Enhanced Liability Standards for ETF Disclosure under the Securities Act: Insights from In re PROSHARES TRUST SECURITIES LITIGATION

Introduction

The litigation case titled In re PROSHARES TRUST SECURITIES LITIGATION (Mark Karasick et al. v. ProShares Trust et al., No. 12–3981, 728 F.3d 96), adjudicated by the United States Court of Appeals for the Second Circuit in 2013, addresses significant issues surrounding the disclosure obligations of Exchange-Traded Funds (ETFs) under the Securities Act of 1933. The plaintiffs, comprising individual investors, filed a class-action lawsuit alleging that ProShares Trust and its affiliates failed to adequately disclose the risks associated with leveraged ETFs, specifically the material omissions and misrepresentations in the offering documents. This commentary delves into the court’s comprehensive analysis, the precedents cited, the legal reasoning employed, and the broader implications for securities law and future litigation.

Summary of the Judgment

The plaintiffs in this case contended that ProShares Trust and ProShares Trust II had omitted critical information in their prospectuses related to the risks of investing in leveraged ETFs, particularly the potential for significant losses when ETFs were held beyond a single trading day. They invoked sections 11 and 15 of the Securities Act of 1933, alleging that these omissions rendered the prospectuses misleading. However, the district court dismissed the complaint with prejudice, a decision that was subsequently affirmed by the Second Circuit Court of Appeals.

The appellate court reviewed the case de novo, adhering to the standard of accepting all factual allegations as true and drawing all reasonable inferences in favor of the plaintiffs. Ultimately, the court upheld the dismissal, agreeing with the district court's assessment that ProShares had sufficiently disclosed the inherent risks associated with leveraged ETFs, thereby fulfilling their disclosure obligations under the Securities Act.

Analysis

Precedents Cited

The court referenced several key precedents to establish the framework for evaluating section 11 and 15 claims. Notably:

LITWIN v. BLACKSTONE GROUP, L.P. (634 F.3d 706): Established the de novo standard of review for dismissals under Rule 12(b)(6).
In re Morgan Stanley Info. Fund Sec. Litig. (592 F.3d 347): Clarified the necessity of identifying unlawful and material omissions for section 11 claims.
Matrixx Initiatives, Inc. v. Siracusano (131 S.Ct. 1309): Emphasized the importance of not setting a low standard for materiality to avoid overwhelming investors with trivial information.
BASIC INC. v. LEVINSON (485 U.S. 224): Defined materiality in the context of security disclosures, stating that information is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision.

These precedents collectively underscore a stringent approach toward establishing liability under sections 11 and 15, focusing on the materiality and significance of omissions or misstatements.

Legal Reasoning

The court meticulously examined whether the disclosures in ProShares' prospectuses met the statutory requirements to prevent the documents from being misleading. Central to this analysis was the concept of materiality under section 11, which mandates that any omission must be material and result in making the statements not misleading.

The plaintiffs argued that ProShares failed to disclose the risks of significant losses over periods longer than one day. However, the court found that ProShares had indeed included comprehensive risk disclosures, explicitly warning investors about the daily investment objectives, the use of leveraged financial instruments, and the potential for significant divergence from underlying indices due to volatility and compounding effects.

Furthermore, the inclusion of hypothetical investment scenarios and line graphs in the prospectuses, which illustrated potential deviations in ETF performance under varying volatility conditions, reinforced the sufficiency of the disclosures. The court emphasized that the disclosures were not only present but were also prominent and clear enough to inform a reasonable investor of the inherent risks.

On the matter of corrective disclosures made by ProShares at the end of the class period, the court held that such revisions do not retroactively render earlier disclosures inadequate. The prospectuses, as originally presented, were found to be sufficient in their warnings and risk explanations.

Impact

This judgment reinforces the high standard courts will uphold regarding disclosure obligations under the Securities Act. Companies offering complex financial instruments like leveraged ETFs must ensure that their prospectuses provide clear, comprehensive, and prominent disclosures of all material risks. The affirmation of the dismissal serves as a cautionary tale that plaintiff claims must articulate plausible and materially significant omissions beyond what is already disclosed.

For future cases, this decision delineates the boundaries of liability for financial product issuers, emphasizing that adequate and clear risk disclosures can shield issuers from class-action lawsuits alleging misleading statements or omissions, provided that all material risks are appropriately communicated.

Complex Concepts Simplified

Exchange-Traded Funds (ETFs)

ETFs are investment funds that trade on stock exchanges, similar to individual stocks. They typically track the performance of a specific index, sector, commodity, or currency. Leveraged ETFs, like those offered by ProShares, use financial derivatives and debt to amplify the returns of the underlying index on a daily basis.

Section 11 and 15 of the Securities Act of 1933

- Section 11: Imposes liability on issuers for any false statements or omissions in the registration statements required by the Securities Act. To prevail, plaintiffs must demonstrate that a material fact was misstated or omitted, leading to the prospectus being misleading.
- Section 15: Extends liability to certain individuals involved in the preparation and distribution of the securities, such as directors, underwriters, and certain officers, if section 11 is violated.

Materiality

In the context of securities law, information is considered material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision. Materiality ensures that only significant information that could influence an investor's decision is required to be disclosed.

Rule 12(b)(6)

A procedural rule that allows a court to dismiss a lawsuit for failure to present a legally valid claim, even if all factual allegations are true. This dismissal is based purely on legal insufficiency of the claim.

Conclusion

The Second Circuit’s affirmation of the dismissal in In re PROSHARES TRUST SECURITIES LITIGATION underscores the critical importance of thorough and clear risk disclosures in securities offerings, especially for complex financial instruments like leveraged ETFs. The court's decision reiterates that as long as issuers comply with disclosure requirements, effectively communicating material risks to investors, they can defend against claims of misleading omissions. This case serves as a benchmark for both issuers and litigants in understanding the boundaries of liability and the standards of disclosure necessary to comply with the Securities Act of 1933.