In the wake of Slack Techs., LLC v. Pirani,[1] many have predicted that Section 11 of the Securities Act of 1933 will decline into a state of near irrelevance. Some have mourned this prospect in the belief that Section 11 induced issuers to comply with high standards of due diligence in public offerings. Others have celebrated it in the belief that, absent a tracing requirement, virtually all holders of a security could sue, and this would encourage the assertion of weaker legal claims because of the enhanced damages. Uniquely, we agree with both sides.

As we argued in our amicus brief to the Supreme Court, tracing should be required in order to keep the potential liability proportionate to the size of the offering. In our view, the real issue is not whether tracing should be required, but how it should (and can) be done. Unless the tracing problem can be solved at the procedural level, Section 11 seems destined to become a little-used antique. Clearly, issuers can find multiple ways to mix registered and unregistered securities into a common pool in order to complicate tracing,[2] and courts have shown little or no willingness to accept purely statistical approaches that show only it was highly likely that the plaintiff’s shares were issued under the registration statement.[3] Nonetheless, we believe that tracing is feasible (even though many commentators have scoffed at this possibility). This implies, in turn, that the problem can be solved without legislation or new SEC rules. We explain our answer in an article that we recently posted on SSRN and here summarize.

The Feasibility of Tracing

What makes tracing possible today involves several developments. The first was the immobilization of securities, which Congress authorized in the early 1970s to solve the paperwork crisis that was slowing share transfers to a degree that threatened market efficiency. Today, as a result of immobilization, legal title will be held by Cede & Co., the nominee of the Depository Trust Company, and its books will show transfers from one broker to another. Although the individual shareholder has only a fractional interest in the larger pool owned by the broker, this does not preclude tracing.

The next development was the appearance of new transactional records which must be maintained by the critical actors in the securities marketplace, including broker-dealers, exchanges, and FINRA. For example, FINRA’s Blue Sheets contain both trading and account holder information, so that for any trade that a firm executes on behalf of its client, the firm is keeping a record of the name of the security, the date of the trades, and the party with whom the firm traded. More importantly, all certified participants in the U.S. securities marketplace are required to submit these detailed records into a pooled, centralized system, known as the Consolidated Audit Trail (“CAT”).[4] Adopted in 2012 as the regulatory response to the “Flash Crash,” it enables regulators to quickly analyze and trace activity throughout the U.S. securities markets. This databank facilitates tracing in a variety of ways, not the least of which is that it eliminates the need to contact the various individual broker-dealers in the chain of title. The CAT system clearly provides that its confidentiality provisions do not restrict disclosures required by an order, subpoena, or legal process.

Because these extensive records are held electronically, modern computing has the capacity to process records for any number of transactions, even if the number climbs into the trillions. Thus, it is possible to quickly trace the chain of title for securities, subject to one important qualification. To trace, one must employ a standard accounting convention, either first in-first out (“FIFO”) or last in-first out (“LIFO”). The combination of computing power and such a rule ends uncertainty and, for example, allows us to follow specifically the typically small number of unregistered shares that might otherwise be asserted to “contaminate” a much larger pool of registered shares and preclude any Section 11 action.

This idea of using an accounting convention to trace assets moving through commingled accounts is widely used in related areas of law. For example, a holder of a security interest may trace property through comingled bank accounts.[5] Under the Restatement of Trusts, a beneficiary may enforce a constructive trust on a wrongful transfer of trust assets by tracing assets through commingled accounts.[6] In the criminal forfeiture context, courts have used these accounting conventions to trace assets, despite account commingling.[7] Finally, in the securities law context, Regulation SHO uses the FIFO method to establish a stock’s basis, and courts have often employed LIFO to determine the damages in securities litigation.[8]

The advantage of using an accounting convention is not that it provides the philosophically most just decision, but that it allows the court to realize two goals that are often in tension: (1) keeping the damages proportionate to the size of the stock issuance, and (2) not allowing defendants to escape any liability (and thereby trivialize Section 11) by deliberately “contaminating” the commingled pool by adding a few shares that were not covered by the registration statement so as to disqualify the entire pool. Finally, use of an accounting convention gives us an individualized answer. It matches the shares to an individual holder (rather than telling us the much less helpful conclusion that there is a 60 percent chance that these shares were covered by the registration statement). Many courts are “allergic” to mathematics but are happy to accept a widely used convention.

The Legality of Tracing: The Impact of the PSLRA

The goal of preserving Section 11 as a viable litigation remedy after Slack Techs., LLC v. Pirani faces a possible obstacle if the plaintiff needs discovery to establish that its shares are traceable to the registration statement. Presumably defendants will not simply turn over documents voluntarily, and they may seek to rely on the Private Securities Litigation Reform Act (“PSLRA”), which denies discovery prior to the trial court’s decision on the defendant’s motion to dismiss. Specifically, Section 21D(b)(3) of the Securities Exchange Act of 1934 provides:

In any private action arising under this chapter, all discovery and other proceedings still be stayed during the pendency of any motion to dismiss, unless the court finds upon the motion of any party that particularized discovery is necessary to preserve evidence or to prevent undue prejudice to that party.[9]

Thus, assuming that a motion to dismiss a Section 11 cause of action will ordinarily be filed by the defendant, it might appear at first glance that the plaintiff is blocked from discovery aimed at determining whether the plaintiff’s shares can be traced to the registration statement.  But, on closer inspection, this conclusion overlooks that Section 11 does not require any proof of intent.

To understand this point, we only need read Section 21D(b)(2) of the Securities Exchange Act, which mandates that:

…in any private action arising under this title in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this title, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.[10]

In a Rule 10b-5 action, this is a formidable obstacle to the plaintiff because it is difficult to plead with particularity facts “giving rise to a strong inference” of scienter (the state of mind necessary to support a Rule 10b-5 action) in the absence of discovery. But this obstacle dissipates in the case of a Section 11 cause of action because Section 11 does not require proof of any state of mind. Indeed, Section 11 is basically a strict liability provision with regard to the corporate issuer.

Assume then that the defendant finds some justification for filing a motion to dismiss in a Section 11 case. Conceivably, the defendant may allege issues involving the statute of limitations, or the defendant may simply assert that the complaint fails the low standard of pleading required by Twombly.[11] Assume further that the defendant will predictably fail to provide any discovery until this motion to dismiss is resolved, and it may argue that dismissal is required because the plaintiff has not to this point provided any evidence that its shares can be traced to the registration statement.

Such arguments strike us as lacking merit. Except when the plaintiff is required to show a “strong inference” of fraud (which is unnecessary in a Section 11 case), neither federal civil procedure nor the PSLRA requires the plaintiff to prove any form of intent at the motion to dismiss stage. Rule 9(b) does require particularized pleadings in fraud actions, but again Rule 9 is inapplicable to Section 11 (which is not a fraud cause of action).[12] Particularized pleading is the exception, not the rule. Indeed, courts have routinely held that Section 11 claims are subject to the liberal pleading standard of Rule 8, which requires that “a short and plain statement of the claim showing that the pleader is entitled to relief” and “a demand for the relief sought.” In short, pleading under Section 11 is governed by Rule 8 and not Rule 9.[13]

Thus, in a Section 11 case, if the plaintiffs plead, on information and belief, that their shares do satisfy all standing requirements, including that the shares are traceable to the registration statement, this should be sufficient to satisfy Section 21D(b)(3)’s requirement at this stage. Proof of plaintiff’s contention that it can trace its shares should not be necessary at this stage (although, after discovery, defendants may be entitled to summary judgment if such proof is still lacking).

Defendants may disagree and insist that the literal language of Section 21(D)(b)(3) entitles them to a stay “during the pendency of any motion to dismiss,” even though their motion has nothing to do with inadequate pleading of intent (which was the justification advanced in the legislative debate over the PSLRA). Still, they will know that a motion to dismiss in a Section 11 case is unlikely to succeed, and thus defendants may delay in filing any such motion in order to delay discovery. This will slow the action down and thereby raise the costs (and possibly lower the return) to the plaintiffs.

In response, the plaintiffs may file a motion under Section 21D(b)(3), asking the court to permit discovery “to prevent undue prejudice” to it. We believe that such a motion should presumptively be granted if defendants are contesting issues unrelated to Section 21D(b)(2). The purpose of Section 21D(b)(2)’s stay of discovery was to protect defendants from burdensome discovery in cases where the plaintiff had not adequately plead particularized evidence giving rise to a “strong inference” of fraud. Thus, if the defendant were only contesting an issue as to the statute of limitations, the delay to the plaintiff results in “undue prejudice” to it because Section 21D(b) is focused on a very different issue that is not here legitimately implicated. Even if a court is unwilling to lift the stay on this basis, it can schedule an early hearing on defendant’s motion to dismiss, which will protect plaintiff from undue delay by defendants who wish to stall the action. We discuss these issues at some length in our article, but so long as the defendant cannot delay indefinitely, the stay will have little impact in a Section 11 case.

Conclusion

One of the attractions of our suggested approach is that it does not require legislation or even significant new SEC rules. If the court having a Section 11 action before it can be asked to schedule an early hearing at which it schedules any motion to dismiss that defendants wish to bring (and denies a dilatory defendant the right to file a later such motion), then defendants cannot delay or prevent the plaintiffs from obtaining discovery. Because a motion to dismiss in a Section 11 case is unlikely to be successful, plaintiffs will experience little delay. The one juncture that remains critical is the readiness of FINRA and the SEC to give litigants access to CAT, and here the SEC can likely encourage FINRA without adopting any rules.

Although the SEC does not have direct regulatory authority over Section 11 claims, Section 28 of the Securities Act grants the SEC general exemptive authority to the extent that any such exemption “from any provision or provisions of this subchapter or of any rule or regulation issued under this subchapter, to the extent that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors.”[14] Arguably, the SEC could adopt a rule under this section which explicitly provides that standard accounting methods shall satisfy Section 11’s tracing requirement.  Short of that step, a desirable approach would be for the SEC to produce a whitepaper or other interpretive guidance that makes clear its views that accounting methods are appropriate to apply to tracing in Section 11 cases.  While courts will ultimately have the decision as to the procedures and conventions to be used, there seems little doubt that the judiciary would benefit from the SEC explaining its views on this topic.

As for discovery, here too the SEC can play a role.  While the SEC’s final rules governing the Consolidated Audit Trail do provide that information held by the CAT, including customer identifying information, is discoverable,[15] the SEC could make clear to all (including FINRA) that these records must be produced to private litigants in the course of Section 11 litigation.  Similar records are also collected by FINRA in a form known as the Electronic Blue Sheets, which are also subject to subpoena, and the SEC could similarly clarify that these should be produced without delay to private litigants.

These are the examples of the actions that the SEC could take immediately to ensure that Slack and its progeny do not result in a complete loss of standing, thereby leading to the death of Section 11 litigation.  Seeking to avoid such an outcome would be fully consistent with the SEC’s mission of promoting investor protection.

ENDNOTES

[1] 143 S.Ct. 1433 (2023) (holding the Section 11 requires a plaintiff “to plead and prove that he purchased shares traceable to the allegedly defective registration statement.”)

[2] One of the simplest techniques is for the issuer to eliminate the “lockup” period normally used in IPOs so that shares held by the founders and the board and management of the issuer could be sold in the public market from the first day of the offering (probably pursuant to Rule 144 or other exemptions), thereby implying that, even in an IPO, not all shares that trade immediately thereafter are covered by the registration statement.

[3] See, e.g., Krim v. pcOrder.com, Inc., 402 F3d 489.

[4] See Rule 613 (“Consolidated Audit Trail”) of Regulation NMS, 17 C.F.R. § 242.613. Rule 613 was adopted after the “Flash Crash” in 2010, during which the securities markets fell 5 percent in a few minutes and then snapped back shortly thereafter. See Preliminary Findings Regarding the Market Events of May 6, 2010 by the Staffs of the CFTC and the SEC to the Joint Advisory Committee on Emerging Regulatory Issues (May 18, 2010). For the adopting release for Rule 613, see Securities Exchange Act Release No. 67457 (July 18, 2012).

[5] See, e.g., Brown & Williamson Tobacco Corp. v. First Nat. Bank of Blue Island, 504 F.2d 998, 1002 (7^th Cir. 1974).

[6] See Restatement (Second) of Trusts §202 cmt. j (1959).

[7] See U.S. v. Banco Cafetero Panama, 797 F.2d 1159 (2d Cir. 1986).

[8] For the use of FIFO under SEC Regulation SHO, see Turan v Comm’r of Internal Revenue, 114 T.C.M. (CCH) 65, 2 (T.Ct. 2017). For the use of LIFO in computing damages in securities litigation, see In re Vivendi Universal, S.A. Sec. Litig., 284 F.R.D. 144, 160 (S.D.N.Y. 2012).

[9] 15 U.S.C. §78u-4(b)(3)(B).

[10] 15 U.S. Code § 78u-4(b)(2)(A).

[11] Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007) (holding plaintiffs must only plead “enough facts to state a claim to relief that is plausible on its face.”).

[12] Fed. R. Civ. P. 9(b) (“In alleging fraud or mistake, a party must state with particularity the circumstances constituting fraud or mistake. Malice, intent, knowledge, and other conditions of a person’s mind may be alleged generally.”).

[13] In re Initial Pub. Offering Sec. Litig., 241 F. Supp. 2d 281, 296 (S.D.N.Y. 2003); see also Degulis v. LXR Biotechnology, Inc., 928 F. Supp. 1301, 1310 (S.D.N.Y. 1996) (“Fraud is not an element in Section 11 [claims] … only a material misstatement or omission need be shown to establish a prima facie case, and scienter need not be alleged.”); Herman & MacLean v. Huddleston, 459 U.S. 375, 382 (1983) (“Although limited in scope, Section 11 places a relatively minimal burden on a plaintiff … If a plaintiff purchased a security issued pursuant to a registration statement, he need only show a material misstatement or omission to establish his prima facie case.”).

[14] 15 U.S. Code § 77z–3.

[15] See Joint Industry Plan; Order Approving the National Market System Plan Governing the Consolidated Audit Trail, Rel. No. 34-79318, at *107, Nov. 15, 2016, https://www.sec.gov/files/rules/sro/nms/2016/34-79318.pdf (“[T]he CAT NMS Plan provides that the confidentiality provision does not restrict disclosures required by: . . . an order, subpoena or legal process”).

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance, and Joshua Mitts, the David J. Greenwald Professor of Law at Columbia University Law School. It is based on their recent article, “Slack v. Pirani and the Future of Section 11 Claims,” available here.