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Defenses in Section 11 and 12 Securities Actions

37. What defenses exist for issuers with potential liability under Sections 11 and 12 of the 33’ Act?

An issuer subject to claims by purchasers of securities under Sections 11 and 12 of the 33’ Act has several available defenses that may relieve her of civil liability. These defenses are as follows:

•    Materiality Defense – The defendant may argue that the false or misleading information is not material and thus should not have had an impact on the purchaser’s decision-making process. Materiality is the kind of information that an average prudent investor would want to have so that she can make an intelligent, informed decision whether or not to buy the security.

⁃    Example: ABC Corp fails to adequately identify the nature of certain operational assets held. While this disclosure is technically incorrect, the disclosure is not one that is likely to be the basis of a decision to purchase shares in the company.

•    Statute of Limitations – The statute of limitation to bring an action against an issuer is one year. The statutory period does not start to run until the time of discovery of the actionable conduct or the conduct would have been made with reasonable diligence. In no case can a plaintiff bring an action more than 3 years after the security is properly sold to the public.

⁃    Example: ABC Corp issued securities pursuant to Rule 504. Eric, a purchaser of shares during the issuance, decides to challenge the issuance under Section 12 in order to force the company to repurchase his shares. His challenge is based upon violation of the general solicitation rules. The company may be able to defend against the action if the issuance took place more than 12 months ago and Eric was aware of the solicitation practices at the time.

•    Due Diligence – An issuer may defend against liability under Sections 11 or 12 if she conducted adequate due diligence and such effort failed to uncover the misleading or omitted material information. With information included in a registration statement, the due diligence defense applies differently to portions of the registration statement that includes “expertised” information versus “non-expertised” information. Basically, the issuer is personally responsible for conducting a reasonable investigation of any information that is not reviewed or certified by a qualified expert. The issuer has a due diligence defense when relying on experts to identify and provide information in the disclosure statement. Courts have interpreted this defense to offer a sliding scale for determining the requirement of personal due diligence versus the ability to rely upon experts. In summary, a successful defense must show that a reasonable investigation of the financial statement of the issuer and controlling persons was conducted. Further, the expert must prove that there was no reason to believe any of the information in the registration statement or prospectus was false or misleading. In effect, this defense requires proof that a party was not guilty of fraud or negligence.

⁃    Example: ABC Corp discloses material in its registration statement. Some of the financial material is incorrectly recorded and thereby inaccurate. The issuance is now the subject of a Section 11 and 12 action by shareholders. The CEO signed the financial projections as being correct, but she depended largely upon the certification of the large outside-accounting firm hired to audit and certify the corporate books. This may be a defense to the shareholder action based upon the CEO’s justifiable reliance upon the auditor’s certification.

•    Negative Causation Defense – Negative causation is a defense claiming that something other than the material misstatement or omission in a disclosure statement caused the damages (i.e., the value of the equity to fall).

⁃    Note: This is a difficult thing to prove. The party asserting the defense will often use professional experts to perform event studies to determine what actually caused the drop in price of the purchased security.

⁃    Example: ABC Corp issued securities last year. The disclosure of information in the registration statement was inaccurate in certain aspects at the time of issuance. Mary, a purchaser of securities, is angry because the shares have dramatically dropped in value. ABC Corp may be able to defend an action by Mary by showing that the drop in value was due to new governmental regulations of the business activity. Further, ABC would have to show that the inaccurate reporting of information did not materially contribute to the drop in value.

•    Discussion: Why do you think the SEC and courts allows for the above-referenced defenses? Do you think a 12-month statute of limitations is fair to issuer and purchaser? Why or why not?

•    Practice Question: ABC Corp is subject to a Section 11 and 12 action for a material misstatement of information in the company’s registration statement. Several purchasers of securities in the initial public offering are angry that the value of the shares have declined. What are four major defenses that ABC Corp may be able to assert in response to the civil action?

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