The Loss Causation Loophole

An interesting issue, which has generated a district court split, is whether securities class actions can be brought against a mutual fund based on misstatements about the fund’s investment objective and holdings. Mutual funds have argued that it is impossible for plaintiffs to establish loss causation. The price of mutual fund shares is not determined by market securities trading, but rather is based on the fund’s net asset value (NAV). The NAV is a statutorily defined formula that depends on the value of the underlying securities held by the fund. Accordingly, the NAV can only decline in response to a change in the value of those securities, not as a result of the disclosure of hidden facts about the fund.

Courts have been reluctant to embrace this argument, with several courts noting that as a matter of public policy mutual funds should not be allowed to escape securities liability. In In re State Street Bank and Trust Co. Fixed Income Funds Investment Litigation, 2011 WL 1206070 (S.D.N.Y. March 31, 2011), however, the court examined claims brought under Section 11 and 12 of the ’33 Act and found that this policy rationale cannot trump the required legal analysis.

Under the Lentell (2d Cir.) decision, plaintiffs must show “that the misstatement or omission concealed something from the market that, when disclosed, negatively affected the value of the security.” Moreover, the damages provisions in Sections 11 and 12 both “tie the recovery of a potential plaintiff to the value of the security.” Given that “the NAV does not react to any misstatements [about the fund’s investment objective and holdings], no connection between the alleged material misstatement and a diminution in the security’s value had been or could be alleged.” The court therefore granted the defendants’ motion to dismiss.

Holding: Case dismissed with prejudice.

Quote of note: “In this case, however, the Court is constrained by the plain language of Section 11(e) and 12(a)(2), which requires a connection between the alleged material misstatements and a diminution in the security’s value. It seems likely that Congress never considered that it might be creating a loophole for fraudulent misrepresentations by mutual fund managers when enacting these provisions. But if this is so, closing the loophole requires legislative action.”

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