Morrison, the restricted scope of Securities Act section 11 liability, and prospects for regulatory reform.

• Author: Grundfest, Joseph A.
• Position: I. Introduction through III. Morrison and the Internationally Distributed, U.S.-Listed IPO, p. 1-38

1. INTRODUCTION II. THE MICRO-STRUCTURE OF INITIAL PUBLIC OFFERINGS AND THE AFTERMARKET TRADING PROCESS A. The Initial Distribution B. The Opening Cross C. Aftermarket Trading III. MORRISON AND THE INTERNATIONALLY DISTRIBUTED, U.S.-LISTED IPO A. Morrison's Holding and the Supreme Court's Rationale B. The Congressional Response C. Morrison and the Securities Act D. Morrison's First Prong: The Domestic Exchange Test E. Morrison's Second Prong: The Domestic Transaction Test IV. THE SECTION 11 TRACING REQUIREMENT A. Section 11 B. The Law and Logic of Tracing C. Practical Implications of the Tracing Requirement V. MORRISON'S IMPLICATIONS FOR SECTION 11 TRACING A. Morrison and the Rule Against Extraterritorial Application B. The Narrow Construction of Implied Private Rights of Action C. The Structure of the Securities Statutes D. Section 11's Text E. Section 11's Legislative History VI. POLICY IMPLICATIONS AND POTENTIAL REGULATORY RESPONSES A. The Domestic Distribution Requirement B. Undertakings Not to Challenge the Right to Assert Section 11 Claims 1. CUSIP Reform 2. Legislative Reform VII. CONCLUSION I. INTRODUCTION

   Section 11 of the Securities Act of 1933 (1) (Securities Act), subject to significant qualifications, imposes strict liability on issuers for material misrepresentations or omissions in registration statements declared effective by the Securities and Exchange Commission (SEC or Commission). It also creates a sliding scale form of negligence liability applicable to underwriters, accountants, the issuer's directors, and other enumerated defendants. (2) Section 11 liability is the source of many of the largest class action securities recoveries in history, (3) and, if plaintiffs satisfy section 11's requirements, it can serve as the most plaintiff-friendly provision of the federal securities laws. (4)

   The operation of section 11 liability is, however, exceptionally complex, (5) and the Supreme Court's recent decision in Morrison v. National Australia Bank Ltd. (6) interacts with the scope of section 11 in a manner that has yet to receive close attention from scholars, regulators, or courts. (7) Careful examination of the mechanics of the initial public offering (IPO) process suggests that Morrison implies a potentially significant reduction in the scope of section 11 liability in any IPO in which listing on a U.S. exchange follows an initial distribution that includes even a small number of shares sold in transactions that are non-domestic under Morrison.

   In a firm commitment underwriting of shares qualified for listing on a U.S. exchange, issuers must complete initial distributions to a minimum of 300 round lot holders before trading on the New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated Quotations system (NASDAQ) can commence. (8) This initial distribution is an off-exchange transaction (9) and can involve sales that occur through foreign brokers regulated by foreign authorities, in transactions that are governed by foreign law and that are subject to foreign forum selection provisions, and in which title transfers offshore in a transaction that is not domestic for purposes of Morrison. (10)

   The first on-exchange transaction of publicly distributed shares occurs only after the initial distribution is complete and operates through an automated computerized algorithm known as the "opening cross." That algorithm seeks to balance aftermarket supply and demand to determine a price at which to initiate aftermarket trading. The price determined in the opening cross need not equal the IPO price and, in some circumstances, diverges significantly from the price at which the initial distribution occurs. Indeed, the fact that the initial distribution and the subsequent on-exchange trading of the initially distributed shares are two distinct transactions governed by distinct legal regimes and market procedures is only emphasized by the potential for disparity between (1) the IPO price, which, by law, must be the price at which the initial, off-exchange, distribution occurs with all investors participating in the distribution, and (2) the opening on-exchange price, which is determined by the opening cross, and need not equal the IPO price at which the shares are initially distributed. (11)

   Morrison holds that liability under the Securities and Exchange Act of 1934 (12) (Exchange Act) attaches only to purchases or sales of securities that are "listed on domestic exchanges and domestic transactions in other securities." (13) Morrison thus establishes a "two-prong" test: for U.S. securities laws to apply, the transaction must either take place on a U.S. exchange or be a domestic transaction. (14) Lower courts have uniformly extended Morrison's holding to the Securities Act and have applied Morrison's presumption against extraterritoriality to a wide range of other statutes. (15) There is, at present, no substantive reason to question Morrison's application to the Securities Act.

   Because the initial distribution of IPO shares does not occur on a domestic exchange, Morrison's first prong is not satisfied. (16) Moreover, an initial distribution of IPO shares to offshore purchasers through offshore accounts governed by foreign regulators and subject to foreign choice of law and venue provisions where title also passes offshore is also not a "domestic transaction," and therefore fails Morrison's second prong. (17) Morrison thus compels the conclusion that, in a class action alleging a violation of section 11, non-domestic purchasers in the initial distribution have no section 11 claims and must be excluded from the plaintiff class.

   This conclusion has significant potential implications for the ability of secondary market purchasers on domestic exchanges to successfully assert section 11 claims. Although domestic purchasers in an initial distribution can clearly pursue section 11 claims, a dispute exists as to whether aftermarket purchasers also have such rights. The Supreme Court has yet to address this question. A minority of lower courts has, however, ruled that aftermarket purchasers have no section 11 claims regardless of the locus of the transaction. (18) If that interpretation is correct, then further analysis of Morrison's implications for aftermarket purchasers is unnecessary because aftermarket purchasers have no section 11 rights regardless of Morrison's holding. The majority view, however, is that aftermarket purchasers have section 11 rights, provided that they can bear the burden of affirmatively tracing their shares to securities that were issued pursuant to the allegedly defective registration statement. (19) Plaintiffs must demonstrate their ability to trace deterministically and cannot rely on probabilistic arguments. (20)

   In every reported instance of successful tracing, plaintiffs have been able to trace their shares to an initial transaction that gave rise to a section 11 claim in the hands of the purchaser in the initial distribution. (21) Accordingly, every example of successful tracing to date can be described as an instance in which the initial purchaser in the distribution has a valid section 11 claim and then sells the security, together with the associated right to bring a section 11 claim, to an aftermarket purchaser. Put another way, until Morrison, the requirement that an aftermarket purchaser be able to trace her shares to an initial transaction in which the initial purchaser in the pre-public trading IPO could assert a section 11 claim was synonymous with the requirement that the aftermarket purchaser trace her shares to securities issued pursuant to the allegedly defective registration statements. The two concepts were simply two different ways of describing precisely the same categories of persons and shares. Therefore, pre-Morrison, there was no rational reason for any court to distinguish between these two locutions of the tracing requirement. It follows that there is no precedent addressing the question of whether, for purposes of section 11 tracing, a plaintiff must trace to shares initially distributed within section 11's domestic reach, or whether it is sufficient to trace to shares that were issued pursuant to the allegedly defective registration statement, even if the initial transaction was non-domestic and thus outside of section 11's reach. It also follows that there is no support in the current case law or academic literature for the existence of a "springing" section 11 claim that would allow aftermarket purchasers to assert section 11 rights that initial purchasers of those shares could not legally assert, post-Morrison.

   But given the operation of the Committee on Uniform Security Identification Procedures (CUSIP) identification system, as well as the netting and commingling of shares that occurs through the modern aftermarket clearance and settlement processes, if even a single share of an offshore IPO distribution is resold in the opening cross, it then becomes impossible as a practical matter for any aftermarket purchaser to successfully trace to shares that were initially purchased in domestic transactions. (22) Thus, the significant post-Morrison question of first impression is whether the courts should interpret the tracing doctrine to allow aftermarket purchasers the right to pursue section 11 claims that did not exist in the hands of the securities' initial purchasers, because those initial purchasers acquired shares in non-domestic transactions that Congress never intended to protect with Securities Act liability. To extend section 11 liability to cover these aftermarket purchasers, courts would have to invent a "springing right of action" allowing aftermarket purchasers to pursue section 11 claims that are unavailable to initial holders.

   While no precedent squarely addresses this question and credible positions can be asserted on both sides, the better interpretation of the law is that aftermarket purchasers must...