(CN) – Investors in a mutual fund who claim the fund managers at Charles Schwab improperly took on undisclosed risks can continue to assert certain misrepresentation claims after surviving a motion to dismiss, a federal judge in Los Angeles ruled.
Charles Schwab Corp. was sued by investors in the company’s YieldPlus Fund. The mutual fund was advertised as an “ultra short term bond fund” which sought to limit its risk exposure by keeping its average portfolio duration to less than a year. According to plaintiffs, the fund took on significantly greater risk by extending its portfolio duration beyond two years, and by concentrating a significant portion of its portfolio in riskier assets such as mortgage-backed securities.
Plaintiffs in a purported class action named Schwab, accounting firm PricewaterhouseCoopers LLP, and individual fund managers as defendants. Schwab moved to dismiss the petition. Judge William Alsup of the Northern District partially granted and partially denied the motion, ruling that plaintiffs failed to sufficiently allege contract violations. Judge Alsup denied the motion as it pertained to allegations of misrepresentations.
“Section 11 [of the Securities Act of 1933] focuses specifically on misstatements or omissions in registration statements. It creates a private right of action for purchasers of securities, against certain enumerated defendants, where any part of the registration statement contained an untrue statement of a material fact or omitted to state a material fact required to be stated.
“The parties dispute whether plaintiffs’ Section 11 claim should be analyzed under the notice pleading standards of Rule 8 or instead under Rule 9(b) [of the Federal Rules of Civil Procedure]. The latter requires that ‘in alleging fraud or mistake, a party must state with particularity the circumstances constituting fraud or mistake.’
“The applicability of Rule 9(b) hinges not on the elements of the claim but rather on the nature of the allegations themselves.
“Although Section 11 claims require a misrepresentation, they are not inherently fraud-based. Scienter is not required for claims under Section 11; defendants may be liable under Section 11 for negligent or even innocent misrepresentations.
“The complaint does not specifically allege fraud; indeed, it assiduously avoids use of the word. Moreover, it also generally avoids averments inherently suggestive of fraud such as that defendants ‘knowingly’ or ‘intentionally’ made the misrepresentations alleged. In their opposition brief, plaintiffs disclaim any allegation of fraud and contend that the complaint asserts merely negligent misrepresentations.
“Defendants claim that, while fraud is not specifically pled, the allegations necessarily constitute fraud.
“This order is unable to hold that the conduct alleged necessarily sounds in fraud. Other explanations are certainly plausible. Indeed, although the complaint does not specifically plead negligence, it alleges a potentially non-fraudulent case of the misrepresentations-that the misstatements arose from breakdowns in internal controls.
“Assuming that material misstatements occurred, [it] is possible that many of the defendants were unaware of the fund’s increasing risk and deviations from stated investment policies, and/or were merely negligent in failing to recognize and prevent them.
“This order declines to characterize the claims as necessarily sounding in fraud where plaintiffs have not expressly pled fraud and have pled non-fraud bases for liability. For these reasons Rule 8 governs the claim; defendants’ motion to dismiss the Section 11 claim for failure to satisfy Rule 9(b) is denied.
“Defendants contend that all of the complaint’s state law claims are preempted by the Securities Litigation Uniform Standards Act (SLUSA). Plaintiff argues, however, that the state claims do not allege untrue statements or omissions and are not related to the purchase or sale of the covered securities.
“This order agrees. The state claims are not, in substance, predicated on misrepresentations or omissions. Rather, each of those claims assert a violation arising from an allegedly unauthorized change of the fund’s concentration policy, which expressly limited concentration to 25 percent of assets in any single industry.
“When applying SLUSA, courts ignore extraneous allegations and focus on the gravamen of the complaint. Because [plaintiffs’] state claims are not predicated on a misrepresentation in connection with a securities transaction, those claims are not preempted.”
Plaintiff is represented by Peter Borkon at Hagens Berman et al out of Berkeley. Defendant is represented by Darryl Rains at Morrison and Foerster LLP out of Palo Alto.