(Reuters) - The hottest investment instrument of the moment is the exchange-traded fund, or ETF. The market for ETFs - which are essentially a basket of diversified securities, often tracking a stock index - is already more than $3 trillion, and both the Securities and Exchange Commission and U.S. stock exchange operators took steps in the last quarter of 2019 to goose that market, making it easier for ordinary investors to buy ETFs.
A ruling last week from a California appeals court will make it much harder for those investors to sue if they believe ETFs failed to tell them about significant risks. The Court of Appeal, First District, ruled that investors who bought BlackRock iShares ETFs on the secondary market do not have standing to assert claims under the Securities Act of 1933 because they cannot show their shares were part of the original ETF offering.
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The Court of Appeal opinion, written by Judge Anthony Klein, acknowledged that it may well be impossible for investors to trace the origin of their ETF shares, given the modern reality that shares are just fungible electronic markers. But the appellate court said the policy implications of ETF trading are an issue for Congress to confront, not a justification for the court to engage in “so great a departure from existing law.”
Plaintiffs’ lawyer Reed Kathrein of Hagens Berman Sobol Shapiro told me the California decision is a “death knell” for shareholder claims that ETF managers like BlackRock didn’t provide adequate risk warnings. BlackRock counsel Eben Colby of Skadden Arps Slate Meagher & Flom, however, said shareholders in the iShares case were advancing an implausible theory to expand liability.
To understand the appellate decision, you have to understand a key difference between open-end mutual funds and ETFs. Both mutual funds and ETFs sell shares in bundled securities and are regulated under the Investment Company Act of 1940. Open-end mutual funds and ETFs both continuously offer new shares for sale to the public and issue annual amended registration statements. But open-end mutual fund shares can only be sold by issuers. If you want to buy a share of a Vanguard fund, for instance, that share must have originated at Vanguard. There is no secondary market for open-end mutual fund shares.
ETFs, by contrast, can be traded on the open market. (Thus the name: Exchange-Traded Fund.) Ordinarily, the Investment Company Act prohibits secondary trading in open-end bundled securities, but the SEC began authorizing fund-by-fund exemptions to that bar about 30 years ago. (Its new ETF rule, in order “to facilitate greater competition and innovation in the ETF marketplace,” will allow qualified funds to come to market without obtaining individual exemptions). With new shares being continuously authorized by ETFs, resold on the secondary markets and held in fungible, undifferentiated buckets at depository trust companies, it’s virtually impossible to trace the history of any particular ETF share.
In the BlackRock case, Hagens Berman argued in its brief for shareholders that share history is a red herring when it comes to disclosure claims under the Securities Act. A 1954 amendment to the Investment Company Act says that the critical disclosure is not the original registration statement but the amended registration statement in effect at the time the investors bought shares. Mutual fund investors can therefore assert Securities Act claims based on funds’ disclosures when they made their purchases, even if those purchases occurred years after the fund was first registered.
Hagens Berman argued that the same is true for ETFs. Investors’ case against BlackRock alleged that the fund manager failed to disclose the risk to iShares ETF investors of stop-loss orders in the event of a flash crash, even though BlackRock became aware of the risk in the wake of a 2010 flash crash. The suit contended that iShares’ amended registration statements between 2010 and 2015 violated the Securities Act by omitting mention of that risk. And according to Hagens Berman, iShares investors who bought their shares in that time frame have standing to sue because the Investment Company Act establishes that the relevant offering document was the amended registration in effect when they bought – not the original offering documents.
Skadden countered in BlackRock’s appellate brief that the Investment Company Act does not give ETF investors standing to sue under the Securities Act. Here’s where the difference between mutual funds and ETFs is crucial. Every open-end mutual fund share can be traced back to the fund because shares don’t trade on the secondary market. So Securities Act liability always lies with the fund. But that’s not true, Skadden said, of ETF shares, in which the chain of Securities Act liability is broken when the shares trade on the secondary market. Hagens Berman’s clients, Skadden argued, could not show that any particular ETF share originated under a particular offering document because all shares are fungible. So they don’t have standing to sue.
The California court agreed with Skadden’s analysis. “As trading of shares on the secondary market is a core feature of ETFs, it is not surprising that the issuer and SEC would recognize the need for accurate disclosure to secondary market investors,” the court said. “But this does not necessarily mean defective disclosure in registration statement amendments must give rise to a cause of action under the 1933 Act where the plaintiffs’ shares were not necessarily offered for sale by the issuer pursuant to the offending document.”
BlackRock counsel Colby of Skadden said the California appeals court simply applied the same reasoning on tracing that applies in every Securities Act case. “Secondary market purchasers often have trouble establishing standing,” he said, because claims must be rooted in offering documents. Colby said it’s no surprise that a 1954 amendment to the Investment Company Act could not save claims arising from a type of investment that wasn’t even created until 1990. “The 1954 amendment,” Colby said, “couldn’t possibly have been intended to apply ... to secondary market trading of mutual fund shares because there was no (such) trading.”
Shareholder counsel Kathrein said the appellate opinion effectively grants ETF issuers a “get out of jail free card” for disclosure failures. Investors may still be able to bring claims under the Securities and Exchange Act of 1934, he said, but only if they can meet the high pleading standards for fraud. Kathrein said he doubts the SEC was aware that by allowing ETFs to trade on the secondary market, it was – according to the California appeals court – insulating issues from liability for disclosure failures. But he also said he doubts that an SEC intent on facilitating ETFs will do anything about it.
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