Suit Suggests Funds May Face New Risk
August 2, 1999
Mutual fund attorneys are reviewing the risk disclosures in key SEC filings for the funds they advise because of what appears to be a unique case making its way through federal court in Nashville, Tenn.
A shareholder in the ESC Strategic Value Fund has filed a class action suit against fund adviser SunTrust Equitable Securities Corp. of Nashville because - after repeatedly urging investors to take a long-term view - SunTrust Equitable recommended the fund liquidate its assets less than two years after it opened.
Allison Hines, a resident of Amsterdam, the Netherlands, alleged in a case filed June 17 that the adviser committed fraud because it levied a sales charge on her $50,000 purchase, did not warn of the risk that the fund might close and then recommended the fund be liquidated less than two years after it opened without refunding the sales charge and other expenses and losses.
SunTrust Equitable recommended liquidating Strategic Value because the fund was not growing quickly, according to Hines. The firm failed to warn investors SunTrust Equitable would recommend closing the fund if it did not generate sufficient fees or if its investment strategy fell out of favor, Hines alleged.
As of Feb. 26, about one month before the fund went out of business, Strategic Value had assets under management of approximately $4.2 million, according to Morningstar of Chicago, the fund tracking firm. Strategic Value A shares lost 26.15 percent of their value for the year ending Feb. 28, according to Morningstar. The return ranked the fund in the bottom 13 percent in the small-cap growth category over that period, Morningstar reported.
Hines lost $15,000 on her investment, according to the complaint. Hines did not request a specific amount of damages, although she is seeking punitive damages in addition to out-of-pocket losses for the sales charge, management fees and investment loss. Hundreds of investors may be eligible to file a claim as part of the suit, according to the complaint.
Ward Cammack, a managing director of SunTrust Equitable, last week denied Hines' allegations and described them as frivolous. He declined to discuss specifics of the case because of the pending litigation. H. Naill Falls, Jr., an attorney for Hines at Falls & Veach of Nashville, did not respond to requests for comment.
SunTrust Equitable is a subsidiary of SunTrust Banks of Atlanta. The firm offers five mutual funds and has approximately $150 million in open-end fund assets under management, Cammack said.
Disclosing the risk that an adviser might close a fund is rare, according to mutual fund attorneys. They could recall no cases in which a fund adviser was sued for closing a fund and not returning sales charges.
Several mutual fund attorneys said they would review mutual fund clients' prospectuses and statements of additional information - the disclosure documents which a fund files with the SEC when it is formed - and consider adding language warning investors that a fund may close. Disclosing that risk should make it easier to prevail in future cases, lawyers said.
"I think it would be a fairly smart disclosure to make," said Carl Frischling, a lawyer with Kramer, Levin, Naftalis & Frankel of New York.
The disclosure could be particularly helpful when a firm repeatedly asserts its own long-term investment strategy, Frischling said. That allegedly is what happened in the case of Strategic Value.
The fund's 1997 prospectus described Strategic Value as following the buy-and-hold investment strategy advocated by well-known value investors Benjamin Graham and David L. Dodd. SunTrust Equitable expected the fund's average holding period for its securities to be two to five years, the prospectus said.
SunTrust Equitable reiterated that long-term investment strategy in the fund's semi-annual report filed Nov. 25, 1998. Although the fund's A shares suffered a loss of 25.72 percent through the six months ending Sept. 30, 1998, SunTrust Equitable urged investors to hold onto their investments.
"Long-term... we believe prospects remain extremely bright for the markets in general, and our holdings in particular," the report said. "Which is why we have no plans to change our strategy - we believe it is a proven one. And we know you've gotta dance with who brung ya' to succeed over the long term."
Strategic Value's board of directors informed shareholders on Feb. 9 that it was liquidating the fund on the recommendation of SunTrust Equitable, Hines alleged. The fund went out of business as of March 26, according to SEC filings.
The boards of directors overseeing funds routinely consider methods of reducing the effect on shareholders of a fund's liquidation, said David Sturms, a mutual fund lawyer with Vedder, Price, Kaufman & Kammholz of Chicago. In some instances, advisers for load funds have refunded sales charges to investors when a fund is liquidated, Sturms said. Citing client confidentiality, Sturms declined to identify the firms.
Rather than liquidate a load fund, fund advisers frequently will merge a fund into another without levying a sales charge, Sturms said. As an alternative, a load fund adviser will permit shareholders from a liquidated fund to invest in another fund in the same fund complex without imposing a sales charge, Sturms said.
The issue that the Hines case raises is important for mutual fund firms. Funds routinely liquidate small funds that have not attracted assets. Advisers normally subsidize the expenses of small funds in order to keep the fund's performance competitive with its peers. A fund usually needs more than $50 million in assets under management before it becomes profitable, according to fund executives. That minimum can dip to $20 million when overhead is unusually low, according to executives.
Mutual fund complexes liquidated 255 funds last year, according to Lipper of Summit, N.J., the fund tracking firm. Through June 30, ninety-nine funds have been liquidated. Lipper was unable to immediately identify the number of liquidated funds which carried sales charges or how long the funds were in operation before they were liquidated.