Morrison, the Restricted Scope of Securities Act Section 11 Liability, and Prospects for Regulatory Reform

Abstract

The strong presumption against extraterritorial application of federal securities laws, as articulated in Morrison v. National Australia Bank, has significant implications for liability under Section 11 of the Securities Act. Morrison restricts federal securities law liability to purchases or sales listed on domestic exchanges and domestic transactions in other securities. In an initial public offering (IPO) of shares qualified for U.S. exchange listing, exchange trading begins only after completion of an off-exchange distribution to at least 300 round lot purchasers. The exchange subsequently conducts an opening cross that sets an initial aftermarket exchange trading price that often differs from the IPO price. Purchasers of IPO shares in the initial distribution are not transacting on a domestic exchange, and therefore cannot satisfy Morrison's first prong. If these purchases are non-domestic transactions, then they also fail Morrison's second prong. It follows that shareholders who engage in non-domestic transactions in an initial distribution of IPO shares have no valid Section 11 claims, even if their securities are subsequently traded on U.S. exchanges. Aftermarket purchasers must satisfy strict tracing requirements in order to assert Section 11 claims. But no precedent suggests that aftermarket purchasers can satisfy the tracing requirement by purchasing from an initial holder who acquired in a non-domestic transaction that Congress never intended to protect with a Section 11 right of action. Put another way, no court has ever recognized the existence of a springing Section 11 right that privileges an aftermarket purchaser with a Section 11 claim that never existed in the hands of the original purchaser. To be sure, aftermarket purchasers may have valid Section 10(b) claims, and therefore have private rights of action that address potential fraud. However, the strong presumption against extraterritorial application of the federal securities laws, the rule of narrow construction of implied private rights of action, the very structure of the federal securities laws, the text of Section 11 itself, and the statute's legislative history, all combine to suggest that the courts should not invent springing” Section 11 rights of action in favor of purchasers who take from initial holders that Congress never intended to protect with Section 11 rights in the first instance. But if an initial public offering involves a non-domestic distribution, and if even a small number of foreign-placed shares enter the market when exchange trading begins, then, given the mechanics of modern securities markets, no aftermarket purchaser will be able to demonstrate that they purchased shares subject to Section 11’s territorial reach. The class with Section 11 rights of action would therefore be limited to domestic purchasers in the initial distribution. This limitation could, in some instances, dilute the incentive to engage in due diligence and have other consequences that the SEC could view as contrary to the public interest. The Commission can respond administratively by requiring that initial distributions occur only through transactions “deemed” domestic by, for example, requiring undertakings that commit registrants not to challenge Section 11’s application to shares originally distributed in non-domestic transactions. In addition, the Commission could cause reforms to the CUSIP numbering system that would allow aftermarket purchasers to satisfy Section 11 tracing requirements in situations where tracing has historically proved impossible. Congress could also address these concerns through legislative action, though recent data suggest such an outcome is unlikely.