Court’s pro-BlackRock ruling could set unsettling precedent

The way ETFs are traded could make claims of misleading prospectuses harder to prove

Court’s pro-BlackRock ruling could set unsettling precedent
ETFs have many beneficial features that are attractive to fund investors, including the ability to trade in public exchanges. But that same ease of trading could be a disadvantage, as a recent case involving a global ETF giant suggests.

A California court has ruled in favour of BlackRock after the firm was sued by ETF investors who suffered losses during a volatile day of trading in 2015, reported the Wall Street Journal.

According to the plaintiffs, BlackRock’s iShares unit for left out critical warnings about risks in fund documents relating to the ETFs it sold. In court submissions, BlackRock countered that its documents provided adequate warnings.

The firm further argued that retail investors claiming they were not informed of the risks must be able to link the shares they bought to specific, provably misleading registration statements that were given when shares were first issued to authorized participants.

However, the firm said in its defense, ETF shares are “fungible and cannot be traced by plaintiffs to any other particular registration statement or amendment thereto.”

ETF trading first occurs in the primary market, when ETF providers create and sell large blocks of shares in their funds to so-called authorized participants. After this transaction, shares of the ETF go to the secondary market, which includes any public exchange where the shares are listed for investors in general to buy.

According to industry experts and lawyers, this structure of ETF trading makes it impossible for fund providers to know where shares from any particular issuance end up, or for investors to trace when the shares they own were issued. Units of mutual funds, on the other hand, are bought directly from the fund managers.

The plaintiffs in the California case pointed to fund sales documents that were published before they bought shares, claiming that they omitted certain risks. They further argued that the shares they bought should be covered by those same materials.

However, San Francisco Superior Court Judge Curtis E.A. Karnow ruled that the investors could not connect their holdings to those statements because of the way ETFs are created and sold. Under a specific section of securities law, he said, investors who buy securities after they are first issued cannot sue, according to the Journal.

Fund lawyers told the publication that current regulations could be interpreted differently by other courts.

If the California court’s decision is upheld, “no retail investor will ever be able to sue for a false registration statement or prospectus” for ETFs, said Reed Kathrein of Hagens Berman Sobol Shapiro LLP, who represented the investors. He said he intends to appeal the ruling.

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