The dismal performance of mutual funds could result in a wave of lawsuits alleging that funds failed to disclose the true risk of their investments, according to several industry lawyers.
Class actions that hinge on disclosure claims related to underperforming bond funds have already been filed against The
Charles Schwab Corp. of San Francisco; Memphis, Tenn.-based Morgan Keegan & Co., a subsidiary of Regions Financial Corp., and OppenheimerFunds Inc. of New York (see related story on Page 22).
As plaintiff's attorneys look for additional cases, more such suits are inevitable, said Robert Skinner, a partner with Boston-based lawfirm Ropes & Grey LLP.
'FOLLOWING THE MONEY'
"My sense is that the plaintiff's bar is doing what they normally do: following the money, targeting funds that have investment losses and finding a theory to fit the facts," he said.
And the theory that funds should be on the hook for losses because they didn't disclose how risky their investments were may prove to be a winner.
However, "the history of disclosure suits in the mutual fund area is not great," said Barry Barbash, a partner in the Washington office of New York law firm Willkie Farr & Gallagher LLP. He is a former director of the Securities and Exchange Commission's Division of Investment Management.
But in a sour market in which complicated derivatives are being blamed for so much investor misery, the argument that "this or that was not disclosed" could find a receptive audience, Mr. Barbash said.
Much depends on the nature of the losses incurred by funds, said Bruce Leto, chairman of the investment management/mutual funds practice group at Stradley Ronon Stevens & Young LLP, a law firm based in Philadelphia.
"With what's happened in last six months, some of these funds are down by dramatic amounts," he said. "It's a question of, were funds following in line with the market, or was something else wrong?"
If a fund's poor performance was the result of risky investments that weren't disclosed, then a suit based on that claim may have a shot at succeeding, Mr. Leto said.
If such suits are successful, it would be a major blow to the fund industry, said Tamar Frankel, a professor at the Boston University School of Law who specializes in mutual fund law.
Disclosure cases are akin to "an atomic bomb," she said.
DIRE CONSEQUENCES
Successful cases would result in judgments ordering the repayment of investor losses, payments which could potentially wipe out a fund, Ms. Frankel said.
It seems unlikely, however, that such cases would be successful, Mr. Skinner said.
"What [plaintiff's attorneys] are really trying to do is to fit disclosure theories around investment losses," he said.
But investment losses by themselves aren't "actionable," Mr. Skinner said.
Even if they never make it to court, disclosure cases could end up costing fund companies a lot of money.
"If there are plaintiffs able to get past dismissal and into discovery ... the defense cost is in the many millions," Mr. Skinner said.
"I think this is what [plaintiff's attorneys] are banking on," he said. "If they can put together a complaint that passes muster, they can impose costs and receive a quick settlement."
Such a scenario would be an added burden to fund advisers, but it wouldn't harm fund investors, said Jeff Keil, president of Keil Fiduciary Strategies LLC, a Littleton, Colo.-based industry adviser.
"From some of the suits I've been involved with, most funds aren't so bold as to flow through legal costs to the shareholders," he said.
A flood of lawsuits isn't a given.
"We have not witnessed a specific correlation between past economic downturns and a substantial increase in fund industry litigation," said Daniel Steiner, general counsel for the ICI Mutual Insurance Co. in Washington, the non-profit mutual fund insurance company owned by the fund industry.
There was just one federal class action related to mutual funds filed at the end of 2001 — months after the technology bubble burst — according to the Stanford Law School Securities Class Action Clearinghouse in Palo Alto, Calif. It was eventually dismissed.
Shortly thereafter, however, there was a dramatic increase in the number of mutual fund class actions filed. Eighteen suits were filed in 2003 and 22 in 2004, largely as a result of illegal market timing and late trading that came to light in 2003.
The database maintained by Stanford, however, isn't a complete picture of all litigation filed against mutual funds, as it covers federal class actions only.
GREATER VULNERABILITY
And even if it were, the market's decline has been so steep this time around that several industry observers said mutual funds are more vulnerable to litigation now than they have ever been.
The prospect of disclosure-related suits is a break from the past when the plaintiff's bar favored suits against mutual funds related to excessive fees.
Those cases, however, have proven nearly impossible to prosecute successfully.
That may change when the Supreme Court rules on an excessive-fee case that could change the standards by which such cases are tried.
The case, filed in 2004, involves a lawsuit against Harris Associates LP, the Chicago-based adviser to the Oakmark Funds. A ruling is ex-pected soon.
But until then, plaintiff's attorneys are tilting toward disclosure-related suits, observers say.That approach has much in common with the slew of litigation still making its way through the courts that alleges tobacco companies knew of the dangers of smoking, but never disclosed those dangers to customers, Mr. Skinner said.
As a result, the fund industry may see lawsuits brought by deep-pocketed firms that don't typically get involved in mutual fund litigation, he said.
E-mail David Hoffman at [email protected].
