For years, mutual fund shareholders have been limited in their ability to successfully allege securities fraud in class actions under the federal securities laws against mutual fund executives, directors and advisers. These litigations routinely failed because established legal precedent requires securities plaintiffs to show that the alleged fraud directly caused the share prices of these funds to drop. Because mutual funds’ share prices are calculated using the value of underlying securities they hold, allegations against mutual fund defendants have been held to be too remote to have any effect on the share prices of the funds.
On July 1, 2016, the Honorable William H. Pauley III, a federal district court judge for the Southern District of New York (“SDNY”), ruled that mutual fund investors in a securities class action can plausibly allege securities fraud even where the alleged misrepresentations had no direct effect on the mutual funds’ share prices. This ruling arises from a securities class action styled Youngers v. Virtus Investment Partners, Inc., et al., in which mutual fund investors alleged that the defendants lied about the performance history of the investment strategy used by the mutual funds, causing them damages. The defendants moved to dismiss this action on the ground that, inter alia, the plaintiff class had not met its burden of establishing “loss causation,” an element of securities fraud that requires a causal link between the alleged fraud and the alleged loss suffered by the investor. Specifically, defendants argued that the plaintiffs failed to show that the alleged misrepresentations in any way affected the funds’ share prices. Judge Pauley noted that the defendants were “correct” in this assertion. Nevertheless, in a decision directly contrary to those of other SDNY judges, Judge Pauley held that the price of a mutual fund share is not necessarily equal to its value, and found that the plaintiff class of mutual fund shareholders had plausibly shown that the defendants artificially inflated the fund’s value even if the price was unaffected by the alleged fraud.
Loss causation and mutual funds
A little more than a decade ago, the U.S. Supreme Court in Dura Pharmaceuticals, Inc. v. Broudo and the Second Circuit Court of Appeals in Lentell v. Merrill Lynch & Co. defined loss causation as the causal connection between the alleged fraud and the alleged harm. It is similar to “proximate cause” in the tort law context, where plaintiffs have to show that the alleged conduct was the primary and direct cause of their injuries. In the securities context, this means that plaintiffs have to show that the defendants, through misstatements or omissions, inflated the value of a security, and that a subsequent disclosure of those misstatements or omissions caused the value of the security to drop, causing damages. This form of “loss causation” materially differs from the “transactional causation” element of securities fraud, which merely requires plaintiffs to show that but for the alleged fraud, they would not have entered into the relevant securities transactions.
Since Dura Pharmaceuticals and Lentell, courts have struggled to apply the “corrective disclosure/value drop” paradigm in the mutual fund context. Unlike publicly traded securities (e.g., stocks), mutual funds are not directly priced by securities markets. Rather, mutual fund share prices are equal to their net asset value (“NAV”), which is a statutorily defined formula that depends on the sum of the market prices of the underlying securities held by the mutual funds, minus any fees. Courts in the Second Circuit have traditionally used the NAV as the measure of “value” when undertaking a loss causation analysis in the mutual fund context. In so doing, these courts have routinely dismissed securities fraud claims involving mutual fund shares for failure to plead loss causation, since the investors would have to show that the alleged misrepresentation about the mutual fund directly caused the value of the underlying securities to drop. By framing the loss causation analysis in this manner, these courts made it virtually impossible for mutual fund investors to survive a motion to dismiss in securities fraud actions.
In Youngers, Judge Pauley deviated from this precedent and held that a mutual fund share’s price, or NAV, is not necessarily representative of its “value” in a loss causation analysis. He posited that because mutual funds are not traded on secondary markets, investors look to factors other than the share price (e.g., performance history) to determine the value of a mutual fund share. If so, in order to establish loss causation and survive a motion to dismiss, mutual fund investors need only show that the alleged misrepresentations caused them to overvalue those other factors. No causal link between the drop in NAV and the alleged misstatements is necessary.
While this decision is not binding on other district court judges in this circuit, it is likely to revive securities fraud litigation in the mutual fund context, at least until this conflict is resolved. Mutual fund investors in this circuit now have legal precedent that allows them to frame loss causation on subjective considerations as opposed to the objective drop in NAV caused by a curative disclosure that prior courts have used since Dura Pharmaceuticals and Lentell. The more traction this decision has with other judges, the more likely it is that mutual fund investors will bring and survive dispositive motions at the pleading stage in securities fraud cases and attain favorable settlements.
Still, the Youngers decision may yet be overturned. At the defendants’ request, Judge Pauley is hearing argument on whether he should certify his July 1, 2016 decision for an immediate appeal. If Judge Pauley denies this request, the case will move forward to the class certification stage and possibly beyond. Such a result would make it more likely that the case will settle or otherwise be resolved before the Second Circuit Court of Appeals can have an opportunity to resolve this conflict in the SDNY and determine once and for all how loss causation should be applied in the mutual fund context. The parties will brief the certification issue over the next two months and Judge Pauley will hear oral argument on this certification request on October 7, 2016. If Judge Pauley certifies the issue for immediate appeal, the Second Circuit can still exercise its discretion not to take up the issue, but most likely the Second Circuit would use that opportunity to resolve this conflict in the SDNY.