On August 5, Labaton Sucharow LLP, a New York law firm specializing in security class action suits and antitrust cases, filed a class action lawsuit (press release) on behalf of all persons who acquired shares in the UltraShort Real Estate ProShares (SRS).

The summary contained on the Labaton Sucharow website alleges there is false and misleading information in the Registration Statement, Prospectuses, and Statements of Additional Information ProShares filed for SRS.

The following details are from the 90 numbered paragraphs (referenced below with #) of the full 31-page Complaint (pdf), along with my comments:

  • The Class is seeking to pursue remedies under Section 11 (Civil Liabilities on Account of False Registration Statement) and Section 15 (Liability of Controlling Persons) of the Securities Act of 1933 (#1).
  • The suit appears to focus on the word “simple” in various ProShares marketing and registration documents, as the complaint consistently puts the word “simple” in quotation marks (#4 and other places).
  • The Complaint acknowledges that SRS seeks investment results that correspond to twice the inverse (–200%) daily performance of the Dow Jones U.S. Real Estate Index (DJREI) (#6).
  • The Complaint then ignores the information in paragraph #6 to incorrectly state that SRS “is supposed to deliver double the inverse return of the DJREI, which fell approximately 39.2 percent from January 2, 2008 through December 17, 2008” in #10. According to my calendar that period is much longer than a day. It is a period of nearly a year and contains 243 market days.
  • Paragraphs #11 & #12 have incorrect examples of the “spectacular tracking error” measured over periods of seven to twelve months that do not properly account for the daily reset.
  • Paragraph #13 states that SRS “…would perform precisely the opposite of investors’ reasonable expectations.” That statement is proven incorrect nearly every day.
  • Paragraph #14 acknowledges that SRS “does not seek to achieve its stated investment objective over a period of time greater than one day.” Correct, so what exactly is this lawsuit about then?
  • Paragraph #15 claims that ProShares’ “greater than one day” risk disclosure is tantamount to a kennel selling a dog that is a cat while disclosing that the dog may have defects.
  • Paragraphs #17 – #21 make extensive reference to the FINRA warnings and the “Insincere Concerns” of recent brokerage actions.
  • Paragraph #23 aserts that ProShares failed to disclose the long term tracking error and SRS actually created the market volatility and caused market dislocations. However, no supporting evidence is provided for these claims.
    Jurisdiction and venue are outlined in #24 – #27.
  • Parties are defined in #28 – #37 with lead Plaintiff being Steven Novick, a resident of the state of Connecticut. Named Defendants are ProShares Trust; ProShares Advisors LLC; SEI Investments Distribution Co.; Michael L. Sapir; Louis M. Mayberg; Russell S. Reynolds, III; Michael Wachs; and Simon D. Collier.
  • Paragraphs #38 – #43 appear to be standard class action lawsuit boilerplate.
    Background information on traditional and leveraged ETFs is in #44 – #48 with #48 acknowledging the effects of daily reset and compounding.
  • “Substantive Allegations” are outlined in #49 – #79, which are essentially the same items raised in #4 – #23. Every example used in the illustrations is for periods much longer than one day.
  • Paragraph #53 states that “Investors who acquired shares in the SRS Fund during the Class Period thought they were protecting their assets by hedging against the unprecedented drop in housing prices across the United States.” However, it makes no mention that the Dow Jones Real Estate Index does not track housing prices.
  • Paragraph #60 claims that ProShares does not market funds like SRS as a day-trading vehicles and that ProShares’ Chairman has publicly stated that investors can use ETFs “for more than a day successfully.” I believe the Chairman’s statement is correct. I could easily produce hundreds of examples to demonstrate this fact.
  • Paragraph #61 says that ProShares acknowledges on its website that “because of the daily objective of leveraged and inverse funds, investors should monitor their performance, as frequently as daily.” This statement almost sounds like they are lawyers for ProShares.
  • In Paragraphs #62 – #67 the Complaint helps ProShares again by pointing out all the documents that describe the risks of investing in inverse leveraged funds like SRS.
  • Paragraph #69 claims that SRS exacerbates volatility and creates illiquidity because it is a one sided instrument. However, SRS is typically among the most liquid and highly traded ETFs and has been a past member of the ETF Billion Dollar Club. The Complaint also fails to mention that SRS has an opposite fund, the Ultra Real Estate ProShares (URE), and together they allow both long and short “demand” to be met independently without artificial constraints.
  • Paragraph #71 states that prospective and actual investors in ProShares have been misled and that SRS is not a “simple” kind of investment. It goes on to say that leveraged and inverse ETFs such as SRS do not constitute a suitable investment or hedging strategy for investors who intend to hold their positions for longer than one day.
  • Paragraphs #72 – #79 are a rehash of the FINRA warnings in #17 and #18 as well as references to articles in the Wall Street Journal that they believe are helpful to their cause.
  • Alleged violations of Section 11 of the 1933 Act are outlined in #80 – #87.
  • Paragraph #85 states “the market price for SRS shares was artificially inflated, and Plaintiff and the Class suffered substantial damages in connection with the purchase thereof.” Now this is a new twist on the logic. Throughout the Complaint they contend that SRS underperforms expectations, but now they say the price is artificially inflated.
  • Paragraph #87 says that Plaintiff could not have reasonably discovered those facts prior to June 2008. I would argue that anyone who looked at the performance prior to June 2008 could have seen there were periods when both the Dow Jones Real Estate Index and SRS showed a loss. Take 8/15/07 – 2/28/08 as an example.
    Violations of Section 15 of the 1933 Act are outlined in #88 – #90.
  • The filing seeks the awarding of compensatory damages, costs and expenses of the action, damages in the form of rescission, and such equitable/injunctive relief as deemed appropriate by the Court.
  • The complaint ends with a demand for trial by jury. If it gets that far, my guess is that jury selection will focus on whether or not the prospective juror understands basic investment math – namely that a 20% loss cannot be recouped with a 20% gain. A basic understanding that the word “daily” does not imply periods of weeks or months should also be a requirement.

A Wall Street Journal article by Daisy Maxey reports that ProShare Advisors said in a statement: “The allegations reported in the complaint are wholly without merit. We plan to defend against this suit vigorously.” Based on what I have read, I would have to agree.

Disclosure: I do not have any positions in any of the securities mentioned. I have been using leveraged and inverse funds that employ a “daily reset” since 1994, and they have always performed as stated in the prospectus. I have no affiliation with any of the parties of this lawsuit. I do not run ProShares advertisements in my publications or on my websites.