Edited by: Eric R. Fischer, Jackson B.R. Galloway and Elizabeth Shea Fries
The Second Circuit recently affirmed a decision by a New York federal court dismissing claims by investors in certain ProShares exchange-traded funds ("ETFs") that the prospectuses contained in the registration statements for those funds failed to disclose risks in violation of Sections 11 and 15 of the Securities Act of 1933 ("1933 Act"). Plaintiffs brought a class action on behalf of purchasers of shares in 44 ETFs during the period August 2006 to June 2009 against the funds, their adviser and distributor, and individuals alleged to be control persons of those entities. The Second Circuit agreed with the district court that the disclosures did in fact warn of the exact risks that later materialized, and thus "a [s]ection 11 claim will not lie as a matter of law."
The three types of ETFs at issue were: (1) an Inverse ETF that aimed to replicate the inverse movement of a specified index over one day; (2) an Ultra Long ETF that tried to double the performance of the underlying index or benchmark on a daily basis; and (3) an Ultra Short ETF designed to double the inverse of the performance of the underlying index or benchmark on a daily basis. As the Second Circuit noted, the ETFs' views "were expressly myopic: long-term objectives were blurred because they were focused only on meeting a benchmark tied to an underlying index one day at a time with a portfolio of different securities." Plaintiffs alleged that the funds' prospectuses omitted the risk that if the funds were held for more than one day, the funds' performance could diverge widely from the performance of the underlying indices and result in substantial losses during a relatively brief period of time, despite the overall direction of the underlying indices. However, the Second Circuit agreed with the district court that such risks were disclosed: the prospectuses stated that "[o]ver time, the cumulative percentage increase or decrease in the net asset value of the [ETFs] may diverge significantly from the cumulative percentage increase or decrease in the multiple of the return of the Underlying Index" due to a compounding effect of daily gains and losses, and that such divergence "could result in the total loss of an investor's investment."
The Second Circuit found Plaintiffs' arguments to be inconsistent, by criticizing Defendants for including some of those risk disclosures in the ETFs' statements of additional information ("SAIs") instead of the prospectuses themselves, while also claiming that those same disclosures misled Plaintiffs about the risks. Plaintiffs also argued that because Defendants changed the risk disclosures at the end of the class period to acknowledge that volatility could cause an ETF to "move in [the] opposite direction as the index" and that investors should be willing to "monitor and/or periodically rebalance their portfolios," Defendants had conceded that their prior disclosures were inadequate, but the Second Circuit rejected that argument: "[t]o hold an issuer who alters disclosures deemed adequate in the first instance suddenly liable because it found a better way to say what has already been said would perversely incentivize issuers not to strive for better, clearer disclosure language."
In re ProShares Trust Securities Litigation, No. 12-3981 (2d Cir. July 22, 2013).
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