Katz v. Gerardi: Claim Splitting and the Definition of Purchasers under the Securities Act of 1933

In Katz v. Gerardi, 655 F.3d 1212 (10th Cir. 2011), the Tenth Circuit Court of Appeals affirmed the dismissal of two class action suits dismissing claims under Sections 11 and 12(a)(2) of the Securities Act of 1933 (“Securities Act”).

Jack Katz and Infinity Clark Street Operating (“Infinity”) both contributed property to a real estate investment trust operated by Ernest Gerardi and later by Archstone-Smith Trust (“Archstone”).  Archstone merged with Lehman Brothers.  The merger permitted investors in Archstone to receive cash or shares in a new investment vehicle.  Katz and Infinity filed separate class action suits against both Gerardi and Archstone alleging that they made false disclosures under Sections 11 and 12(a)(2) of the Securities Act of 1933.

Infinity’s complaint was filed in 2007 in the United States District Court for the District of Colorado.  All claims were dismissed except for one alleging breach of contract, which was stayed pending arbitration.  Katz’s complaint was filed in Illinois in 2008 and removed by Archstone to the United States District Court for the District of Colorado.

Once in Colorado, Katz amended his complaint to include Infinity as a plaintiff.  As a result, Infinity was a plaintiff in two separate actions in the same court.   The Colorado District Court subsequently dismissed Infinity from the case concluding that the plaintiff had engaged in claim splitting.

The rule against claim splitting requires a plaintiff to bring all claims against a defendant in a single suit to maximize use of judicial resources.

Infinity argued that claim splitting did not apply because there had been no final judgment in the original action.  The Tenth Circuit found the argument unpersuasive because the test for claim splitting was not whether there was finality of judgment, but whether the first suit would preclude the second suit.  As the court reasoned:

Our precedent cannot be clearer: the test for claim splitting is not whether there is finality of judgment, but whether the first suit, assuming it were final, would preclude the second suit. This makes sense, given that the claim-splitting rule exists to allow district courts to manage their docket and dispense with duplicative litigation.  If the party challenging a second suit on the basis of claim splitting had to wait until the first suit was final, the rule would be meaningless. The second, duplicative suit would forge ahead until the first suit became final, all the while wasting judicial resources.

The court also concluded that Infinity “essentially admit[ed] claim splitting” by adding the same securities claims to the other action filed in Colorado.  Moreover, at oral argument, “Infinity even conceded the securities law claims can be litigated in its other lawsuit.”

The court also affirmed the dismissal of the securities claims brought by Katz.   Section 11 provides a cause of action for false information in a registration statement.  Section 12(a)(2) provides a cause of action against parties who provide prospectuses or communications which include untrue statements of material fact.

Both sections 11 and 12(a)(2) require plaintiffs to show they were the purchaser of securities to have standing.  A seller of a security cannot, therefore, bring an action under these provisions.    The fundamental change doctrine provides an exception to this requirement.  This exists when “the shareholder is faced with the choice of either holding stock in a nonexistent corporation or exchanging his shares for value… [in] mergers.”  As the court described:  “The doctrine enables a shareholder, whose investment has been fundamentally changed, to meet the causation and reliance requirements of the securities laws even though the shareholder has not made an actual purchase or sale of securities.”

Katz received cash for his units because of the merger and, as a result, sold rather than purchased securities.   He nonetheless asserted that he had standing as a purchaser under the fundamental change doctrine.  Concluding that the doctrine applied to claims under the Securities Exchange Act of 1934, the court declined to apply it to claims under the 1933 Act.   Even were the doctrine applicable to such claims, however, the court held that it did not allow plaintiff to be transformed into a seller.

Further, even if we adopted the fundamental change doctrine and applied it to Katz's 1933 Act claims, it is still no help. In a forced sale, he is still a seller, not a purchaser. To find that Katz has standing, we would still have to assume he purchased the "new" A-1 Units, which he never did. In fact, Katz owned the same A-1 Units both before and after the merger was announced. Nothing can convert the sale of his A-1 units for cash into a purchase of shares he never acquired.

Because Infinity was improperly included in claims it did not make in its original suit and because Katz did not have standing to make a claim under the Securities Act of 1933, both cases were dismissed.

The primary materials for this case may be found on the DU Corporate Governance website.