Securities Litigation Alert: Second Circuit Adopts Restrictive View Of Purchaser-Seller Rule, Limiting Section 10(b) Standing To Transactions In Securities Of Company "About Which" Alleged Misstatements Were Made

• Jurisdiction: United States,Federal
• Law Firm: Cadwalader, Wickersham & Taft LLP
• Subject Matter: Corporate/Commercial Law, Corporate and Company Law, Securities, Shareholders
• Author: Mr Jason Halper, Ellen V. Holloman, Philip S. Khinda, Adam Magid, Jonathan Watkins and Diane Lee
• Published date: 25 January 2023

Looking back, 2022 was light on groundbreaking appellate-level securities decisions. The U.S. Court of Appeals for the Second Circuit, however, closed out the year with a notable decision in Menora Mivtachim Insurance Ltd. v. Frutarom Industries Ltd.,¹ articulating a new, restrictive conception of the purchaser-seller rule that limits the class of plaintiffs with standing to recover under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Rejecting a test that would require only a 'direct relationship' between the alleged misrepresentation and the price of a security bought or sold, the Second Circuit limited Section 10(b) standing to plaintiffs 'who purchased or sold the securities about which a material misstatement was made.'² The decision closes the door, at least in the Second Circuit, on claims by purchasers or sellers of the securities of one company, based on alleged misstatements about another, even if the two companies are merging and their prospects (and share prices) are inherently linked. The influence of the decision in other circuits, where case law on the purchaser-seller rule is sparse, remains to be seen.

Background

Endorsed by the Supreme Court nearly 50 years ago in Blue Chip Stamps v. Manor Drug Stores, the purchaser-seller rule limits 'the plaintiff class for purposes of a private damage action under ' 10(b) and Rule 10b-5 . . . to actual purchasers and sellers of securities.'³ The Supreme Court found support for the rule in the text of the Securities Exchange Act of 1934 and the Securities Act of 1933, widespread acceptance of the rule in lower courts, and Congress's repeated rejection of attempts to expand the scope of the judicially created cause of action under Section 10(b) and Rule 10b-5.⁴ The Court also expressed concern about 'the danger of vexatious litigation which could result from a widely expanded class of plaintiffs under Rule 10b-5.'⁵ Applying the rule, the Court denied Section 10(b) standing to plaintiffs who allegedly refrained from buying a company's stock, and thus missed the opportunity to profit from a rise in share price, due to defendants' unduly pessimistic statements about the company's prospects.⁶

While Blue Chip Stamps clearly required a purchase or sale of a security for Section 10(b) standing, it did not define precisely what that security must be, other than the statement that plaintiffs must 'at least [have] dealt in the security to which the prospectus, representation, or omission relates.'⁷ That was the issue in Frutarom. There, the plaintiffs were a putative class of investors who acquired shares of International Flavors & Fragrances Inc. (IFF), a publicly traded U.S.-based seller of flavoring and fragrance products, between May 2018 and August 2019. In May 2018, IFF announced its agreement to acquire Frutarom Industries Ltd., an Israel-based company in the same industry. Plaintiffs alleged that following the announcement, Frutarom made materially misleading statements about its compliance with anti-bribery laws and the sources of its business growth, which IFF incorporated into its public filings. The merger closed in October 2018, and Frutarom became a wholly owned subsidiary of IFF. Almost a year later, IFF publicly acknowledged that in advance of the merger, Frutarom had made 'improper payments'i.e., bribes'to representatives of a number of customers.' IFF's share price dropped by nearly 16% after the announcement.

Plaintiffs filed suit in the Southern District of New York, asserting violations of Section 10(b) and 20(a) of the Exchange Act and Rule 10b-5 against two sets of defendants: IFF and two of its officers, and Frutarom and five of its...