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Suing for shareholder losses arising from false registration statements, which accompany public offerings, will be more difficult under a recent ruling by the 5th U.S. Circuit Court of Appeals. On March 1 a three-judge panel of the 5th Circuit affirmed a 2003 decision by U.S. District Court Judge Sam Sparks in Austin to dismiss claims of shareholders who filed a class action under section 11 of the Securities Act of 1933. The suit was brought against pcOrder.com and its directors, majority shareholder, officers, and lead underwriters. Sparks found that, with one exception, the lead plaintiffs were unable to show that the pcOrder.com shares they bought in the stock market could be traced to the company’s two public offerings in 1999. The plaintiffs allege that these offerings were accompanied by false or misleading registration statements. In a first-of-its-kind ruling by a federal court of appeals, the 5th Circuit panel unanimously held in Jerry Krim, et al. v. pcOrder.com Inc. that shareholders who purchase shares of company stock after the shares mix in the market with shares from other sources cannot rely on statistical probabilities to establish section 11 standing to sue over a public offering. In the opinion, the panel closely examines the requirement that shareholders complaining, under section 11, of false registration statements must be able to trace the shares they bought directly to the challenged offering. “The 5th Circuit defined who could have standing to bring an action under 11,” says Gary Ewell, attorney for pcOrder.com underwriters Goldman Sachs & Co., Credit Suisse/First Boston, and SG Cowen & Co. Ewell heads the litigation practice of Vinson & Elkins’ Austin office. “The ruling forecloses a potential significant loophole for lawsuits that try to use this statute to create a large class action of those who did not buy shares directly from a public offering but instead simply bought in the open market,” says Noel Hensley, lead defense counsel in Krim and a partner in Dallas’s Haynes and Boone. Hensley represents Trilogy Software Inc., pcOrder.com’s controlling shareholder. Ewell says that pcOrder.com’s stock reached the market by means other than the public offerings when the company’s executives sold about 800,000 shares. (James Baskin, the plaintiffs’ attorney and the principal in the Baskin Law Firm in Austin, did not return telephone calls seeking comment.) The plaintiffs alleged in their brief that there is no “sound reason” for prohibiting the use of circumstantial or statistical evidence to prove standing under section 11. The greater than 99 percent probability that plaintiffs Gene Burke and Jean Schwartzburke acquired some of pcOrder.com’s IPO stock and the greater than 90 percent probability that plaintiff David Petrick acquired some stock from the two questioned offerings — as their expert witness testified before Sparks at a 2002 hearing on class certification — should be sufficient to meet the section 11 requirement for standing, the plaintiffs argued. According to the plaintiffs’ brief, three shareholders filed separate class actions between December 2000 and February 2001, asserting claims against pcOrder.com. As noted in the brief, Sparks consolidated those suits in Krim. But Sparks denied class certification in October 2002, after conducting an evidentiary hearing. Acting on a motion from the defense, Sparks dismissed the suit in May 2003, prompting the plaintiffs’ appeal to the 5th Circuit. In 2003 the Fifth Circuit held in Rozenzweig v. Azurix Corp. that after-market stock purchasers do not inevitably lack standing to sue under section 11 but must demonstrate the ability to “trace” their shares to the prospectus they allege is defective. Rozenzweig left unanswered the question of what is necessary to trace shares to the defective prospectus when shares enter the market by means other than the public offering. The 5th Circuit answered that question in Krim. The 5th Circuit’s decision to strictly interpret the section 11 requirement is important to companies that can be held liable even if they make an innocent mistake in a prospectus, says Baker Botts’s James Maloney, who is representing pcOrder.com in the case. The plaintiffs argued in their brief to the 5th Circuit that nothing in the text or the legislative history of section 11 precludes the use of statistical evidence to establish standing, and courts should not support such a limitation. But the 5th Circuit panel held that an interpretation that standing can be established merely by probabilities “cannot be squared” with what Congress intended in section 11. “We decline the invitation to reach further than the statute,” Judge Patrick Higginbotham wrote in the opinion. Maloney, who chairs Baker Botts’s securities litigation group, says Krim also is important because the 5th Circuit addressed the policy argument in light of developments in the market since 1973. Before 1973, shareholders received paper certificates identifying their stock, while today stock is held in a fungible mass in a street name. In the opinion, the 5th Circuit recognized that present market realities may render section 11 “ineffective as a practical matter” in some instances in which stock is purchased by means other than a public offering. According to the opinion, that is an issue for Congress to address. “It is not within our purview to rewrite the statute to take account of changed conditions,” Higginbotham wrote. A version of this story originally appeared in Texas Lawyer, a sibling publication of Corporate Counsel.

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