Alert April 12, 2011

Federal District Court Cites Absence of Loss Causation in Dismissing Section 11 and Section 12(a)(2) Claims Based on Mutual Fund’s Mortgage-Related Securities Holdings

The United States District Court for the Southern District of New York dismissed claims under Section 11 and 12(a)(2) of the Securities Act of 1933 against a mutual fund’s sponsor and related parties (collectively, the “Sponsor”) asserting misrepresentations in the fund’s offering documents, holding that plaintiff’s losses could not be causally connected to those purported misrepresentations.  The complaint claimed, among other things, that statements in the fund’s offering documents about the fund’s objectives of maintaining a diversified portfolio, seeking liquidity and investing in high quality debt securities were misleading because of the fund’s extensive investments in mortgage-related securities, resulting in subsequent declines in the fund’s share price during the subprime mortgage crisis.

In simple terms, Sections 11 and 12(a)(2) permit a plaintiff to bring a claim for depreciation in the value of a security based on a material misstatement or material omission (in a mutual fund’s registration statement in the case of Section 11, and in a prospectus or oral statement in the case of Section 12(a)(2)).  While loss causation is not a required element of Section 11 or 12(a)(2) claims, those claims are subject to an affirmative defense that the depreciation was not caused by the alleged misstatement or omission.  The court noted that if this lack of a causal connection were apparent on the face of the complaint, the court could dismiss the complaint. 

The court cited two cases as principal authority on this issue of loss causation:  Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), and Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005).  The court reasoned that both these decisions stood for the proposition that in order for there to be loss causation, “the disclosure of the facts hidden by the material misstatement, whether by a ‘corrective disclosure’ theory or by a ‘materialization of the risk’ theory, must negatively affect the value of the security.” 

Applying this precedent, the court concluded that whatever the Sponsor may have said about the diversification, liquidity and credit quality of the fund’s portfolio, it was “simply irrelevant to loss causation.”  The court stated that in Section 11 and 12(a)(2)’s statutory scheme, “it is crucial that there be a revelation of the concealed risk and that the revelation caused a depreciation in the value of the security.”  For mutual funds, the court noted that the fund’s share price is not determined by secondary market securities trading.  Rather, the fund’s net asset value is calculated according to a formula dictated by the Investment Company Act of 1940 that depends on the value of the underlying securities.  The fund’s NAV thus accurately reflected the value of investments that the fund held at any given time, and could not have been inflated by alleged misstatements or omissions in the prospectus.  The court agreed that the defendants had successfully shown that the declines in the fund’s share price were caused by the decline in value of the fund’s holdings, not the misrepresentations and omissions alleged by the plaintiff.  While the purportedly false statements about the fund’s composition may have induced the plaintiff to purchase shares, “that proves only transaction causation, not loss causation.”  The court rejected the plaintiff’s “run on the fund” argument for the same reason, finding that significant redemption activity prompted by the fund’s declining share price may have put pressure on the fund to liquidate, but the liquidation caused losses because of the decreasing value in the fund’s underlying securities. 

On the basis of the foregoing, the court concluded that the defendants were entitled to dismissal of the complaint.  The court acknowledged that while certain federal district courts had taken a similar approach, In re Morgan Stanley Mutual Fund Securities Litigation, No. 03 Civ. 8208 (RO), 2006 WL 1008138 (S.D.N.Y. Apr. 18, 2006) and In re Salomon Smith Barney Mutual Fund Fees Litigation, 441 F. Supp. 2d 579 (S.D.N.Y. 2006), others had issued decisions supportive of the plaintiff’s approach to loss causation, citing In re Charles Schwab Corp. Securities Litigation, 257 F.R.D. 534 (N.D. Cal. 2009); In re Evergreen Ultra Short Opportunities Fund Securities Litigation, 705 F. Supp. 2d 86 (D. Mass. 2010); and Rafton v. Rydex Series Funds, No. 10-CV-01171-LHK, 2011 WL 31114 (N.D. Cal. Jan. 5, 2011).