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Undue Limitations in the Section 10(b) Purchaser-Seller Requirement

In a forthcoming article, we address recent restrictions and diverging approaches among the federal courts to the purchaser-seller requirement for a private action under Section 10(b) of the Securities Exchange Act and Rule 10b-5. The “Purchaser-Seller Rule,” commonly referred to as the standing requirement for a private Section 10(b) action, was initially articulated by the Second Circuit in Birnbaum v. Newport Steel Corp. and embraced by the Supreme Court in Blue Chip Stamps v. Manor Drug Stores. On its face, this requirement is simple and makes intuitive sense. As stated in Blue Chip Stamps: “A private damages action under Rule 10b-5 is confined to actual purchasers or sellers of securities.” Therefore, instances of investor inaction are not within the scope of the securities laws’ main catch-all antifraud provision.

But questions remain regarding discrete securities transactions and the necessary nexus between a purchase or sale of securities and the alleged fraudulent-disclosure deficiency. The Second Circuit in particular has grappled with this question in cases like Public Service Employees Union Pension Trust Fund v. Nortel Networks, and In re NYSE Specialists Securities Litigation. In Nortel, the court focused on the relationship between the plaintiffs’ transactions and the allegedly fraudulent conduct, holding that the plaintiffs lacked standing to bring a claim under Section 10(b).  Nonetheless, the court opined that, in certain major transactions such as a merger or acquisition, a different result may be appropriate. NYSE clarified the scope and applicability of Nortel’s “direct relationship” test to non-issuers, addressing some of the problems with Nortel’s holding. However, Nortel and later cases left open the question of whether purchasers of stock of an acquirer could bring suit under Section 10(b) against alleged violators who engaged in misconduct with respect to the acquired entity that caused the acquirer’s stock to decrease in value.

Menora Mivtachim Insurance Ltd. v. Frutarom Industries Ltd., a 2022 Second Circuit case, addressed this question and held that Section 10(b) standing is only open to purchasers or sellers “of securities about which the misstatement was made.” The panel’s holding marked a significant narrowing of the universe of potential plaintiffs in private actions under Section 10(b). Strikingly, Judge Pérez’s concurrence in Frutarom recognized that the court unnecessarily created new law, engaging in undue judicial policymaking.

In Frutarom, the target company in connection with a merger transaction allegedly made material misstatements about itself which induced plaintiffs to buy stock in its acquirer, International Flavors & Fragrances, Inc. (“IFF”). The case dealt with the merger of Frutarom Industries and a wholly owned subsidiary of IFF and involved misstatements made by Frutarom (about, among other things, Frutarom’s business practices and compliance with applicable anti-corruption laws) that were incorporated by reference into IFF’s Form S-4 registration statement. On appeal, the Second Circuit opined that the Purchaser-Seller Rule must be narrowly construed because the Section 10(b) private action was a judicial creation. The panel further relied upon language in Blue Chip Stamps, which expressed concerns about undue expansion of the Section 10(b) remedy and vexatious litigation, to justify its holding. As such, the court dispensed with the relational inquiry present in Nortel and held that plaintiffs lacked standing to sue under Section 10(b).

The application of Frutarom’s rationale has posed challenges for district courts in the Second Circuit. For example, one court, applying Frutarom, denied standing to a plaintiff class in a merger and de-SPAC, despite acknowledging the merits of plaintiffs’ concern that Frutarom essentially creates a “loophole” whereby management of a pre-SPAC private entity can escape private Section 10(b) liability for fraudulent conduct. See In re CarLotz, Inc. Securities Litigation. Frutarom’s construction of the Purchaser-Seller Rule has also been used to preclude standing for purchasers of American depository shares and may extend to options and other derivatives, removing purchasers or sellers of those securities from the protections of Section 10(b). Further, because the plain language of Frutarom only articulates standing where a “misstatement” was made and does not contemplate pure omissions, concern arises that Frutarom’s Purchaser-Seller Rule could be applied to exclude scheme liability, thereby vitiating Rule 10b-5(a) and (c). At best, this is an instance of careless drafting on the part of the Frutarom court, and at worst, it is fundamentally inconsistent with Section 10(b)’s language and Supreme Court precedent.

Not only has Frutarom created difficulties in application, it is fostering division among the federal courts. As of this writing, a line of cases is developing in federal district courts where Frutarom’s holding and rationale have been rejected. These district courts have embraced a more holistic view of the standing requirement in a Section 10(b) private action. See, e.g., In re CCIV/Lucid Motors Securities Litigation. These cases criticize Frutarom for the brevity of its rationale and misconstruction of the standing requirement as articulated in Birnbaum and Blue Chip Stamps. Further, this division presents the realistic possibility of a circuit split on the issue of Section 10(b) standing, which could require Supreme Court resolution.

Our article analyzes these and other cases and ultimately makes recommendations for a balanced approach to Section 10(b) standing that fits within the existing statutory and regulatory framework while providing for proper investor protection. We reason that Frutarom’s approach is unduly restrictive, overly formulaic, and poorly reasoned — therefore, its holding and rationale should be rejected. Instead, in situations where a plaintiff or seller did not purchase or sell a security of an entity about which a material misstatement or omission was made, we propose that the correct approach to Section 10(b) standing looks to the nexus among (i) the plaintiff’s purchase or sale transaction, (ii) the alleged misstatement(s) or omission(s), and (iii) the alleged injury. We assert that, if there is adequately pleaded a sufficient connection among the plaintiff, the transaction, and the injury, then standing is proper under Section 10(b) and should be conferred.

A more flexible position on Section 10(b) standing is a practical necessity, since the concerns about “vexatious litigation” and investor inaction articulated in Blue Chip Stamps are not present in Frutarom or related cases. And while such an approach would require plaintiffs to sufficiently allege loss causation as a condition of Section 10(b) standing, it would not otherwise modify the requirements for private actions under Section 10(b). This balanced approach would allow for greater flexibility that is consistent with statutory construction and with Blue Chips. Additionally, our nexus approach to Section 10(b) standing provides greater commercial certainty than Nortel’s ambiguous relationship inquiry, since plaintiffs would need to adequately plead a causal connection between an alleged disclosure deficiency and their actual injury.

Significantly, our approach would effectuate Section 10(b)’s purpose as articulated by the Supreme Court in Herman & MacLean v. Huddleston, where the Court opined, “[A] Section 10(b) action can be brought by a purchaser or seller of ‘any security’ against ‘any person’ who has used ‘any manipulative device or contrivance in connection with the purchase or sale of a security’.” By removing a significant number of otherwise meritorious plaintiffs from the protection of Section 10(b), Frutarom stands in stark contrast to the instructions of the Supreme Court.

Frutarom represents an undue limitation of the Section 10(b) purchaser-seller requirement, founded in judicial activism and detrimental in application. A more functional approach to Section 10(b) standing must be adopted if investors in this context are to be accorded the protections that Congress and the Supreme Court intended.

This post comes to us from Professor Marc I. Steinberg, the Rupert and Lillian Radford Chair in Law at SMU Dedman School of Law, and Antonio Partida, a 2024 graduate of SMU Dedman School of Law and an incoming corporate & securities associate at Jackson Walker LLP. This post is based on their article, “Undue Limitations in the Section 10(b) Purchaser-Seller Requirement,” forthcoming in Tulane Law Review and available here.

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