- Fifth Circuit Rulings on Aftermarket Standing and Scienter
- March 10, 2005 | Author: Jennifer Barrett Poppe
- Law Firms: Vinson & Elkins LLP - Houston Office ; Vinson & Elkins LLP - Austin Office
The Fifth Circuit recently issued two opinions of some importance for future securities litigation. The Court's opinion in Krim v. pcOrder.com is the first by a circuit court to address whether evidence of statistical probability standing alone can be used by aftermarket purchasers to "trace" securities to a public offering and confer standing to sue under the liability provisions of Section 11. The R2 Investments LDC v. Phillips decision reiterates that allegations of scienter must be particularly strong when only circumstantial evidence of intent is alleged in 10b-5 class actions.
Statistical Probability Insufficient to Establish Standing in Section 11 Claims
In Krim v. pcOrder.com, No. 03-50737 (5th Cir. March 1, 2005)1, the Fifth Circuit became the first circuit court to address an important standing issue for claims by "aftermarket purchasers" under Section 11 of the Securities Act of 1933 -- whether statistical probability alone is sufficient to "trace" shares to a public offering.
Section 11 imposes civil liability when materially false statements are made in a public offering but limits claims to "any person acquiring such security." In Rosenzweig v. Azurix Corp., 332 F.3d 854 (5th Cir. 2003), the Fifth Circuit held that "aftermarket purchasers" (i.e., persons who acquire shares in the open market after a public offering) may have standing under Section 11 if they can demonstrate the ability to "trace" at least one of their shares to the faulty registration. The court reasoned that when all available shares originate from a single public offering, as they did in Rosenzweig, then aftermarket purchasers necessarily have standing to sue. However, the court in Rosenzweig left open the question of what evidence would be sufficient to "trace" shares to a challenged public offering when shares entered the market by other means.
In pcOrder.com, five aftermarket purchasers filed class actions against the company, its directors, officers, majority shareholder, and lead underwriters under Section 11. Plaintiffs claimed they were misled by allegedly false registration statements filed in connection with the company's initial public offering in February 1999 and its follow-on offering in December 1999. Because additional shares entered the marketplace through insider sales beginning in June 1999, plaintiffs attempted to "trace" their shares to the two challenged public offerings in an effort to establish standing to sue. They presented only expert testimony that the statistical probability of at least one of their shares originating from each offering was over 99%. The district court rejected this evidence as insufficient since it was "likely that any street name shareholder can make a similar claim with regard to one share."
On appeal, the Fifth Circuit upheld the dismissal and ruled that "'statistical tracing' would impermissibly expand the statute's standing requirement." The Court noted that Section 11 is concerned with "the initial distribution of securities" and limits claims to the "narrow class of persons" whose securities are the direct subject of the prospectus and registration statement. Allowing any street name shareholder to make a claim under Section 11 "cannot be squared with the statutory language," and the Court declined the invitation to reach further than the statute.
The Court also relied on analogies to other areas of the law to demonstrate the inadequacy of statistical proof in this context. For example, the Court reasoned that the likelihood a U.S. citizen resides somewhere other than Wyoming is 99.83%. Yet this statistical likelihood is not sufficient to support diversity jurisdiction in a suit against a Wyoming resident. Similarly, if a blue-colored bus causes an accident and 80% of all blue buses are owned by one company, a plaintiff cannot recover against that company simply by statistical proof that a bus from this company probably caused the accident.
The Court expressly limited its holding in two ways. First, the Court noted that if the plaintiff owned more shares than were available from sources other than the offering, then the plaintiff would own at least one share from the public offering and would likely have standing under Section 11 (although the Court declined to consider the effect that short-selling may have on this determination). Second, the Court recognized that although the plaintiffs' claims in this action were based entirely on statistical evidence, the use of statistical evidence might be appropriate in different circumstances if combined with other evidence.
The Court's opinion wisely restricts the use of "statistical probability" evidence in claims brought by aftermarket purchasers. Class action plaintiffs have long sought to bring claims under the liability provisions of Section 11 in hopes of avoiding the more rigorous reliance, causation, and scienter requirements in Rule 10b-5 cases.
Circumstantial Evidence of Scienter Must be Greater Where Motive Unclear
In R2 Investments LDV v. Phillips, No. 04-10030 (5th Cir. Mar. 1, 2005)2, the Fifth Circuit reiterated that when the motive for fraud is not apparent, circumstantial evidence of scienter must be particularly strong to satisfy the pleading requirement for securities class actions under the Private Securities Litigation Reform Act. The Court affirmed dismissal of a putative class action alleging 10b-5 violations relating to a public company's failure to complete a tender offer to repurchase notes.
The company issued $300 million in debt securities in 2000 and acknowledged in SEC filings that it was obligated to make a tender offer to repurchase $160 million of the notes in early 2001. The company later made the required tender offer but failed to complete it and filed for bankruptcy. Plaintiffs claimed that the officers and directors of the company violated Rule 10b-5 because they knew the company was financially incapable of funding both the tender offer and continuing operations, yet failed to disclose these adverse facts both before and after the tender offer was made.
With respect to the period before the tender offer was made, plaintiffs alleged that internal documents showed: the company had only $168.4 million in available cash; certain lenders had refused to renew lines of credit; and the company expected additional cash to come from a planned acquisition among other sources. The Court ruled these circumstantial allegations were insufficient to raise a strong inference of scienter prior to the tender offer, noting that the $168.4 million was a "worst case" estimate and that the inference that sufficient cash would come only from the planned acquisition was unwarranted. On this last point, the Court emphasized that "inferences of scienter survive a motion to dismiss only if they are both reasonable and 'strong' inferences."
For the period after the tender offer was made, plaintiffs alleged that defendants failed to disclose: the company had only $185 million in cash; the company was negotiating to restructure its accounts payable; and the company anticipated cash needs of $80 million for continuing operations in the first quarter of 2001. The Court also found these circumstantial allegations to fall short, noting that when the proposed acquisition fell through one week after making the tender offer, the company disclosed that it would not receive $120 million in cash, that its previous financial projections were no longer reliable, and the company was reviewing its business plan in light of recent developments. The Court stated: "In the context of [the company's] previous disclosures, the time span in question, and the absence of apparent motive, R2's allegations that defendants knowingly failed to make additional disclosures regarding [the company's] financial position are not sufficient to raise a strong inference of scienter."
The Court's ruling in R2 Investments reflects a healthy skepticism in cases where plaintiffs allege only circumstantial evidence of scienter. The opinion reminds us that allegations about material misstatements and omissions, standing alone, are not enough to sustain a claim of securities fraud. While courts must accept plaintiffs' well-pleaded allegations as true for purposes of a motion to dismiss, they need not adopt unreasonable inferences from those allegations or assume in hindsight that all material misstatements and omissions were intentional.
1 Vinson & Elkins L.L.P. represented the underwriters in the district court and on appeal of this matter.
2 Vinson & Elkins L.L.P. represented the company's auditors in this matter. All claims against them were dismissed by the district court, and no appeal was taken.