Source: https://www.hbsslaw.com/cases/blackrock-ishares-etf-august-24-2015-flash-crash-litigation
Timestamp: 2019-04-23 13:59:19+00:00

Document:
Hagens Berman Sobol Shapiro LLP filed a complaint on behalf of a class of BlackRock ETF investors against BlackRock Inc., iShares Trust and their affiliates. The case is brought on behalf of investors of BlackRock iShares Exchange Traded Funds (“ETFs”) who used market or stop loss orders and suffered losses when the underlying value of the assets in BlackRock ETFs disengaged from the ETF price during the August 24, 2015 ETF Flash Crash. The potential class includes those who purchased iShares ETFs between June 16, 2013 and August 24, 2015 (the “Class Period”) and sold their iShares ETFs on August 24, 2015 pursuant to a market or stop-loss order, and were damaged thereby. Defendant-Respondent iShares Trust is registered with the SEC as an open-end management investment company under the ICA. The iShares Trust, the world’s largest ETF. Defendant BlackRock, Inc. (BlackRock), in turn, controls the iShares Trust. As of 2015, BlackRock had $4.65 trillion assets under management (AUM) – making it the world’s largest asset manager.
While the trial court held the plaintiffs stated a claim for relief, it held a trial on the merits of whether plaintiffs (retail investors) had standing to sue. Each plaintiff investor purchased at least one BlackRock iShares ETF and, due to market or stop-loss orders, each suffered financial losses in the August 2015 flash crash – a gut-wrenching day when ETF trading prices fell dramatically and, due to the nature of their sale orders, caused plaintiffs substantial but avoidable financial losses. Importantly for standing purposes, it was uncontested that iShares ETFs were sold to each plaintiff after, and pursuant to, allegedly defective SEC disclosure documents or amendments thereto issued or filed between 2012 and 2015. The crux on standing is whether this suffices for plaintiffs to invoke the Securities Act. The trial court held plaintiffs did not have standing. The legal issue is of first impression because ETFs are relatively unique and recent security instruments.
Most laypeople are familiar, if only through their jobs, with mutual funds and individual stocks often selected for a 401(k) plan. But, as an investment vehicle, ETFs are less known and – as even BlackRock freely acknowledged – less understood. This knowledge gap made BlackRock’s pitch to investors highly material in attracting trillions of dollars now invested in BlackRock ETFs under defendants’ management and control.
A stop-loss order mandates that an investor’s security be bought or sold once the stock value hits a certain price; it is intended to limit an investor’s loss. Once a security’s price drops to the targeted lower price, the stop-loss converts to a market order – meaning the trade is automatically executed at market price. But during the August 2015 flash crash, stop-loss orders had the opposite effect. Instead of reducing risk, many ETF investors were surprised and damaged as a result.
Before the August 2015 flash crash, BlackRock observed that during high volatility, ETF values were impacted much more than mutual funds and regular securities. On May 6, 2010, U.S. equity markets experienced a flash crash when U.S. equities, and ETFs holding them, declined precipitously for one-half hour. Numerous ETFs traded 60% lower than the value of their underlying assets. BlackRock later observed that this was similar to a 2008 crash where ETFs traded 5-8% lower than the underlying asset values.
As detailed in the operative complaint, BlackRock was on ample notice of the volatility risk for investors in iShares ETFs. But because of BlackRock’s failure to warn investors, including plaintiffs, of potential consequences from a flash crash, many investors and investment advisors remain ignorant of the risks of using stop-loss orders with ETFs. Although the Offering Documents disclosed that ETFs are subject to volatility, investors were not advised of the known inherent risk of using stop-loss or market orders with ETFs – the very selling methods that caused plaintiffs’ losses here.
On August 24, 2015, BlackRock ETF investors who had placed market orders or protective stop-loss orders before or at market opening suffered drastic losses. Of all ETFs, 19.2% experienced price declines of more than 20% (compared to only 4.7% of corporate securities). For example, BlackRock’s iShares Select Dividend ETF dropped more than 35% by 9:42 a.m. EST when the underlying investments within the fund dropped only 2-4% – a disengagement of over 30%.
Since the crash at issue in this case, the leading stock exchanges – including NASDAQ and the New York Stock Exchange – announced their intent to eliminate “stop-loss orders” and “good-til-canceled” orders. So, when BlackRock failed to protect its investors from sharp single-day declines, the major exchanges stepped in.
who sold On August 24, 2015 pursuant to a market order or stop-loss order” and were damaged thereby.
Relevant to standing, the last amended registration statements preceding plaintiffs’ ETF purchases were admitted at trial. Several named plaintiffs received an Offering Document, such as a prospectus, in connection with their iShares ETF purchase.
Holding that plaintiffs state viable claims for relief, the trial court twice rejected defendants’ attempt to terminate this action at the pleading stage.
Although defendants sought dismissal on the pleadings three times, their standing argument was virtually an afterthought.
First, defendants demurred to the original complaint.
But defendants did not challenge standing and their demurrer was “taken off calendar.” Defendants then filed separate answers. Neither alleged standing as an affirmative defense.
After the trial court stayed all discovery, defendants moved for judgment on the pleadings.
Again, standing to sue was not disputed. The trial court granted dismissal with leave to amend so plaintiffs could plead facts “‘to demonstrate conformity with the statute of limitations.’” Although not at issue now, plaintiffs later cured.
More significantly for present purposes, the trial court also ruled that plaintiffs stated viable Securities Act claims.
After plaintiffs filed their First Amended Complaint (FAC), defendants once more sought judgment on the pleadings. Concurrently, they again filed separate answers. Eight months after suit was initiated – and facing the prospect of litigating the action on the merits – the individual defendants added standing to their affirmative defenses.
The BlackRock defendants did not.
Despite defendants’ failure to raise standing earlier, the trial court ruled that plaintiffs lack Section 11 standing and entered judgment.
The “trial” was two hours of oral argument. No witnesses testified; there were no credibility determinations. The parties stipulated “to the admissibility of the trial declarations and exhibits thereto” already on file.
In its statement of decision, the trial court concluded that “plaintiffs have no standing to bring their § 11 or dependent § 15 claims in this case.” After the final judgment entered for defendants, plaintiffs timely appealed.
On appeal plaintiffs assert the fundamental error permeating the trial court’s decision is reading the ICA’s plain language, in a case involving an investment company security, out of the standing inquiry.
When the ICA is restored to its proper place in the analysis, plaintiffs necessarily have standing to assert their claims.
The contrasting nature of the language is readily apparent. ICA standing is afforded to those “sold” a security, without limitation. The Securities Act’s more restrictive language, enacted before the ICA, only underscores that Congress intended broader standing for Securities Act claims involving investment companies.
The trial court thus gave “sold” in the ICA an unduly grudging application to negate the very standing provided by Section 24(e). The trial court’s interpretation cannot be squared with the plain language. The Securities Act focuses on specific offerings of specific securities; ICA standing turns simply on the sale of a security governed by the statute. There is no dispute that iShares ETFs were sold to plaintiffs, and the proposed class, after the latest applicable amendment to the pertinent registration statement for the fund. This gives them standing. There is no other interpretation of standing faithful to the straightforward language used by Congress in Section 24(e).
Indeed, the trial court’s ruling that plaintiffs nonetheless needed to trace their shares, evidently through chain of title, erroneously renders the standing inquiry the same for two statutes that are written very differently. (4AA1546-1547.) Under the trial court’s reading, the broader ICA standing language is rendered surplusage.
Together, the Securities Act as supplemented by the ICA create a uniform set of rules to protect investors in investment company transactions.
The Securities Act “was drafted with an eye to the disadvantages under which buyers labor” in public offerings. (Wilko v. Swan (1953) 346 U.S. 427, 435.) “Section 11 creates ‘correspondingly heavier legal liability’ in line with responsibility to the public[.]” (Herman & MacLean v. Huddleston (1983) 459 U.S. 375, 381, fn. 12.) And, contrary to the trial court’s assumption, the Securities Act’s protections are not restricted to initial offerings but, more expansively, “public offerings.” (Gustafson v. Alloyd Co. (1995) 513 U.S. 561, 571 (Gustafson).) There was no dispute that investment companies, as in this case, continuously offer their shares to the public.
Section 11 imposes “virtually absolute liability” where a registration statement contains “an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading.” 15 U.S.C. § 77k(a); In re Direxion ETF Tr. (S.D.N.Y. 2012) 279 F.R.D. 221, 232.) Section 11 and 12 claims do not require a plaintiff to prove causation, reliance or scienter. Id. Stating a Securities Act claims places “a relatively minimal burden on a plaintiff.” (Litwin v. Blackstone Grp., L.P. (2d Cir. 2011) 634 F.3d 706, 716.) It would be inconsistent to give Section 11 in the Securities Act a robust application but investor rights under the ICA a toothless one.
77f(a) (§6(a) of the 1933 Act).
requirements forty days after the effective date of the registration statement.
Defendants’ ETFs are registered under the ICA. [stating on first page of each: “Registration Statement Under the Investment Company Act of 1940”].) Every Prospectus and Statements of Additional Information filed by the defendants acknowledges the ICA as the applicable law. By contrast, the Securities Act mandates registration of specific securities in each statement and not an indefinite amount of a class of shares on a continuous basis.
Defendants’ ETF amendments to their own registration statements filed under the ICA illustrate the distinction. [Compare S-1 Registration Statement, filed solely under Securities Act] with Form N-1A Registration Statements for ETFs, filed under both Securities Act and ICA].) As legally required, the form S-1 registration statements explicitly list details about the securities offered therein, including the “Title of Each Class of Securities to be Registered” and the “Amount to be Registered.” By contrast, defendants’ Form N-1A registration statements for ETFs, registered pursuant to the ICA, do not contain these specifics.
When Congress added Section 24(e) of the ICA, it rejected calls to similarly amend Section 6(a) of the Securities Act.
The trial court thus erroneously ignored not just the differing statutory language but its manifestations in defendants’ Offering Documents – along with subsequent indications that the Securities Act and ICA are written differently because they serve different salutary goals in protecting investors.
The SEC did not exempt defendants from Section 11 or 12 liability to ETF investors who purchased their shares in the secondary market.
In assessing plaintiffs’ standing, it is also significant that the SEC must affirmatively exempt an investment company from the Securities Act. To allow trading on an open market, the SEC has granted exemptions under its narrow authority within the ICA.
As investors are the very persons the statutes and regulations were designed to protect the SEC cannot grant exemptions from the statute to diminish the rights and protections of investors.
Like mutual funds, ETFs register an “indefinite amount” of shares which they continuously offered and in a constant process of redemption and reissue. (15 U.S.C. § 80a-24(f).) Unlike Securities Act-regulated companies, which register to issue a set number of shares, investment companies must file annual amendments to their registration statements. (17 C.F.R. § 270.8b-16(a).) The prospectus must be updated annually. (15 U.S.C. § 80a-24(e).) The prospectus also must be made available to any investor. (15 U.S.C. § 80a-24(d); 15 U.S.C. § 77d(3).) BlackRock itself, in commenting on enhanced prospectus disclosure, agreed with the SEC that investors in the secondary market are the intended primary recipients of each prospectus.
The SEC adheres to the ICA statutory structure that the disclosure requirements in the registration statements and prospectuses of ETFs are intended for investors in the secondary market. For example, in adopting a final rule revising ETF prospectus disclosure in 2009, the SEC reiterated that the rule revisions were “intended to result in the disclosure of more useful information to investors who purchase shares of exchange-traded funds on national securities exchanges.” In no uncertain terms the SEC stated: “The proposed amendments for ETF prospectuses were designed to meet the needs of investors (including retail investors) who purchase ETF shares in secondary market transactions rather than financial institutions that purchase creation units directly from the ETF.
Thus, the SEC has expressed the clear position that the annual disclosure obligations under the ICA in the amendments to the registration statements are targeted to the investor trading in the secondary market. Accordingly, the secondary market investor has standing under the governing provisions of the ICA to make the claim for defective disclosure under Sections 11 and 12(a)(2) of the Securities Act.
Section 24(e)’s legislative history confirms that purchases after a defective amendment to a registration statement suffice for standing.
Indeed, under the ICA and until recent SEC exemptions, redeemable securities such as ETFs were not sold on a national exchange or secondary market. (U.S. v. Cartwright (1973) 411 U.S. 546, 547-549.) BlackRock’s ability to do so, to the tune of trillions of dollars under management, is thus a legally unique privilege granted by the SEC.
Thus, because of the unique nature of investment companies and their “continuous offering practices” of “the same class of shares,” Congress dictated that the registration statements and prospectuses would be “updated annually . . . regardless of the need to offer new shares.” Congress also dictated that the prospectus be used by dealers (regardless of their participation in a distribution) and that liability under Section 11 for defective registration statements would be extended to each investor sold shares after the amendment, with the statute of limitation running anew for such investors.
The 1954 House and Senate Reports stated that Section 24(e) aimed to require the entire registration statement to meet the standards of Section 11 “not only on the original effective date but also on the effective date of each post-effective amendment.” Congress added 24(e) to the Investment Company Act of 1940 to ensure that Section 11 liability would not dissipate simply because a new amendment was filed.
Respectfully, these floodgates are illusory. Plaintiffs allege, and the trial court held a claim was stated, that the Offering Documents failed to disclose risks specific to ETFs before the August 2015 flash crash. This typifies the sort of case that will be brought if Section 24(e) of the ICA is given a plain-language interpretation. Moreover, ETFs can be sold only by Authorized Participants who have purchased them from issuers such as defendants, who, in turn, can sell them only to broker-dealers. They are then limited to being sold on a national exchange or by broker-dealers. (4AA1452-1453, 1476.) Therefore, secondary market investors cannot, among themselves, sell and purchase ETFs.
Relying on Section 11 “tracing” decisions, the trial court mistakenly extrapolated Securities Act standing to the ICA.
Here, similarly, there is only one continuous offering, and one registration statement, it is undisputed, with amendments. Under the ICA, again, no individual shares are registered or specified. Rather an “indefinite amount” of shares are registered under §24(f) in a continuous offering and redemption cycle. (15 U.S.C. § 80a-24(f).) By relying on chain-of-title tracing decisions applying Section 11 of the Securities Act, the trial court committed legal error.
The case is on appeal to the Court of Appeal of California, First Appellate District, Division Two, No. A153511. Plaintiff/Appellant has filed it’s opening brief linked above.

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