In a ruling of potential importance for investment advisers and directors/trustees of registered investment companies, a California appellate court affirmed a lower court ruling on January 23, 2020 in Garth Jensen, et al. v. iShares Trust, et al.¹ The court held that a class of individual investors who purchased exchange-traded fund (ETF) shares in the secondary market lacked standing to bring a claim for allegedly false or misleading registration statements under Section 11 of the Securities Act of 1933. The court based its holding on the fact that Plaintiffs could not trace their purchases of ETF shares back to an initial offering. The court’s ruling may have broader implications as to whether retail investors holding shares of ETFs ever would have standing to sue under Section 11.

Background

Section 11 of the 1933 Act provides a cause of action to any person against (among others) the issuer of a security for a materially false or misleading registration statement. Section 11 includes a “tracing requirement” that a plaintiff who purchased securities in the secondary market must be able to trace the chain of title of the shares back to a purchase under the initial registration statement. Section 12(a) of the 1933 Act provides a cause of action to any person against the seller of a security for a materially false or misleading prospectus. Unlike Section 11, Section 12(a) generally does not permit claims based on secondary market purchases, and thus “tracing” is not at issue in a Section 12(a) claim.

Plaintiffs, a purported class of investors who purchased ETF shares in the secondary market, filed suit in California state court June 2016 under Sections 11 and 12(a), claiming that the investment adviser portrayed these ETFs in its initial registration statement as safe investments, without disclosing the risk of using stop-loss orders during times of market volatility such as “flash crashes.” Plaintiffs alleged that Defendants failed to disclose that the ETFs were especially vulnerable during flash crashes; Plaintiffs claimed that the increased volume of sell orders decreases liquidity and causes the ETFs’ market price to plummet while the value of the underlying assets remains relatively steady.

The California state court entered judgment on the pleadings in favor of Defendants as to Plaintiffs’ claim under Section 12(a)(2), holding that Section 12 applies only to initial offerings and does not provide standing to purchasers in the secondary market. The question of whether Plaintiffs had standing under Section 11 proceeded to a bifurcated bench trial, after which the trial court entered judgment in favor of Defendants on the grounds that, as secondary market purchasers, Plaintiffs could not trace their shares to an offering made under a misleading registration statement. As a “continuously offered” security, the ETFs’ registration statements were amended annually numerous times after the initial offering.

Appellate Ruling

Plaintiffs appealed the lower court’s denial of standing under Section 11, arguing that the Investment Company Act of 1940 confers standing to investors who purchase shares in the secondary market based upon a misleading registration statement, regardless of the offering documents in effect when the shares were issued. More specifically, Plaintiffs argued that Section 24(e) of the 1940 Act expanded the reach of Section 11 for funds subject thereto. Section 24(e) provides that, for the purposes of Section 11, the latest amendment to a registration statement controls all securities sold thereafter. Plaintiffs interpreted the statutory phrase “securities sold after such amendment” to encompass sales in the secondary market.

The California appellate court rejected Plaintiffs’ interpretation and read Section 24(e) to refer to the sale of securities registered by the challenged amendment, noting that the 1940 Act provides investment companies engaged in continuous offerings with the option to register shares by filing an amendment to the original registration statement instead of filing a new registration statement. The court reasoned that “a provision in separate legislation that does not appear to have been intended to expand standing under the 1933 Act and certainly could not have been enacted with secondary market transactions in mind – is too weak a basis” to expand standing under Section 11.

Significance and Potential Impact on ETF Shareholder Litigation

In its opinion, the Court acknowledged that ETFs – which are designed to be traded on the secondary market – often are impossible to trace back to an initial offering. Given the realities of the “continuous offering” of ETFs and the frequent (no less than annual) amendment of their registration statements, the court’s holding significantly circumscribes (if not eliminates) Section 11 liability for ETF issuers as to shares purchased on the secondary market. Under the court’s ruling, it would be difficult for shareholders (other than authorized participants who purchase ETFs directly from sponsors in an ETF’s initial offering) to trace their shares to the initial offering documents.

It is unclear whether federal district courts addressing this issue will follow the reasoning of the California appellate court. Even if they do not, the decision certainly limits the attractiveness of California state courts for claims against funds under the 1933 Act. That is a meaningful limitation because of the increased number of filings in that forum in light of the Supreme Court’s March 2018 decision in Cyan, Inc. v. Beaver County Employees Retirement Fund,² in which the Court unanimously held that state courts have concurrent jurisdiction to hear claims under the 1933 Act, but defendants are barred from removing class actions alleging only 1933 Act claims from state to federal court. The decision also underscores the effect that the growing number of 1933 Act claims pending in state courts in California and elsewhere may have on the resolution of open legal issues for civil claims brought under the 1933 Act.

Footnotes

1) No. A153511, 2020 WL 373299 (Cal. Ct. App. Jan. 23, 2020). All facts in this OnPoint are based on publicly available information.

2) 138 S. Ct. 1061, 200 L. Ed. 2d 332 (2018).