G. Liabilities Under the 1933 Act Objectives providing full disclosure of material information to potential investors in newly issued securities and Generally preventing fraud and/or misrepresentation in the interstate sale of securities. Conduct resulting in liability Accordingly, the kinds of conduct that may result in liability under the 1933 Act may be sorted broadly into two categories (1) Liability for improper disclosure or violation of section 5 registration provisions o Section 11 of the 1933 Act provides for liability where the issuer misrepresents or fails to state a material fact in the registration statement. In addition, liability may arise under section 12(a)(l) of the Act as the result of an improper offer in the pre-filing period (see supra, §111); failure to deliver the required prospectus in the post-effective period (see supra, §178); or other violations of section 5. (2) Liability for fraud or misrepresentation in general o In addition to the above, the 1933 Act includes liability provisions covering fraud or misrepresentation in the interstate sale of securities in general (i.e., whether or not registration with the S.E.C. is involved). [SA §§12(a)(2), 17; Remedies for 1933 Act violations A wide range of remedies is available in actions under the 1933 Act, depending in the first instance on the nature of the plaintiff. That is, there are different remedies available to the S.E.C. than are available to a private plaintiff (e.g., an aggrieved investor). Private lawsuits - When investors sue under the 1933 Act, they are typically looking to receive payment in compensation for what has turned out to be a bad investment. This may be accomplished in two ways: o Damages - A plaintiff entitled to receive damages does not receive the full amount invested in the securities, but rather receives the amount lost (subject to certain limitations). Section 11 of the 1933 Act, discussed below, gives purchasers the right to receive damages. o Rescission - A plaintiff receiving rescission gets back the full amount invested in the securities. In effect, the sale is reversed, the plaintiff returns the securities and gets back her cash. Section 12(a)(l) and (2) of the 1933 Act, discussed below, give purchasers the right to rescission. S.E.C. lawsuits - The S.E.C., as part of its enforcement responsibility, may sue persons alleged to have violated the 1933 Act. In such an action, the S.E.C. has several kinds of remedies available: o Cease-and-desist orders - Cease-and-desist orders resemble injunctions, in that each directs the respondent to stop violating the Act. o Distinguish—injunctions - There are some important differences between cease-and-desist orders and injunctions, including the following: The cease-and-desist order is issued administratively, i.e. by the S.E.C. itself, while an injunction is issued by a federal district judge; Violation of a cease-and-desist order may result in a civil monetary penalty under 1933 Act section 20(d), while violation of an injunction may lead to a contempt proceeding; and The S.E.C. can obtain a cease-and-desist order without the need to show that future violations of the securities laws are likely, while an injunction requires such a showing. o Types of orders - There are two kinds of cease-and-desist orders: temporary and permanent. Temporary orders - Temporary cease-and-desist orders may be issued against broker-dealers, investment advisers, investment companies, and certain other regulated entities. [SA §8A(c)(2)] Note - The temporary cease-and-desist order may be issued ex parte—i.e., without notice to the respondent or a hearing—if the S.E.C. deems it appropriate. Permanent order - Permanent cease-and-desist orders may be issued against anyone violating the 1933 Act. Notice must be given to the respondent, who is also entitled to a hearing before an administrative law judge. o Order for an accounting and disgorgement - In connection with a proceeding for a permanent cease-and-desist order, the S.E.C. may also order the respondent to furnish an accounting and to disgorge any monies received in violation of the 1933 Act, including reasonable interest. [SA §8A(e)] Injunctive relief - Section 20(a) of the 1933 Act authorizes the S.E.C. to conduct investigations into possible violations of the Act. Section 20(b) gives the S.E.C. the power to seek injunctive relief from the federal courts whenever it appears that the Act or the rules thereunder have been or are about to be violated. o Civil fines available in injunctive actions - In addition to obtaining an injunction against future violations of the securities laws, the S.E.C. has the authority, in connection with any injunctive action, to seek civil monetary penalties. Amount of penalty - The penalties that can be imposed are: Up to $5,000 ($50,000 for corporations) for each violation;
Up to $50,000 per violation ($250,000 for corporations) for fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement; and Up to $100,000 per violation ($500,000 for corporations) if the violation meets the requirements of 2/, above, and in addition directly or indirectly caused substantial losses or created a significant risk of substantial losses to other persons. Criminal sanctions - Section 24 of the 1933 Act imposes criminal penalties upon conviction of a willful violation of any of the provisions of the 1933 Act, including violation of section 17(a), the general fraud provision of the 1933 Act. (See infra, §§820 et seq.) "Willful" violation of section 17(a) means that the defendant had the intent to defraud or that he made representations without knowing whether or not they were true. It need not be shown that the defendant knew that a "security" (as defined by the 1933 Act) was being sold or that defendant knew he was violating some specific provision of the securities laws. [United States v. Brown]
EXAM TIP If an exam question involves a person criminally charged under section 24 of the 1933 Act, remember that it is not a defense that the person did not know that the thing fraudulently sold was a security or that the sale violated the 1933 Act. The defendant need only have intentionally defrauded a victim or made representations without knowing whether they were truthful. Remember also that a willful violation of section 5 (e.g., failure to register offers of securities) can also be a criminal violation.
SUMMARY Damages equal to the amount lost by plaintiff. Rescission Cease-and-desist orders (temporary or permanent) issued by the S.E.C. requiring the defendant to stop violating the 1933 Act and, if the order is permanent, to disgorge any monies received in violation of the Act. Injunctions issued by a federal court prohibiting future violations of the 1933 Act; the injunction may include award of a civil monetary penalty. Criminal sanctions issued by a federal court for willful violation of the 1933 Act.
Comparison of 1933 Act anti-fraud provisions with common law fraud remedies Elements of common law action - At common law, a defrauded purchaser of securities had to prove the same elements to recover as any other defrauded purchaser of goods: Material fact - The plaintiff had to show that the defendant seller of the securities misstated, or failed to state, a material fact that the seller was under a duty to disclose. Reliance - In addition, the plaintiff had to show that she relied on the misrepresentation. Privity - The plaintiff also had to show that there was privity of contract between her and the defendant (i.e., that plaintiff had purchased the security from the specific seller being sued). Causation - Also, the plaintiff had to show that the defendant's misrepresentation was the actual and the proximate cause of the plaintiff's loss. Scienter - Finally, the defendant had to have had actual knowledge of the misrepresentation or omission; i.e., the defendant's misrepresentation must have been intentional. o Lesser burden under 1933 Act - In general, the liability provisions of the 1933 Act are less demanding on defrauded purchasers than was the common law. The 1933 Act makes recovery easier for purchasers of securities by lightening the burden of proof they must carry with respect to the above elements (see infra, §§749 et seq.). Express Civil Liabilities Introduction - The 1933 Act contains three express liability provisions. Section 11—liability for misstatements or omissions in registration statement or prospectus - Section 11 of the 1933 Act imposes liability on designated persons for material false or misleading statements or omissions in an effective registration statement or prospectus. o Persons subject to liability - The following persons can be held liable under section 11 for material misstatements in the registration statement or prospectus: Every person who signs the registration statement - Every person who signs a registration statement can be held liable for material misstatements or omissions in the statement. The following persons must sign the registration statement: The issuer; The principal executive officers of the issuer; The principal financial officer of the issuer; The comptroller or principal accounting officer of the issuer; and
A majority of the members of the board of directors of the issuer. Every director of the issuer - Every person who was a director of the issuer at the time the registration statement became effective can also be held liable, even if the director did not sign the registration statement. Every person named as "about to become" a director - In addition, every person who is named in the registration statement (with his consent) as about to become a director of the issuer may be held liable. Every "expert" who certifies preparation of registration statement - All "experts" who consent to being named as having prepared or certified part of the registration statement may be held liable under section 11. For example, accountants are "experts" as to the certified financial statements included in the registration statement. Every underwriter involved in the distribution - Underwriters may also be held liable under section 11. Control persons - Finally, persons who "control" any person who is liable under section 11 may be held jointly and severally liable with the liable persons, unless the controlling person had no knowledge of nor reasonable grounds to believe in the existence of the facts on which the liability of the controlled person is alleged to rest. [SA §15] o Elements of plaintiff's cause of action Material misstatements or omissions - To recover damages under section 11, the plaintiff must prove that there has been a misstatement of, or a failure to state, a "material" fact. Definition of "material" - Material facts here are those matters to which there is a substantial likelihood that a reasonable investor would attach importance in deciding whether to purchase the registered security. Judicial expansion of definition - The rule 405 definition has been elaborated on by the courts, which have held that a fact is material when it is more probable than not that a significant number of traders in the security would have wanted to know it before deciding to deal in the security. Example—material facts: o A Corp. decided to acquire B Corp. through an exchange of A's securities made directly with B's shareholders. o However, A failed to disclose that a major reason for acquiring the target company (B) was the amount of surplus cash that could be drained from B into A. o A's failure to make this disclosure and to disclose the estimated amount of such cash (when estimates were known or could have been obtained from B's management) were held to be material omissions. [See Feit v. Leasco Data Processing Equipment Corp.] o Limited reliance requirement - In general, the plaintiff need not prove that she purchased in reliance on the misstatement to recover. Exception—after-acquired securities - However, if the issuer sends out an earnings statement covering the period of one year after the effective date of the registration statement, a person thereafter acquiring some of the registered securities must prove reliance on the misrepresentation or omission to recover. [SA §ll(a)] But note - The plaintiff need not actually have read the registration statement to prove reliance. It is sufficient that she relied on secondary sources that repeated the misstatement. And note - If any post-effective amendments are filed, the one-year period will run from their filing date rather than the filing date of the original registration statement. Secondary market purchasers - The language of 1933 Act section 11 provides a cause of action to "any person acquiring" the security that was the subject of the defective registration statement. Until 1995, courts interpreted this to mean that even persons who purchased a security in the secondary market (as opposed to those who purchased the security in the issuer's public offering) could recover under section 11, as long as they could prove that the specific securities purchased were issued in the offering registered by the defective registration statement (a procedure called "tracing" the securities). however, a conflict in the decisions has arisen, with some courts holding that only underwriters and purchasers in the initial offering have standing under section 11. Other courts have continued to follow the traditional view that as long as secondary purchasers can trace the securities to the registration statement, they have section 11 standing. o Privity of contract not required - Under either view, privity of contract with the defendant is not required under section 11; that is, a purchaser with standing may sue any person described by the statute as a potential defendant. Causation and damages - The plaintiff need not prove that her loss (i.e., decline in value of the securities) was caused by the misrepresentation. (Note: This was an element of the plaintiff's cause of action at common law.) o Reduction of damages - However, the defendant may be able to reduce the damages by proving that all or some portion of the damages resulted from some cause other than the misrepresentation or omission of material fact in the registration statement. [SA §ll(e)] Example: A court has taken into account a general decline in stock market prices after the date plaintiff purchased the issuer's stock, and allowed the defendant issuer a discount in damages equal to the percentage decline in the Standard and Poor's index of stock market prices. [Feit v. Leasco Data Processing Equipment Corp., supra, §751]
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JS Example: Another court sustained a loss causation defense when the defendant's misstatement was "barely material," and the price of the security actually increased somewhat upon public disclosure of the misstatement. [Akerman v. Oryx Communications, Inc., 810 F.2d 336 (2d Cir. 1987)] General affirmative defenses - Any defendant (including the issuer) subject to liability under section 11 may claim the following defenses. That the alleged false statements were actually true; That the misstatements or omissions were not of material facts; That the plaintiff-purchaser knew of the misleading statements or omissions and invested in the securities anyway; and That the statute of limitations has run. Under section 11, the period of limitations is one year after discovery of the false statement, with an overall limitation of three years after the security is first bona fide offered to the public. [See SA §13] This means that if a portion of the issue remains unsold after three years, for example in a continuous offering, purchasers after that time are not protected by section 11 of the Act. Due diligence defense—experts and nonexperts In addition to the above defenses, all defendants (except issuers) have a "due diligence" defense under section 11. In applying this "due diligence" defense, section 11 makes a distinction between "experts," i.e., those who certify part of the registration statement as being true (such as certified public accountants who certify that the financial statements were prepared according to generally accepted accounting principles), and "nonexperts," or all others who may be held liable pursuant to section 11. Section 11 also draws a distinction between the standard of care (i.e., what constitutes due diligence) required of nonexperts who review material prepared by other nonexperts, and that required of nonexperts reviewing statements of experts. Statements made by experts - To avoid liability under section 11, experts may demonstrate that they have met the following test of "due diligence" as to representations they made in the registration statement: o That they actually believed that the statements they made were true; and o That their belief was reasonable. For their belief to be reasonable, the experts must have made a reasonable investigation into the facts supporting the statements made. Normally, this means that they must at least have performed up to the standards of their profession (e.g., accountants must make an investigation of the facts that would conform to the standards of their profession and must state the issuer's financial results according to the generally accepted accounting principles set forth by the S.E.C.). [See Escott v. BarChris Construction Corp.,] Note, however, that while compliance with professional standards (e.g., by an accountant) establishes a reasonable investigation, it does not automatically shield the professional from liability. For example, an accountant who conducts an investigation in accordance with GAAP (generally accepted accounting principles) and GAAS (generally accepted auditing standards) would still be liable under section 11 if she consciously chose not to disclose a known material fact on a registration statement. [Monroe v. Hughes, 31 F.3d 772 (9th Cir. 1994)] Statements made by nonexperts - "Nonexperts" who make statements that appear in the registration statement are held to the same standard of "due diligence" as experts. Thus, nonexperts must o actually believe that the statements made were true and o their belief must be reasonable—i.e., based on a reasonable investigation of the facts. Test - for reasonable investigation by nonexperts - Under section 11, the test for defining the scope of a "reasonable investigation" is what a prudent person would do in the management of her own affairs. [See SA §ll(c)] Note - As a practical matter, however, there is no single standard. The court looks at each individual defendant and, based on the person's position with the issuer, responsibilities relative to the issuer and the registration statement, and background, skills, training, and access to information, the court determines what the person should have done to fulfill the obligation of a "reasonable investigation." Comment - In other words, the test is really what kind of investigation a prudent person in the defendanfs position, with the same responsibilities, skills, etc., would have made. [Escott v. BarChris Construction Corp., supra]
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Application—attorney drafting registration statement - An attorney who is also a member of the issuer's board of directors and who drafts the issuer's registration statement (and collects facts from the issuer to do so) does not "certify" his work and thus is a "nonexpert" as to the registration statement in general. [Escott v. BarChris Construction Corp., supra] Reasonable investigation by attorney - In BarChris, the court indicated that the attorney-director did not have to conduct an independent audit of the issuer, but that a reasonable investigation would go beyond merely trusting the opinions and responses of the issuer's officers as to material facts. Therefore, a reasonable investigation by the attorney would include: Looking at original written records (e.g., written contracts) to verify statements in the registration statement; An examination of the issuer's facilities, operations, material contracts, corporate minutes and other documents, and major items important to its financial condition; Use of a comprehensive questionnaire for directors and officers to elicit information required to be disclosed (such as whether they had any conflicting interests); and Having an accountant check any suspicious items disclosed by the lawyer's investigation. Distinguish—drafting attorney as corporate insider - Note that if the lawyer drafting the registration statement becomes so involved with the issuer and the registration that he is held to be a "corporate insider" (like the other management officers), he will then be held to the same high standard of diligence as other officers (see infra, §770). [Feit v. Leasco Data Processing Equipment Corp.] Drafting attorney as expert - It is also conceivable that an attorney might be requested to certify (as an expert) some portion of the registration statement. In this case, the attorney would be held to the due diligence standard of an expert (supra, §760). EXAM TIP Don't let professional pride sway you on your exam. Remember that an accountant is considered an "expert" under rule 11—and so is held to the expert's standard of due diligence. An attorney who drafts the registration statement is not considered an expert. The difference lies in their jobs: The accountant certifies that financial statements were prepared in a certain way while the drafting attorney makes no such certification. Nonexperts reviewing statements by other nonexperts - A nonexpert not involved in the actual drafting of the registration statement (such as a member of the issuer's board of directors) may also be potentially liable under the 1933 Act for statements made in the registration statement by other nonexperts. To avoid such liability, the nonexpert must show that she exercised due diligence appropriate to her position in reviewing the statements made by other nonexperts. Standard of diligence required - The standard of diligence required for nonexpert reviewers is the same as for nonexperts concerning their own representations in the registration statement Application Underwriters - Underwriters qualify as nonexperts and so must make a reasonable investigation of the nonexpert portions of the registration statement. They cannot simply rely on assurances of accuracy from the issuer's management, attorneys, etc. [See Escott v. BarChris Construction Corp., supra, §763] Note - that normally the "lead underwriter" (usually the underwriting firm that first established contact with the issuer, and which structures and manages the underwriting for all of the other underwriting firms) will conduct an investigation of the issuer for all members of the underwriting syndicate to satisfy the due diligence requirement. However, if the lead underwriter conducts a faulty investigation, this does not absolve the other underwriters. The S.E.C. has stated that a participating underwriter must be satisfied that the managing underwriter has made the kind of investigation that the participant would have performed if it had been the manager. Inside directors and executive officers - The standard of diligence imposed on directors who are also part of management (i.e., officers of the issuer) and on the principal executive officers of the issuer is even higher than that imposed on underwriters. Not all of the inside directors and executive officers will be required to do the same things to show due diligence. What is required of each depends on the person's position, access to information about the offering, etc. However, it is clear that these persons are virtual guarantors of the accuracy of the registration statement, and it will be difficult for them to escape responsibility for material misstatements. [See Feit v. Leasco Data Processing Equipment Corp.] For example, if there are misstatements made relating to the issuer's financial condition, the issuer's chief financial officer will have a hard time sustaining his burden of showing that he really did not know of the misrepresentations. [See Escott V. BarChris Construction]
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Outside directors - Outside directors (those who are not employed by the issuer as part of management) must also meet the due diligence test for nonexperts. However, their position differs from inside directors in that although they must discharge the duty of a director, they cannot realistically be expected to do a great deal to check on the accuracy of the registration statement. Thus, the issue is how extensive is the duty of an outside director? It appears from the cases that outside directors will probably be expected to attend directors' meetings during the time registration is underway and will also be held responsible for reading directors' meeting minutes, reading the drafts of the registration statement before filing and, in a general way, questioning company management, accountants, and legal counsel. [See Weinberger v. Jackson, 1990 WL 260676 (N.D. Cal. 1990)] But if this investigation turns up apparent misstatements, the directors must personally check into these matters and require company counsel to check into them. | Escott v. BarChris Construction Corp., supra—holding liable two directors who failed to read the registration statement and one who gave it only a cursory review] Note again that what is actually expected of any specific director will depend in part on his background and familiarity with the registration process. For example, a lawyer-director might be expected to make a more extensive investigation than a doctor-director. [See Escott v. BarChris Construction Corp., supra] Nonexperts reviewing statements made by experts - Nonexperts (such as outside directors) are held to a lower standard of care when reviewing statements made by experts than when reviewing statements made by other nonexperts. Normally no investigation required - Because nonexperts are entitled to rely on statements made by experts, in most cases no investigation need be made by the nonexpert. Rather, the reviewing nonexpert need only show that he did not believe the statements made by the expert to be false and that he had no reasonable ground to believe they were false. Burden generally met - Nonexpert defendants usually will be able to meet this burden of proof. For example, in the BarChris case, most of the nonexperts were held not liable for misrepresentations made by the issuer's expert accountants.
STANDARDS OF DUE DILIGENCE EXPERTS Actual and reasonable belief that statement was true Requires reasonable investigation into facts, generally performed up to the standards of the profession. NONEXPERTS REVIEWING STATEMENTS OF OTHER NONEXPERTS Actual and reasonable belief that statement was true General standard: What a prudent person would do in the management of her own affairs. o UNDERWRITERS Lead underwriter must conduct a reasonable investigation; other underwriters must be satisfied that the lead underwriter made such an investigation. o INSIDE DIRECTORS\ MANAGERS Virtual guarantors of the accuracy of the registration statement; probably liable no matter how diligent. o OUTSIDE DIRECTORS Must attend directors' meetings during registration process; read minutes of meeting, registration drafts, etc. NONEXPERTS REVIEWING STATEMENTS OF EXPERTS No actual belief that statement was false and no reason to believe it was false Generally, nonexperts are entitled to rely on statements of experts, so no investigation is required unless facts show a potential problem.
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When investigation is required - However, if facts suggest that the portions of the registration statement supplied by experts contain misstatements, the underwriters must make a reasonable investigation. [In re Software Toolworks, Inc., 50 F.3d 615 (9th Cir. 1994)] Example: In Software Toolworks, supra, the underwriters discovered a memo raising doubt as to whether the issuer was properly recognizing revenue. The underwriters confronted the issuer's accountants, who had
approved the revenue recognition, demanded from the accountants reconfirmation in writing that the revenue recognition was appropriate, and contacted other accounting firms to verify the revenue accounting used by the issuer. The court held that the underwriters' investigation was reasonable. Measure of damages - Where the plaintiff proves that there was a material misrepresentation or omission in the registration statement and that the securities purchased are traceable to the registered offering, the plaintiff can recover any damages suffered as a result of a decline in value of the securities. [See SASll(e)] o If the stock is sold prior to filing suit - If the stock is sold prior to the filing of a lawsuit, the plaintiff may recover the difference between the price she paid for the stock (but not exceeding the price at which the security was offered to the public) and the price at which it was sold prior to suit. Example: X bought stock in a registered offering for $10; she sold it for $6 prior to filing suit and it was selling at $5 at the time of the suit. X can recover only $4 per share (the difference between the price paid and the price at which she sold). o If the stock has not been sold prior to suit - If the stock has not been sold prior to the suit, the purchaser may recover either: The difference between the price she paid (not exceeding the offering price) and the value of the security at the time of the suit; or The price at which the stock was sold after the suit was instituted but before judgment, if such damages are less than those that result from using the value at the time of the suit. Determining value - If a court is required to determine the value of the issuer's securities at the time of the suit, it may consider various factors besides the actual market value. For example, it may adjust market value to account for "panic selling" then taking place, which may depreciate the securities beyond their normal investment value. [Beecher v. Able, 435 F. Supp. 397 (S.D.N.Y. 1975)] Plaintiff not required to mitigate damages - If the plaintiff buys securities that decline in value due to misrepresentations made in the registration statement and then files suit, she need not sell the securities to mitigate damages just because the market price begins to rise o Example: A buys debentures at $100 each. They decline to $75 at the time of the suit, rise to $100 while the suit is going on, but decline again to $70 just before judgment (at which time the plaintiff sells). The plaintiff's damages are measured by the difference in the price she paid ($100) and the value at the time of the suit ($75). [Beecher v. Able, supra; and see SA §ll(e)(3)] Limits on recovered amount o Offering price as ceiling - In no case can the amount recovered exceed the price at which the security was offered to the public. [SA §ll(g)] o Liability of underwriter - Also, the total liability of an underwriter cannot exceed the offering price of the securities that the underwriter sold to the public. o Loss causation defense - Finally, the defendant is not liable for damages that are proven to result from factors other than the misstatement in the registration statement. Joint and several liability—contribution - All persons (except outside directors) who are liable under section 11 (a) are jointly and severally liable, and every person who becomes liable to make any payment under section 11 may recover contribution from any person who, if had they been sued would have been liable, unless the person who has become liable was guilty of fraudulent misrepresentation and the person who has not become liable was not. o Exception—outside directors - In actions brought under SA section 11, outside directors of the issuer are liable: Jointly and severally for knowing violations of section 11;and Proportionately to their respective degrees of fault for all other violations of section 11.
Section 12(a)(l)—liability for offers or sales in violation of section 5 - Section 12(a)(l) provides that any person who offers or sells a security in violation of any of the provisions of section 5 of the 1933 Act shall be liable to the purchaser for: (i) the consideration paid (with interest) less the amount of any income received on the securities (i.e., a suit for rescission); or (ii) for damages if the purchaser no longer owns the security. Liability for any violation of section 5 - Liability under section 12(a)(l) is absolute for any violation of any provision of section 5. Such violations include a sale of unregistered securities, failure to deliver the required prospectus, making an illegal offer in the pre-filing period, etc. Control persons - Persons who "control" any person liable under section 12(a)(l) may be held jointly and severally liable with the controlled person, unless the controlling person had no knowledge of or reasonable grounds to believe in, the existence of the facts on which the liability of the controlled person is alleged to rest. Participant liability - Section 12(a)(l) imposes liability on those who offer or sell a security in violation of section 5. But the 1933 Act nowhere says who may, for these purposes, be regarded as a statutory "seller" (or offerer). Clearly the person who passes title to the security is a seller, but may anyone else be regarded as a "seller" for purposes of section 12(a)(l)? Courts were in conflict over this question until 1988, when the Supreme Court decided Pinter v. Dahl, 486 U.S. 622 (1988).
Facts of Pinter - Pinter, an oil and gas operator and securities broker, sold unregistered oil and gas interests to Dahl in an attempted private placement. Later, Dahl solicited some of his friends to purchase additional interests, because Dahl believed the interests were good investments. Pinter sold the interests to DahPs friends on the strength of Dahl's representations that the friends qualified as private placement investors. It turned out that the friends were not qualified private placement investors, and when the investment became worthless, Dahl and his friends sued under section 12(a)(l). Pinter counterclaimed, alleging, among other things, that Dahl was a "seller" under section 12(a)(l) and therefore that Dahl was required to contribute toward the amounts awarded the other plaintiffs. Definition of "seller" - The Supreme Court held in Pinter that a "seller" for section 12(a)(l) purposes includes: o The person who actually passes title to the security; and o Persons who solicit the purchase from the purchaser. Persons who are not sellers - Under Pinter, however, the term "seller" does not include persons whose sole motivation in acting is to benefit the buyer.
Defenses to a section 12(a)(l) cause of action No sale of a "security" - One defense to a section 12(a)(l) cause of action is to prove that there was no offer or sale of a "security" as that term is defined in the 1933 Act. No violation of section 5 - Another defense is that no violation of section 5 ever occurred (i.e., the offering of securities was exempt from the registration provisions of section 5 of the 1933 Act). No privity - Unlike section 11, section 12(a)(l) imposes a condition of privity of contract between the plaintiff-purchaser and the seller-defendant. Therefore, a common defense to a section 12(a)(l) action is that no privity of contract existed. o Example: Issuer sold to A, who resold to B, who resold to C (a broker), who resold to the plaintiff. Since the plaintiff has privity only with C, C is the only person against whom the plaintiff can bring a section 12(a)(l) action. Consequently, if C were found not to have violated section 5 (even though A and B had committed violations), plaintiff could not sustain a section 12(a)(l) action. [Winter v. D.J. & M. Investment & Construction Corp., 185 F. Supp. 943 (S.D. Cal. I960)] o Note - Remember, however, that persons who solicit the plaintiff's purchase, although they do not actually pass title to the security, are nevertheless held to be "sellers." Statute of limitations - As under section 11, the period of limitations is one year after the violation, but in no event more than three years after the security was bona fide offered to the public. As above, if a portion of the issue is sold after three years from the first bona fide offer to the public, section 12(a)(l) is unavailable. o Note—laches may not be available - One court has held that laches (an equitable counterpart to the statute of limitations that evaluates staleness of a claim in terms of the prejudice caused by a knowing delay in bringing a suit, rather than by the mere passage of time) is not a defense in a section 12(a)(l) action where the period of limitations has not yet run. [Straley v. Universal Uranium & Milling Corp., 289 F.2d 370 (9th Cir. 1961)] No interstate commerce - Section 12(a)(l) incorporates the requirements of section 5. Section 5 is specific as to how the means of interstate commerce must be used for there to be a violation. Hence, this may preclude as broad an interpretation of interstate commerce as this term is given elsewhere in the securities laws. [See United States v. Robertson, 181 F. Supp. 158 (S.D.N.Y. 1959)] Section 12(a)(2)—general civil liability under the Act - The 1933 Act generally prohibits fraud in the interstate offer or sale of securities. Section 12(a)(2) of the Act provides that any person: Who offers for sale a security (whether or not exempted from the registration requirements of section 5, except for certain government and bank securities) by the use of any means of interstate commerce; By means of a prospectus or oral communication that contains an untrue statement or omission of material fact (the purchaser not knowing of such untruth or omission); and Who cannot sustain the burden of proof that he did not know and in the exercise of reasonable care could not have known of the untruth o is liable to the purchaser of the security. [See SA §12(a)(2)] Scope of section 12(a)(2) actions - Except with respect to securities exempt under section 3 (a) (2) (certain government and bank securities), section 12(a)(2) applies whether or not the securities were registered pursuant to section 5 of the Act, whether or not they were offered under an exemption from the Act, and whether the securities were offered in writing or orally. Example: If XYZ Corp. makes an offering of its securities, section 12(a)(2) applies to any misrepresentations made by XYZ, whether the offering is registered or unregistered (i.e., even though XYZ uses an exemption from registration, such as the private offering exemption). Plaintiff's cause of action - A buyer bringing a section 12(a)(2) action may sue for rescission to recover the consideration paid for the securities, plus interest, and less any income received; or for damages, if the securities have already been sold. In either case, the plaintiff must show the following: o Sale of a security - The plaintiff must prove that there has been an offer or sale of a "security" as that term is defined in the 1933 Act
Use of jurisdictional means - The cases have held that the language of section 12(a)(2) requires that liability be limited to persons "who offer or sell securities by use of any means or instruments of transportation or communication in interstate commerce or the mails." [United States v. Robertson, supra] Note - Most decisions have indicated that this requirement is satisfied if any part of the sale (including delivery after the sale) involves such means. [United States v. Robertson, supra] Application - Thus, as long as any means of doing interstate commerce is used (e.g., use of a phone or mail service), this is sufficient (even though the transaction itself does not involve more than one state). [Lennerth v. Mendenhall, 234 F. Supp. 59 (N.D. Ohio 1964)] o Sale by means of a prospectus or oral communication - Section 12(a)(2) also requires that the offer or sale of securities occur by means of a "prospectus or oral communication" that includes the misrepresentation or fails to disclose the material fact. Since section 12(a)(2) does not have a reliance requirement, individual plaintiffs need not actually read the writing that contains the misrepresentation. [See Alton Box Board Co. v. Goldman, Sachs & Co., 560 F.2d 916 (8th Cir. 1977)] Section 12(a)(2) applicable only to primary offerings - The Supreme Court has held that section 12(a)(2) does not apply to a private, secondary sale of a security. [Gustafson v. Alloyd Co., Inc., supra, §754] Facts of Gustafson - Gustafson involved a closely held corporation that was sold to a partnership pursuant to a contract of sale. The contract contained what turned out to be misstatements regarding the corporation's financial condition. Although the contract itself provided for adjustments in the purchase price if the company's condition was not as represented, the purchasers elected to rescind under section 12(a)(2) rather than demand a contractual rebate of part of the purchase price. The Court's analysis - The Supreme Court characterized the issue as whether the contract for sale of the corporation was a "prospectus" within the meaning of section 12(a)(2). The Court reasoned that "prospectus" ought to mean in section 12(a)(2) the same thing it means in section 10. "Prospectus" in section 10, however, does not include contracts for sale of the type at issue. (Recall that section 10 is the basis for the disclosure requirements under the 1933 Act. Few, if any, documents drafted for a purpose other than 1933 Act registration will contain adequate disclosure under section 10. (See supra, §§110 et seq.)) Section 10 includes only statutory and preliminary prospectuses used in public offerings, and these, held the Court, are the only "prospectuses" that can give rise to liability under SA section 12(a)(2) Significance of Gustafson - Gustafson has been widely criticized because it fails to take into account the definition of "prospectus" in SA section 2(a)(10) (see supra, §132). However, it seems clear that for now section 12(a)(2) will not apply to private, secondary sales of securities. Moreover, the Court apparently considers section 12(a)(2) to apply only to primary public offerings by issuers or their shareholders, thus foreclosing application of section 12(a)(2) to public sales in the secondary market. This restrictive reading of the 1933 Act parallels some of the Court's recent decisions under the 1934 Act (e.g., Central Bank v. First Interstate Bank, infra, §1517) and may foreshadow additional decisions still to come. o Untrue statement or omission of material fact - The plaintiff must also show that there was an untrue statement of, or an omission to state, a material fact. Example: D was an exclusive dealer in Penn Central notes and sold a large note to P shortly before Penn Central went bankrupt. D knew that P was required by law to purchase only the highest quality notes, that Penn Central had large losses, and that other banking firms were removing Penn Central notes from their approved buying lists. D's opinion as to the quality of the security was a material fact under section 12(a)(2). [See Franklin Savings Bank of New York v. Levy, 551 F.2d 521 (2d Cir. 1977)] Note: The court in Franklin indicated that D's knowledge that P was required to purchase only the highest quality notes constituted a representation that the note it sold to P was of the highest quality. Such a representation is a misrepresentation (if untrue) unless D makes a reasonable investigation of the financial facts and exercises reasonable care in arriving at a conclusion as to quality. o Defendant's knowledge of the untrue statement - The plaintiff must plead that the defendant knew, or in the exercise of reasonable care should have known, of the untrue statement. However, the defendant then must bear the burden of proof on the issue (i.e., that he did not know, and in the exercise of reasonable care could not have known, of the untrue statement). o No reliance or causation - Note that the plaintiff need not prove reliance on the misrepresentation (see supra, §804). Section 12(a)(2) requires, however, that the sale be accomplished by means of a prospectus (or oral communication) that contains a material misstatement or omission. One court has suggested that this language requires a showing of "some causal relationship between the misleading representation and the sale." [Alton Box Board Co. v. Goldman, Sachs & Co., supra] Defenses - To avoid liability under section 12(a)(2), a defendant may raise the following defenses: o Lack of knowledge - The defendant may show that he did not know, and in the exercise of reasonable care could not have known, of the untrue statement. Note that this is basically a simple negligence standard. Investigation requirement - Whether an investigation is required depends on all the circumstances, but an underwriter probably has to make a reasonable investigation of an issuer. [Sanders v. John Nuveen & Co., 619 F.2d 1222 (7th Cir. 1980), cert, denied, 450 U.S. 1005 (1981)]
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According to the Sanders court, there is no substantive difference between the investigation required to establish reasonable care under section 12(a)(2) and that required to prove due diligence for a nonexpert under section 11. [See also Ambrosino v. Rodman & Renshaw, Inc., 972 F.2d 776 (7th Cir. 1992)] Standards - And note that different standards have not been established with regard to statements made by experts and nonexperts (as they have under section 11. Waiver and estoppel - The defendant may claim the defenses of waiver and estoppel if it can prove that the plaintiff has shown sufficient approval or acceptance of the defendant's misconduct. Plaintiff's knowledge - The defendant can also show that the plaintiff knew of the untrue statement. Privity - Under section 12(a)(2) (as in section 12(a)(l) above), there must be privity of contract between the plaintiff and the defendant. Participant liability - Like section 12(a)(l), section 12(a)(2) imposes liability on persons who "offer or sell" a security. Pinter (supra, §791) addressed the question of participant liability and who is deemed a "seller," but only with respect to section 12(a)(l). The Court expressly reserved any decision on the parallel requirement in section 12(a)(2). Lower courts addressing the issue since Pinter, however, have generally held that Pinter applies to section 12(a)(2), as well as to section 12(a)(l). [See, e.g., Royal American Managers, Inc. v. IRC Holding Corp., 885 F.2d 1011 (2d Cir. 1989)] Consequently, the same rules presently apply to participant liability under section 12(a)(l) and (2). Statute of limitations - The period of limitations for a section 12(a)(2) cause of action is one year after discovery of the false statement or material omission, or after such discovery should have been made in the exercise of reasonable diligence, but not more than three years after the sale. Laches - It is uncertain whether laches applies to section 12(a)(2) actions. Loss causation in section 12(a)(2) cases—section 12(b) - In an action brought under section 12(a)(2), the defendant can escape liability to the extent that she can prove that all or any portion of the loss otherwise recoverable under section 12(a)(2) was caused by something other than the defendant's alleged misstatement or omission. [SA §12(b)] This defense is similar to the defense available under section 11, where a defendant is permitted to establish that some or all of the plaintiff's loss arises from factors other than the misrepresentation. Note - The difficulty with this defense lies in its requirement that the defendant "prove" that something in particular caused the loss. It is notoriously difficult to prove why the price of a security changed at any particular time, and under new SA section 12(b), the burden falls on the defendant to do so. The great majority of cases under section 12(a)(2) (in which such proof is not available) will be unaffected by this defense.
Section 17—S.E.C. Anti-Fraud Enforcement Criminal liability and injunctions - As discussed above, sections 11, 12(a)(l), and 12(a)(2) of the 1933 Act provide plaintiffs with express causes of action based on specific types of misconduct in connection with the issuance of securities. These sections, however, are not available to the S.E.C., which is not a party to securities transactions. The Act therefore contains a provision—section 17— generally prohibiting fraud in connection with any offer or sale of securities. The S.E.C.'s 1933 Act anti-fraud enforcement is based on section 17, which makes it unlawful for any person in the offer or sale of securities by use of any means or instruments of transportation or communication in interstate commerce or by the use of the mails, directly or indirectly: To employ any device, scheme, or artifice to defraud [SA §17(a)(l)]; or To obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact [SA §17(a)(2)]; or To engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser [SA §17(a)(3)]. Scope - Note that section 17(a) is not limited to sales; it applies to offers as well. Who is protected - The Supreme Court has held that section 17(a)(l) prohibits fraud against brokers as well as against purchaser-investors. [United States v. Naftalin, 441 U.S. 768 (1979)] Rationale - The Court held that although section 17(a)(3) specifically mentions "purchaser," this term should not be read into sections 17(a)(l) or (2), which are more general and cover fraud on brokers. The thrust of Naftalin is that sections 17(a)(l) and (2) apply to persons generally, in addition to purchasers of securities. Implied civil liability - There is a long-standing split in the federal circuit courts over whether section 17(a) of the 1933 Act includes an "implied" civil cause of action permitting private persons to sue under the section and thereby, perhaps, avoiding some of the more onerous requirements of other sections of the 1933 and 1934 Acts (e.g., 1933 Act section 12(a)(2), see supra, §§799 et seq.; o 1934 Act section 10(b) and rule 10b-5, see infra, §§895 et seq.} that create fraud remedies for private plaintiffs. The trend is clearly away from an implied remedy under section 17(a). This is the better view, because an implied
remedy would conflict with the express remedies contained in each act. [See Landry v. All American Assurance Co., 688 F.2d 381 (5th Cir. 1982)] Conduct standard Causes of action for damages - If a private cause of action is implied in section 17, the plaintiff would have to prove that the defendant acted intentionally or with actual knowledge. [Sanders v. John Nuveen & Co., 554 F.2d 790 (7th Cir. 1977)] o Injunctive actions brought by the S.E.C. - However, the Supreme Court has held that in civil injunctive actions brought by the S.E.C., a distinction must be made between the various subsections of section 17(a). Subsection 17(a)(l) requires a showing of scienter, while the two remaining subsections require only a showing of negligence. [Aaron v. S.E.C., 446 U.S. 680 (1980)] Liability Under the Securities Exchange Act of 1934 - A complete understanding of the liability provisions of the 1933 Act is impossible without also considering the provisions of the 1934 Act. The provisions of each statute overlap, and each has advantages and disadvantages in comparison with the others. Indemnification Officers, directors, and control persons - Officers, directors, and control persons of an issuer may be exposed to substantial liability under the securities laws and substantial litigation expenses in defense of securities actions. The laws of the various states vary as to whether and to what extent these persons (acting as representatives for the corporation) may be indemnified against such liability by the issuer. o No judicial decision - There is no direct judicial authority on the question whether indemnification of officers, directors, or control persons by the issuer against liabilities and expenses incurred in connection with the 1933 Act is unlawful. When such a decision comes, it will undoubtedly be based on the policy considerations underlying the 1933 Act. o Policy of the S.E.C. - It is currently the policy of the S.E.C. that before it will approve a registration statement, indemnification must either be waived by such persons or a statement must be made in the prospectus to the effect that the S.E.C. considers such indemnification against the policy of the 1933 Act (and therefore unenforceable) and that such persons promise to submit the question (if it arises) to a court of competent jurisdiction for a decision. [Regulation S-K Item 512(h)] Sanction - The S.E.C. will deny acceleration of the effective date of the registration statement unless this statement is made in the prospectus. Underwriters - Note that indemnification by the issuer of the underwriters is common. The S.E.C. has done nothing to discourage this, even though some scholars believe that there is no reason to make a distinction between officers and directors on one hand, and underwriters, on the other. Actual knowledge of misstatement - One court, however, has held that at least where the underwriter has actual knowledge of materially misleading statements or omissions contained in the prospectus, the underwriter cannot rely on an indemnification agreement to escape liability. Rather, public policy requires that such underwriters be equally liable with the issuer to investors who have received the incorrect prospectus. [See Globus, Inc. v. Law Research Service, Inc., 418 F.2d 1276 (2d Cir. 1969), cert, denied, 397 U.S. 913 (1970)] Negligence - It is still questionable what the result would be in a case where the underwriter was only negligent with respect to the inclusion of inaccurate information in the prospectus. Contribution - A related question involves whether contribution is available in actions brought under sections of the 1933 Act that do not expressly provide for contribution (i.e., sections other than section 11; see supra, §784). The courts have been friendlier to the idea of contribution in these actions than they have been to claims for indemnification. Distinguish indemnification - While indemnification is the payment of all of a party's costs and expenses, contribution involves only the allocation of the damages among the defendants. S.E.C. policy - So far, the S.E.C. has not attempted to discourage claims for contribution. o Rationale - Contribution does not violate the policies underlying the 1933 Act; which expressly provides for contribution in a section 11 case. In fact, contribution furthers the policies of the Act, insofar as contribution tends to ensure that all defendants will bear some of the burden of the violation. Liability Insurance - Another important issue in the area of liability is whether an issuer can purchase insurance to cover potential liabilities that could not be properly indemnified under state law. Availability of insurance - State law varies, but many states do allow such insurance, and commercial policies are available. Insurance policies are not uniform with respect to what conduct they insure against; however, most do not insure against willful misconduct. S.E.C. policy – Thus far, the S.E.C. has drawn a distinction between indemnification and insurance and has not discouraged insurance. [SA Rule 461(c)] o Rationale - The reasons for this distinction are: If insurance were unavailable, the cost to the issuer's shareholders arising from liability could be high;
Underwriters might refrain from marketing securities; and Directors and others might be unwilling to serve companies involved in the registration process.
Stipulations Contrary to Liability Provisions Void - Any condition, stipulation, or provision (as in a contract of sale) purporting to bind any person acquiring any security to waive compliance by the seller with any of the provisions of the 1933 Act or its rules and regulations is void. Example: A sold B stock in an unregistered public offering. Later, A offered to return the money for the stock and gave B 10 days in which to respond to the rescission offer. B did not respond. Still later, B sued for rescission under what is now section 12(a)(l) of the 1933 Act. The court held that B had not waived his rights under the 1933 Act by failing to respond to A's offer of rescission. [Meyers v. C & M Petroleum Producers, Inc., 476 F.2d 427 (5th Cir. 1973)]