(Article from Securities Law Alert, July 2019)
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On June 25, 2019, the Eastern District of New York dismissed with prejudice a securities fraud action alleging misrepresentations in a mutual fund’s offering documents in violation of Sections 11 and 12(a)(2) of the Securities Act. Emerson v. Mutual Fund Series Trust, 2019 WL 2601664 (E.D.N.Y. 2019) (Spatt, J.). The court held plaintiffs failed to allege any material misstatements or omissions, and specifically found that statements concerning the fund’s investment strategy were inactionable. However, the court rejected defendants’ contention that plaintiffs could not satisfy the loss causation requirement for Securities Act claims because a mutual fund’s misstatements or omissions do not directly affect the fund’s net asset value (“NAV”). The court held that plaintiffs can rely on the “materialization of the risk” framework discussed in the Second Circuit’s decision in Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005), to demonstrate loss causation in Securities Act claims against mutual funds.
Statements Concerning the Fund’s Investment Goals Were Inactionable
Plaintiffs alleged that “[d]efendants misrepresented the [f]und as a low-risk investment” by describing the fund’s investment objectives as “capital appreciation and capital preservation in all market conditions” and characterizing the fund’s investment strategy as “market neutral.” Plaintiffs contended that these representations were misleading in view of “the [f]und’s significant investment in naked call options, which rendered the [f]und susceptible to large losses in rapidly rising markets.” The court found these statements inactionable “because they merely articulate the goals of the [f]und, rather than promise a particular investment strategy.” The court observed that the fund’s stated objectives were “to generate returns on investments while avoiding losses—the aspiration of nearly all mutual funds.” The court reasoned that it could not “fathom how any mutual fund could escape liability if such vacuous pronouncements became actionable simply because the [f]und suffered losses against its best wishes.”
A Reasonable Investor Considers the “Totality of the Disclosures” and Conducts Basic Mathematical Analyses of Financial Data
Plaintiffs also claimed that defendants misleadingly “conveyed that the [f]und did not write uncovered call options.” The court found that the statements at issue were not misleading “when read in conjunction with the totality of the disclosures in the Offering Documents.” The court noted that the offering documents were “replete with disclosures regarding the [f]und’s investment in uncovered call options and the associated risks.”
The court found it particularly significant that the fund “publish[ed] an itemized list of every single investment and option in the [f]und’s portfolio” on a quarterly basis. The court concluded that “a reasonable investor would have determined that the [f]und did not cover its written options with purchased options by simply comparing the two numbers” in the itemized list. The court explained that “[p]laintiffs cannot allege the [f]und failed to disclose its investment in uncovered call options when it could have ‘discovered’ the truth purely through simple arithmetic.” The court emphasized that “the Securities Act creates liability for misleading statements, not statements that an investor simply misunderstood.” The court observed that the “disclosure requirements are not intended to attribute to investors a child-like simplicity. Rather, investors are presumed to have the ability to be able to digest varying reports and data.”
The court found that disclosures concerning the fund’s writing of uncovered call options put plaintiffs on inquiry notice of their alleged claims for purchases made more than one year before they brought suit. Plaintiffs argued that the accrual of their claims was delayed by defendants’ reassurances concerning the fund’s capital preservation and risk mitigation strategies. But the court explained that “an investor may not reasonably rely on words of comfort from management when there are direct contradictions between defendant’s representations and the other materials available to plaintiffs regarding the possibility of fraud.” The court also found meritless plaintiffs’ argument that “determining whether a plaintiff had sufficient facts to place it on inquiry notice is often inappropriate for resolution on a motion to dismiss.” The court noted that the Second Circuit has “stated that courts can readily resolve the issue of inquiry notice as a matter of law on a motion to dismiss . . . where the facts needed for determination of when a reasonable investor of ordinary intelligence would have been aware of the existence of fraud can be gleaned from the complaint and papers . . . integral to the complaint.”
Plaintiffs Cannot Assert a Securities Fraud Claim Based Solely on the Ineffectiveness of Risk Mitigation Strategies
With respect to plaintiffs’ claims based on the fund’s risk management-related statements, the court found “the [f]und’s representations merely announced the goal of mitigating losses, rather than providing a guarantee that the [f]und would, in fact, avoid such losses.” The court explained that “[n]o reasonable investor would consider such an abstract promise to mitigate losses, untethered from any specific form of hedging, material to their investment decision” in light of the fund’s other disclosures. The court reasoned that plaintiffs “could perhaps allege a misrepresentation if the fund did not actually use” the risk management techniques it claimed to employ. But plaintiffs “cannot . . . recover simply because those methods failed to actually minimize losses to the [p]laintiffs’ satisfaction.”
Plaintiffs May Recover Losses in Mutual Fund Shares Under the Securities Act
The court then addressed the “economic reality” that “any decline in a mutual fund’s NAV would result solely from changes in the value of the mutual fund’s underlying investments, as opposed to any of the fund’s statements or omissions.” The court considered “what effect this economic reality has on a plaintiff’s ability to recover for Securities Act violations by mutual funds that implicate the principle of loss causation.”
In In re State Street Bank and Trust Co. Fixed Income Funds Investment Litigation, 774 F. Supp. 2d 584 (S.D.N.Y. 2011), the court dismissed Securities Act claims against a mutual fund for failure to plead loss causation. The court noted that Sections 11 and 12(a)(2) of the Securities Act “tie the recovery of a potential plaintiff to the value of a security.” The State Street court found that plaintiffs’ claims under Sections 11 and 12(a)(2) must be dismissed because “the NAV does not react to . . . any misstatements in the [f]und’s prospectus” and thus “no connection between [an] alleged material misstatement and a diminution in the security’s value ha[d] been or could be alleged.”
The Emerson court was “unwilling to concur with State Street” because the State Street court “effectively found mutual funds categorically exempt from liability for misrepresentations under the Securities Act.” 2019 WL 2601664. The court explained that “[i]f Congress intended such a sweeping loophole, it would have said so directly.” The Emerson court determined that “the most coherent way to address loss causation in the context of mutual funds would be through the ‘materialization of the [concealed] risk’ framework discussed in Lentell.” The court found that in the case before it, plaintiffs had adequately alleged “an at least plausible basis for defeating loss causation” by pleading that “the mutual fund issuer misrepresented the composition of the portfolio, concealing the fact that it had potentially unlimited exposure to rapid upward swings in the S&P 500.” The court explained that it could not say that “the revelation of the [f]und’s overinvestment in naked call options had no causal connection to decline in the [f]und’s NAV.”