The U.S. Court of Appeals for the Second Circuit upheld the dismissal by a lower court of investors’ claims that certain ETF prospectuses failed to adequately disclose the risk of significant losses over an extended period of time.
In a July 22, 2013 decision, the court dismissed claims against officers and directors of ProShares Trust and its investment adviser that certain ProShares ETF prospectuses failed to warn about the possible magnitude and probability of loss in investments held for more than a day, even when investors correctly predicted the overall direction of the ETFs’ underlying index.
The ProShares ETFs are designed to provide a return equal to a specified multiple of an index or other benchmark, or the inverse return of the index or benchmark, for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, the ETF’s returns over periods other than one day likely will differ in amount and possibly direction from the target return for the same period. The compounding effect can be exacerbated when the ETF is “geared,” or leveraged, to produce a multiple of the return.
In this case, during a period of unusual market volatility in 2006-2009, certain ultra-short ProShares ETFs experienced significant losses, even when the performance of the underlying index would indicate a potential gain. The plaintiffs claimed that they lost money after holding their ETF shares for more than one day and that ProShares violated Sections 11 and 15 of the Securities Act of 1933 because it failed to disclose the risks of holding the shares for longer than one day.
The court stated, in sum, that the prospectuses adequately described the risks. It rejected the plaintiffs’ claims that the prospectuses should disclose with specificity the level of risk under various market scenarios. “ProShares cannot be expected to predict and disclose all possible negative results across any market scenario,” the court said.
The court bluntly assessed the adequacy of the prospectus disclosures: “[N]o reasonable investor 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.”
The court rejected the plaintiffs’ argument that by including “corrective disclosure” after the lawsuit was filed to enhance risk disclosure, the ETFs effectively acknowledged that the original disclosure was defective: “We have previously noted that where the ‘quality of [a] disclosure could have been improved[,] the advisability of revision does not render what was done deceptive or misleading.’”
Rather, the court said, the test is whether the prospectuses, as written, “adequately apprise the reader of the essential nature” of the securities. The court held that the original disclosure was adequate, and that the revisions did not alter its conclusion that the earlier prospectuses adequately warned of the effect of volatility on the magnitude and probability of a loss.
This case sends a message that specific risk disclosures warning of an eventual outcome need not anticipate the extent of potential loss in under every possible circumstance, and that subsequent enhancement of prospectus disclosure does not by itself mean that the prior disclosure was inadequate.
Disclosure: Morrison & Foerster represents the independent trustees of ProShares.