A FURTHER NOTE ON KIRCHER (AND MUTUAL FUND LITIGATION IN GENERAL)

No one will be surprised if the Supreme Court affirms Kircher (thus permitting Judge Easterbrook's opinion to stand). The plaintiff fundholders will thus be left without a remedy, because as holders they have no cause of action under federal law. The losses they suffered in the value of their fund shares because of abusive trading at the fund level will become permanent. Note that this is not a case like a conventional securities fraud case in which the value of the fund shares would have fallen anyway when the truth came out. Here, the value fell because insiders were permitted to trade in fund shares. Innocent fund holders saw NAV fall bit by bit but only later found out why. In other words, the harm was real and not just a matter of a market correction.

The good news is that the plaintiffs may still have a cause of action (though it may now be barred by the statute of limitations).

First, they could sue derivatively on behalf of the fund. After all the fund was a party to the abusive trading in fund shares. So the fund clearly has standing under federal law. One problem is that the plaintiff must make a demand on the board of directors of the fund to sue the culprits. The board will likely refuse, but it is unclear that such a decision would be upheld even under the business judgment rule. Another problem is that in a derivative action the fund should ordinarily recover. That might lead to speculative trading in fund shares. (Outsiders might buy into the fund seeking a share of the recovery which would presumably be added to NAV at some point.) That could be avoided by individual recovery. But the courts are reluctant to order individual recovery.

Second, the plaintiffs could file a class action for equitable relief under FRCP 23(b)(2). Presumably, the reason they sued in state court in the first place was that they knew (or worried) that they could not maintain a class action in federal court because they were mere holders. But suppose they filed an action against the fund seeking to compel the fund to sue the culprits and to distribute the proceeds (if any) by issuing new shares to members of the class. (That would avoid the problem of speculation in fund shares by soaking up the recovery.) To be sure, this procedure looks a lot like a derivative action, but for the bit about issuing new shares to the class members. But so what?

For a fuller discussion, see How to Compensate Mutual Fund Investors for Late Trading and Market Timing.