Alert November 22, 2011

Federal District Court Refuses to Dismiss Section 11 and Section 12(a)(2) Claims, Rejecting Argument That Decline in Mutual Fund’s Net Asset Value Only Results from Changes in Value of Fund Holdings, Not Prospectus Misrepresentations

The United States District Court for the District of Colorado (the “Court”) denied a motion to dismiss a complaint filed against the adviser, distributor and trustees of several mutual funds alleging misrepresentations in the funds’ offering documents that violated Sections 11 and 12(a)(2) of the Securities Act of 1933.  The complaint claimed, among other things, that the funds were marketed as stable investments focused on preservation of capital, when in reality they utilized extremely risky strategies by investing in low quality, unrated or illiquid bonds, or highly leveraged derivative instruments known as “inverse floaters.” 

After finding that the alleged misrepresentations and omissions may have been material to fund investors, the Court rejected defendants’ argument that declines in mutual fund value are always the result of factors other than prospectus misrepresentations, because (i) the net asset value (“NAV”) of fund shares is determined by a daily valuation of fund assets and liabilities and (ii) mutual funds are not traded on secondary markets.  The Court found that the plaintiffs’ losses were plausibly linked to the alleged misstatements and omissions because the funds’ underlying assets (and hence its NAV) allegedly declined when long-term and derivative holdings had to be liquidated “for reasons obscured or undisclosed in Fund offering statements.” 

The Court thus disagreed with a recent decision by the United States District Court in the Southern District of New York, Yu v. State Street Corporation, which had concluded that whatever defendants may have misrepresented about the diversification, liquidity and credit quality of the fund’s portfolio, it was “simply irrelevant to loss causation” under the 1933 Act.  (For more on the Yu decision, see the April 12, 2011 Financial Services Alert.)  The Court noted that establishing loss causation would involve complex legal and factual determinations, and was unwilling to hold that misrepresentations in open-end mutual fund prospectuses “are categorically excluded from investors’ reach under the 1933 Act.”  Rather, the Court noted that “[t]he fact that the pro rata ‘price’ of a mutual fund’s aggregate holdings is set by mathematical formula rather than the actual market does not mean that the underlying value of those aggregated holdings cannot be squandered or diminished (and thereby reflected in NAV) by actions or materializations of risk about which purchasers of fund shares have been misled.”

In re Oppenheimer Rochester Funds Group Securities Litigation, No. 1:09-md-02063-JLK-KMT (D. Colo. Oct. 24, 2011).