Until recently, a drop in a mutual fund company’s net asset value (NAV) has been the test used by the Southern District of New York (SDNY) to determine if plaintiffs have pled a plausible theory of loss causation in a securities class action. Per SEC regulations, the price of a mutual fund’s shares is calculated according to a fund’s NAV, which equals a fund’s assets minus liabilities, divided by the number of shares. Since the value of a mutual fund’s NAV is affected by the value of the underlying securities, securities claims against mutual fund companies are often dismissed as too remote because the plaintiffs cannot show that the alleged fraud caused a drop in the value of the fund’s underlying securities.
However, a recent decision by SDNY Judge William H. Pauley in Youngers v. Virtus Investment Partners, Inc. et al, Case 1:15-cv-08262-WHP has put this legal precedent in question. In his ruling on defendants’ motion to dismiss, Judge Pauley held that a plausible theory of loss causation can be pled against mutual fund companies based on subjective factors such as misrepresentations of performance history. The court noted that the complaint asserts that one of the key factors investors used to value the funds was the performance history and since that performance history was misleading (the purported performance history failed to indicate the results were back-tested), it caused the value of the fund’s shares to inflate. When the valuation proceeded to be false, plaintiffs allege that they lost the difference between the inflated value at the time of purchase and the true value. Based on these allegations, Judge Pauley allowed the claims to proceed even though the alleged misrepresentations had no direct effect on share price.
Notably, this ruling is in conflict with holdings by other judges in the SDNY. Further, Judge Pauley, in response to the defendants’ request, has agreed to consider briefing on whether this issue should be certified for immediate appeal, and has set this issue for hearing on October 7, 2016. If certification is granted, it presents an opportunity for the Second Circuit Court of Appeals to resolve this issue, but the Second Circuit can still exercise its discretion not to consider the case. If certification is not granted and the matter proceeds toward class certification, it may be settled before the Second Circuit would have the opportunity to resolve this issue on appeal. However, until the issue of how the loss causation analysis is to be applied in the mutual fund context is resolved, the door will remain open for plaintiffs to file securities class actions against mutual fund companies based on subjective, rather than objective factors.
If you would like to view the memorandum in support of defendants’ motion to certify the court’s July 1, 2016, opinion and order for interlocutory appeal, you can do so by clicking here. We will continue to monitor this matter and provide a further update in a future posting. In the meantime, underwriters should be mindful of the impact that this ruling could have on mutual fund companies’ exposure to securities class actions.