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From Securities Regulation Daily, July 22, 2013

Risks of ETF investment were adequately disclosed

By Rodney F. Tonkovic, J.D.

A Second Circuit panel affirmed a district court judgment dismissing claims under Securities Act Section 11 against an issuer of exchange-traded funds (ETFs). The panel agreed with the district court’s holding that the registration statement sufficiently warned of the risks that materialized (In re ProShares Trust Securities Litigation, July 22, 2013, Wesley, R.).

Background. The underlying action was brought by purchasers of ETFs who sought to hold ProShares Trust liable for alleged material misrepresentations in the ETFs’ prospectuses. The ProShares registration statements at issue disclosed that the ETFs pursued daily investment objectives and daily investment results. The registration statements warned that ProShares used aggressive investment techniques and that investments for beyond-a-day periods could result in a total loss due to mathematical compounding and leveraging.

The plaintiffs asserted that ProShares failed to disclose the magnitude and probability of loss for beyond-a-day investments in ProShares ETFs despite the correct predictions regarding the overall movement of the indices underlying the ETFs. The plaintiffs alleged further that the registration statements contained “contra-indicators” of successful long-term investments that these failures to disclose made materially misleading. The U.S. District Court for the Southern District of New York dismissed the complaint with prejudice after concluding that the registration statements sufficiently presented the risk that the ETFs, when held for a period of greater than one day, could lose substantial value in a relatively brief period of time, particularly in periods of high volatility.

Omissions. The panel agreed with the district court’s conclusion that a reasonable investor would be adequately warned of the allegedly omitted risks. First, while acknowledging that the offering documents warned that the value of long-term ETF investments “may diverge significantly” from that ETF’s underlying index, the plaintiffs maintained that this disclosure did not speak to a divergence that could result in actual, substantial loss. Judge Wesley, writing for the panel, stated that there was no meaningful distinction between “diverge significantly” and “actual loss.” He explained that, when the disclosures were fairly read and taken in context, investors were “on notice that an ETF’s value might move in a direction quite different from and even contrary to what an investor might otherwise expect.”

The plaintiffs also argued that ProShares failed to disclose the probability of certain long-term losses under certain circumstances. The plaintiffs asserted further the ProShares had mathematical formulae that could accurately predict potential market conditions and their effect on ETF shares. The court was not persuaded, stating that, even if such formulae existed, there was no actionable omission. The omission was a general one, regarding hypothetical investments, time periods, and market conditions. ProShares was not expected to predict and disclose all possible negative results for any possible market scenario, the court stated.

ProShares also consistently disclosed the effect market volatility had on ETFs. “No reasonable investor,” Judge Wesley wrote, “could read these prospectuses without realizing that volatility, combined with leveraging, subjected that investment to a great risk of long-term loss as market volatility increased.”

Misrepresentations. The panel then concluded that a reasonable investor would not have been misled by any of the alleged misrepresentations. According to the panel, tables showing the hypothetical costs of investing in ProShare ETFs for one-, three-, five-, and 10-year periods, when placed in context, would not lead a reasonable investor into thinking that the ETFs were safe multi-year investments. The panel agreed here with the district court’s finding that this did not undermine the emphasis on the daily nature of the ETFs. There was also accompanying language indicating that the tables were for illustrative purposes only and were not meant to suggest actual returns.

Next, the plaintiffs asserted that line-graph examples in the prospectuses misled them regarding the extent of an ETFs divergence from its underlying index. The panel stated that the correlation-risk disclosure expressly warned that there was no guarantee that an ETF will achieve a high degree of correlation with its benchmark. Taken in context with the disclosures in the complete offering documents, the panel concluded that it would be implausible for a reasonable investor to expect that an ETF’s divergence from its underlying index would be only minimal.

Finally, the plaintiffs argued that ProShares used wedge graphs to bury a principal-risk disclosure. The panel characterized this argument as a mere repackaging of the earlier assertion that ProShares failed to disclose the effect of excess daily volatility. The panel stated that the effects of excess market volatility had been sufficiently warned of in the volatility disclosures and prospectuses. Additionally, all of the ProShares prospectuses made clear that the ETFs were subject to a high degree of risk, and, from them, a reasonable investor would understand the potential for “rapid, substantial loss,” the judge wrote.

The case is No. 12-3981.

Attorneys: Christopher Lovell (Lovell Stewart Halebian Jacobson LLP) for Mark Karasick, Steven Schnall, Sherri Schnall, Francisco Javier De Lion Diaz, Rene LaCroix, Anthony Kouri, Anthony Alexander, Jay Bilyeu, Judy Bilyeu, Michael Eric Codlin, Wendy Rockwell-Goff, Robert Schumacher, James Hershman, Dorothy Hershman, Scott Tessler, Richard Rhoads, Martin Gary Norris, Dorothy Lowell, Nancy Hitchins, Thomas Truong, Edward Cisneros, Chris Honcik, Stephen Shoap, Dmitri Routski, Elena Lavender-Bowen, David Bowman, David Chow, Mark Everett Brown, Jonathan Dean, Lawrence Lewis Sinsel, Jr., Kenneth L. Kramer, Lawrence I. Weiner, John E. Killough, Alan Parker, Scott A. Smeltz, Howard Schwack, Douglas Jones and Stephen Herman. Joel H. Bernstein (Labaton Sucharow LLP) for Steven S. Novick. David A.P. Brower (Brower Piven, A Professional Corporation) for Susan Asai and Stephen C. Herman. Mark C. Rifkin (Wolf Haldenstein Adler Freeman & Herz LLP) for Howard Schwack. Robert A. Skinner (Ropes & Gray LLP) for Proshares Trust, Proshare Advisors LLC, SEI Investments Distribution Co., Michael L. Sapir, Louis M. Mayberg, Simon D. Collier, ProShares Trust II, Edward Karpowicz, William E. Seale, Charles Todd and Barry Pershkow.

Companies: Proshare Advisors LLC; Proshares Trust; ProShares Trust II; SEI Investments Distribution Co.

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