Jensen v. Ishares Trust
| Decision Date | 23 January 2020 |
| Docket Number | A153511 |
| Citation | 44 Cal.App.5th 618,258 Cal.Rptr.3d 1 |
| Court | California Court of Appeals Court of Appeals |
| Parties | Garth JENSEN et al., Plaintiffs and Appellants, v. ISHARES TRUST et al., Defendants and Respondents. |
Attorneys for Plaintiffs and Appellants: Hagens Berman Sobol Shapiro, Reed R. Kathrein, Berkeley, Peter E. Borkon, Danielle Smith, Berkeley, Kevin K. Green
Attorneys for Defendants and Respondents: Skadden, Arps, Slate, Meagher & Flom, Jeremy A. Berman, Eben P. Colby, Patrick M. Hammon, Palo Alto, Stroock & Stroock & Lavan, John R. Loftus, Los Angeles
Kline, P.J. Investors who purchased shares of exchange-traded funds sued the issuers of the fund and associated entities for violations of disclosure requirements under the federal Securities Act of 1933. The trial court entered judgment for respondents after finding appellants lacked standing to pursue their claims. Appellants’ challenge to this ruling is based on a provision of the Investment Company Act of 1940 they view as conferring standing and various differences between exchange-traded funds and traditional investment vehicles. We affirm.
BACKGROUND
Appellants are individual investors who purchased one or more shares of BlackRock iShares Exchange-Traded Funds (ETFs) and thereafter suffered financial losses when their shares were sold pursuant to "market orders" or "stop-loss orders" during a "flash crash" on August 24, 2015, when ETF trading prices fell dramatically. Appellants maintain that BlackRock’s registration statements, prospectuses and amendments thereto (collectively, "offering documents") issued or filed between 2012 and 2015, were false or misleading in that they failed to sufficiently disclose the risks associated with flash crashes. Appellants purchased their ETF shares after these allegedly defective offering documents were issued or filed.
Respondent iShares Trust (iShares) is registered with the United States Securities and Exchange Commission (SEC) as an open-end management investment company under the Investment Company Act of 1940 (ICA) (15 U.S.C. § 80a et seq.), and encompasses numerous separate ETFs. BlackRock Fund Advisors (BFA) is the investment advisor for the BlackRock iShares Funds at issue in this case. BFA is a subsidiary of BlackRock, Inc. (BlackRock), which controls iShares, BFA and BlackRock Investments, LLC, the distributor for iShares. The remaining respondents on this appeal are four of the 11 individual defendants named in the complaint.
According to the allegations of the complaint and evidence before the trial court, ETFs, which first came to market in the 1990s, are investment companies that are registered under the ICA as open-end funds or unit investment trusts. ( SEC Concept Release: Actively Managed Exchange-Traded Funds, 17 C.F.R. Part 270 [Release No. IC-25258 ].) Instead of transacting in individual shares, however, ETFs sell and redeem shares, at net asset value (NAV),1 only in large aggregations or blocks called "Creation Units." ( SEC Concept Release: Actively Managed Exchange-Traded Funds, 17 C.F.R. Part 270 [Release No. IC-25258 ].) Creation units are sold to "authorized participants," such as broker-dealers or large institutional investors, which may then sell some or all of the shares to investors in the secondary market; creation units are not sold directly to retail investors.2 (Ibid. ) ETFs are listed for trading on national securities exchanges, allowing investors to purchase and sell ETF shares at market prices, not necessarily at NAV. ETFs have some characteristics of traditional open-end funds, which issue redeemable shares, and some characteristics of closed-end funds, which generally issue shares that trade on exchanges at negotiated prices and are not redeemable. ( SEC Concept Release: Actively Managed Exchange-Traded Funds, 17 C.F.R. Part 270 [Release No. IC-25258 ].) Early ETFs passively track the performance of specific United States equity indices; newer ones often are actively managed and seek to track indices of fixed-income instruments and foreign securities.3
Appellants alleged that BlackRock portrayed ETFs as safe investments, designed to reduce and protect investors from market volatility, despite being aware of particular risks that it failed to disclose to investors. At issue in the present case is the use of stop-loss orders with ETFs. A stop-loss order requires that an investor’s security be bought or sold when the stock value hits a certain price; when the stock price drops to the preset price, the order is automatically converted to a market order and the security trade is automatically executed at market price. Stop-loss orders are generally used to limit risk, but in times of high volatility can have the opposite effect. Appellants alleged that the use of stop-loss and market orders to hedge ETF risk "amplifies the disengagement of ETF values from their NAV" due to "lack of liquidity in the ETF market": "When ETF markets are highly illiquid, market sell orders sweep through available purchase orders, allowing ETF prices to plummet and reflect a sales price completely unrelated to an ETF’s underlying value."
On May 6, 2010, equity markets in the United States experienced a "flash crash" in which equities and ETFs holding equities declined "precipitously" for approximately a half hour during afternoon trading. Many ETFs traded 60 percent lower than the value of their underlying assets. BlackRock later observed that this was similar to a 2008 crash, when ETFs traded 5-8 percent lower than the underlying value of their assets. BlackRock reported to regulators that in the 2008 and 2010 crashes, stop-loss orders increased the volume of sell orders for ETFs, resulting in decreased liquidity and exacerbation of disproportionate declines in ETF prices as compared to the ETF’s underlying assets. In 2011, BlackRock wrote to the SEC that it expected "mini-flash" crashes to recur and ETF investors needed education on the use of market and stop-loss orders. In 2013, BlackRock acknowledged that the 2010 flash crash disproportionately affected "US ETFs holding US equities."
Appellants alleged that the offering documents pursuant to which they purchased respondents’ ETFs disclosed that ETFs are subject to volatility but did not disclose "the known inherent risk" of using stop-loss orders with ETFs, despite respondents’ admitted knowledge of the likelihood of disproportionate harm and belief that more flash crashes were inevitable. iShares "continuously issues and redeems ETF shares," issuing and selling new shares of each series in primary market transactions pursuant to registration statements or amended registration statements filed with the SEC. Accordingly, iShares registration statements are amended at least annually.
On August 24, 2015, another flash crash occurred. BlackRock ETF investors who had placed market or stop-loss orders prior to or at the opening of the market suffered disproportionate losses as their shares were sold below their designated stop prices and below the net asset value of the shares. Price declines of more than 20 percent occurred in 19.2 percent of all ETFs, compared with declines of 4.7 percent in corporate securities. For example, one of BlackRock’s iShares ETFs dropped more than 35 percent while the underlying investments in the fund dropped only 2 to 4 percent; another ETF dropped over 60 percent.
BlackRock has since admitted that during the crash, " ‘retail investors who had standing stop-loss orders were especially impacted.’ " As a result of the August 24, 2015, flash crash, the New York Stock Exchange and other exchanges announced that stop-loss orders and " ‘good-til-canceled’ " orders would no longer be accepted.
Appellants’ original class action complaint was filed on June 16, 2016, and alleged claims under sections 11, 12(a)(2) and 15 of the 1933 Act. ( 15 U.S.C. §§ 77k ( section 11 ) 77l (section 12), 77o (section 15).)4 Respondents moved for judgment on the pleadings, which was granted (on a statute of limitations issue) with leave to amend. The trial court noted, however, that appellants’ allegations concerning misstatements in and omissions from the offering documents were sufficient to state a claim. Appellants filed their first amended complaint on January 6, 2017. Respondents again moved for judgment on the pleadings, this time asserting for the first time that appellants lacked standing.5 Their argument was that liability under sections 11 and 12(a)(2) of the 1933 Act applies only to initial offerings, and appellants purchased their ETF shares on the secondary market. The court granted the motion as to the section 12 claim on this basis but denied it as to the claims under sections 11 and 15.6 As to section 11, the court cited case law holding that a plaintiff has standing if shares purchased in the secondary market can be traced back to an offering made under a misleading registration statement, and found the record insufficient to determine the issue at that time.
The parties agreed to a bifurcated bench trial on the issue of "standing/tracing." The trial consisted of the parties’ arguments based on evidence submitted by means of declarations and attached exhibits, the parties having waived objection to the admissibility of the declarations and exhibits thereto and exhibits to the trial briefs and limited their objections to weight or relevancy of the evidence. Appellants argued they were not subject to the tracing requirement under section 11 because iShares is governed by the ICA and, under section 24(e) of the ICA ( 15 U.S.C. § 80a-24(e) ) (section 24), the latest amendment to a registration statement governs all securities sold after it goes into effect, no matter how or to whom they were sold. Thus, according to appellants, they had standing if they purchased their shares after respondents issued defective registration statements or prospectuses, regardless of what offering documents were in effect when the shares were...
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