Vanished Without A Trace: The Disappearance of Section 11 Rights

The principal advantage of a Section 11 claim under the Securities Act of 1933 over a Section 10(b) claim under the Securities Exchange Act of 1934 is that, unlike Section 10(b), a Section 11 claim does not require scienter, nor even negligence. Section 11 is strict liability for any misstatement or omission of a material fact in the prospectus.

The federal courts have always required a Section 11 plaintiff to trace the shares purchased back to the shares issued in the offering being sued upon. The original purchaser in the public offering could always and can still today produce a confirmation from the broker-dealer handling the purchase stating “Prospectus Enclosed” with the purchase price at the initial offering price on the cover of the prospectus. In the old days, subsequent open-market purchasers could trace their shares back to the offering through the chain of physical stock certificates showing the names of the record and beneficial owners backward to the date of the prospectus. However, following the 1960s “paper crash” automation became necessary and today, the Depository Trust Company, known as DTC, operates a paper-less net book entry system that does not assign a separate CUSIP number to prospectus shares as opposed to non-prospectus shares. Whether intended or not, this use of the same CUSIP number eliminates the ability to trace shares back to a secondary or initial public offering once the first non-prospectus shares enter the pool of shares, typically a Rule 144 sale 90 days after the offering.

For example, if a company issues 1 million common shares in an initial public offering on January 29, 2010, all shares traded in the open market after the opening trade can only come from one source: the initial public offering. Assume that, on April 30, 2010 there is a Rule 144 sale of 1,000 shares. At that point it becomes impossible to trace any shares back to the offering through the DTC “Bermuda Triangle” net book-entry system. Courts have rejected efforts to statistically calculate the percentage of prospectus shares assuming equal turnover ratios of all shares. Thus, although the statute confers one year of protection for investors in public offerings, in the real world strict liability attaches only until the first entrance into the market of non-prospectus shares, typically 90 days until the first Rule 144 sale.

The situation is worse for purchasers of secondary public offerings. Except for the initial purchasers in the underwriting themselves, the pre-existence of non-prospectus shares means that there is immediately a complete inability to trace shares purchased after the secondary offering back to that offering. Thus, for secondary offerings, there is, in the real world, no ability by any open-market purchaser to trace even a purchase made seconds after the secondary offering went effective.

Thus, as a practical matter, the Securities Industry Association and DTC have eliminated the statutory rights of Americans to complete protection, for one year, against misstatements or omissions of material fact in a prospectus. The federal courts have enforced the law on the books, while the industry has engaged in self-help and rewritten the book used in the real world.
There is a real world solution, if there is a will to protect public investors. The Securities & Exchange Commission has the power to promulgate rules requiring DTC and its participant member firms to assign a separate CUSIP number to prospectus shares for one year from the date of the offering in which the shares were sold to the public. These shares would be fungible for all other purposes with shares of the same class of stock. However, these shares would be identified as the shares entitled to Section 11 protection during the one-year period the Congress intended the public to be entitled to rescission or damages without proof of fault, much less fraud.

The cost to create and, for one year from the offering(s), maintain additional CUSIP numbers is negligible whereas the benefit to public investors is immense. Proving fraud is far more difficult than proving that any important fact was not correct or left out of the prospectus. There is no good reason to continue to permit the industry to gut the strongest federal securities claim of public investors in public offerings. The SEC should act to enforce the statutory rights of public investors.

How To Protect Public Investors In America

Here are ten ways to protect public investors in America:

1. End the practice of SEC and FINRA to permit settling defendants to deny the settled allegations in subsequent civil litigation by public investor victims, thus giving the investors collateral estoppel as a matter of law. The present practice is the defendant neither admits nor denies the allegations, but is barred from denying the allegations in any forum except the one where it counts...in court. While this may force more cases to trial and require more Enforcement staff, the end result is that anyone adjudicated to have violated the federal securities laws is ruined financially so, in the long run, there is a genuine deterrent effect.

2. Expand SIPC insurance coverage of public investors, excluding institutions, to cover losses up to $1 million in adjudicated open-market frauds by issuers and others through a de minimis per share surcharge of .00001 per share to be paid by the broker-dealer executing the buy side of the trade. This covers losses that cannot be recovered from the wrongdoers.

3. Increase required broker-dealer minimum net capital to $1 million.

4. Require auditors to carry $1 million of insurance coverage for every public company audit client.

5. Require every market-maker making a market in a Bulletin Board or Pink Sheet stock to file a Rule 15c2-11 form before commencing to make a market, and a quarterly update for each stock. Add an enhanced certification, to be personally signed by the head of trading and the chief compliance officer, stating: "I have thoroughly reviewed the most recent filings, press releases and financial statements of the issuer XYZ, and hereby certify that our quotations and the trades which we executed were made at prices which reasonably reflect the financial condition of the issuer and its business prospects."

6. Ban "Flash" Trading or any other arrangements to pay for order flow as inside market information that is simply legalized front-running of public customer orders.

7. End mandatory arbitration of investor claims against their broker including an industry representative as a mandatory included arbitrator, making the panels exclusively public arbitrators unaffiliated with the industry.

8. Make securities class actions like Federal False Claims Act or other qui tam actions re original whistleblower cases claiming to uncover a securities fraud. The case is filed under seal for 90 days. The SEC can choose to take over and litigate the case itself and the whistleblower get a flat 15% of the recovery, or the SEC declines and the private litigant goes forward for a flat 30% of the recovery.

9. A flat-out ban on any form of "pay-to-play" direct or indirect in connection with the purchase or sale of a security. Prohibit any payment to anyone for introducing or finding business from any public or union pension fund PERIOD.

10. Require adjudicated securities violators to register with the SEC and provide a quarterly update of a complete report of any direct or indirect relationship with any public company or broker-dealer or hedge fund, including a list of all securities purchased or sold.