On January 23, 2020, the California Court of Appeal, First Appellate District, in the case of Jensen v. iShares Trust, 2020 Cal. App. LEXIS 61, affirmed a lower court ruling that individual investors who purchased shares in exchange-traded funds (“ETFs”) through the secondary market and then incurred losses lacked standing to pursue their claims for violations of various provisions of the federal Securities Act of 1933 (the “Securities Act”) against the issuer and associated entities principally because the investors purchased the shares in the secondary market and not in an initial offering. Both the Securities Act and the Securities Exchange Act of 1934 (the “Exchange Act”) establish causes of action for material misstatements and omissions in securities transactions. However, the federal courts have exclusive jurisdiction under Section 27 of the Exchange Act while state and federal courts generally enjoy concurrent jurisdiction under Section 22 of the Securities Act.
ETFs are generally structured as open-end management investment companies that are registered with the Securities and Exchange Commission (“SEC”) under the Investment Company Act of 1940 (the “ICA”). ETFs sell and redeem shares at net asset value (“NAV”) and only in large blocks that are sold to institutional investors or broker-dealers, who in turn may sell shares to investors in the secondary market. ETFs are listed for trading on national securities exchanges, enabling investors to purchase and sell ETF shares at market prices that do not necessarily correspond to NAV.
In Jensen, plaintiffs asserted in the trial court that the defendants’ offering documents that were filed with the SEC or issued before the plaintiffs purchased their shares of ETFs were false or misleading in not sufficiently disclosing risks involved in investing in ETFs, particularly the risk that during a “flash crash” numerous sales orders would trigger stop-loss orders—requiring in this case the automatic sale of an investor’s ETF shares when their value declined to a specific price—resulting in large financial losses to those such as plaintiffs who were forced to sell at a price significantly lower than the ETFs NAV. A flash crash is a very brief time in which prices of securities decline substantially, and plaintiffs asserted in Jensen that several flash crashes occurred.
The complaint in Jensen alleged violations of several federal securities laws, including sections 11 and 12(a)(2) of the Securities Act. Section 11 provides a right of action for purchasers against issuers and related persons for a material misrepresentation or omission in a registration statement for the issuance of securities. Section 12(a)(2) provides a right of action for purchasers against sellers who make a material misstatement or omission in a prospectus (or other communication) used (or made) as part of the sale of securities to the purchaser, unless the seller can show that it did not know, and in the exercise of reasonable care could not have known, of such untruth or omission. Under both sections, the purchaser must not know of such untruth or omission at the time of purchase. Under section 11, unless the purchaser knew of the untruth or omission, the issuer is strictly liable for material misstatements or omissions in the registration statement.
The trial court dismissed the section 12 claim because the plaintiffs had purchased their shares in the secondary market, and in the court’s view section 12 only applies to initial offerings. As to section 11, under case law plaintiffs can have standing for shares purchased in the secondary market only if the shares can be traced back to a misleading registration statement. The trial court rejected plaintiffs’ argument that the tracing requirement did not apply in light of section 24(e) of the ICA. That section applies to funds issued by an open-end investment company and provides that for section 11 purposes the effective date of the latest amendment filed with the SEC is regarded as the effective date of the registration statement with respect to shares sold after the date the amendment becomes effective. Plaintiffs asserted the word “sold” refers to a sale on the secondary market, but the trial court determined it applies only to the initial sale. Since the plaintiffs could not show that the shares of ETFs they purchased were initially offered to the public by the issuer under a defective registration statement or amendment, they had no standing under section 11. The trial court indicated that the plaintiffs’ interpretation would mean that “all securities, including those sold in an initial offering pursuant to a perfectly innocent registration statement, could be the subject of a section 11 suit if the securities ended up in the hands of someone—anyone—after a much later infirm registration statement.” [emphasis in the original]
The plaintiffs appealed as to the standing issues under sections 11 and 12. The appellate court affirmed the trial court’s judgment, noting that both sections do not require scienter, reliance or loss causation in contrast to the comparable anti-fraud statute under section 10(b) of the Exchange Act, but do apply in narrower circumstances. Thus, for section 11 standing, purchasers must be able to trace their shares back to the allegedly defective registration statement, even though the court acknowledged that it would be extremely difficult to do so given that open-end management companies do not register a specific number of shares and ETF shares are held by the Depository Trust Company “in fungible bulk, meaning that there are no specifically identifiable shares held or owned by any ETF investor.” The court also rejected the plaintiffs’ assertion that in adopting section 24(e) Congress intended to apply a different and broader section 11 standing test for open-end management companies than other issuers.
As to section 12(a)(2) standing, the appellate court determined that most of the case law has held that only purchasers in the initial offering satisfied the requirement. The court indicated that there could be circumstances in which a purchaser in the secondary market could have standing, but concluded that the complaint failed to allege “direct and active participation in the solicitation of the immediate sale to hold the issuer liable as a §12(2) seller” quoting Shaw v. Digital Equipment Corp. (1st Cir. 1996) 82 F. 3d 1194, 1214-1215.
This e-Bulletin was prepared by William Ross, of counsel to Hirschfeld Kraemer LLP. Mr. Ross is a member and past co-chair of the Corporations Committee of the Business Law Section of the California Lawyers Association.