The opinion of the court was delivered by: WOLIN
This matter is before the Court upon Defendants' Motion to Dismiss the Second Amended Class Action Complaint (hereinafter the "SAC") pursuant to Federal Rule of Civil Procedure 12(b)(6) for failure to state a claim upon which relief can be granted. This motion has been decided upon the written submissions of the parties pursuant to Federal Rule of Civil Procedure 78. For the reasons set forth below, the Court will grant in part and deny in part defendants' Motion to Dismiss.
The dispute in this case centers on how well defendants disclosed the risks inherent in two mutual funds they were selling and whether the mutual funds only assumed the risks which the associated prospectuses disclosed they would assume. Shareholders in the two mutual funds allege that defendants, in violation of federal securities laws and state laws, misrepresented and failed to disclose the risks of investing in those funds and failed to register one of the funds with the Securities Exchange Commission.
Plaintiffs Blatt, Biderman, Semalsy, Inc., Myr-Ale Corp., Gold, Inc., Galias Fray, Inc., Dominguez, M. Rubin & Sons, Ltd., and Bondy purchased shares of the Merrill Lynch Short-Term World Income Portfolio (hereinafter "World Fund") between June 1990 and August 1991, and seek to represent a class of investors who purchased World Fund shares between June 9, 1990 and October 31, 1992. None of these individuals or companies is a citizen or resident of the United States.
Plaintiffs Hatkoff and Field purchased shares of Merrill Lynch Short-Term Global Income Fund, Inc. (hereinafter the Global Fund") in August 1991, and July 1992, respectively, and they seek to represent a class of investors who purchased the Global Fund shares between September 15, 1990, and October 31, 1992. Both Hatkoff and Field are citizens and residents of the United States.
The defendants are subsidiaries or affiliates, or employees of Merrill Lynch & Co., a publicly owned holding company that, through its subsidiaries and affiliates, provides investment, financing, insurance and related services.
Defendant Merrill Lynch, Pierce, Fenner & Smith Incorporated (hereinafter "MLPF&S"), a subsidiary of Merrill Lynch & Co., is a securities broker-dealer which sold shares of the funds.
Defendant Merrill Lynch Funds Distributor, Inc. (hereinafter "MLFD"), a subsidiary of Merrill Lynch & Co., was the distributor of the Global Fund and was involved in the promotion and sale of the World Fund shares.
Defendant David B. Walter (hereinafter "Walter") was the Vice President of Global Fund, and Vice President and Portfolio Manager of MLAM. Walter was actively involved in the marketing of the funds.
Defendant World Fund is a mutual fund incorporated as an "exempted company" under the laws of the Cayman Islands; and as such, the World Fund did not register with the Securities Exchange Commission (hereinafter "SEC"). World Fund was the issuer of World Fund securities.
Defendant Global Fund is a mutual fund registered with the SEC under the Investment Company Act of 1940, 15 U.S.C. §§ 80a-1 et seq. (hereinafter the "Investment Company Act"). Global Fund was the issuer of Global Fund securities.
In 1990, the defendants created two essentially identical funds, the Global Fund and the World Fund (collectively the "Funds"). In public offerings commencing in August 1990, MLPF&S sold shares in the Funds to its retail clients. Global Fund shares were sold to U.S. citizens and World Fund shares were sold to foreigners. The proceeds from these sales, net of MLPF&S's sales commissions and management fees, were paid to MLAM. MLAM, in turn, invested the Funds' monies. The aggregate of MLAM's fees are alleged to have exceeded $ 200 million.
The Funds were Marketed through prospectuses, sales brochures, and marketing guides. The prospectuses stated that the Funds sought "as high a level of current income as is consistent with prudent investment management" and were "designed for the investor who seeks a higher yield than a money market fund and less fluctuation in net asset value than a longer-term global bond fund." (SAC P 63 (a), (b).) The prospectuses also stated that the portfolios were to be composed of "high quality debt securities" not to exceed three years. (SAC P 63(c).)
The prospectuses also disclosed some of the risks associated with investing in the Funds. The Global Fund prospectus, for example, stated:
The Fund will invest its assets in debt securities denominated in at least three different currencies, including the United States dollar. At times, the Fund may seek to hedge its portfolio against currency risks through the use of futures, options on futures and currency transactions. Investment on a global basis involves special considerations. See 'Special and Risk Considerations.' There can be no assurance that the investment objective of the Fund will be realized.
(Compl. Ex. 4 at 1.) The World Fund prospectus contained the same warning. (See Compl. Ex. 2 at 4.) Both prospectuses further warned that the net asset value of the Funds' shares would be affected by changes in the general level of interest rates, and that the Funds may engage in various strategies, utilizing options, futures and currency transactions, to hedge the portfolios against interest rate and currency risks. (Compl. Ex. 4 at 7, 11; Compl. Ex. 2 at 6, 7.) With respect to the various hedging strategies, the prospectuses warned of the risks associated with options, futures and currency transactions. Specifically, the prospectuses warned that "utilization of futures transactions involves the risk of imperfect correlation in movements in the price of futures contracts and movements in the price of the securities and currencies which are the subject of the hedge." (Compl. Ex. 4 at 16; see Ex. 2 at 9.) Therefore, "if the price of the futures contract moves more or less than the price of the security or currency, the Fund[s] will experience a gain or loss which will not be completely offset by movements in the price of the debt securities which are the subject of the hedge." (Id.)
With respect to the World Fund, Merrill Lynch represented to the SEC that the World Fund would not do business or be sold in the United States.
D. The Alleged Misrepresentations and Omissions
Plaintiffs posit that the Funds had no prospects for success from their inception and served no other economic purpose than to provide the defendants with millions of dollars of profit in sales proceeds, fees, and other commissions, and that in order to cover their high fees defendants would engage in risky speculative positions in derivative securities. Plaintiffs further allege that in order to induce investors defendants materially misrepresented the true risks associated with investing in the Funds.
In support of this argument, plaintiffs argue that the Funds' when fully hedged against currency risk would only lock in a yield equal to the yield on short-term U.S. Treasuries of comparable maturity, and once the defendants' fees, loads, other charges, and the Funds' transaction costs were deducted, the Funds' yield from a portfolio fully-hedged against currency risk, would be "drastically less than," the yields on riskless, short-term Treasuries. Therefore, the plaintiffs allege that at the time the Funds were sold, the Funds simply did not make any sense as either an investment or as a speculative position. (SAC PP 59, 60.) As a consequence, plaintiffs further allege that the Funds engaged in speculation to earn higher yields. Indeed, plaintiffs allege that the Funds invested in $ 1 billion worth of derivative securities thereby subjecting the Funds' assets to substantial risk. Accordingly, plaintiffs conclude that the Funds were unsuitable for risk-adverse investors, and that the prospectuses failed to contain an appropriate warning concerning the risks involved.
Plaintiffs also allege that World Fund shares were regularly solicited and sold in the United States through defendants to non-United States citizens, despite Merrill Lynch's contrary representation to the SEC. (SAC PP 51-53).
Based on these alleged misrepresentations and omissions described above, plaintiffs assert eight claims in the Second Amended Complaint. Counts one and two of the complaint allege that the defendants failed to register the World Fund and its shares with the SEC in violation of section 7(d) of the Investment Company Act, 15 U.S.C. § 80a-7(d), and section 12(1) of the Securities Act of 1933 (hereinafter the "Securities Act"), 15 U.S.C. § 77l(1). Counts three, four and five assert that the defendants misrepresented and failed to disclose material facts concerning the risks of investing in the Funds, in violation of section 12(2) of the Securities Act, 15 U.S.C. § 77l(2), section 10b of the Securities Exchange Act of 1934, (hereinafter the "Exchange Act"), 15 U.S.C. § 78j(b) (1988), and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5. Count seven alleges that the Funds deviated from their fundamental investment policy of providing shareholders with as high a level of current income as is consistent with prudent investment management in violation of section 13(a)(3) of the Investment Company Act, 15 U.S.C. § 80-13(a)(3). Counts six and eight allege that the defendants breached their fiduciary and contractual duties, and committed negligence, gross negligence, and common law fraud, in violation of applicable state law.
E. Defendants Motion to Dismiss
Defendants tell a different story and move for dismissal pursuant to Federal Rule of Civil Procedure 12(b)(6). The Defendants argue that the Court must dismiss plaintiffs' federal securities claims because (i) the prospectuses and other materials attached to the complaint sufficiently disclosed the risks that plaintiffs claim were misrepresented and concealed, (ii) the statute of limitations period has expired, and (iii) there are no private rights of action under the Investment Company Act of 1940, 15 U.S.C. 80a-1 et seq. In addition, defendants seek dismissal of plaintiffs' state law claims for lack of supplemental jurisdiction.
Plaintiffs filed their Original Complaint in the United States District Court for the District of California on June 8, 1993 as a putative class action on behalf of World Fund investors. On September 15, 1993 plaintiffs filed their First Amended Complaint adding the putative plaintiff class of Global Fund investors and adding Global Fund as a defendant. On April 22, 1994, the Southern District of California granted defendants' transfer motion pursuant to 28 U.S.C. § 1404. With leave of the Court, plaintiffs then filed their Second Amended Complaint. The Second Amended Complaint added new federal claims for violations of section 7(d) of the Investment Company Act, 15 U.S.C. § 80a-7(d), section 12(1) of the Securities Act, 15 U.S.C. § 77l(1), and section 13(a)(3) of the ...