Several shareholder suits filed recently highlight the increased litigation exposure that mutual funds, advisers and boards, among others, may experience in turbulent markets. Each of the suits is grounded in misleading fund disclosure.

Industry Concentration Disclosure Litigation

The U.S. District Court for the Northern District of California recently issued an order under which it permitted a plaintiff, suing on behalf of its clients who were shareholders of a bond fund, to survive a motion to dismiss based on a claim of misleading prospectus disclosure concerning collateralized mortgage obligations (CMOs). The most significant aspect of this case is that a court, for the first time, held that Section 13(a) of the 1940 Act provides fund shareholders with an implied private right of action. Section 13(a) provides, in relevant part, that a fund may not deviate from its policy to concentrate investments in any particular industry or any other fundamental policy as set forth in its registration statement without shareholder approval.In its complaint, plaintiff alleged that the fund, its adviser and distributor violated Section 13(a) by deviating from the Fund’s investment objective to track the Lehman Brothers U.S. Aggregate Bond Index because the fund invested in high risk non-U.S. agency CMOs that were not part of the Lehman Index and were substantially more risky than the U.S. agency securities and other instruments that comprised the Index. The plaintiff also alleged that the fund invested more than 25 percent of its total assets in U.S. agency and non-agency mortgage-backed securities and CMOs despite a concentration limit of 25 percent in any one industry.

In response, defendants argued that the fund’s disclosure documents indicated that it would only “attempt” to track the Lehman Index and specifically that “[t]here can be no guarantee that [the fund] will produce the desired results.” Moreover, the fund’s prospectus affirmatively disclosed to investors that the fund may invest in securities that are not part of the index, including CMOs. Defendants also argued that mortgage-backed securities are not an “industry” for purposes of the 25 percent concentration limit. They also claimed that changing an industry classification, as they did in 2006 by changing the fund’s classification of non-agency mortgage-backed securities from constituting an “industry” to not constituting an “industry,” was not a change to a concentration policy requiring shareholder approval.

In its ruling, the court found that shareholders have an implied right under Section 13(a) of the 1940 Act to sue investment companies and related parties for violations of that section. Furthermore, the court found both of plaintiff’s allegations sufficient to survive a motion to dismiss (i.e., both were factual matters that could not be resolved on the pleadings alone), despite defendants’ arguments that the fund’s actions were in line with its prospectus and statement of additional information disclosure. Defendants have appealed the court’s order.

A similar suit was recently filed against another fund company, its distributor, certain members of the fund’s board, chairman and former CEO, treasurer and former portfolio manager, claiming that the fund company misled investors in its marketing of a high yield fund. It should be noted that between September 2007 and the end of 2008, the fund suffered an approximate 80 percent drop in its net asset value. The complaint alleges that:

  • the prospectus made misrepresentations regarding the risk associated with investments in the fund, including risks related to illiquidity and investments in CMOs;
  • the fund invested more that 25 percent of its total assets in mortgage-backed securities in violation of its policy against investing more that 25 percent of its assets in any one industry; and
  • the fund utilized leveraging devices that resulted in borrowing in excess of its 33 1/3 percent limit disclosed in fund documents.

The complaint also alleges claims against the trustees for not seeking shareholder approval for the alleged changes in investment strategy made by the fund. A response to the complaint has not yet been filed. Other similar lawsuits have been filed around the country against fixed income funds.

Ultra Short Disclosure Litigation

Several class action suits have also been filed against ultra short funds and related parties in connection with disclosures. Claims made in a pending case in the U.S. District Court for the Northern District of California under the Securities Act of 1933 (1933 Act) and state law allege, among other things, that the defendants:

  • made misrepresentations regarding the investment policies and risk profile of the fund, including that the fund was an “ultra short term bond fund” that sought to keep the fund’s average portfolio duration to one year or less, when the fund actually had an average duration of over two years;
  • misrepresented the nature of the fund stating that it was similar to “safe” and “stable” money market funds because it was managed to “help maintain a high degree of share price stability and preserve investors’ capital,” when the fund invested an increasing portion of its assets (more than 45 percent) in mortgage-backed and asset-backed securities that were risky rather than “safe” and “stable”; and
  • mispriced a material portion of the fund’s assets when those assets were deteriorating in value and liquidity, thus overstating the value of the fund’s holdings.

Defendants argued that plaintiffs did not meet the applicable pleading standards because, among other things, they could not establish loss causation. The court dismissed certain state law claims against the defendants, but allowed the misrepresentation claims under the 1933 Act to proceed. Specifically, the court found that plaintiff’s allegations met the applicable pleading standards and that the disclosure statements alleged to have been made were sufficient to establish loss causation.

Each of the above cases demonstrates an increased exposure to misrepresentation claims that fund companies and their advisers, directors and others face in this down market. As discussed above, an increasing number of courts are permitting misrepresentation claims to proceed past the motion to dismiss stage despite defendants’ arguments that the risks of investing in the funds were appropriately disclosed. Of course, once a motion to dismiss is defeated, costs associated with litigation increase dramatically and defendants will be faced with the difficult decision of the advisability of settlement versus the unsure outcome of litigation.