Why a BlackRock Legal Victory Could Make It Harder for ETF Investors to Sue
September 24 2017 - 8:29AM
Dow Jones News
By Sarah Krouse
Investors could have a more difficult time suing exchange-traded
fund managers for misrepresenting risks following a California
court decision in favor of ETF giant BlackRock Inc.
A group of investors who lost money during a wild day of ETF
trading in 2015 accused BlackRock's iShares unit of leaving out
certain warnings about what could go wrong in fund documents.
BlackRock said in court documents that its warnings were
adequate.
Because of the way ETF shares are created and sold, those
investors were unable to link their holdings to a specific
registration statement that they said misrepresented certain risks
and therefore couldn't sue, according to San Francisco Superior
Court Judge Curtis E.A. Karnow.
In his ruling last Monday, the judge said investors who purchase
securities after they are first issued are unable to sue under a
specific section of securities law.
The case showcases the evolving legal and regulatory
infrastructure surrounding the relatively nascent ETF market as the
products gain popularity and are tested by market events, according
to fund lawyers. Globally ETFs hold $4.2 trillion in assets, up
from less than a trillion a decade ago. BlackRock's iShares unit is
the biggest ETF provider in the world, with $1.5 trillion in assets
at the end of June.
The court's decision could limit investors' ability to sue ETF
providers for leaving out or misrepresenting risks in fund
registration statements in the future, these lawyers say.
If the decision stands, "no retail investor will ever be able to
sue for a false registration statement or prospectus" for ETFs,
said Reed Kathrein, an attorney for the investors at Hagens Berman
Sobol Shapiro LLP. He said he plans to appeal the decision.
While ETFs share some similarities with mutual funds, their
structure and mechanics are distinct, and subject to different
rules. ETFs trade on exchanges like stocks and typically track the
performance of indexes. They have some tax and trading advantages
over mutual funds and have pulled in hundreds of billions of
dollars in investor cash in recent years.
But the same structure that has made ETFs popular trading and
investing products also makes it impossible for individual
investors to track when the shares they own were issued and for
fund providers to see who owns them in real time, industry experts
and lawyers say. Shares in mutual funds are purchased from fund
managers themselves.
ETF providers first create and redeem shares in their funds in
large blocks with so-called authorized participants in exchange for
baskets of securities. This is referred to as the primary market
and shares are then sold to individual investors and others in the
so-called "secondary market."
The investors who brought the class-action suit against
BlackRock lost money on Aug. 24, 2015, when large stock share-price
declines triggered a wave of trading halts and dozens of ETFs
traded at sharp discounts to the sum of their holdings.
Those investors alleged in part that BlackRock failed to clearly
state the risks of buying and selling ETFs using particular order
types, even though the fund firm had known for years that such
risks existed.
BlackRock defended its disclosures and successfully argued that
retail investors bringing the case must be able to link their
shares to registration statements that were misleading when shares
were first issued to authorized participants. That, however, isn't
possible, BlackRock said.
Shares in ETFs are "fungible and cannot be traced by plaintiffs
to any other particular registration statement or amendment
thereto, much less one that was materially false and misleading
when the shares were first sold in the primary market," BlackRock
said in court documents.
Investors in the California case unsuccessfully argued that
shares they bought after the publication of fund sales documents
that they say omitted certain risks should be covered by that
material.
Other courts could interpret current regulations differently,
fund lawyers say.
"It's a very interesting precedent," to apply the standard of
linking a specific security to a particular registration statement
to ETFs, said Jay Baris, chair of Morrison & Foerster LLP's
investment management practice.
There are other avenues for ETF investors to sue investment
managers, but one such option requires proving that the money
manger intended to mislead investors, which is a more difficult
standard to meet, fund lawyers say.
Write to Sarah Krouse at sarah.krouse@wsj.com
(END) Dow Jones Newswires
September 24, 2017 08:14 ET (12:14 GMT)
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