LIABILITY UNDER THE SECURITIES ACT OF 1933
The 1933 Act provides for both criminal and civil liability for individuals who violate its provisions in the issuance of securities. Civil liability generally arises when a purchaser of securities sues the issuer (or its agent) for failure to comply with the registration or applicable exemption requirements under the ’33 Act. This often includes (unintentionally) failing to make or making incomplete or erroneous disclosures of material information to purchasers of securities. Criminal liability generally arises when an issuer (or its agent) willfully violates the securities laws in a manner that defrauds or deceives a purchaser of securities. Remedies for civil and criminal violation range from the ability to recuperate the amount paid for the securities to fines and imprisonment.
What is civil liability under “Section 11” of the ’33 Act?
Sections 11(a) and (b) of the ’33 Act provide for strict liability (tort liability) for issuers who make material misstatements or omissions in the issuance of securities. This provision primarily applies to omissions and errors in disclosure pursuant to a public offerings. For example, an error in a private placement memorandum or registration statement could give rise to Section 11 liability.
Requirements for Liability
To be liable for a Section 11 violation, the issuer must make a material misstatement or omission of information in the transaction. An individual may be liable if the final registration statement contains any:
• untrue statement of material fact;
• omits material facts required by a statute or government regulation; or
• omits information that makes the stated information materially misleading.
The plaintiff does not have to demonstrate or prove any reliance on the statement. It is sufficient to demonstrate that the information was erroneous or misleading. The limitation is that the purchaser must not know that the information is erroneous or misleading at the time of purchase. Lastly, the securities the plaintiff purchased must be traceable to the registration statement or disclosure document at issue. This requirement is easy to meet in an IPO, but it may be difficult in subsequent purchases of shares issued in private offerings.
Who is Potentially Liable?
The issuer is potentially liable under Section 11. Further, Section 15 makes any person or entity that controls an issuer potentially liable. This provision provides for joint and several liability for the controlling person or entity under agency principles. Liability extends to those who endorse or signe their names (“signer”) to assert the veracity of the information. This generally leads to potential liability for corporate directors, underwriters, and others who take part in the preparation of the registration statement or prospectus. Any “signer” has a due diligence defense, though an insider CEO and CFO will have hard time asserting this defense. The due diligence defense regards the amount of effort and care the signer exercised in verifying the erroneous or omitted information. Section 11(e) provides for rescission of the transaction (along with interest) or damages suffered (losses sustained) from the later sale of the securities.
• Discussion: What do you think about Section 11 liability for omissions or errors in disclosure? Do you think these provisions adequately make officers accountable for public disclosures? Why or why not?
• Practice Question: ABC Corp is going through the registration process. It files the S-1 containing all relevant financial and non-financial information. It also translates this information into a prospectus that it distributes to potential purchasers. What is ABC Corp’s potential liability if some of the revenue calculations are erroneous in the accompanying financial statements?
What is civil liability under “Section 12” of the ’33 Act?
Section 12 of the ’33 Act provides for civil liability for issuers of securities in two situations.
• Section 12(a)(1) – This provision provides a civil cause of action for purchasers of securities against issuers who sell securities without registering the securities or perfecting an exemption. Within the applicable statute of limitations, the purchaser must show that she purchased the shares from the issuer.
⁃ Note: This includes a situation where an issuer attempts to perfect one or more registration exemptions that fail.
• Section 12(a)(2) – This provision provides a cause of action for purchasers against issuers who makes a material misstatement or omission in a prospectus or other communication made as part of the sale of securities to the purchaser. The purchaser must not know that the information is incorrect at the time of purchase.
⁃ Note: Liability under Section 12(a)(2) is in addition to liability under Section 11.
As a remedy for violation under either subsection, the purchaser may rescind the purchase and receive interest on the money invested and any damages incurred by the investment. Generally, these causes of action are only available to purchasers in the original issuance of the securities. Individuals who purchase the securities in a subsequent sale cannot bring these actions. The issuer is potentially liable under Section 12, which makes anyone controlling the issuer potentially liable. The SEC may also bring a civil action against the issuer.
• Discussion: Why do you think that failure to register or perfect an exemption may lead to civil liability for an issuer? Should a purchaser who is not negatively affected by a failure to register or a misstatement of material information be able to force the company to repurchase the securities? Why or why not?
• Practice Question: ABC, LLC issues securities pursuant to a Rule 506(b) exemption. Unfortunately, some of the investors did not meet the accredited investor or sophistication requirements. No other registration exemptions apply to the offering. What does this potentially means for ABC?
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 has declined. What are four major defenses that ABC Corp may be able to assert in response to the civil action?
What is liability under “Section 17” of the ’33 Act?
Section 17 of the ’33 Act is an anti-fraud provision applicable to the initial sale or issuance of securities. It makes it illegal to “employ any device, scheme, or artifice to defraud … obtain money or property … engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.” It is primarily a government enforcement provision and courts generally do not allow a private cause of action by purchasers against the issuer under this provision.
• Note: Section 17 is very similar in nature to Rule 10(b)(5) of the Securities Exchange Act of 1934, which is a common fraud prevention provision. The primary difference is Section 17 does not require the government to demonstrate a specific mental intent of the issuer to defraud purchasers of securities.
• Discussion: Why do you think Congress provided specifically for a government civil action based upon fraudulent practices? Do you think the statute is sufficiently broad to cover all types of fraudulent conduct in the issuance of securities? Why or why not?
• Practice Question: ABC Corp is issuing securities to finance its growth. The directors purposely generate false information to include in the financial disclosures provided to investors. These disclosures are instrumental in the investor’s decision to invest in ABC Corp. What is the potential for director liability under Section 17 of the ’33 Act?
What is the potential criminal liability for violations of ’33 Act?
Section 24 of the ’33 Act allows the Department of Justice (DOJ) to bring a criminal action against anyone who knowingly and willfully violates the ’33 Act. This normally only arises in situations where an issuer commits fraud in the sale of securities. The SEC cannot bring a criminal action itself, but it regularly works in hand with the DOJ to substantiate claims of securities fraud.
• Note: Conviction under this provision allows for up to a $10,000 fine and up to 5 years in prison.
• Discussion: How do you feel about this consumer fraud statute? Why do you think the DOJ, rather than the SEC, is charged with pursuing criminal charges in securities actions under Section 24?