A federal court has refused to make it easier for “aftermarket” purchasers of stock to sue over misstatements made in registration statements to the Securities and Exchange Commission in connection with an IPO.
The Securities Act of 1933 allows “any person acquiring” shares issued pursuant to an untrue registration statement to sue for damages. That standard is met by investors who purchased stock during the relevant public offerings—those who buy in the secondary market have a much more difficult time meeting the standard because their stock must be “traceable” back to the public offering.
In a recent case in the Texas-based 5th Circuit, aftermarket purchasers of a dot-com’s stock claimed that they should be allowed to sue because there was a very high statistical probability that they had at least one public offering share. But the court said that adopting that argument would be contrary to the intent of Congress.
“[A]ccepting such ‘statistical tracing’ would impermissibly expand the statute’s standing requirement. Because any share of [the company’s] stock chosen at random in the aftermarket has at least a 90 percent chance of being tainted, its holder, according to [the plaintiffs], would have [the right to sue]. In other words, every aftermarket purchaser would have standing for every share, despite the language of [the statute] limiting suit to ‘any person acquiring such security.’ … This cannot be squared with the statutory language – that is, with what Congress intended,” the court said in Krim, et al. v. pcOrder.com, Inc., et al. (decision available from the box at right).
Closing The Floodgates
Maloney
James Maloney of Baker Botts in Houston, who represented pcOrder.com, told Compliance Week that the ruling is an “important decision” that could have opened the floodgates for lawsuits by aftermarket purchasers if the court had come out the other way. “Section 11 [of the 1933 Act] is a strict liability statute,” said Maloney. “If there is a misstatement, no matter how innocent, and that misstatement is material, then the person has a claim for damages,” he said, explaining why litigation over IPO statements should be “limited to those who see and rely upon the prospectus.”
Maloney noted that the statute “worked perfectly well until 1973,” which was the year in which the system went paperless. Prior to that time, says Maloney, investors had physical shares with numbers, making tracing of the investment more simple. With the establishment of the paperless system, the ability to trace shares back to an IPO was effectively lost. “[Now] within days of the IPO,” says Maloney, “the stock is turning, and within days—if not hours—nobody out there buying or selling has any connection to the prospectus.”
Aftermarket purchasers can still sue over IPO misstatements, Maloney said, but they have to do so under Rule 10b-5, which is more difficult because it is not a strict liability provision and a showing of intent is required.
99.85 Percent Not Enough
The initial public offering of pcOrder.com stock was conducted on Feb. 26, 1999, and a secondary public offering was made on Dec. 7, 1999. In connection with each offering, the company filed a registration statement with the SEC.
Several holders of pcOrder.com stock filed multiple lawsuits against the company under Section 11 of the Securities Act of 1933. The plaintiffs alleged that the registration statements were false and misleading by indicating that pcOrder.com had a viable business plan, had an ability to generate and report accurate operating and financial information, and was not competing with parent Trilogy Software for revenue.
A federal judge in the Western District of Texas dismissed the suit for lack of legal standing, because the lead plaintiffs couldn’t trace their stock back to either of the two public offerings. For example, one of the lead plaintiffs, Gene Burke, had purchased 3,000 shares in June 1999, when non-IPO shares had intermingled with IPO shares, though IPO shares still constituted 99.85 percent of the share pool. Burke made additional purchases of stock after the secondary public offering, when IPO and SPO shares constituted 91 percent of the market.
Despite the favorable percentages, the judge noted that there was no way to track Burke’s individual shares—and those of other lead plaintiffs—once the pool became “contaminated” with outside shares. Therefore, the plaintiffs could not sue even though there was nearly a 100 percent probability that each lead plaintiff had at least one share of PO stock.
On appeal, the 5th Circuit became the first appellate circuit in the country to address the “statistical tracing” argument and said that it wasn’t sufficient to give the plaintiffs the right to sue under the 1933 Act.
The court said that there is “no reason to categorically exclude aftermarket purchasers” entirely from suing as long as “the security was indeed issued under that registration statement and not another.” This traceability requirement “is satisfied, as a matter of logic, when stock has only entered the market via a single offering,” the court noted.
However, in the case of pcOrder.com, the stock did not enter the market through a single offering. The court acknowledged that, when Congress enacted the Securities Act of 1933, “it was not confronted with the widespread practice of holding stock in street name.” However, that “impediment” to suing under Section 11 of the 1933 Act is not something for the courts to correct, the 5th Circuit said.
“That present market realities, given the fungibility of stock held in street name, may render Section 11 ineffective as a practical matter in some aftermarket scenarios is an issue properly addressed by Congress. It is not within our purview to rewrite the statute to take account of changed conditions,” the court stated.
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