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James Rafton, Trustee of the James v. Rydex Series Funds

January 5, 2011

JAMES RAFTON, TRUSTEE OF THE JAMES
AND CYNTHIA RAFTON TRUST, ET AL., PLAINTIFFS,
v.
RYDEX SERIES FUNDS, ET AL.,
DEFENDANTS.



The opinion of the court was delivered by: Lucy H. Koh United States District Judge

United States District Court For the Northern District of California

ORDER DENYING IN PART AND GRANTING IN PART DEFENDANTS' MOTIONS TO DISMISS

re: docket #39 and #42

In this putative securities class action, Plaintiffs James Rafton, a Trustee of the James and Cynthia Rafton Trust, and James Darst, Jr., a Trustee of the James and Hillary Darst Trust (collectively "Plaintiffs"), allege that Defendants, several entities and individuals associated with the "Rydex Inverse Government Long Bond Strategy Fund" (the "Fund"), violated federal securities laws by misrepresenting who was an appropriate investor in the Fund and by failing to adequately disclose a "mathematical compounding effect" that would cause the Fund to deviate from its benchmark, the inverse price of the 30-Year U.S. Treasury Bond. Defendants include entities and officers responsible for issuing, managing, and distributing shares of the Fund ("Rydex Defendants"), and also individuals that are Independent Trustees of the Fund ("Independent Trustee Defendants"). The Rydex Defendants and the Independent Trustee Defendants have filed separate motions to dismiss, although each set of Defendants joins in the other's motion. The Court held a hearing on Defendants' motions on December 16, 2010. For the reasons discussed below, the Rydex Defendants' motion to dismiss is DENIED and the Independent Trustee Defendants' motion to dismiss is DENIED IN PART and GRANTED IN PART. pled allegations in Plaintiffs' Complaint and construes material facts in the light most favorable to Accordingly, unless otherwise noted, the following background draws heavily from the allegations in Plaintiffs' First Amended Complaint ("FAC").

Plaintiffs are trustees of Trusts that invested in the Rydex Inverse Government Long Bond Strategy Fund (the "Fund"). According to Plaintiffs, they purchased or acquired shares in the Fund between March 20, 2008 and December 19, 2008. However, the Plaintiffs allege a class period of Defendants are the Fund, PADCO Advisers, Inc. d/b/a Rydex Investments, Inc. (the Fund's manager and investment advisor), Rydex Distributors, Inc. (the Fund's distributor and principal underwriter), Richard M. Goldman (CEO of the Rydex Distributor), Carl G. Verboncoeur (Vice President of Fund), Michael P. Byrum (Chief Investment Officer of the Fund), and individual Patrick T. McCarville, and Roger Somers). Id. at ¶¶ 9-23. to track a particular benchmark, and specifically to track the inverse price movements of the 30-24 Year U.S. Treasury Bond ("Long Treasury Bond"). Id. at ¶ 30. As an "inverse" fund, the Fund was designed to produce investment returns that are the opposite of the performance of the underlying benchmark, i.e., when the price of the benchmark decreases, the price of the fund should increase by the same percentage. Id. According to Plaintiffs, most inverse funds are designed to track a benchmark on a daily basis and reset daily. Id. at ¶ 31. With this daily re-

I. BACKGROUND

For purposes of ruling on Defendants' motion to dismiss, the Court accepts as true well-Plaintiffs. Marceau v. Blackfeet Housing Authority, 540 F.3d 916, 919 (9th Cir. 2008).

A.The Parties and the Rydex Inverse Government Long Bond Strategy Fund March 19, 2007 to March 19, 2010. FAC ¶ 1.

(President of the Fund), John O. Demaret (Chairman of Board of Trustees of Fund), Nick Bonos Trustees of the Fund (Corey A. Colehour, J. Kenneth Dalton, Werner E. Keller, Thomas F. Lydon, The Fund is a mutual fund, similar to an "exchange-traded fund" ("ETF") that was designed setting, such funds are subject to a "mathematical compounding effect" that leads a fund's price to deviate from the inverse movement of the benchmark for periods beyond a single day. Id. In a two-day example, if a benchmark index starts at 100 and closes at 101 on the first day, and goes back down to close at 100 on the second day, the benchmark is even over the two-day period, but the Fund (assuming it also started at 100 and has met its daily goal) will have actually lost value over the same two-day period. In this example, the calculation for the Fund is: 100 (start), 99 (end of day one, dropping 1% from 100 to 99 as benchmark increased 1% from 100 to 101), 99.98 (end 8 of day two, increasing 0.99% from 99 to 99.98 as benchmark decreased 0.99% from 101 to 100).

The compounding effect is more pronounced in periods of high volatility, in which the benchmark moves up and down in greater amounts. Id. at ¶ 32. Plaintiff's central allegation is that, because of this compounding effect, inverse funds are not appropriate for investors seeking to hold the investment for longer than a single day. Id. at ¶ 33. relevant to the putative class period were issued pursuant to a July 30, 2007 Registration Statement and Prospectus (collectively "2007 Registration Statement"), a July 29, 2008 Registration Statement and Prospectus (collectively "July 2009 Registration Statement"). Id. at ¶ 35. According to Plaintiff, each of the Registration Statements contained substantially similar untrue statements of material fact and/or omitted material facts, as "investors holding Fund shares during the Class period lost money even though the benchmark price of the U.S. Treasury Long Bond fell--precisely the type of period during which investors would have expected to make money." Id. at ¶ 38. For example, Plaintiffs allege that between March 20, 2008 and February 22, 2010, the price of the U.S. Treasury Long Bond fell by 4.91%, but the Fund price did not increase 25 and instead also fell by 11.29%. Id.

B.Plaintiffs' Allegations Regarding the 2007, 2008 and 2009 Registration Statements The Fund sold four classes of shares: Advisor, Investor, A and C. Id. at ¶ 34. The shares Statement and Prospectus (collectively "July 2008 Registration Statement"), and a July 29, 2009 18 Effect of Leverage. The July 2007 Registration Statement contains these statements:

1.The July 2007 and July 2008 Registration Statements

The 2007 and 2008 Registration Statements for the Fund included information about Fund Objective, Principal Investment Strategy, Investor Profile, and Understanding Compounding & the FUND OBJECTIVE The Inverse Government Long Bond Strategy Fund seeks to provide total returns that inversely correlate to the price movements of a benchmark for U.S. Treasury debt instruments or futures contracts on a specified debt instrument. The Fund's current benchmark is the inverse of the daily price movement of the Long Treasury Bond.

The Long Treasury Bond is the U.S. Treasury bond with the longest maturity, which is currently 30 years. The price movement of the Long Treasury Bond is based on the daily price change of the most recently issued Long Treasury Bond.

For the Northern District of California If the Fund meets its objective, the value of the Fund's shares will increase on a daily basis when the price of the Long Treasury Bond decreases. When the price of the Long Treasury Bond United States District Court increases, however, the value of the Fund's shares should decrease on a daily basis by an inversely proportionate amount (E.G., if the price of the Long Treasury Bond increases by 2%, the value of the Fund's shares should go down by 2% on that day).

PRINCIPAL INVESTMENT STRATEGY

Unlike a traditional index fund, the Fund's objective is to perform, on a daily basis, exactly opposite its benchmark, the Long Treasury Bond. As its primary investment strategy, the Fund enters into short sales and swap transactions, and engages in futures and options transactions. On a day-to-day basis, the Fund holds U.S. Government securities or cash equivalents to collateralize its short sales and derivative positions.

INVESTOR PROFILE

Investors who expect the value of the Long Treasury Bond to go down and want investment gains when it does so. These investors must also be willing to bear the risk of equal losses if value of the Long Treasury Bond goes up." Id. at ¶ 39. Similarly, the July 2008 Registration Statement stated:

FUND OBJECTIVE

The Inverse Government Long Bond Strategy Fund seeks to provide total returns that inversely correlate to the price movements of a benchmark for U.S. Treasury debt instruments or futures contracts on a specified debt instrument. The Fund's current benchmark is the inverse (opposite) of the daily price movement of the Long Treasury Bond. The Long Treasury Bond is the U.S. Treasury bond with the longest maturity, which is currently 30 years. The price movement of the Long Treasury Bond is based on the daily price change of the most recently issued Long Treasury Bond.

If the Fund meets its objective, the value of the Fund's shares will increase on a daily basis when the price of the Long Treasury Bond decreases. When the price of the Long Treasury Bond increases, however, the value of the Fund's shares should decrease on a daily basis by an inversely proportionate amount (e.g., if the price of the Long Treasury Bond increases by 2%, the value of the Fund's shares should go down by 2% on that day).

PRINCIPAL INVESTMENT STRATEGY

Unlike a traditional index fund, the Inverse Government Long Bond Strategy Fund's objective is to perform, on a daily basis, exactly opposite the daily price movement of the Long Treasury Bond. The Fund employs as its investment strategy a program of engaging in short sales and investing to a significant extent in derivative instruments, which primarily consist of futures contracts, interest rate swaps, and options on securities and futures contracts. Under normal circumstances, the Fund will invest at least 80% of its net assets in financial instruments with economic characteristics that should perform opposite to fixed income securities issued by the U.S. Government. This is a nonfundamental investment policy that can be changed by the Fund upon 60 days' prior notice to shareholders. On a day-to-day basis, the Fund may hold U.S. Government securities or cash equivalents to collateralize its short sales and derivative positions.

INVESTOR PROFILE

The Inverse Government Long Bond Strategy Fund is intended for investors who expect the value of the Long Treasury Bond to go down and want investment gains when it does so. These investors must also be willing to bear the risk of ...


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