Comment: Statistical loophole closed

A recent session of the 5th Circuit Court in Texas found that aftermarket buyers are not fully protected under Section 11 of the Securities Act of 1933. A three-judge panel upheld the 2003 decision of US District Court Judge Sam Sparks, who dismissed a suit brought by Jerry Krim and others against pcOrder.com. 

In the late 1990s securities litigators noted a marked increase in claims brought as putative class actions under Section 11 of the Securities Act, which imposes liability for even innocent material misstatements in public offering registration documents. Recently plaintiffs and their counsel have sought to extend certification of Section 11 to include not only original public offering (IPO) investors but also aftermarket purchasers. The ruling by the court should serve to greatly curtail such actions. 

The case in question was brought against pcOrder.com and its directors, majority shareholder, officers and lead underwriters. Krim and his fellow plaintiffs accused the company of making material statements in the IPO documents that were incorrect. Specifically, the suit alleged that the documents falsely claimed to have a viable business plan and the ability to report accurate information, and that pcOrder.com was independent from the parent company, Trilogy. 

Under Section 11 a shareholder must prove that some of the shares he or she owns form part of the original offering. Up to now this has been argued using what is called ‘statistical tracing’. Prior to the Krim finding, no court of appeal had spoken on how a purchaser in today’s aftermarket can trace shares to a particular offering. 

The claimants said they should be allowed to sue because there is a very high statistical probability that they had at least one IPO share. In one example presented to the court, an investor bought stock in 1999 when IPO shares constituted 99.8 percent of all available shares. He then bought further shares at a later date when IPO shares were 91 percent of the market. 

The court rejected this method of tracing ownership to original IPO shares. In passing judgment, it stated: ‘Accepting such statistical tracing would impermissibly expand the statute’s standing requirement. Because a share of 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 limiting suit to those who purchase securities that are the direct subject of the prospectus and registration statement.

This finding has important ramifications for all issuers and purchasers of shares. The basic requirement of Section 11 to make possible the tracing of shares back to the original offering has become far more problematic since 1973. Up to that year all shareholders received paper share certificates that were numbered and thus easily traced to a specific offering. Since then shares have increasingly been bought and sold under a street name, making the ownership and issuance path much more difficult to trace. 

The development of electronic share issuance has further exacerbated the situation. Considering that Delaware, home to more registered companies than any other US state, has just passed rule HB 150 allowing companies to issue in electronic format only, becoming the 46th state to do so (see page 12), it is likely we will see far fewer class action Section 11 suits being brought.