New Liability Exposure for Intermediaries in Private Placements

The following post comes to us from Roger Wiegley, General Counsel at AXA Liabilities Managers and founder of The Corporation Secretary.

The recent Supreme Court decision in Janus Capital Group, Inc. v. First Derivative Traders confirmed prior Court decisions regarding Rule 10b-5 of the Securities Exchange Act of 1934: Intermediaries in securities transactions could not be found liable for the issuer’s or seller’s violation of that rule. Fund managers and other intermediaries, such as broker-dealers, have no doubt taken great comfort in the Janus Capital decision. That comfort is misplaced. New provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act should dramatically change the liability exposure of intermediaries in the sale of securities.

Under Rule 10b-5, adopted by the SEC in 1942 pursuant to Section 10(b) of the 1934 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 misleading” in connection with the purchase or sale of securities. This clearly applies to issuers and sellers, but the question before the Court in Janus Capital and prior cases has been the extent to which intermediaries in a securities transaction can be found liable for the issuer’s or seller’s primary violation. Somewhat surprisingly, in the past seventeen years the Supreme Court has considered this question twice before its most recent decision.

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 Securities Exchange Act § 10(b) 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 may be brought only by the SEC in an enforcement action.

The Supreme Court decided Janus Capital Group, Inc. v. First Derivative Traders, No. 09-525, on 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.

Despite these favorable decisions regarding Rule 10b-5, the Dodd-Frank Act has the potential to greatly increase liability for secondary participants through two little noticed provisions. These two provisions, which added new Sections 9(a)(4) and 9(f) of the Securities Exchange Act of 1934, should dramatically change the liability exposure of intermediaries in the sale of securities, such as broker-dealers, investment advisers and fund managers. The new provisions in the 1934 Act may even apply to accountants and attorneys who participate in securities transactions.

New Section 9(a)(4) of the 1934 Act 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 1934 Act applied only to securities traded on an exchange. Now it applies to any securities, excluding government securities—another change that was part of the Dodd-Frank Act.

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 1934 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, an 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 broker-dealer had “reasonable ground to believe” because the broker-dealer 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 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 1933 Act and Section 9(f) of the 1934 Act.  It would be an absurd result if the “due diligence” defense was sufficient to avoid liability under Section 11 of the 1933 Act but not under Section 9(f) of the 1934 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 1934 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 1934 Act and who will be included in the phrase “willing participant”.

What should a placement agent or other intermediary do in this new environment? The answer is really no different from what it was in past, although now it has more weight: Conduct a proper due diligence investigation for the offering. Coincidentally, the Financial Industry Regulatory Authority (FINRA, the successor to the NASD) recently published a notice to remind broker-dealers of their due diligence obligations in private placements of securities (FINRA Regulatory Notice 10-22, April 2010). This Regulatory Notice did not create any new obligations. To quote from the Notice, “The Securities and Exchange Commission (SEC) and federal courts have long held that a [broker-dealer] that recommends a security is under a duty to conduct a reasonable investigation concerning that security and the issuer’s representations about it.” Large investment banking firms, when acting as underwriters in a public offering, have had a long history of conducting a very thorough due diligence investigation before they offer any of the securities. This is really their only means of establishing a defense against liability under Section 11 of the Securities Act of 1933 (i.e., there is no liability if the underwriter “had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading”.) In contrast, small broker-dealers making private placements often conduct just a cursory due diligence examination consisting of little more than discussions with the issuer. These broker-dealers lack the resources of a large investment banking firm and they are reluctant to incur the cost of outside service providers because the cost typically cannot be recovered if the placement is unsuccessful, as is often the case. Adding to this issue is the fact that many of the specialist firms that offer via the internet to conduct due diligence investigations for broker-dealers deliver a work product that is generally far below the standard adhered to by underwriters.

This will have to change. Placement agents in private placements will find that the only way to reduce the risk of liability for false statements in an offering document (and reduce the risk of a FINRA enforcement action) is through a properly conducted and properly documented due diligence investigation. Other participants in a private placement, such as attorneys and accountants, may themselves require that the placement agent conduct such a due diligence investigation before they agree to participate. These defensive measures will no doubt evolve over time, but the threat is real today.

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