In Jensen v. iShares Trust, 2020 Cal. App. LEXIS 61 (Cal. App. Jan. 23, 2020), a rare state court decision addressing claims under the Securities Act of 1933 (“1933 Act”), the California Court of Appeal rejected plaintiffs-appellants’ attempt to evade the “tracing” requirement under Section 11, 15. U.S.C. § 77k, which provides standing only to those plaintiffs who can trace their shares purchased in a secondary market transaction to an initial offering made under a misleading registration statement.  Appellants argued that they were not subject to the tracing requirement because the respondent, an open-end management investment company, also was governed under the Investment Company Act of 1940 (“ICA”), 15 U.S.C § 80a, et. seq., which appellants argued extends standing to purchasers no matter how or from whom their shares were purchased.  The Court rejected the argument, unequivocally reaffirming that the 1933 Act is focused only on initial public offerings and other primary market transactions, and so any claims brought thereunder must satisfy its strict standing (i.e., tracing) requirements.

Appellants were individual investors who purchased shares of the BlackRock iShares Exchange-Traded Fund (ETF) and suffered financial losses when the market experienced a “flash crash” on August 24, 2015 that resulted in appellants’ “stop-loss” orders being filled at lower prices.  They asserted claims for violations of Sections 11 (15 U.S.C. § 77k), 12(a)(2) (15 U.S.C. § 77l(a)(2)) and 15 (15 U.S.C. § 77o) of the 1933 Act against iShares, an investment company under the ICA, as well as iShares’ various controlling agents.

More specifically, appellants alleged that iShares knowingly failed to disclose the increased inherent risks of using stop loss orders with ETFs.  Stop-loss orders provide a mechanism for investors to limit their loss on a particular position by requiring that the investor’s security be bought or sold when the stock value hits a certain price, at which point it automatically is converted to a market order to be executed at market price.  In times of high volatility and thus decreased liquidity, however, stop-loss orders may have the opposite effect, resulting in a greater parity between the price of an ETF and the price of the ETF’s underlying assets.  That is precisely what happened when the flash crash occurred in August 2015 and resulted in appellants’ losses.

ETFs by their nature are not sold directly to individual investors; instead they are sold in large blocks to certain authorized participants such as broker-dealers or institutional investors, who then resell all or some of those shares to the individual investors in the secondary market.  Recognizing they likely could not satisfy Section 11’s tracing requirement, appellants instead argued they were not subject to it.  They seized on language in Section 24(e) of the ICA, which provides:  “For the purposes of section 11 of the Securities Act of 1933, as amended, the effective date of the latest amendment filed shall be deemed the effective date of the registration statement with respect to securities sold after such amendment shall have become effective.”  15 U.S.C. § 80a-24(e).  They argued that this language reflected congressional intent to allow broader standing for 1933 Act claims that involved investment companies like iShares.

In rejecting the argument, the Court emphasized that the 1933 Act does not cover secondary market transactions, which are instead covered under the Securities Exchange Act of 1934 (“1934 Act”), and that claims for violations of the antifraud provisions of the 1934 Act require that a plaintiff prove additional elements such as scienter and reliance.  The Court observed that the 1933 Act on the other hand provides expansive, “virtually absolute” liability under for corporate issuers for even innocent material misstatements.  Because of the “relaxed liability requirements” provided under the 1933 Act, the Court held that it is critical a putative plaintiff first satisfy Section 11’s tracing requirement.  The fact that the investments at issue were sold by an investment company did not transform appellants’ Section 11 claim derived from the 1933 Act into one instead governed by the ICA.

To further support its conclusion, the Court found ambiguity in the “sold after” language of Section 24(e).  In doing so, it reasoned that the language could be — and should be — read in a manner consistent with the overarching purpose of the 1933 Act:  primary market transactions involving public offerings by the issuer.

The Court then analyzed appellants’ claim under Section 12(a)(2) of the 1933 Act.  Section 12(a)(2) carries an even higher standing bar for plaintiffs seeking to assert claims thereunder.  It allows claims to be brought only by direct buyers against their direct sellers in the IPO.  The express privity requirements suggests that purchasers in private or secondary market offerings, even if they are able to trace their purchase to the initial public offering, do not have standing to bring actions against the issuer under Section 12(a)(2).  The Court concluded by noting that “this problem is a function of appellants’ decision to pursue claims under the 1933 Act.”

The Court’s decision not to relax the 1933 Act’s standing requirements should give assurance to issuers that plaintiffs will have to satisfy those strict requirements in California state courts to assert claims under the 1933 Act.