I still get a sizeable knot in my stomach when I think about Barclays’ over-issuance debacle, but a recent 2nd Cir. decision suggests that some good for Barclays and other issuers may come out of the company’s misfortune. This Sullivan & Cromwell memo notes that in Knapp v. Barclays PLC, (2d. Cir.; 3/26), the Court affirmed the SDNY’s prior decision dismissing Securities Act claims brought by purchasers of an exchange traded note involved in the over-issuance.

The plaintiffs brought claims for rescission under Section 12(a)(1) of the Securities Act, and for misstatements under Section 11 of the Act. This excerpt from S&C’s memo summarizes the 2nd Cir.’s decision to affirm the lower court’s decision to dismiss the case:

As to the Section 12(a)(1) claim for rescission, the court held that the 4:1 reverse-split was not a “sale” that can trigger liability under the Securities Act. In resolving this novel issue, the court emphasized that the reverse-split did not constitute a “disposition for value” (which is the statutory definition of “sale”), because the reverse-split did not change the “nature of the investment” and the plaintiffs made no investment decision when Barclays exercised its contractual right to effectuate a reverse-split.

As the court stated, the “combination of four notes into one larger note is exactly the kind of nonsubstantive exchange that will not be treated as a sale.” Because the reverse-split “alter[ed] only the form of the securities,” the exchange did “not require distributees to give any value in exchange.” The court further explained that “[t]his conclusion neatly matches the purposes of the Securities Act”: “The design of [the Securities Act] is to protect investors by promoting full disclosure of information thought necessary to informed investment decisions. But when an issuer announces a mandatory split, as happened here, investors have no choice and make no investment decision.”

As to the Section 11 claim for misstatements, the court followed the strict tracing requirement that the Supreme Court adopted in Slack. Addressing Slack for the first time in the Second Circuit, the court explained that, “[b]ecause section 11 focuses on securities issued under a ‘particular registration statement,’ plaintiffs must first plead that they acquired securities ‘traceable to that allegedly defective statement.’”

Although the plaintiffs argued that the notes they received after the reverse-split were traceable to the registration statement that Barclays issued on the same day that the reverse split took effect, the court rejected that argument based on a careful parsing of the language in that registration statement. The registration statement’s “own terms show that it does not cover those [notes] but rather governs the ‘initial sale of the [post-split] [notes]’ that Barclays still held in its inventory, and which it had thus not distributed via the [reverse] split.” Accordingly, because the plaintiffs failed to meet Slack ’s tracing requirement, the court affirmed the dismissal of the Section 11 claim without addressing whether there were any misrepresentations in the registration statement.

From an issuer’s perspective, the decision is helpful precedent. Not only does it indicate that the 2nd Cir. isn’t amenable to efforts to end run Section 11’s tracing requirement, but it’s nice to have something to point to from one of the nation’s most respected appellate courts holding that stock splits don’t involve a “sale” of securities.

– John Jenkins