Why a BlackRock Legal Victory Could Make It Harder for ETF Investors to Sue

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)