Eastern District Of New York Dismisses Putative Class Action Regarding Mutual Fund Disclosures For Failure To Adequately Allege Misstatements And Omissions
On June 25, 2019, Judge Arthur Spatt of the United States District Court for the Eastern District of New York dismissed with prejudice a putative securities class action brought by investors in a mutual fund asserting violations of the Securities Act of 1933 (“Securities Act”) against the fund’s registrant, certain executives, investment advisor, and underwriter. Emerson v. Mutual Fund Series Trust, No. 2:17-CV-02565 (ADS) (GRB), 2019 WL 2601664 (E.D.N.Y. June 25, 2019). Plaintiffs alleged that the fund’s offering materials misrepresented that the fund was low-risk, when in fact it engaged in speculative investments that exposed the fund to substantial downside risk in rising markets. Id. at *1. The Court held that the complaint alleged “no actionable misstatements or omissions,” and dismissed the complaint with prejudice. Id. at *15.
Plaintiffs alleged that the fund sold uncovered call options in early 2017 as a directional bet that the S&P 500 would not rise significantly in value. When the S&P 500 rose dramatically during the first half of February 2017, the fund lost a significant portion of its value. Id. at *4. Plaintiffs further alleged that the fund’s strategy had rendered portions of its offering materials materially misleading, including in particular with respect to the fund’s “(1) stated objective of capital preservation and portrayal as a low-risk, low-volatility investment with low correlation to equity markets; (2) options strategies and risks; (3) purportedly robust risk management procedures; and (4) past performance.” Id. at *5. The Court concluded with respect to each category of statements that plaintiffs failed to identify any actionable misstatements or omissions.
First, the Court rejected plaintiffs’ argument that defendants misrepresented the fund’s investment strategy—by stating, for example, that its objective was “capital appreciation and capital preservation in all market conditions, with low volatility and low correlation to the US equity market,” and that the strategy was “designed to produce returns that are not correlated with equity market returns.” Id. at *15. The Court concluded that these statements “merely articulate[d] the goals of the Fund, rather than promise[d] a particular investment strategy.” Id. at *15. The Court also noted that, although the term “capital preservation” might connote that principal would be protected from loss, when combined with the term “capital appreciation,” it reflected “the aspiration of nearly all mutual funds”—to increase returns while avoiding losses. Id. Moreover, the Court pointed to risk disclosures regarding “upside risk” (i.e., losses in bull markets) and that the use of options meant there was risk based on the direction of the stock market. Id. at *16.
For similar reasons, the Court rejected plaintiffs’ argument that the use of uncovered call options rendered inaccurate a statement that the fund “places a strong focus on risk management that is intended to provide consistency of returns and to mitigate the extent of losses.” Id. at *21. The Court concluded that “[n]o reasonable investor would consider an abstract promise to mitigate losses, untethered from any specific form of hedging, material to their investment decision in light of the numerous [risk] disclosures.” Id.
The Court also rejected the argument that defendants falsely represented that the fund did not write uncovered call options. While noting that language in the fund’s risk disclosures regarding covered call options might imply that the fund did not write uncovered call options, and that this interpretation “may be reasonable in a vacuum,” the totality of the disclosures made clear that the fund could, and did, write uncovered call options. Id. at *17. In addition to risk disclosures regarding uncovered call options, the Court emphasized that the fund made quarterly disclosures reflecting “every single investment in its portfolio” and that “it was plainly apparent from these itemized lists that the Fund’s portfolio consisted of a significant number of uncovered call options.” Id. at *19. The Court rejected plaintiffs’ arguments that these quarterly disclosures were outside the total mix of information that would be considered by a reasonable investor, or that the investors could not reasonably understand how to interpret them; rather, the Court concluded that investors were presumed to have “the ability to be able to digest varying reports and data,” and defendants had no obligation to explain to plaintiffs how to read a detailed accounting of the fund’s portfolio. Id. at *20.
Last, the Court rejected plaintiffs’ argument that the fund’s prospectus misrepresented its past performance history by highlighting returns that pre-dated its existence as a mutual fund, from the period when the fund was structured as a hedge fund and had substantially fewer assets under management. Id. at *22. The Court held that the fund adequately disclosed the material differences between the fund’s prior operations and its current structure as a mutual fund, including the different legal requirements. Id. Moreover, while plaintiffs argued that the prospectus omitted how the mutual fund’s larger size limited its ability to execute its strategy, the Court held that plaintiffs’ theory went well beyond an omission and would require the fund to criticize its own strategy, which it had no duty to do. Id.
Despite dismissing plaintiffs’ claims for failure to allege any actionable misstatements or omissions, the Court addressed several remaining arguments. The Court rejected defendants’ argument that the complaint established a “negative causation” affirmative defense because plaintiffs could not show that their losses were caused by the alleged misrepresentations. Defendants argued, relying on In re State Street Bank and Trust Co. Fixed Income Funds Investment Litigation, 774 F. Supp. 2d 584 (S.D.N.Y. 2011), that because the share price of a mutual fund is calculated according to its Net Asset Value (“NAV”), alleged misrepresentations regarding a fund’s investment objective and holdings can have no effect on the fund’s share price; in other words, any decline in a mutual fund’s NAV would result solely from changes in the value of the fund’s underlying investments, not any of the fund’s statements or omissions. The Court, however, declined to follow State Street, instead concluding that, under the Second Circuit’s decision in Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005), plaintiffs had sufficiently alleged a causal connection between the purported misrepresentations and the decline in the fund’s NAV. Specifically, the Court reasoned that, under Lentell, an actionable loss can “be caused by the materialization of [a] concealed risk,” which constitutes a method of establishing loss causation that is distinct from disclosure of the risk. Id. at *24. Thus, even though “NAV appears to be the best vehicle for assessing the losses suffered by a mutual fund,” the “literal cause of an investor’s loss need not be the revelation of the misrepresentation to the market” as long as the loss resulted from the materialization of the concealed risk. Id. at *25-26. Here, therefore, defendants’ alleged misrepresentations regarding the composition of the fund’s portfolio did not need to cause a market reaction devaluing the fund; it was enough that plaintiffs alleged that defendants concealed the risk of the fund’s exposure to upward movements in the S&P 500.
The Court also concluded that plaintiffs failed to establish that the individual defendants were statutory sellers under Section 12 of the Securities Act, even though they had signed the fund’s registration statements. Id. at *28-29. Although some district courts within the Second Circuit have held that signing a registration statement is sufficient to allege solicitation, the Court sided with more recent decisions that have held—citing Courts of Appeals outside the Second Circuit, which has yet to address the issue—that merely signing a registration statement does not constitute solicitation for purposes of Section 12 of the Securities Act, in contrast to Section 11 which expressly imposes liability upon every signer of a registration statement. Id. at *28.