New Sections 9(a)(4) and 9(f) of the Securities Exchange Act of 1934 were added by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Although little noticed thus far, these two provisions could soon become very common in lawsuits relating to losses from inadequate disclosure in private placements, especially lawsuits where intermediaries are named as co-defendants with the issuer of the securities.
First, some history. Under Rule 10b-5, adopted by the SEC in 1942 pursuant to Section 10(b) of the Securities Exchange Act, it is unlawful “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not the misleading” in connection with the purchase or sale of securities. This clearly applies to issuers and sellers but the perennial question has been extent to which intermediaries in a securities transaction can be found liable for the issuer’s or seller’s primary violation. Somewhat surprisingly, the U. S. Supreme Court, which limits its review of cases to those with broad significance, has addressed this question three times in the past 17 years.
In Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994) the Supreme Court held that private plaintiffs may not maintain “aiding and abetting” suits under the Rule 10b-5 against participants in a sale or purchase of securities, other than the seller or purchaser, for misstatements or omissions in connection with the sale or purchase. The Central Bank decision reversed a long history of court decisions and SEC enforcement actions in which participants in a transaction, including banks, accountants, trustees, and attorneys, were found liable as “aiders and abettors” under Rule 10b-5. Fourteen years after Central Bank, the Supreme Court reached the same result in Stoneridge Investment Partners, LLC v. Scientific-Atlantic, Inc. 552 U.S. 148 (2008), by holding that plaintiffs do not have a private right of action against secondary parties for “aiding and abetting” securities fraud committed by a primary violator. Such aiding-and-abetting claims under the federal securities laws may be brought only by the SEC in an enforcement action.
Then, very recently, the Supreme Court decided Janus Capital Group, Inc. v. First Derivative Traders, No. 09-525 (June 13, 2011). The Court held in Janus Capital that the investment adviser to the Janus Funds could not be liable in a private action under Rule 10b-5 for false statements in prospectuses issued by the Funds, even though the investment adviser wrote the prospectuses and the employees of the Funds were also employees of the investment adviser. The Court ruled that only the “maker” of a false statement can be liable under Rule 10b-5 and the “maker” is “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” The Court concluded that the mutual fund itself was the entity with “ultimate authority” over the prospectuses because it had the statutory obligation to file the prospectuses with the SEC. Hence, only the mutual funds, not the investment adviser, could be found liable under Rule 10b-5,
Fund managers and other intermediaries, such as broker-dealers, have no doubt taken great comfort from the very literal reading of Section 10(b) expressed in the Janus Capital decision because many commentators thought the Supreme Court would erode, if not reverse, the Central Bank and Stoneridge Investment decisions.
This comfort is probably misplaced. While Rule 10b-5 may not be a concern for secondary participants, there is a new and bigger threat from new Sections 9(a)(4) and 9(f) of the Securities Exchange Act. These new provisions are likely to dramatically change the liability exposure of intermediaries in the sale of securities, such as broker-dealers, investment advisers and fund managers. The new provisions may even apply to accountants and attorneys who participate in securities transactions. It is even possible that directors of the issuer will be caught in web of these new sections of the Exchange Act.
New Section 9(a)(4) makes it unlawful for any broker, dealer or other person selling or offering to sell (or purchasing or offering to purchase) any security other than a government security, “to make. . . for the purpose of inducing the purchase or sale of such security, . . . any statement which was at the time and in the light of the circumstances under which it was made, false or misleading with respect to any material fact, and which that person knew or had reasonable ground to believe was so false or misleading.” Previously, Section 9 of the Exchange Act applied only to securities traded on an exchange. Now it applies to any securities, excluding government securities.
Looking only at the new Section 9(a)(4), one might argue that the logic of the Janus Capital decision should still apply, i.e., that the broker, dealer or “other person” must still “make” the false statement to be held liable, and the maker of the statement is the issuer of the relevant document in which the statement is found. The problem with this line of reasoning is that Dodd-Frank also added new Section 9(f) to the Exchange Act, which says that anyone who “willingly participates” in an act or transaction in violation of Section 9(a) is liable to the person who bought the security. “Willingly participates” is not defined. Moreover, there is no requirement in Section 9(f) that the willing participant have knowledge of the false statement, intent to misrepresent a material fact, or even a careless disregard of the facts given to offerees. Willing participation is what every broker-dealer, banker, attorney, and accountant does when they become involved in a securities transaction. The language of Section 9(f) also has wording that seems to suggest joint and several liability. It allows the “willing participant”, if found liable, to seek recovery from any other violator of Section 9(a). Presumably, this allows the plaintiff to seek recovery from the willing participant, rather than an issuer who may be insolvent, and gives the willing participant a right to sue its own client for a recovery.
Courts will have to resolve the apparent conflict between the language of Section 9(a)(4), which requires that the broker, dealer or other person to have “knowledge” that the statement was false or misleading, and Section 9(f), which only requires “willing participation” in the transaction. But even if courts rule that “willing participation” under Section 9(f) requires knowledge of the false or misleading statement, they may allow plaintiffs to allege that the participant had “reasonable ground to believe” because the participant worked with the issuer in the preparation of the offering documents. “Reasonable ground to believe” is a jury question. Did the participant have enough knowledge of the seller and the securities to allow an inference that the participant had reasonable ground to believe that the statement in question was false? If so, liability attaches.
The burden would then shift to the willing participant to show that it conducted a proper “due diligence” investigation and nothing was discovered that led it to believe that the offering document contained a false or misleading statement. This would make sense because, without a due diligence defense, participants would be worse off under Section 9(f) than underwriters (and directors) in a public offering under Section 11 of the Securities Act of 1933, where a due diligence defense is available. In fact, an underwriter of securities in a registered public offering can now be sued under both Section 11 of the Securities Act and Section 9(f) of the Exchange Act. It would be an absurd result if the “due diligence” defense was sufficient to avoid liability under Section 11 of the Securities Act but not under Section 9(f) of the Exchange Act. Hence, if the courts require plaintiffs to allege “reasonable ground to believe” based on “willing participation” in the transaction, thereby making it possible for a jury to infer knowledge, then the due diligence defense should be implicit in Section 9(f).
In any event, these amendments to the Exchange Act change the landscape that was created by the Supreme Court in the context of securities cases brought under SEC Rule 10b-5. It will be interesting to see how the courts interpret the new Sections 9(a)(4) and 9(f) of the Exchange Act and who will be included in the phrase “willing participant”. Could it include a corporation’s directors? Plaintiffs’ lawyers will no doubt argue that it does.
An affiliate of The Corporation Secretary