Fund Case Raises Disclosure Liability Issues

As markets have continued to drop, new lawsuits against mutual funds, fund companies and directors are beginning to be filed. A District Court in California recently issued a decision that, if followed more widely, has potentially significant implications for future mutual fund-related litigation. The case, In re Charles Schwab Corporation Securities Litigation, was brought by a group of fund investors in the Schwab YieldPlus Fund. The plaintiffs alleged that although the fund was described in its prospectus as an ultra short term bond fund that would have an average portfolio duration of less than one year and limit its risk exposure, it nonetheless extended its average portfolio duration beyond two years and concentrated its portfolio in risky assets such as mortgage-backed securities.

The district court’s opinion in the matter, which largely supported the investors, covered numerous complex issues; we highlight three of those issues here. In reading this summary, it is important to recognize that the investors who are suing the fund have not yet proved their case at trial – rather, at this stage of the litigation, the court assessed whether, assuming their factual claims were true, they had a valid case. However, although this matter is nowhere near final, it is worthwhile to highlight the claims that investors are bringing and courts’ initial reactions to those claims.

Standard of Liability under sections 11 and 12 of the Securities Act – Sections 11 and 12 of the Securities Act permit investors, broadly speaking, to sue the sellers of securities for misstatements and omissions in the registration statements for those securities. In ordinary cases of this type, a litigant will lose if the defendants can show that the misrepresentation did not cause the investors’ losses. In this case, the defendants argued that “even if the fund misrepresented its investment policies and/or risk profile, those misrepresentations could not have caused plaintiffs’ losses because the misrepresentations did not cause the decline in the value of the portfolio’s asset holdings.” [Slip op. at 9]

The Schwab court rejected this defense, holding that if it were accepted, virtually no section 11 or 12 claim could ever be brought against a mutual fund successfully. Instead the court held that investors could meet the standard if they demonstrated that “that defendants’ misstatements and omissions concealed the price-volatility risk (or some other risk) that materialized and played some part in diminishing the market value of the security.” [Slip op. at 10; internal quotation marks and citations omitted]. Although the difference between these two approaches may seem technical, the standard adopted by the Schwab court is considerably broader, and would permit numerous additional cases to proceed. The correct standard is currently a matter of considerable debate in legal and academic circles, and how it is ultimately resolved will have a significant impact on the future of litigation against funds, fund advisers and even directors under the Securities Act.


State Law Claims for Change of Fundamental Policies Without a Shareholder Vote -- The Schwab decision also has the potential to significantly expand investors’ ability to sue based on alleged violations of provisions of the Investment Company Act that do not otherwise contain a private right of action. In recent years, courts have strictly limited investors’ ability to bring these types of cases directly under the Investment Company Act. One example of this is the provision of the Act that requires a shareholder vote before a fund changes any of its fundamental policies. While the Investment Company Act is clear that a shareholder vote is required in these circumstances, absent an enforcement action by the Commission, this provision is almost impossible to enforce, as courts have generally held that fund investors cannot sue funds under the Investment Company Act for violation of this provision.

In this case, the fund did not formally change its fundamental policies, but rather changed certain definitions, so that mortgage-backed securities would no longer be considered an “industry.” This permitted the fund to invest in mortgage backed securities in excess of the industry concentration limits in the fund’s fundamental policies. The fund investors argued that this was effectively a change in the fund’s fundamental policies, but rather than suing under the Investment Company Act, they argued that the failure to seek shareholder approval was an unfair business practice under California law. The fund argued that this type of suit was not permitted under the Securities Litigation Uniform Standards Act, which bars, among other things, a lawsuit under state law based on “an untrue statement or omission of a material fact.” Here, however, the court agreed with the investors that the case did not involve fraud – indeed, as the court noted, the investors conceded that the fund had fully disclosed the relevant change.

Liability of Independent Directors – In addition to suing the management company and its personnel, the investors in Schwab also sued the fund’s independent directors. In this instance, the investors’ claims are rooted in the fact that the directors signed the registration statement. On this basis, the court allowed the claims to proceed against the directors, including the claim that the directors violated California law by signing a registration statement that incorporated an unapproved change to the fund’s fundamental policies.

Conclusion and Lessons – Perhaps the primary “lesson” of the Schwab case is the increased risk that sellers of securities face when markets are, as they have been over the past six months, down significantly. In contrast to fraud actions under rule 10b-5, where the remedy is damages, the remedy in a section 11 or 12 lawsuit is refund of the purchase price of the security. That makes suits under sections 11 and 12 unappealing when markets are moving up, but highly appealing when markets are moving down. In addition, as the case suggests, persons such as directors who sign a misleading registration statement can be exposed to liability.

Of course, not every legal theory relied upon in the Schwab decision has been tested on appeal, and of course the investors have not yet proven the truth of their factual allegations at trial. Thus, much could change. But the Schwab decision is one reminder of the risks of relying on selling fund shares based on misleading prospectuses.