California Appellate Court Holds Secondary Market Purchasers of ETFs Lack Standing To Bring Securities Act Claims
On January 23, 2020, the Court of Appeal of the First Appellate District of California affirmed a lower court’s judgment holding that investors lacked standing to pursue claims under Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 against an open-end management investment company (the “Company”), its investment advisor, the investment advisor’s parent company, and certain members of the board of trustees of the Company. Jensen v. iShares Tr., 44 Cal. App. 5th 618 (Ct. App. 2020), review denied (May 27, 2020). Plaintiffs, who purchased shares of exchanged-traded funds (“ETFs”) on the secondary market, claimed that the Company failed to adequately disclose the risks associated with “flash crashes” that were known to occur in the ETF market. The Court affirmed the lower court’s dismissal, holding that plaintiffs lacked standing under Section 11 because they could not satisfy the tracing requirement and that plaintiffs lacked standing under Section 12(a)(2) because they failed to allege direct contract with defendants.
Plaintiffs are individual purchasers of shares of the Company’s ETFs who allegedly suffered losses when their shares were sold pursuant to “stop-loss orders” during a flash crash on August 24, 2015 when ETF trading prices fell dramatically. Plaintiffs alleged that in registration statements, prospectuses, and related amendments filed between 2012 and 2015, the Company failed to disclose the risks associated with flash crashes in the ETF market, and specifically the impact that stop-loss orders could have on investments in shares of ETFs during flash crashes.
The lower court never reached the issue of whether the Company had made material misrepresentations or omissions, focusing instead on the question of whether plaintiffs, who had purchased their shares on the secondary market, had standing to bring suit under the Securities Act. The lower court dismissed the Section 11 claims because plaintiffs had not satisfied the tracing requirement and dismissed plaintiffs’ Section 12(a)(2) claims on the ground that purchasers in the secondary market do not have standing under Section 12(a)(2).
The Court of Appeal reviewed the decision de novo because the lower court’s denial was based solely on statutory interpretation. With respect to the Section 11 claims, plaintiffs argued that they were not subject to the tracing requirement because the Company was governed by the Investment Company Act (the “ICA”). Specifically, plaintiffs argued that Section 24(e) of the ICA provides that, “for the purposes of [Section 11],” the latest amendment to a registration statement governs all securities “sold after” it goes into effect, even with respect to sales of an investment company’s securities in the secondary market. According to plaintiffs, Section 24(e) therefore conferred standing to bring suit under Section 11 to any investor in the secondary market who purchased an investment company’s securities “sold after” an amendment alleged to violate the Securities Act. The Court disagreed, holding that the simplest interpretation of Section 24(e)’s reference to Section 11 is as clarification that a claim may be based upon false or misleading statements in the most recent amendment, despite Section 11’s reference only to registration statements. The Court further noted that nothing in the wording or legislative history of the ICA suggested that Congress intended Section 24(e) to alter the Securities Act’s focus on the sale of securities by an issuer in the primary market and the disclosures accompanying such sales. Although the Court conceded the difficulty inherent in satisfying the tracing requirement in the context of ETF share purchases, it also noted that “the difficulty of tracing shares held in fungible aggregate is neither unique to ETFs nor a new problem.”
With respect to the Section 12(a)(2) claims, plaintiffs argued that they had standing to sue defendants (even though they did not purchase their shares directly from defendants) because defendants actively solicited plaintiffs’ purchase of securities to further their own financial motives. The Court disagreed, holding that plaintiffs failed to allege any direct contact between defendants and plaintiffs, and, to the extent they alleged any contact between defendants and investors generally, it was in connection with attempts to prevent ETF shareholders from divesting themselves of the shares, not in connection with solicitation of new purchases of shares. The Court therefore affirmed dismissal of plaintiffs’ Section 12(a)(2) claims because plaintiffs failed to establish that any of the defendants had the direct relationship necessary to be considered a “statutory seller” under Section 12(a)(2).