The U.S. District Court for the District of Massachusetts (the “Court”) denied a motion to dismiss for failure to state a claim as to all but one of the claims in the complaint for a class action lawsuit filed by mutual fund investors against the fund, the fund’s investment adviser, the adviser’s parent, the adviser affiliate serving as the fund’s distributor, certain executives of the adviser and the fund’s trustees. The complaint asserted violations of the federal securities laws under Section 11 and 12(a)(2) of the Securities Act of 1933, as amended (the “Act”), and control person liability under Section 15 of the Act. Plaintiffs alleged that defendants misrepresented the nature of the fund’s investment objective and strategy in the fund’s offering documents as a safe, liquid and stable investment offering when the fund was comprised of illiquid, risky and volatile securities.
Background. The plaintiffs alleged that during the period between October 28, 2005 and June 23, 2008, the fund’s net asset value (“NAV”) ranged from $9 to $10 per share, due at least partly to defendants’ artificial inflation of the fund’s NAV. Eventually, according to the plaintiffs, the fund’s assets were re-priced and the fund was ultimately liquidated with significant losses to the fund’s investors. Plaintiffs alleged that they lost approximately 25% of the value of their fund investments because of defendants’ misrepresentations in the fund’s offering documents that included: (i) misleading statements about the fund’s objectives, (ii) misrepresentations about the fund’s holdings of illiquid assets and (iii) misleading statements comparing the fund to certain securities indices.
Fund Objective. The fund’s investment objective as set forth in its offering materials was to “seek to provide income consistent with preservation of capital and low principal fluctuation” and included the statement that “the fund seeks to provide investors with a high level of current income while reducing price volatility.” The offering documents stated that the fund’s investment strategy was “to seek the highest total return by maximizing income and minimizing price fluctuations.” Defendants argued that these statements were simply “general and indefinite” statements of objective which are not actionable under securities laws. The Court, however, found that the statements in the fund’s prospectus were more than “mere aspirations” and instead were properly viewed as “key guidelines that established the [f]und’s investment strategy and laid down the basic ground rules it would follow.” The Court also found that, although the fund’s prospectus contained general statements of the fund’s goals, these statements were nevertheless surrounded by more detailed specific statements about the fund which clarified the context in which the more general statements appeared and which, when read together, “made distinct claims about the posture of the [f]und, its investment strategies and the rules under which it would operate.” For example, the fund’s prospectus stated that the fund intended to maintain an average portfolio duration of one year or less, that it would not invest more than 15% of its net assets in illiquid securities and that its returns would be comparable to those in certain specific indices.
Defendants also argued that the statements about the fund’s objectives were not actionable since the prospectus contained language that “bespoke caution” about the risks of investing in the fund. The Court found that the bespeaks caution doctrine only applies to soft, future-looking statements and does not apply to statements of present fact like those contained in the fund prospectus which laid out the “ground rules” for the fund. In addition, the Court found that the warning contained in the prospectus that the fund is not guaranteed to meet its goals did not specifically warn of the alleged risky nature of the fund’s investments so as to “bespeak caution.”
Fund’s Holding of Illiquid Assets. Plaintiffs alleged that the fund’s offering documents misrepresented the extent of the fund’s investments in illiquid assets by stating that the fund would not invest more than 15% of its net assets in illiquid securities when, in reality, the fund invested a much greater portion of its assets in private placement securities (“Rule 144A Securities”) that were illiquid. Defendants argued that there was no basis for finding that the Rule 144A Securities in which the fund invested were illiquid. Noting plaintiffs’ “detailed allegations concerning the inherent illiquidity of Rule 144A Securities,” the Court indicated that a factual dispute regarding whether such securities were illiquid could not be resolved by the Court on a motion to dismiss for failure to state a claim.
Comparison of the Fund to Indices. The fund’s offering documents contained a series of statements comparing the fund to certain named indices. Plaintiffs alleged that the comparisons of the fund to these indices were materially misleading because the fund’s longer portfolio duration made it much more susceptible to unanticipated changes in interest rates and therefore riskier than the indices. Defendants argued that these statements were merely intended to provide some basis for comparison as opposed to an exhaustive description of the fund’s risks. The Court found that the fund’s offering documents had in fact invited investors to use the index comparisons to assess the fund’s risks since the materials clearly stated that the comparisons were “intended to provide . . . some indication of the risks in investing in the fund” and held that the plaintiffs’ allegations regarding statements comparing the fund to certain indices, in conjunction with other alleged misrepresentations, stated a claim under Sections 11 and 12 of the Act.
Loss Causation. In response to defendants’ argument that plaintiffs had failed to plead loss causation, the Court observed that although Sections 11 and 12(a) of the Act require a causal link between defendants’ misstatements and plaintiffs’ economic loss, loss causation is not an element of a prima facie case under Sections 11 and 12. Nevertheless, the Court noted that courts have occasionally dismissed claims under Sections 11 and 12 when it was “apparent on the face of the complaint that plaintiffs would not be able to establish loss causation.”
Specifically, defendants argued that, even if there were misstatements about the fund’s investment strategy and risk profile in the fund’s offering documents, plaintiffs’ economic loss could not have been caused by such misstatements because the price of the fund’s shares was determined by the fund’s NAV whose decline resulted from the depreciation and re-valuation of the underlying assets held by the fund, rather than from any misstatements in the fund’s offering documents.
The Court found that defendants’ view of loss causation was “too narrow,” citing In re Charles Schwab Corp. Sec. Litig., 257 F.R.D. 534 (N.D. Cal. 2009) (“Schwab”) which, in rejecting arguments similar to those made by the defendants in the present case, noted that “[such a 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 . . . [and] would immunize a scheme that purported to invest in low-risk [securities] but in fact invested in legitimate but high risk [securities].” Again citing Schwab, the Court indicated that “loss causation is ‘not limited to the common ‘corrective-disclosure-price drop scenario,’’ in which the alleged misrepresentation [is] followed by a corrective disclosure that [leads] indirectly to a drop in share price.” In this regard, the Court stated that “[a] plaintiff may also establish loss causation by alleging that ‘the subject of the fraudulent statement or omission was the cause of the actual loss suffered [or] that [the] defendants’ misstatements and omissions concealed the price-volatility risk . . . that materialized and played some part in diminishing the market value of the security.’”
The Court noted that plaintiffs alleged that “defendants made false representations about the riskiness of the fund’s investments and artificially inflated the NAV” during the relevant time period and that “when the alleged misstatements were ultimately revealed, the NAV declined in value, resulting in losses to the fund.” Ultimately, the Court found that such “allegations [were] sufficient to demonstrate that there is a colorable claim of loss causation which is all that is required to survive a motion to dismiss.”
Dismissal of Section 12(a)(2) Claims Against the Fund’s Trustees. The Court granted the dismissal of plaintiffs’ Section 12(a)(2) claims against the fund’s trustees on the ground that plaintiffs had failed to establish that the trustees were “sellers” within the meaning of Section 12(a)(2). Section 12(a)(2) of the Act imposes liability on any person who “offers or sells” a security by means of a prospectus or oral communication containing a material misstatement or misleading omission. Plaintiffs alleged that the individual trustees signed the registration statements and participated in the drafting, preparation and/or approval of the fund’s offering materials. In dismissing the Section 12(a)(2) claims against the fund’s trustees, the Court indicated that it was following the precedent set in Shaw v. Digital Equip Corp., 82 F.3d 1194 (1st Cir. 1996), which held that “such acts are insufficient to establish a statutory seller relationship with the plaintiffs.”
Dismissal of Section 15 Claim Against the Fund’s Trustees Denied. The Court denied the trustee defendants’ motion to dismiss plaintiffs’ Section 15 control person liability claim. Section 15 of the Act provides for joint and several liability for persons who control any person liable under Sections 11 or 12 of the Act. The trustee defendants argued that their “mere status as a director or trustee [was] insufficient to demonstrate control under Section 15” and that accordingly, plaintiffs had not sufficiently alleged that the trustees exercised “control” over the fund. Plaintiffs, on the other hand, argued that “the individual defendants were ‘culpable participants’ in the violations of Sections 11 and 12 based on their having signed or authorized the signing of one or more registration statements and having otherwise participated in the process which allowed the offerings to be successfully completed.” In particular, plaintiffs’ complaint alleged that each trustee “participated in the drafting, preparation, and/or approval of various untrue and misleading statements” and that the trustees had the “power and influence to direct the management and activities of [the] [f]und and its employees [and, accordingly,] were able to, and did, control the contents of the [o]ffering [m]aterials.” Ultimately, the Court found that plaintiffs’ allegations of control with respect to the trustees were sufficient to withstand a motion to dismiss. The Court also noted that whether a defendant is a “controlling person” is typically a question of fact that cannot be resolved on a motion to dismiss for failure to state a claim.