of $1.00 per share. (JBASF ¶ 4; Hr. Tr. at 12:17-24.) The shares of the Money Market Portfolio are registered under the Securities Act of 1933. (Id. at 12:25-13:2.) During the 1999 fiscal year, which ended on October 31, 1999, id. at 11:25-12:2, the Fund had four directors: George Stauder, Richard Dalrymple, Caroline Lewis, and Lawrence Toal, id. at 13:9-12; Def. Ex. T at 2. Of the four, only George Stauder was an interested director; the remaining three were independent directors. (Hr. Tr. at 13:25-14:4, 14:13:15.) The three independent directors comprised the Fund's Audit Committee. (Pl. Ex. 21 at 1.) The 1999 Annual Report further identifies TDWIS as the Fund's administrator and shareholder servicer, Ernst Young LLP as the Fund's independent auditors, and Swidler Berlin as the Fund's Legal Counsel. (Def. Ex. T at 2.) The Fund's investment manager was TD Waterhouse Asset Management, Inc. ("TDWAM"), a Delaware corporation and registered investment advisor under the Investment Advisors Act of 1940. (Hr. Tr. at 17:2-4; Def. Ex. P at 24.) As the investment manager, TDWAM "manages the money for the money market portfolio." (Hr. Tr. at 16:25-17:1.) TDWAM and TDWIS, as their names suggest, as related entities. TDWIS is a wholly owned subsidiary of Waterhouse Investor Services, Inc. TDWAM is a wholly owned subsidiary of Waterhouse National Bank, which is a wholly owned subsidiary of Waterhouse Investor Services. (Def. Ex. II; Def. Ex. P at 24.)
B. TDWIS and the Fund
Beginning in 1996, the Fund contracted with TDWIS to serve as the Fund's administrator and shareholder servicer. (Id. at 18:18-21; Def. Ex. JJ; JSASF ¶ 9.) This contract, the Shareholder Services Agreement for Waterhouse Affiliated Brokers/Dealers, provides, inter alia, that TDWIS was entitled to receive the fees described in the Fund's Shareholder Servicing Plan. (Def. Ex. JJ at 2.) The Shareholder Servicing Plan provides that TDWIS' servicing agent's fee would be computed monthly "at an annual rate of up to .25% of the average daily net asset value of the Fund shares beneficially owned or attributable to such clients." (Id. at 5.) In other words, TDWIS was entitled to receive "shareholder servicing fees from the mutual fund company in an amount up to .25[%] of the net assets of the [F]und." (Hr. Tr. 23:1-2.) In addition, TDWIS was entitled to be paid an administrator's fee by the Fund in the amount of .10% of the average daily net assets of the Fund's Money Market Portfolio. (JSASF ¶ 14.)
C. The Decision Not to Recoup the Fees
Unfortunately, the proceedings in this case, even when supplemented by the evidentiary hearing after remand, have produced only a patchwork of vague and contradictory statements regarding TDWIS' decision not to recoup the waived fees from the Fund. Here I have attempted to piece together these fragments to provide a picture of what most likely occurred.
Sometime after Integrated's error was discovered, representatives of TDWIS and TDWAM, together with the Fund's counsel, counsel to the independent directors of the Fund, and the auditors, among others, discussed possible solutions on several occasions. (A314 at 49:12-14; A166 at 64:20-A167 at 65:5; A141 at 26:13-15, 26:2-20.) Ultimately, "a collective decision" was reached "based on all the facts and understanding of the issues involved." (A324 at 89:12-13.)
Page numbers beginning with "A" correspond to pages of the Appellate Appendix.
After this decision was made and the supplemental shareholder distribution was effectuated on November 29, 1999, Michelle Teichner ("Teichner"), the Senior Vice President of Operations and Compliance for TDWAM, A307 at 23:18-A308 at 24:14; Def. Ex. T at 2, informed the Fund's Audit Committee of the accounting error on December 8, 1999, Pl. Ex. 21 at 1, 2 (counting, bates # TD 0111, TD 0113). George Stauder, the only interested director, was also present at the Audit Committee meeting, as were a variety of professionals that serviced the Fund and related entities. (Pl. Ex. 21 at 1.) The Audit Committee discussed the issue both with and without the presence of management. (Id. at 5-6.) The Audit Committee was not, however, presented with a variety of solutions and input in order to make a decision. It did not actively serve to mediate the conflict or decide the best course of action. Instead, David Hartman ("Hartman"), Senior Vice President of TDWAM, A152 at 5:14-18, informed the Audit Committee that it was not necessary to reissue financial statements, that the shareholders had not been harmed because TDWIS waived its fees, and that "management concluded that the optimal method of distributing the under-accrued income was . . . to make a one-time lump sum distribution to shareholders in the full amount of the under-accrued income." (Id. at 2, 3 (counting, bates # TD 0113, 0114).) In the closed session without management, a representative of Ernst Young reported that management had contacted the auditors promptly and cooperated fully with them to resolve the problem. (Id. at 4, 5 (counting, bates # 0115, 0116).) Later that morning, the full Board met and ratified the shareholder distribution. (Pl. Ex. 20 at 8 (counting, bates # TD 0136).) The December 8, 1999 meetings were the first time that any member of the Board learned of the accounting error. (Hr. Tr. at 26:24-27:17.)
In November 1999, Teichner was employed by both TDWAM and TDWIS. (Hr. Tr. at 11:4-7.)
III. CONCLUSIONS OF LAW
Both on appeal and on remand, TDWIS has attempted to cast the shareholder distribution as its only available option. TDWIS has asserted that it was forced to distribute the unreported income in its entirety to shareholders because it had no contractual or other legal right to the waived fees. There is some evidence in the record that supports this position, though it consists only of a few short sentences of conclusory opinions with no reasoning. Margery Neale, Esq. ("Neale"), for example, who represented the Fund, A135 at 3:10-4:22, as well as TDWAM and TDWIS in connection with her activities with the Fund, A136 at 5:2-10, opined that "there was no contractual right to the payment," A324 at 90:11-12. Likewise, Teichner testified at the evidentiary hearing it was her understanding, based on Neale's advice, that TDWIS had no contractual or legal right to the waived fees. (Hr. Tr. at 36:19-24.) These opinions, however, are belied by the other statements by these very same witnesses. For example, at trial Teichner testified that the decision to make the shareholder distribution was a "business decision to avoid any sort of reputational damage" that was "based on not taking an aggressive legal stance." (A314 at 50:2-7.) Similarly, when Neale was pressed on the issue, she explained that TDWIS opted for "the most conservative course of action," and that an attempt to recoup the fees was the "more aggressive stance," which could have prompted an SEC investigation due to TDWIS' or TDWAM's failure to properly oversee the accounts during the 18-month period during which Integrated's accounting error went unnoticed. (A325 at 92:3-19.) In the last analysis, Neale conceded that the decision not to recoup the fees was "a business decision, based on lawyer's advice, generally, that the cost on the one hand and the cost on the other and that the safer course was to make the payment." (A326 at 96:4-7.) Credibility is obviously for the trial Judge to assess and here neither Neale or Teichner come out smelling like a rose.Further, even if we put credibility aside, Neale's proffered rationale for the lack of a contractual right to payment for the waived fees does not withstand scrutiny. According to Neale, "all of the service providers in question were affiliates of the investment advisor, and under the Investment Company Act there were all kinds of prohibitions and restrictions on the ability to make payments to affiliates of [the] investment advisor." (A324 at 90:4-8.) Yet, as set out earlier, TDWIS was indisputably entitled to be paid by the Fund for its shareholder servicing and administrative services notwithstanding the fact that it was an affiliated entity. It is unclear what altered Neale's view on the Fund's ability to pay affiliated entities. If the sudden appearance of some $3.8 million of previously unreported income created a conflict of interest that did not previously exist, it would seem that this is precisely the situation where the Audit Committee and independent directors should have been called upon to intervene, particularly since one of the independent directors, Carolyn Lewis, "spent over 30 years at the . . .SEC in various positions including Senior Financial Analyst, Branch Chief and Assistant Director," Def. Ex. P at 22.
Neale further opined that it would be difficult to get the Board to agree that TDWIS was entitled to recapture the waived fees when TDWIS "originally . . . had a contractual right to certain payments, but voluntarily made the decision to waive that money." (A325 at 94:18-20.) Nonetheless, Neale testified that it was possible the Board would approve payment of the fees given that such a large sum of unaccrued income had been discovered. (Id. at 94:4-7.) Inexplicably, no one from TDWIS, TDWAM, or the Fund bothered to contact the Board on this score either. Indeed, the Board was not even informed of the accounting error until after the shareholder distribution had been decided upon and executed.
Further reinforcing the voluntary nature of TDWIS' decision not to recoup the fees is the December 16, 1999 memorandum from Hartman to Countrywide Fund Services, Inc. ("Countrywide" or "CFS"), Integrated's predecessor, in which he noted that the supplemental distribution to shareholders was the "optimal method" of distributing the income and the "most prudent" course of action. (A471-472, Pl. Ex. 22 at 1, 2.) This memorandum indicates that TDWIS decided not to deduct the excessively waived fees from the shareholder distribution because this would necessitate the issuance of new financial statements and would require the approval of the Fund's Board and its independent directors. (A472, Pl. Ex. 22 at 2.) Again, there is no indication that this topic was ever broached with the Board.
Hartman's memorandum also sets out that a representative of Countrywide had informed TDWIS that the waived fees could be reimbursed via Countrywide's insurance policy. (Id.) This, it seems, provided a readily available source of payment while enabling TDWIS to take a more conservative approach to the waived fees. TDWIS apparently then adopted the view that Countrywide and/or Integrated should pay for the waived fees because they made the original accounting error. This view is embodied in a handwritten note on Teichner's letterhead, which reads:
no opinion necessary — business decision to pay shareholders best course of action now may not be best course of action later in the future. Don't want to be "tied" in the future. CFS made the error, their problem. They should take responsibility for the error.
If insurance not enough to cover , not our problem.
Just compensate for the error
did not pay ourselves back — given our business + reputation not comfortable keeping money
Not prepared to take bus. risk (taking our fees, SEC would not be comfortable w/this option) to pay for their mistake
(A719, Def. Ex. Q.)
Certainly, Integrated's accounting error does not rank among the best practices, but there also remains the issue — to which Neale herself alluded — that this error went unnoticed by the Fund, TDWAM, or TDWIS for a year and a half. Yet, TDWIS insisted that Integrated recompense it for all of the waived fees when, in reality, there were a variety of solutions to the $3.8 million quandary. TDWIS simply expected Integrated's insurance to cover the loss so it could safeguard its reputation and pursue the most conservative course.
Finally, the theory that TDWIS now advances with respect to its legal entitlement to the waived fees cannot be squared with the Shareholder Service Agreement, which authorized payment to TDWIS, and the pleadings in this case. In both the Complaint and Amended Complaint, TDWIS averred that it did not seek reimbursement for the waived fees directly from the Fund because of the need to avoid "severe reputational damage" and "regulatory problems with the Securities and Exchange Commission ("SEC"). (Compl. ¶ 1.) Indeed, in its description of the decision not to recoup the fees directly from the Fund, TDWIS alleged that it "carefully considered and determined not to attempt to recover the waived fees from the Portfolio" and "decided that the most prudent course of action was to distribute the full amount of under-accrued income to the Portfolio's shareholders, without attempting to assert a claim for the waived fees." (Id. ¶¶ 15, 16.) This decision was based on TDWIS' belief that the cost of an SEC inquiry and the potential reputational damage, though difficult to quantify, "would exceed the amount of the waived fees." (Id. ¶ 15.) Neale testified at her deposition that she read the pleadings in the case and gave comments upon them. (A143 at 33:16-25.) She did not believe that there was anything inaccurate about these statements. (Id.) Moreover, these allegations were repeated for a second time, in sum and substance, in TDWIS' amended pleading. (1st Am. Compl. ¶¶ 1, 17, 18.) Notably, at no time did anyone from the Fund, TDWAM, or TDWIS ever attempt to contact the SEC to inquire about how best to handle the discovery of unreported income or whether payment to TDWIS would create problems. (Hr. Tr. at 29:20-30:3.)
In light of all of the evidence, it is beyond peradventure that TDWIS' failure to recoup or even attempt to recoup the unnecessarily waived fees constituted an intervening cause that prevents any recovery on its breach of contract claim. TDWIS' decision to distribute the entire amount of the unreported income to the Fund shareholders was a voluntary business decision that it made without consultation with the Board, the independent directors, or any regulatory authorities. Instead, the officers and service professionals of the Fund, TDWAM, and TDWIS weighed the costs and benefits of each possible solution. TDWIS cannot now foist the cost of this decision upon Integrated. In sum, TDWIS has not demonstrated with certainty that the damages it allegedly incurred were caused directly by Integrated's accounting error and were not the result of its independent business decision to forgo any attempt to recapture the waived fees from the unaccrued income.
On remand, TDWIS argues that once it established Integrated's breach, i.e., its accounting error, Integrated had the burden of proving that TDWIS' failure to re-coup the fees was an intervening cause. I adhere to my prior ruling on this score as well. As I previously held, it is TWDIS' burden to "demonstrate with certainty that the damages were caused by the breach directly and were neither remote nor the result of intervening causes." TD Waterhouse Investor Servs., Inc., 2003 WL 42013, at *10 (citing Kenford Co., Inc. v. Erie County, 67 N.Y.2d 257 (1986)). The Second Circuit was not bashful in remanding certain aspects of my initial decision. I am quite sure that had it believed I erred with respect to the burden of proof, the Circuit would have let me know. Indeed, the Second Circuit recently clarified that an intervening cause is not an affirmative defense, but rather, proof of the lack of an intervening cause is part and parcel of the causation element — a "crucial component" of a plaintiff's prima facie case. Nat. Mkt. Share, Inc. v. Sterling Nat. Bank, ___ F.3d ___, No. 04 Civ. 1206, 2004 WL 2965964, at *5 (2d Cir. Dec. 23, 2004). In so holding, the Second Circuit expressly rejected the case law upon which TDWIS relied in arguing that Integrated had the burden to prove the existence of an intervening cause, Haven Assoc. v. Dorno Realty Corp., 503 N.Y.S.2d 826 (2d Dep't 1986). Id. at *6. In any event, in this particular case it matters not who precisely shoulders the burden of proof, as the issue of intervening cause is not even a close call.
IV. CONCLUSION
For the foregoing reasons, I adhere to my prior ruling that TDWIS' breach of contract claim suffers from a fatal causal defect and must therefore be dismissed. The Clerk of the Court is instructed to close this case and remove it from my docket.SO ORDERED.