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DH2, Inc. v. Athanassiades

December 14, 2005


The opinion of the court was delivered by: Amy J. St. Eve, District Court Judge


Plaintiff DH2, Inc. has filed a Second Amended Complaint ("SAC") alleging securities fraud in connection with Defendants' mutual fund pricing. The case pertains to the pricing of foreign securities held in mutual funds. Defendants have moved to dismiss the SAC. As discussed in detail below, Defendants' motion is granted in part and denied in part.


I. The Parties

Plaintiff DH2 is a corporation organized under the laws of Illinois, with its principal place of business in Northbrook, Illinois. (R. 62-1, SAC, ¶ 18.) DH2 invests in mutual funds, variable annuities, and other investment instruments in accordance with a proprietary, highly confidential trading strategy. (Id. ¶ 18.) DH2 manages the assets of two of its affiliates -- Emerald Investment, LP ("Emerald") and Elkhorn LLC ("Elkhorn"). (Id.)

Defendant Equitable Life Assurance Society of the United States ("Equitable") is owned and controlled by the AXA Group, a company headquartered in France. (Id. ¶ 19.) It sells variable annuity contracts to the investing public. (Id. ¶ 20.)The variable annuity contracts enable investors to invest in separate accounts managed by an Equitable captive entity -- Equitable Advisors Trust ("EQAT"). (Id.) These separate accounts are a form of mutual fund. (Id.) Accumulator and Equi-Vest are two variable annuity contracts offered by Equitable. (Id. ¶ 34.)

Defendants Theodossios Athanassiades, Jettie M. Edwards, David Wayne Fox, William Michael Kearns, Jr., Christopher P.A. Komisarjevsky, Peter Dana Noris, Harvey Rosenthal, and Gary S. Schpero were Trustees of EQAT. (Id. ¶¶ 22-29.) (Collectively, these Defendants are referred to as the "Trustees" or the "Individual Defendants"). Plaintiff alleges that Equitable and each of these Trustees exercised control over EQAT's pricing within the meaning of the Investment Company Act, 15 U.S.C. § 80a-2(a)(9). (Id. ¶¶ 30-31.) DH2 further alleges that each Trustee owed it "the highest duty of good faith and loyalty." (Id. ¶ 55.) As such, DH2 contends that the Trustees should have acted in DH2's best interests, and not placed "the interests of Equitable or other classes of investors ahead of DH2's interests." (Id. ¶ 55.)

II. DH2's Trading Strategy

"DH2 is a 'market timer' -- a firm that exploits mutual fund mispricing that occurs when market prices for the fund's underlying securities have become stale due to events after the relevant trading market has closed." DH2, Inc. v. U.S. S.E.C., 422 F.3d 591, 592 (7th Cir. 2005).

It "trades in mutual funds and makes money by taking advantage of short-term price/value discrepancies that occur when the current value of a fund's portfolio securities has changed and that change is not yet reflected in the fund's share price." Id. DH2's core corporate asset consists of its proprietary and confidential trading strategy. (R. 62-1, SAC, ¶ 33.) DH2's trading strategy is a closely held trade secret, and DH2 expends significant efforts to minimize the risk of disclosing this strategy. (Id.) DH2's continued profitability depends on its ability to employ this confidential strategy. (Id.)

III. DH2's Investments

EQAT is a form of mutual fund that exists solely to hold and invest assets within variable insurance contracts for the benefit of the owner of the variable insurance contract. (Id. ¶ 35.) EQAT contains multiple different portfolios, each of which acts as a separate investment fund that issues interests or shares. (Id.) "Subaccounts," a form of mutual fund, are the underlying investment options of the variable annuities. (Id. ¶ 36.) An investor in a variable annuity contract initially makes an investment or contribution to Equitable, then the investor may allocate that contribution between and among the designated investment funds, or subaccounts, of EQAT. (Id.) The investor may make subsequent contributions to Equitable in the same manner. (Id.)

The Accumulator is a variable annuity contract offered to the public by Equitable. (Id. ¶¶ 34, 58.) Equitable marketed this product to DH2 by prospectuses and related documents. (Id. ¶ 58.) According to the prospectus:

Our business day is any day the New York Stock Exchange is open for trading. Each business day ends at the time trading on the exchange closes or is suspended for the day. We calculate unit value for our variable investment options as of the end of each business day. This is usually 4:00 p.m. Eastern Time... If your contribution, transfer or any other transaction request, containing all the required information, reaches us on a non-business day or after 4:00 p.m. on a business day, we will use the next business day. (Id. ¶ 61.)

On September 15, 1999, DH2 made an initial contribution to Equitable of $900,000. (Id. ¶ 63.) Equitable issued DH2 a Certificate, explaining that the investment product is a "combination fixed and variable deferred annuity," and that Equitable "will provide the benefits and other rights pursuant to the terms of this Certificate." (Id.) DH2 made the following additional capital contributions to its account with Equitable: $561,000 (September 19, 1999); $130,000 (December 27, 1999); $1,000,000 (January 4, 2000); $485,000 (July 27, 2000); and $490,000 (July 31, 2000). (Id. ¶ 118.) Equitable's total contributions and investment gains amount to approximately $7.5 million. (Id. ¶ 63.) DH2's contract permitted it to transfer its contributions among EQAT investment funds "at any time" without any penalty or charge. (Id. ¶ 66.) In 1999, Emerald -- DH2's affiliate -- invested in both the Accumulator and Equi-Vest products based on similar information. (Id. ¶¶ 69-72.)

IV. Pricing of Funds

As the Seventh Circuit recently summarized: The Investment Company Act of 1940, 15 U.S.C. §§ 80a-1 et seq. ..., requires mutual fund shares to be sold and redeemed at a price that: will bear such relation to the current net asset value of such security computed as of such time as the rules may prescribe ... for the purpose of eliminating or reducing ... any dilution of the value of other outstanding securities of such company or any other result of such purchase, redemption or sale which is unfair to holders of such other outstanding securities. 15 U.S.C. § 80a-22(a) (emphasis added). For purposes of computing NAV, the ICA defines "value" as follows: "(i) with respect to securities for which market quotations are readily available, the market value of such securities; and (ii) with respect to other securities and assets, fair value as determined in good faith by the board of directors [.]" 15 U.S.C. § 80a-2(a)(41)(B) (emphasis added).

Plaintiffs contend that EQAT is required to determine the purchase and redemption price of each of its funds by determining the net asset value ("NAV") per share of each such fund. (Id. ¶ 42.) According to the SAC, the Investment Company Act dictates the price at which each of the EQAT portfolio fund share purchases and redemptions is conducted, and the process for establishing that price. Plaintiff alleges that Section 2(a)(41) of the Investment Company Act mandates the use of actual market quotations of each individual security within the fund to calculate the NAV of the fund and the purchase and redemption of prices of fund shares. (Id. ¶ 40.) In essence, DH2 alleges that Defendants should have used market quotations, rather than fair value pricing to calculate the NAVs and establish the share price of the funds at issue.

Plaintiff further alleges that Equitable should have used actual market quotations to compute the NAVs "even if those quotations were as old as 72 hours." (Id. ¶ 45.) Defendants are not permitted to use fair values, DH2 asserts, to value underlying assets unless actual market quotations are not readily available. (Id.) When Defendants are permitted to use fair values, they must estimate them individually, portfolio security-by-security, by the funds' directors, "who are required to calculate what a buyer and seller would pay now ... for each security." (Id.) The Trustees must determine the fair value when employed in good faith. (Id. ¶ 44.) Plaintiff alleges that Defendants do not have discretion to select a different pricing method. (Id. ¶ 40)

V. The Emerald Action

In 2000, Emerald sued Equitable in the Northern District of Illinois. American National Bank and Trust Co., et al. v. AXA Client Solutions, et al., No. 00 C 6786 (the "Emerald Action"). (Id. ¶ 77.) Emerald premised the Emerald Action on Equitable's alleged restrictions and interference with Emerald's market-timing trading strategy. (Id. ¶¶ 73-77.) It asserted claims for breach of contract and for promissory estoppel. (Id. ¶ 77.)

During the course of the Emerald Action, Plaintiff alleges that Emerald improperly disclosed to Equitable DH2's confidential trading strategy. Although a protective order governed the disclosure of such information, Plaintiff alleges that Equitable violated the protective order numerous times and used the confidential discovery to interfere with Emerald's and DH2's trading. (Id. ¶ 99.) On May 28, 2002, the court in the Emerald Action sanctioned Equitable for violating the protective order.*fn2 (Id. ¶ 106.)

VI. Defendants Adopt Fair Value Pricing

DH2 alleges that in September 2001, the Trustees approved a "fair value pricing" scheme whereby Defendants 1) planned to adjust the NAV routinely at 4:00 pm Eastern Time in violation of statutory requirements, and 2) failed to conduct the fair valuation as required by law because not all of the Trustee Defendants personally conducted or closely supervised the valuations with care or in good faith. (Id. ¶ 92.) DH2 further alleges that Defendants did not design their methodology to estimate a 4:00 p.m. Eastern time value of the NAV, but rather to "generally target the next day's close because that's where the best data is available." (Id.) Furthermore, DH2 contends that Defendants failed to disclose this fair value pricing scheme to DH2 or the investing public. (Id. ¶¶ 93-95.)

Prior to implementing the fair value pricing methodology, Defendants issued a "Statement of Additional Information" regarding fair value pricing and foreign securities. That statement provided:

If the Trust determines that a material change in the value of a foreign security has occurred after the close of trading in the foreign market(s) in which a Portfolio invests but before the close of regular trading on the NYSE, the Trust may use fair value methods to reflect those changes. In addition, the Trust may use fair value methods to value securities in other situations, for example, when a particular foreign market is closed but the Trust is open. This ...

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