Investor Suit Against ProShares Dismissed

By
Olly Ludwig and Cinthia Murphy
September 11, 2012
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Three years later, a federal judge says ProShares is off the hook.

A federal court in New York dismissed a class action suit against ProShares, the world’s biggest purveyor of leveraged and inverse ETFs, saying charges that it didn’t fully inform investors of risks of investing in its funds didn’t stand up to scrutiny, according to court documents.

Furthermore, the U.S. District Court for the Southern District of New York found charges by the plaintiffs that the New York-based fund company knew in advance that investors could lose a lot of money were “implausible,” the court ruling said.

The lawsuit was filed in August 2009 by investors who were not in full command of how the company’s leveraged and inverse funds work. The ETFs are designed to magnify returns of their underlying indexes by two or three times, and some also deliver the inverse returns of their indexes. The ruling appears to encompass all the remaining legal action against the company, putting the entire episode in the rearview mirror.

The rude awakening for investors came when they began to grasp that the funds, because they rebalance daily, frequently have returns that deviate significantly from those of their indexes.

At the heart of the matter is the funds’ performance during the height of the credit crisis—mid-2008 through the first half of 2009—when many of the ProShares funds faced substantial losses despite “their underlying indexes having moved in a direction that the investors expected to be favorable during the period,” the documents said.

ProShares manages around $22.5 billion in assets spread across its more than 40 leveraged and inverse funds.

"We were always confident that the allegations were without merit and we are pleased that the claims have been dismissed in their entirety," ProShares General Counsel Amy Doberman told IndexUniverse.

Risks Stated "In Plain English"

The suit detailed multimonth performance data for various indexes underlying ProShares funds and compared them with the ETFs’ performance during that same period.

“ProShares had an as yet undisclosed mathematical formula from which it could be determined, in advance, that there was a ‘must lose’ risk that, at high enough levels of volatility, investors who held ETFs for periods longer than one day could quickly lose a large portion of their investment, no matter which direction the underlying index or benchmark moved,” the lawsuit argued, noting that this “must lose” risk materialized during the height of the crisis.

But Judge John Koeltl wrote in the Sept. 10 opinion that, contrary to what investors were charging, ProShares was explicit in disclosing particular risks associated with investing in its leveraged and inverse ETFs.

He said that the registration statements at issue “stated in plain English” that the ETFs’ objectives were daily only, and their performance could “diverge significantly” from the underlying index when they were held for longer than one day.

“This was the precise risk that the plaintiffs allege later materialized: the plaintiffs held the ETFs for long periods of time beyond one day, and their value diverged significantly from the expected daily result causing large losses,” the judge said in the ruling.

“The complaint is an example of alleging fraud by hindsight,” he added, quoting a previous court ruling dealing with the issue of materiality.

“The plaintiffs’ assertion that ProShares knew in advance through a mathematical formula that large losses would occur is implausible,” he said. “Whatever formula was used for the ETFs, it would necessarily rely on inputs from the underlying index or benchmark, and those inputs could not be known in advance.”

“It is not a material omission to fail to predict future market performance,” he concluded.

 

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