The 10b-5 Daily

Section 11 of the ’33 Act creates civil liability for misstatements in a registration statement. The class of persons who can sue under the statute, however, is limited to those who purchased shares issued pursuant to the registration statement in question. To have standing, an investor must have either acquired his shares in the offering or, if he purchased them in the aftermarket, be able to “trace” them back to the offering. As a general matter, the later introduction of non-offering shares into the market (e.g., via the sale of shares by insiders) generally defeats the ability of subsequent investors to trace their shares back to the offering because the intermingling of the shares makes it virtually impossible to establish that the purchased shares are offering shares.

In Krim v. pcOrder.com, 2005 WL 469618 (5th Cir. March 1, 2005), the plaintiffs tried a statistical approach to solving the problem of aftermarket standing for Section 11 claims. Although the plaintiffs conceded that they could not demonstrate that their shares were issued pursuant to the registration statement, they asserted the existence of standing based on expert testimony indicating that given the number of shares they owned and the percentage of offering stock in the market, the probability that they owned at least one share of offering stock was nearly 100%. The court rejected this statistical tracing theory, finding that “Congress conferred standing on those who actually purchased the tainted stock, not on the whole class of those who possibly purchased tainted shares – or, to put it another way, are at risk of having purchased tainted shares.”

Holding: Dismissal affirmed.

Quote of note: “The fallacy of Appellants position is demonstrated with the following analogy. Taking a United States resident at random, there is a 99.83% chance that she will be from somewhere other than Wyoming. Does this high statistical likelihood alone, assuming for whatever reason there is no other information available, mean that she can avail herself of diversity jurisdiction in a suit against a Wyoming resident? Surely not.”

The litigation arising out of the “research analyst” scandals (where major investment banks have been accused of disseminating overly optimistic research and investment recommendations to garner investment banking business) continues to raise interesting legal issues. Both the Second and Third Circuits, for example, have recently addressed whether the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) mandates the dismissal of class actions based upon state law seeking to recover various types of damages related to the allegedly biased research.

SLUSA preempts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. In Dabit v. Merrill Lynch, 2005 WL 44434 (2d Cir. Jan. 11, 2005), the Second Circuit addressed two state class actions (brought on behalf of Merrill Lynch brokers and brokerage customers respectively) alleging losses based on biased research. In both cases, the plaintiffs generally did not dispute that the lawsuits were “covered class actions” and concerned “covered securities.” The issue was whether Merrill Lynch’s alleged misrepresentations were “in connection with the purchase or sale” of those securities. The court held that to be prohibited under SLUSA “an action must allege a purchase or sale of covered securities made by the plaintiff or members of the alleged class.” As for the brokers, the court found that the proposed class of brokers who were injured by holding the recommended stocks included purchasers and therefore, in part, satisfied the “in connection with requirement.” Because the court could not “distinguish any non-preempted subclass, SLUSA requires that the claim be dismissed.” A separate claim regarding commissions lost by the brokers when their customers left Merrill Lynch due to the scandal, however, was allowed to proceed in state court.

The brokerage customers also received a mixed decision. The Second Circuit followed a number of other circuits in finding that the claims based on commissions paid to Merrill Lynch in reliance on the research were “preempted because they necessarily involve allegations of a purchase or sale ‘in connection with’ this alleged misconduct.” In contrast, the claims related to the annual fees paid by the customers were not preempted because the fees were “paid whether or not the customer transacts in the account, and the misrepresentations inherent in the alleged nonperformance and statutory violations therefore do not necessarily ‘coincide with’ a securities transaction.”

Last week, the Third Circuit addressed the same issues and came to similar conclusions. In Rowinski v. Salomon Smith Barney, Inc., 2005 WL 356810 (3rd Cir. Feb. 16, 2005) a putative class of Salomon brokerage customers brought a class action in Pennsylvania state court alleging that the company’s dissemination of biased investment research breached the parties’ service contract, unjustly enriched Salomon, and violated state consumer protection law. The plaintiffs sought “an amount equal to the amount of any and all fees and charges collected” from the class by Salomon. The court held that the “in connection with the purchase or sale” requirement under SLUSA must, as it is in the context of Rule 10b-5 actions, be broadly interpreted. Looking at a number of factors, including whether the fraudulent scheme coincided with the purchase or sale of securities and whether the nature of the parties’ relationship was such that it necessarily involved the purchase or sale of securities, the court found that the class action fell “well within the bounds of SLUSA” and upheld its dismissal.

Quote of note (Rowinski): “Plaintiff also contends that as master of his own complaint, he is entitled to plead around SLUSA. But SLUSA stands as an express exception to the well-pleaded complaint rule, and its preemptive force cannot be circumvented by artful drafting. In this context – where Congress had expressly preempted a particular class of state law claims – the question is not whether a plaintiff pleads or omits certain key words or legal theories, but rather whether a reasonable reading of the complaint evidences allegations of ‘a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.’”