The U. S. District Court for the Southern District of New York (the “Court”) granted a motion to dismiss a class action lawsuit filed by mutual fund investors against the sponsor and investment adviser of the fund, certain executives of the investment adviser and the fund’s trustees asserting fraud and misrepresentation claims under Sections 11 and 12(a)(2) of the Securities Act of 1933 and control person liability under Section 15 of that Act. The plaintiffs alleged that the defendants misrepresented the nature, extent and consequences of the fund’s investments in mortgage-related securities. The Court granted the defendants’ motion to dismiss the plaintiffs’ amended complaint because it failed to plead actionable material misrepresentations in the fund’s offering documents.
Background. During the period between July 2005 and May 2008, the fund’s net asset value (“NAV”) fell 34%. According to the complaint, the decline was due to large write‑downs to the value of the fund’s mortgage-related holdings. The fund was ultimately liquidated on May 30, 2008. The plaintiffs’ complaint alleged that the fund’s offering documents mislead investors in three ways: (i) a misleading description of the fund’s investment strategy; (ii) misrepresentation of the extent of the fund’s exposure to mortgage‑related securities; and (iii) inflated valuations of the fund’s mortgage-related securities, which led to overstatements of the fund’s NAV.
The Court’s Findings.
Fund Description. The fund’s prospectus described its non-fundamental investment objective as to “seek high current income and liquidity by investing primarily in a diversified portfolio of high-quality debt securities….” The plaintiffs alleged that this description was materially false because the fund was invested primarily in risky mortgage‑related investments. The Court found that the complaint did not adequately plead falsity.
In reaching its conclusion, the Court compared and contrasted the investment objective of the fund to the investment objective of a money market fund included in the same prospectus, which had an objective to maximize current income to the extent consistent with the preservation of capital and liquidity. The Court noted that the two descriptions that appeared near to each other indicates that the “high-quality” language cannot be read as an implicit representation that the fund posed little or no risk. The Court interpreted “high-quality” to mean a description of the related credit grade of the fund’s holdings and cited disclosure in the fund’s prospectus that described the holdings as 80% rated in the two highest Standard & Poor’s rating categories, “AAA” or “AA.” The Court found that the fund’s portfolio complied with the description of the fund’s investment objectives and the nature of its securities and that the complaint made no factual allegations about the fund’s mortgage-related holdings. For example, the complaint did not include other facts by which the quality of the mortgage-related securities might be judged or allege that the fund’s holdings fell within a “low-quality” subset of the mortgage-related sector.
The plaintiffs alleged that the “high-quality” description conflicted with contemporaneous market information about the developing subprime mortgage crisis. The Court stated that the accuracy of the statements must be assessed in light of information available at the time the documents were published. At a minimum, the Court stated that the complaint must plead facts to demonstrate that the alleged omitted facts both existed and were knowable at the time of the offering.
The Court stated that even assuming that the allegations show that the fund’s reference to “high-quality … investment grade debt instruments, such as mortgage‑related securities,” to be false, the plaintiffs failed to allege that the general statement was material within the context of the totality of the information available in the prospectus and marketplace. The Court stated that the plaintiffs could not claim that the defendants misled them as to information readily available in the public domain.
Exposure to Mortgage-Related Securities. The plaintiffs alleged that the fund’s offering documents misrepresented the extent to which the fund invested in mortgage‑related securities. The fund’s annual report disclosed the percentage of the fund’s portfolio securities that was comprised of “asset-backed securities,” “mortgage-backed securities” and “international debt.” The complaint stated that some of the mortgage-related securities were incorrectly characterized as asset-backed securities. The Court noted the defendants’ definition of “mortgage-backed securities” included in the prospectus as instruments backed by first mortgages or first deeds of trust, therefore, implicitly, excluding other types of mortgage-related instruments from the mortgage-backed securities category.
The Court found that the annual report’s percentage breakdown appeared to be accurate because the mortgage-backed securities category, consistent with the definition in the prospectus, did not include all mortgage-related securities. The Court also noted that the complaint did not plead that the misrepresentation was material. A claim under Section 11 and 12(a)(2) must plead materiality of the alleged misrepresentation or omission. To be material, the Court noted that the complaint should have included information about the “miscategorized” securities to show that the table, describing the percentage of holdings in the various categories, distorted the fund’s risk profile or that its inaccuracy would have otherwise been significant to a reasonable investor deciding how to act. Because the plaintiffs did not allege facts sufficient to plead that the categorizations were materially misleading, the Court stated that the claim must be dismissed. The Court also noted that the table in question was not prominently displayed and that detailed schedules for each category included the names of the securities. Given the total mix of information, the Court did not think that a reasonable investor would believe that the “mortgage-backed securities” category represented the extent of the fund’s mortgage holdings. Even if the table was inaccurate in isolation, the Court found that the inaccuracy was immaterial as a matter of law.
- Inflated Valuations of Mortgage-Related Securities. The plaintiffs alleged that the fund overstated the value of its mortgage-related holdings, which caused the fund to overstate its NAV. The Court acknowledged that there is no single, objectively acceptable method for valuing complex instruments at issue in the complaint, and noted that valuation of mortgage-backed securities involves the exercise of judgment. The Court then considered the fund’s description of its valuation methodology and stated that the defendants’ valuations could only be false and misleading if they were inconsistent with the described methods. The Court found that the plaintiffs’ claim fails because the plaintiffs did not allege any facts to suggest that the defendants deviated from the prescribed valuation methods. The plaintiffs did not allege facts about which securities were overvalued or how any valuation conflicted with the procedures described in the prospectus. The Court also stated that the fact the fund eventually took large write-downs on its mortgage-related securities does not stand for the proposition that the values stated before the write-down were inaccurate. Because the plaintiffs did not allege facts about how the value of the fund’s mortgage-related holdings conflicted with the defendant’s valuations, the Court dismissed the third claim.