The Future of Claims Against Mutual Funds

This post comes to us from David M. Geffen of Dechert LLP.

My recent article, “A Shaky Future for Securities Act Claims Against Mutual Funds“, considers the liability of mutual fund issuers under §§ 11(a) and 12(a)(2) the Securities Act.

In a Securities Act § 11(a) or § 12(a)(2) action, a plaintiff complains of a materially misleading statement (misstatement) in an issuer’s registration statement (prospectus). In the article, I explain why a mutual fund issuer, by establishing a loss causation defense, should prevail in defending these actions. For a mutual fund, establishing a loss causation defense is straightforward, and a mutual fund can defeat § 11(a) and § 12(a)(2) claims at the pleading stage of a lawsuit.

Courts have described an issuer’s liability under § 11(a) and § 12(a)(2) as “strict” or “near-strict.” Therefore, the regular and successful deployment of loss causation defenses by mutual funds marks a significant change. In effect, mutual funds are largely and, perhaps, wholly insulated from Securities Act § 11(a) and § 12(a)(2) claims.

In Parts I and II of the article, I describe the elements of claims under § 11(a) and § 12(a)(2) in the context of mutual funds, including the price-depreciation measure of damages in both statutes.

The article’s core analysis is contained within its Part III, where I explain why, for a mutual fund, establishing a loss causation defense is straightforward. Unlike a security traded on an exchange, the price of a mutual fund share is calculated each day according to a statutory formula that relies on the market value of the portfolio securities owned by the fund. Shares are offered for sale by the fund continuously at each day’s calculated price and redeemed by the fund, when a fund shareholder chooses, at that day’s calculated price. There is no secondary market for a mutual fund’s shares.

Accordingly, there is no mechanism for a misstatement in a mutual fund’s prospectus to affect a fund share’s price and, therefore, there is no mechanism for a misstatement or its revelation to cause a plaintiff’s losses. Because changes in a fund share’s price cannot be caused by a prospectus misstatement, a mutual fund defendant can prevail by establishing the loss causation defense permitted by § 11(e) or § 12(b). The defense simply is that any misstatement identified by the plaintiff could not cause the fund share’s price to depreciate and, therefore, did not cause the plaintiff’s losses.

If that outcome seems harsh, consider that the justification for liability without reliance under § 11(a) and § 12(a)(2) is that a misstatement causes the market to overestimate the value of a security. A purchaser is harmed by the misstatement, even if he did not rely on it, because the market price is inflated by the misstatement. However, Congress did not consider how § 11(a) and § 12(a)(2) should apply to mutual funds. This includes considering that neither price inflation nor overpayment occurs when an investor purchases shares of a mutual fund while the fund’s prospectus contains a misstatement. Thus, price inflation and overpayment, which justify liability without reliance for non-fund issuers, do not justify similar liability for mutual funds.

Part IV presents the practical implications if plaintiffs cannot succeed against a mutual fund under § 11(a) and § 12(a)(2). A plaintiff’s inability to make out a claim under § 11(a) and § 12(a)(2) should deter plaintiffs from instigating lawsuits under the Securities Act against mutual funds based on prospectus misstatements. Plaintiffs may be relegated to claims under Rule 10b-5, the Investment Company Act and state law.

Part V of the article discusses the reported decisions, beginning in 2003, in which a court relied on the same conclusions in Part III to dismiss § 11(a) or § 12(a)(2) claims against mutual funds.

Due to the increased ease with which a fund could escape liability under § 11(a) or § 12(a)(2), plaintiffs and some courts may seek to reject the article’s core analysis. For this reason, in Part VI of the article, I present the counterarguments on which such plaintiffs and courts probably would rely to reject the article’s core analysis as a means to deprive a fund of a loss causation defense.

One such counterargument is that Rule 10b-5 contains a loss causation requirement and, in suits under Rule 10b-5, an expansive loss causation test applies to fraudulent misstatements. Accordingly, the argument goes, the courts should show similar flexibility for purposes of loss causation under § 11(a) and § 12(a)(2). Here, Part VI proved prescient because a recent district court opinion, In re Charles Schwab Corp. Sec. Litig., 2009 WL 262456 (N.D. Cal. Feb. 4, 2009), rejected a fund’s loss causation defense by relying, without explanation, on Rule 10b-5’s expansive loss causation test.

Part VI presents the counterarguments and, then, explains why each counterargument is an insufficient basis to reject the article’s Part III core analysis as a means to deprive a fund of a loss causation defense.

The article, which appears in the Spring edition of the Securities Regulation Law Journal, is available here.

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