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Flinn v. Bank of America Corp.

United States District Court, D. Vermont

March 30, 2016



Geoffrey W. Crawford, Judge United States District Court.

Plaintiffs are a married couple who invested in a derivative security created by Defendant Bank of America Corporation ("BOA"). Between September 2010 when Plaintiffs first purchased the securities and December 2014 when they sold a portion of their investment, they lost a substantial amount of money. As of September 1, 2015, they continued to hold the remainder of their purchase, which had greatly declined in value. They seek rescission and compensatory and punitive damages on a variety of claims including federal and state-law claims of fraud. (See Doc. 1.)

BOA has moved to dismiss the Complaint under Fed.R.Civ.P. 12(b)(6). The court heard argument on the Motion on January 13, 2016. For the reasons that follow, BOA's Motion to Dismiss (Doc. 8) is DENIED.


In setting out the facts, the court relies on the allegations of the Complaint supplemented by the offering documents which are attached to the Motion to Dismiss and explicitly mentioned in the Complaint, as well as material that may properly be noticed. The authenticity of the offering documents is not disputed.[1] They include a September 29, 2010 Supplement and 29-page Final Pricing Supplement (Doc. 8-3); a three-page description of the Investable Volatility Index (Doc. 8-4); and a 21-page promotional document or "primer" entitled "Why invest in Volatility?" dated July 30, 2010 (Doc. 8-5).

I. Strategic Return Notes Linked to the Investable Volatility Index

In 2010 BOA developed a securities product which it called a Strategic Return Note ("SRN"). (Doc. 1 ¶ 3.) The SRNs were offered to investors as a hedge against declines in the equity market as reflected in increases in market volatility. (Id.) In order to price and administer the SRNs, BOA created a daily index which it called the Investable Volatility Index ('TVI" or "Index"). (Id.) The price of the SRNs was determined mainly by the level of the IVI.[2]

Volatility is a measurement of the rate at which prices change over time. It is similar to acceleration in the world of physical bodies. Prices which change very slowly from day to day or month to month have a low rate of volatility. Prices which drop or rise very quickly have a high rate of volatility. In the case of the SRNs at issue here, the IVI measures volatility in the equity futures market by comparing reported prices for a broad-based index of equity futures contracts located over a spread of three months with a midpoint five months from the current date. If the change in prices over time is low, volatility (the rate of change) will be low. If futures prices rise or fall greatly, volatility will be high.

Although volatility only describes the rate of price change without regard to direction, economists have noted that volatility measures tend to increase at times of market decline. (See Doc. 8-5 at 3 & n.5 (noting that "volatility tends to rise most sharply when equity markets are under significant stress").) For this reason, a security whose value rises with increased volatility may be seen by an investor as an asset whose price rises when his or her equity portfolio decreases. Such an investment may operate as a hedge against stock market losses, and the parties agree that BOA marketed the SRNs on this basis.

The creation of the IVI is described in detail at pages 15-18 of the Final Pricing Supplement (Doc. 8-3 at 18-21). The summary that follows does not do full justice to the mathematics involved in computing the IVI, but it describes the general process which appears in the offering documents.[3] In understanding the IVI, the starting point is that as in the case of many derivative indices, it is purely synthetic; it does not reflect the value of an asset owned by an investor. It is a daily value derived from prices for future options which are reported on a daily basis by the Chicago Board Options Exchange ("CBOE").[4] It is not a bundle of securities or other assets like a mutual fund. In creating the IVI, BOA neither buys or sells anything, and it holds no assets on behalf of the purchasers of the SRNs.

The next step towards understanding the IVI is to understand its purpose. The Final Pricing Supplement describes it in this way: "The Index is designed to measure the return of an investment in the forward implied volatility of the S&P 500® Index." (Doc. 8-3 at 18.)[5] "Volatility" is a "statistical measure of the variability in the price of [an] asset over a period of time." (Doc. 8-3 at 18.) One dictionary definition of volatility is:

An extreme fluctuation in price that affects a stock, bond, or other financial instrument and is usually accompanied by unusually high trading volume. Volatility is caused by expectations of poor earnings, unexpected bad news from some other company in the industry, or external events, such as expectations of a war or political turmoil. Poor economic data or bearish comments from Federal Reserve officials also can cause volatility.

Webster's New World Finance and Investment Dictionary 344 (2003).

The "implied" volatility of an option "is a market measure related to the volatility of the underlying asset from that current day to the option's expiration." (Doc. 8-3 at 18.)[6] It is prospective-not historical-and reflects the predictions and expectations of investors who trade in stock market option contracts during the selected period. In other words, implied volatility is "[a]n estimate of the expected volatility of the security that an option is based upon, determined by the price, or premium, of the option." Webster's New World Finance and Investment Dictionary 167 (2003). "Factors affecting implied volatility are the exercise price of the options, the risk-free rate of return, the option's maturity date, and the price of the option." Id.

"Forward" implied volatility "is a market measure related to the volatility of the underlying asset between two dates in the future." (Doc. 8-3 at 18.) "The Index measures the forward implied volatility of the S&P 500® Index for a three-month period, the mid-point of which is approximately five months in the future." (Id.) The IVI measures the rate of change in option prices within the three-month window selected by the creators of the IVI. The rate of change is recalculated each day as new options prices are added ("bought") at the most remote time and the most recent prices drop out of the Index ("sold"). The IVI is purely synthetic-it holds no options contracts-but it is intended to mimic the experience of an investor who holds a wide range of S&P 500 futures spanning the three-month "forward" period.

The level of the IVI is the result of holding a "theoretical portfolio" of forward implied volatilities computed from the Index Components. (See id.) "This portfolio is rebalanced on a daily basis to approximate the forward implied volatility of the S&P 500® Index for a three-month period, the mid-point of which is approximately five months in the future." (Id.) Inspection of the process for calculating the IVI reveals that, the level of the IVI on each day depends on the previous day's level plus a return on that level. (See Doc. 8-3 at 34.) The return is positive if the weighted sum of forward implied volatilities has increased, and is negative if the weighted sum of forward implied volatilities has decreased. (See id.)[7]

II. Fee Structure

The SRNs came with two types of fees: a one-time 2% "sales charge" and an annual "Index Adjustment Factor." Both of those fees appear in the calculation of the redemption or exchange amount for the SRNs. (See generally Doc. 8-3 at 5-6.) The SRNs are sold in units at $10.00. The exchange or redemption amount of each SRN is $9.80 times the "Adjusted Ending Value" divided by the "Starting Value." The "Starting Value" of the Index is the average of the closing levels of the Index on the first five "Calculation Days" shortly before the settlement date of the SRNs. The "Adjusted Ending Value" is the average of the closing levels of the Index, reduced by the "Index Adjustment Factor, " on five days during a period shortly before maturity or exchange. The $9.80 figure in the equation reflects the 2% "sales charge."

The "Index Adjustment Factor"-also referred to as the "holding, " "roll, " or "carry" cost-is defined as "[a] daily reduction of 0.75% per annum, calculated each calendar day on and after the last day of the Initial Determination Period that will be applied and accrue daily (on the basis of a 365 day year) against the level of the Index." (Id. at 6.) As a result of the cumulative effect of the "Index Adjustment Factor" over the five-year term on the SRNs, "the level of the Index shortly before the stated maturity date, as reduced by the accrued Index Adjustment Factor, will be approximately 3.67% lower than the level of the Index reported by the CBOE (which does not include this reduction)." (Id. at 22.) As a result of both of the fees, the level of the Index would have to increase by more than 5.93% from the Starting Value in order for the investor to receive at least the $10 original offering price upon maturity, five years after purchase of the SRNs. (Id. at 5.)

III. Plaintiffs' SRN Investments

The SRNs were first offered in 2010. In September 2010, Plaintiffs' broker at Merrill Lynch told them about a new product "designed to provide principal protection" under which Plaintiffs "would give up some upside for protection on the downside." (Doc. 1 ¶¶ 10-11.)[8] On or about September 22, 2010, the broker called Plaintiff Gloria Flinn and stated that if Plaintiffs wished to invest in the new product, they had to commit that day. (Id. ¶ 12.) At a cost of $10 per unit, Plaintiffs invested $200, 000 for 20, 000 units of SRNs. The "Starting Value" for the Index was 281.69. (Doc. 8-3 at 2.)

These SRNs had a five-year redemption period. Like other buyers, Plaintiffs were permitted to redeem the SRNs at quarterly intervals. They could also resell on the secondary market at any time. By March 2012 the value of Plaintiffs' SRNs had dropped by 65%. (Doc. 1 ¶ 36.) Later in 2012, Plaintiffs invested an additional $50, 909.70 to purchase 12, 540 more units.[9] (See Id. ¶ 18.) Because BOA stopped issuing new SRNs in early 2011, Plaintiffs' 2012 transactions were purchases of resales. (Id. ¶ 17.)

In October 2013, Plaintiff Gloria Flinn came across an October 18, 2013 story in Barron's entitled "VIX Creator: Volatility ETPs 'Virtually Guaranteed to Lose Money.'" (Id. ¶ 19.)[10] The Barron's story referred to a forthcoming paper by Robert E. Whaley- credited as the creator of the VIX-in which Whaley asserts that the most popular exchange-traded funds and notes tied to the VIX are "not suitable buy-and-hold investments" and are "virtually guaranteed to lose money through time." Brendan Conway, VIX Creator: Volatility ETPs 'Virtually Guaranteed to Lose Money', Canon's Focus on Funds (Oct. 18, 2013), http:/[11] According to Plaintiffs, reading that story led to their efforts "to understand the mechanism and behavior of SRNs, " and to their conclusion that BOA misled and defrauded them. (Doc. 1 ¶ 19.)

Plaintiffs' investment experience with the SRNs was poor. The court accepts as true for purposes of the Motion to Dismiss the claims that Plaintiffs invested a total of $250, 909.70. (See Doc. 1 ¶¶ 13, 18.) In December 2014 Plaintiffs sold 3, 500 units for $0.57 per unit. (Id. ¶ 37.) On June 16, 2015, Plaintiffs demanded rescission from BOA; BOA declined to respond. (Id. ¶ 20.) As of September 1, 2015 (the date of Plaintiffs' Complaint), the value of Plaintiffs' remaining 29, 040 units was below one dollar per unit. (See Id. ¶ 37.)[12] The maturity date for the SRNs was September 25, 2015. (Doc. 8-3 at 2.)

IV. Statements and Disclosures in the Offering Documents

A. The Three-Page Description of the IVI

Before Plaintiffs invested in the SRNs, they received the three-page description of the Investable Volatility Index (Doc. 8-4). (See Doc. 1111.) That document described some of the benefits of investing in SRNs, including "diversification benefits" stemming from "[n]egative correlation to equities" and protection against "the risk of extreme equity market declines." (Doc. 8-4 at 2.) The document described the IVI as an index "designed to provide a benchmark for investing in equity market volatility." (Id.) It stated that "[o]n a historical basis, the Index has maintained consistently high negative correlation with the S&P 500® Index and performed best in periods of extreme equity market dislocation, in sharp contrast with many other assets." (Id.) In a section entitled "Index Mechanics, " the document stated: "The Index measures the forward implied volatility of the S&P 500® Index for a three-month window centered approximately five months in the future, and the Index return reflects transaction costs associated with rolling a hypothetical position to maintain this exposure." (Id.)

The document asserted that the Index could be used to "[h]edge an [e]quity [p]ortfolio": "On a historical basis, even small hypothetical allocations to the Index significantly improved performance by reducing risk and increasing risk-adjusted returns." (Id. at 3.) The following chart accompanied that assertion:

Allocation to the Index Has Potential to Improve Risk-adjusted Returns

(Image Omitted)

(Id.) The S&P 500 Total Return Index ("SPTR") is the bottommost line at December 2008. Above it appear the 90% line and on top the 80% line.

The chart shows the experience of investors who placed 10% and 20% of their portfolio in the IVI between December 2004 and June 2010. This experience closely tracked the total S&P 500 return figures during market increases from December 2004 through late 2009. The value of the portfolios stayed significantly above the total S&P 500 return during the bad year of 2008. With the ensuing recovery, they began to track the S&P gains as before. The document asserted that "[t]he Index may help to moderate a portfolio's return distribution, thus reducing the occurrence of large losses." (Id.)

The three-page description of the IVI also included the following statement regarding risk factors:

Please note that there are risks arising from an investment linked to the Index, including but not limited to the following:
• The Index methodology includes features, including a deduction for transaction costs, and a multiplier of ...

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