A California state court held that shareholders of exchange-traded funds (ETFs) have standing to sue under Section 11 of the Securities Act of 1933 (“1933 Act”) for an alleged prospectus misstatement only if they can trace their ETF shares back to shares that were originally sold pursuant to a materially false or misleading registration statement. Jensen v. iShares Trust, Superior Court of California, County of San Francisco, Case No. CGC-16-552567 (September 18, 2017).

The complaint alleged that the ETF registration statement failed to disclose the risk of “stop orders” during rapid market declines. A “flash crash” occurred on May 6, 2010, which resulted in large, rapid market declines when large sales orders overwhelmed the securities markets, followed by an abrupt return to pre-crash prices by the end of the day. The rapid decline triggered automated stop-loss orders, which involve placing a standing order to sell when the stock price drops below a specified “stop” price. The stop-loss transactions resulting in large losses to shareholders who sold shares during the rapid decline.

In considering a motion to dismiss, the court considered a novel question of whether it should apply the “tracing” concept to the ETF shareholders who bought the ETF shares on the secondary market. When someone buys shares on the open market, it is difficult, if not impossible, to trace the shares to a particular registration statement in effect when the shares were first offered.

Section 11 of the 1933 Act provides a cause of action to anyone who buys a security issued under a materially false or misleading registration statement. The statute provides that the registration statement is effective “only as to the securities specified therein as proposed to be offered.”

Section 24(e) of the Investment Company Act, as amended (the “1940 Act”), provides that for purposes of Section 11 of the 1933 Act, the effective date of the latest amendment filed is considered the effective date of the registration statement with respect to securities sold after the date the amendment becomes effective. The issue was whether the term “sold” refers to the initial sale, as defendants argued, or any sale on the secondary market.

The ETF initially sold the shares to “Authorized Participants” (“APs”) the financial institutions that can directly buy shares from and sell shares directly to the ETF itself. The APs then place those shares on the secondary market, where investors can trade them freely.

It has been long established that aftermarket purchasers who can trace their shares to an allegedly misleading registration statement have standing to sue under Section 11 of the 1933 Act. The court reasoned that if any plaintiff who buys shares on the secondary market can bring a Section 11 claim based on an allegedly misleading prospectus, then any ETF shareholder can bring a lawsuit, even if the shares were sold “pursuant to a perfectly innocent registration statement.”

Our Take

This case is novel in that it appears to be the first time a court applied the tracing requirement to ETF shares.

Section 11 of the 1933 Act was enacted long before the invention of ETFs. It would be fair to conclude that Congress did not have ETFs in mind when it adopted Section 11. But the court held that the legislative intent of the statute applies to shares of ETFs, just as it would apply to shares of any other issuer purchased on the secondary market.

ETF shareholders may howl that this judicial approach effectively would cut off their ability to sue an ETF for defective disclosure. ETFs and their directors, however, will be protected against open-ended Section 11 liability if any ETF shareholder can sue for an alleged misstatement that applies only to a small number of shares issued a long time in the past.

It is not clear whether the federal courts, or any other state courts, will adopt this position.