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

• Author: Grundfest, Joseph A.
• Position: IV. The Section 11 Tracing Requirement through VII. Ccnclusion, with footnotes, p. 38-69

4. THE SECTION 11 TRACING REQUIREMENT

   Having addressed Morrison's implications for the placement of initially distributed shares, and having established that non-domestic purchasers in the initial distribution cannot bring a section 11 claim, the next question is whether and how Morrison implicates the section 11 rights of shares traded in the aftermarket on a U.S. exchange, subsequent to completion of the initial distribution. This deceptively simple question requires a complex analysis because section 11 is unique among all the liability provisions of federal securities law in that it requires proof of "tracing" as a pre-condition to any aftermarket purchaser's ability to assert a section 11 claim. It is the definition of the tracing requirement that raises the possibility that no aftermarket purchasers can assert a valid section 11 claim--even if they transacted on a U.S. exchange--as long as a single share of the initial distribution was sold in a non-domestic transaction and then re-sold in the opening cross.

   More precisely, the law of section 11 tracing has evolved in a manner that creates a significant ambiguity with regard to the analysis of the implications of the Court's decision in Morrison, because pre-Morrison precedent fails to distinguish between a requirement that plaintiffs (1) trace to shares simply issued pursuant to a defective registration statement, as opposed to a requirement that they (2) trace to shares that were initially acquired in a domestic distribution that Congress intended to protect with section 11 rights. The absence of this distinction in the literature is entirely unsurprising because, in a pre-Morrison world, the two conditions were synonymous. Under the now-rejected conduct and effects tests, shares issued pursuant to a defective registration statement and listed for trading on a U.S. exchange typically gave rise to a valid section 11 claim in the hands of the original purchaser, without regard to the locus of the transaction. Identically, every initial purchaser with a valid section 11 claim acquired shares issued pursuant to a defective registration statement. Again, the purchaser would achieve this status without regard to the locus of the transaction. The courts therefore had no cause to analyze a circumstance in which an initial purchaser acquires securities issued pursuant to a defective registration statement but has no valid section 11 claim because, pre-Morrison, such situations did not exist.

   Morrison, however, disrupts this status quo and, for the first time, creates situations in which purchasers in the initial distribution of registered securities do not have valid section 11 claims even if the shares they purchased were issued pursuant to the allegedly defective registration statement because the transaction was offshore. What then does section 11's tracing requirement mandate? Is it sufficient to demonstrate that the shares purchased in the aftermarket were issued pursuant to the allegedly defective registration statement, even if the original purchaser has no section 11 rights because they purchased in a non-domestic transaction that Congress never intended section 11 liability to reach? Or, must the plaintiff demonstrate that the shares purchased in the aftermarket were both issued pursuant to the allegedly defective registration statement and that the initial holder acquired the shares in a transaction subject to section 11's territorial reach?

   To address this question of first impression, this Part IV begins with a summary of section 11 liability and a description of the evolution and logic of the section 11 tracing requirement. The analysis then describes the practical challenges to satisfying the section 11 tracing requirement, as the law existed prior to Morrison. This analysis is a prologue to the more complex consideration of Morrison's implication for the ability of aftermarket purchasers to assert section 11 claims, which is presented in Part V.

   1. Section 11

      Section 11 of the Securities Act, subject to significant conditions, creates an express private right of action for damages in the event a registration statement declared effective by the SEC contains a material misrepresentation or omission. (224) For an issuer, subject to various defenses, section 11 liability can be "virtually absolute." (225) Other enumerated defendants, including underwriters, directors, auditors, experts, and any other person signing the registration statement, bear the burden of demonstrating that they can satisfy a sliding scale "due diligence" defense in order to avoid liability. (226) Plaintiffs need not establish scienter. (227) Purchasers who knew of the alleged untruth or omission as of the time of the acquisition cannot bring suit under section 11. (228) Lower courts are inconsistent in their description of section 11 as containing a reliance requirement. Some suggest that reliance is not an element of plaintiffs' cause of action. (229) Others have concluded that plaintiffs benefit from a presumption of reliance that can be rebutted, for example, by proof that the plaintiff had entered into a legally binding commitment to purchase the securities at issue before the allegedly fraudulent registration statement was on file. (230)

      Damages under section 11 are calculated as the difference between the purchase price and either the value of the shares at the time the lawsuit was commenced, the price at which the plaintiff previously sold the security, or the price at which the security was sold after suit but before judgment. (231) Damages cannot, however, exceed the offering price. (232) The statutory reference to "value" as distinct from price can raise complexities in the calculation of damages. (233) Defendants can also reduce their exposure by bearing the burden of establishing "negative causation," through a demonstration that the decline in price or value subsequent to the offering was attributable to factors other than the alleged fraud. (234)

      Causes of action under the federal securities laws are cumulative. (235) Plaintiffs who are unable to assert section 11 claims because, for example, they are unable to satisfy section 11's tracing requirement, are not foreclosed from all available avenues for relief. They can still pursue claims under section 10(b) of the Exchange Act, or any other provision of state or federal law.

   2. The Law and Logic of Tracing

      One of the most significant constraints on a plaintiffs' ability to file a section 11 claim arises from the law's tracing requirement. Early decisions made clear that suit could be maintained by "those who purchase securities that are the direct subject of the prospectus and registration statement," (236) i.e., participants in the initial distribution of an IPO or other registered shares. The lower courts are split, however, as to whether section 11's coverage is limited to purchasers who acquire their shares directly from issuers or underwriters (initial purchasers), or whether section 11 claims can also be brought by plaintiffs who purchase securities in the aftermarket, for example, on a national exchange (aftermarket purchasers). (237) Every court that has recognized aftermarket standing has, however, conditioned plaintiffs' claim on an ability to satisfy a strict "tracing" requirement.

      The Supreme Court has yet to consider whether aftermarket purchasers may assert section 11 claims and, if so, subject to which, if any, tracing conditions. If the Court determines at some point to address this question, and if it rules that aftermarket purchasers cannot assert section 11 claims, then no further analysis of Morrison's implication for aftermarket standing is necessary: aftermarket purchasers will then not be able to assert section 11 claims without regard to the locus of any transaction. (238) If, however, courts continue to recognize aftermarket section 11 rights of action subject to a tracing requirement, then Morrison has significant potential implications for the evolution of the tracing requirement.

      Barnes v. Osofsky (239) is the genesis case that establishes the tracing doctrine, and later courts have followed its logic closely. (240) In Barnes, Judge Friendly faced claims by objectors to a class action securities fraud settlement that limited recovery to "persons who could establish that they purchased securities issued under" (241) the allegedly defective registration statement when the issuer had pre-existing registered shares of the same class traded on the same market. (242) As framed by Judge Friendly, the question presented "is whether the district court was right in ruling that [section] 11 extends only to the purchasers of the newly registered shares." (243)

      Judge Friendly began with an analysis of section 11's text and observed an ambiguity in the statutory language. Section 11(a) provides that if a registration statement as declared effective contains a material misrepresentation or omission "any person acquiring such security ... may, either at law or in equity, in any court of competent jurisdiction, sue." (244) "[T]he difficulty, presented when as here the registration is of shares in addition to those already being traded, is that 'such' has no referent." (245) Does "such" refer most broadly to all securities of the same class or nature as those registered by the allegedly defective filing? Or, does "such" refer more narrowly only to the specific securities registered pursuant to the allegedly defective filing?

      Judge Friendly resolved the question in favor of the narrower interpretation, thereby imposing upon plaintiffs a tracing requirement. In reaching this conclusion, Judge Friendly first observed that the "broader reading would be inconsistent with the overall statutory scheme." (246) The Securities Act and Exchange Act contain other provisions that clearly provide remedies addressing aftermarket purchases and sales. (247) In contrast, the "stringent penalties [of section...