Federal District Court Rebuffs Mutual Fund’s Prospectus Liability

In a decision that could sharply curtail the potential liability of mutual funds and their advisers and directors for non-fraudulent prospectus misrepresentations, on March 31, 2011, the U.S. District Court for the Southern District of New York dismissed a putative class action arising out of the precipitous decline in the share price of a mutual fund during the 2007 and 2008 credit crisis. [1] The plaintiffs asserted claims under §§ 11 and 12(a)(2) of the Securities Act of 1933 (Securities Act), alleging that the prospectus for the SSgA Yield Plus Fund misrepresented the Fund’s exposure to mortgage-related securities.

The court rejected the plaintiffs’ claims on loss causation grounds. The measure of permissible damages under §§ 11 and 12(a)(2) is limited to the decline in a security’s value that results from the revelation of the artificial inflation of the security’s purchase price by a misrepresentation. Because the only price at which a mutual fund may sell or redeem its shares is determined by a statutory formula based on the net asset value (NAV) of the securities owned by the fund, prospectus misrepresentations cannot inflate a fund’s NAV nor, upon revelation, cause the NAV to decline. Accordingly, the court found that the plaintiffs’ complaint failed to allege the requisite loss causation and, therefore, dismissed the action with prejudice.

Background to the Lawsuit

In Yu v. State Street Corp., the plaintiffs alleged that their investment losses from investing in the SSgA Yield Plus Fund were caused by the materialization of a risk that the prospectus had misrepresented and concealed; namely, the Fund’s exposure to mortgage-related securities. The defendants moved to dismiss on various grounds, including that it was apparent from the face of the complaint that the plaintiffs could not recover their alleged losses due to the defendants’ loss causation defense.

The Yu Decision

The court rejected the plaintiffs’ loss causation theory and granted the defendants’ motion to dismiss. The court relied on the Second Circuit’s 2005 decision in Lentell v. Merrill Lynch & Co. [2] and the plain language of §§ 11 and 12. Lentell, which interpreted the loss causation requirement of § 10(b) of the Securities Exchange Act of 1934, recognized that a plaintiff’s losses could be caused by the “materialization of the concealed risk,” provided “that the misstatement or omission concealed something from the market that, when disclosed, negatively affected the value of the security.” [3]

After examining the plain language of §§ 11 and 12, the court concluded that the statutory remedy applies only if the prospectus misrepresentations inflate the market price of a security. When such misrepresentations are revealed, this statutory scheme contemplates that the market will correct the price of the security by eliminating the artificial inflation caused by the misrepresentation, resulting in a lower price. Loss causation thus requires a misrepresentation that artificially inflates a security’s share price by concealing a risk that is subsequently revealed, as well as a resulting correction and decline in that share price. As the court held, “[i]n this statutory scheme, it is crucial that there be a revelation of the concealed risk and that the revelation cause a depreciation in the value of the security.” [4]

In the case of a mutual fund, prospectus misrepresentations neither cause inflation of a fund’s NAV nor, when revealed, depreciation of a fund’s NAV. Therefore, loss causation cannot be established for claims against a mutual fund under §§ 11 and 12(a)(2). The court cited two Southern District decisions involving claims against mutual funds under §§ 11 and 12(a)(2) that reached similar loss causation conclusions. [5]

Equally significant, the Yu court rejected the plaintiffs’ reliance on three recent district court opinions involving §§ 11 and 12(a)(2) claims against mutual funds in which each district court had expressly rebuffed the loss causation defense that the Yu court found dispositive. [6] Schwab was the first of the three decisions, and Evergreen and Rafton expressly relied on the Schwab court’s analysis.

The Schwab court, which cited to Lentell’s “materialization of the risk” analysis, found that plaintiffs’ prospectus misrepresentation claims were sufficient to establish loss causation. [7] In addition, the Schwab court rejected the defendants’ loss causation defense on policy grounds because: “[d]efendants’ narrow formulation of loss causation would effectively insulate mutual fund companies from claims for a wide range of material misrepresentations regarding fund policies, risks and investment decisions.” [8] Similar policy concerns also were articulated by the courts in Evergreen and Rafton to reject the loss causation defense.

The plaintiffs in Yu relied on the loss causation theory in Schwab, invoking the “materialization of risk” loss causation theory endorsed in Lentell. Specifically, the plaintiffs argued loss causation was established because the fund misrepresented the composition of its portfolio, concealing the risk that the fund is not as diversified as the prospectus represented, and this risk later “materialized”, driving down the price of the fund shares, when the sector to which the fund was overexposed collapsed. [9] The Yu court rejected this reading of Lentell as “a bit too facile” because it omitted the second part of the Lentell inquiry; namely, whether the misrepresentation “concealed something from the market that, when disclosed, negatively affected the value of the security.” [10]

The Yu court also rejected Schwab, Evergreen and Rafton on the grounds that “these cases appear to be reasoning from effect to cause, as each begin their arguments about loss causation with a policy rationale” that determined the legal analysis – “i.e., that mutual fund issuers ought to be subject to private securities fraud claims, and any other construction would be ‘absurd’.” [11] Instead, the court found that it was bound by the plain language of the statutes, which restricts damages to depreciations in the NAV that result from the revelation of misrepresentations that previously inflated the NAV by concealing something from the market. [12]

Conclusion

Whether Yu and the strong loss causation defense it recognizes becomes the law of the land remains to be seen. The outcome of the current legal debate in the courts is significant for both investors and the wide array of persons potentially subject to the narrow but, nevertheless, unyielding demands of the Securities Act. Section 11 provides that every person signing a mutual fund’s registration statement (including the fund), every director or trustee of the fund, the fund’s executive officers, the auditors certifying the financial statements in the fund’s registration statement and the fund’s underwriter, may be liable for a prospectus misrepresentation. This potential strict liability – which requires neither an intent to defraud on the part of a defendant nor reliance on the misrepresentation by a plaintiff – counsels in favor of the strict loss causation defense recognized by the court in Yu.

The plaintiffs’ bar likely will continue to bring Securities Act claims against mutual funds and their advisers, at least until the federal appellate courts bring greater clarity to this loss causation issue. Moreover, in future litigation, the plaintiffs’ bar also may adopt additional pleading strategies, both creative and familiar, to hedge its bets. We will continue to report on developments in this important series of cases.

Endnotes

[1] Yu v. State Street Corp., No. 08 Civ. 8235, 2011 WL 1206070 (S.D.N.Y. Mar. 31, 2011).
(go back)

[2] 396 F.3d 161 (2d Cir. 2005).
(go back)

[3] Id. at 173.
(go back)

[4] 2011 WL 1206070, at *8.
(go back)

[5] In re Morgan Stanley Mutual Fund Sec. Litig., No. 03 Civ. 8208, 2006 WL 1008138 (S.D.N.Y. Apr. 18, 2006); In re Salomon Smith Barney Mutual Fund Fees Litig., 441 F. Supp. 2d 579 (S.D.N.Y. 2006). See also David M. Geffen, A Shaky Future For Securities Act Claims Against Mutual Funds, 37 Sec. Reg. L.J. 20 (2009).
(go back)

[6] See In re Charles Schwab Corp. Sec. Litig., 257 F.R.D. 534 (N.D. Cal. 2009); In re Evergreen Ultra Short Opportunities Fund Sec. Litig., 705 F. Supp. 2d 86 (D. Mass. 2010); Rafton v. Rydex Series Funds, No. 10-CV-01171-LHK, 2011 WL 31114 (N.D. Cal. Jan. 5, 2011).
(go back)

[7] See 257 F.R.D. at 547.
(go back)

[8] Id.
(go back)

[9] See 2011 WL 1206070, at *5.
(go back)

[10] 396 F.3d at 173.
(go back)

[11] 2011 WL 1206070, at *8.
(go back)

[12] The fund industry, of course, has been subject to investor claims and enforcement actions alleging prospectus misrepresentations under many other theories, including Rule 10b-5 under the Securities Exchange Act of 1934, provisions of the Investment Company Act of 1940 and various state laws.
(go back)