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Private Placement Securities Litigation

By Peter M. Saparoff, John F. Nucci, and Joel D. Rothman – September 9, 2015

The Securities Act of 1933, 15 U.S.C. §§ 77a et seq. (the Securities Act), defines a “security” as “any note, stock, treasury stock, security finance, security-based swap, bond, debenture . . . investment contract . . . or warrant or right to subscribe to or purchase, any of the foregoing.” Put more simply, a security is a certificate attesting to the right of ownership, in some way. Perhaps most relevant here is the term “investment contract.” In SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the Supreme Court defined an investment contract as, essentially, an investment in a common enterprise, where the investor is led to expect a return of profits solely from the efforts of others.

Typically, securities are sold or otherwise offered in accordance with the Securities Act, which regulates the public offering of securities. In general, securities offerings must be registered with the Securities and Exchange Commission (SEC) in accordance with the provisions of section 5 of the Securities Act. Section 5 states that, among other things, it is unlawful for any person to sell or deliver unregistered securities or to fail to file a registration statement along with a sale of securities. These provisions generally exist to protect unaccredited, ordinary investors from being taken advantage of in the offering of securities by more sophisticated entities (i.e., the issuers and underwriters offering securities to the public). Notwithstanding the general rule requiring registration, the Securities Act contains a few notable exemptions (chief among them are section 4(a)(2), Regulation D, and Rules 504, 505, and 506). It is important to note that unregistered private offerings can be risky for ordinary, unsophisticated investors because unregistered offerings typically lack certain of the explicit protections that are required by section 5 through an SEC registration statement.

This article explains some of the key rules and regulations governing private placement offerings, as well as some areas where securities lawyers can find themselves in danger of running afoul of the securities laws when they are involved in private placements.

Pertinent Rules, Regulations, and Enforcement Tools

Section 12(a)(1) of the Securities Act. While private placement offerings are unregistered, they are not immune from the federal securities laws.

Section 12(a)(1) of the Securities Act, 15 U.S.C. § 77l(a)(1), provides for a private cause of action to persons who have been aggrieved by an unregistered offering of securities, private or otherwise, by placing a general prohibition on the sale of unregistered securities. It states that “any person who . . . offers or sells a security in violation of section 77e of this title . . . shall be liable . . . to the person purchasing such security from him.” Section 77e (which is the same as section 5, discussed above) makes it unlawful to sell unregistered securities through interstate commerce (unless an exception applies). In other words, section 12(a)(1) provides that any person or entity that offers or sells unregistered securities by means of interstate commerce is liable to the purchaser of that security.

Section 12(a)(1) is a very buyer-friendly statute. Barring proof of an applicable exemption, section 12(a)(1) provides for strict liability against one who offers or sells a security in violation of section 77e. Thus, an aggrieved buyer is not required to prove scienter or negligence on the part of the issuer or seller. In fact, the seller’s knowledge of the violation does not even need to be proven. A plaintiff simply needs to prove that a seller used the interstate commerce system, the mails, or even an interstate phone call, to offer or sell unregistered securities. In addition, in Pinter v. Dahl, 486 U.S. 622 (1988), the Supreme Court expanded the meaning of “seller” under the statute to include not only the owner who passes title to the securities but also a person who solicits the purchaser if the solicitor did so in service of the solicitor’s or the buyer’s financial interest.

However, while this is a relatively easy standard to meet, the plaintiff must show that the seller used the modes of interstate commerce with respect to a specific plaintiff, not just in general. In addition, the statute of limitations for a claim under section 12(a)(1) is fairly rigid as set forth in section 13 of the Securities Act, 15 U.S.C. § 77m, which states that an action is prohibited “unless brought within one year after the violation upon which it is based.” Section 13 also provides that a claim may not be brought, under any circumstances, “more than three years after the security was bona fide offered to the public.” In addition, in Police & Fire Retirement System v. IndyMac MBS, Inc., 721 F.3d 95 (2d Cir. 2013), the Second Circuit held that while American Pipe tolling applies to the one-year statute of limitation, it does not apply to the three-year statute of repose. See Am. Pipe & Constr. Co. v. Utah, 414 U.S. 538, 551 (1974) (holding that filing of class action lawsuit suspends running of filing deadline for all class members).

Despite these limitations, a properly plead claim under section 12(a)(1), filed within the statutory period, stands a good chance of success. In the event of a judgment in favor of the plaintiff, a court may order either monetary damages or rescission of the sale. However, section 12(a)(1) also requires a victorious plaintiff to tender back the securities in question if he or she still holds them. Failure to do so is a viable defense.

Section 12(a)(2) of the Securities Act, 15 U.S.C. § 77l(a)(2), does not apply to unregistered private placement offerings. However, as discussed below, some substantially equivalent state blue-sky statutes may apply.

Section 10(b) of the Exchange Act, Rule 10b-5, and section 17(a) of the Securities Act. In the event that either a plaintiff or the government is aggrieved by a fraudulent sale of securities, several options are available to them. Perhaps chief among them is a claim under Rule 10b-5, 17 C.F.R. § 240.10b-5, and section 10(b) of the Securities Exchange Act of 1934 (the Exchange Act), 15 U.S.C. § 78j. Rule 10b-5 makes it unlawful

for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange:

  • To employ any device, scheme, or artifice to defraud;

  • 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; or

  • To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security.

In other words, Rule 10b-5 prohibits the use of interstate commerce to perpetrate a fraud on any person in connection with the sale of securities, registered or otherwise.

Somewhat similar to Rule 10b-5 is section 17(a) of the Securities Act, 15 U.S.C. § 77q(a). Section 17(a) makes it unlawful

for any person in the offer or sale of any securities . . . by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly—

  • to employ any device, scheme, or artifice to defraud, or

  • to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or

  • to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

Although it appears facially similar to Rule 10b-5, there are a number of differences between the two statutes. As an initial matter, under Rule 10b-5 there is a private cause of action for a private plaintiff. On the other hand, according to a majority of courts, section 17(a) does not allow a private cause of action. Compare Pfeffer v. Cressaty, 223 F. Supp. 756 (S.D.N.Y. 1963) (private cause of action allowed), and Frischling v. Priest Oil & Gas Corp., 524 F. Supp. 1107 (N.D. Ill. 1981) (same), with Crookham v. Crookham, 914 F.2d 1027 (8th Cir. 1990) (no private cause of action), and Currie v. Cayman Res. Corp., 835 F.2d 780 (11th Cir. 1988) (same). In addition, Rule 10b-5 requires proof of scienter for all three subsections. Section 17(a), on the other hand, only requires proof of scienter under section 17(a)(1); proof of negligence suffices under subsections (a)(2) and (a)(3). See Aaron v. SEC, 446 U.S. 680, 695–96 (1980).

Further, in Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011), the Supreme Court interpreted Rule 10b-5(b)’s prohibition against “mak[ing] any untrue statement of a material fact” as extending only to those with “ultimate authority” over an alleged false statement. In contrast, some argue that liability under section 17(a)(2) may not be contingent on whether one has “made” a false statement. Instead, it may turn on whether one has obtained money or property “by means of” an untrue statement. The SEC has taken the position that section 17(a)(2) allows a defendant to be held primarily liable if he or she uses a misstatement to obtain money or property, even if the defendant personally has not made a false statement in connection with the offer or sale of a security. See Matter of John P. Flannery, Securities Act Release No. 33-9689 (Dec. 15, 2014), appeal docketed, No. 15-10820 (1st Cir. Jan. 16, 2015).

SEC enforcement and penalties. The SEC has a broad arsenal of tools available to it to combat fraudulent or unregistered offerings of securities. Under section 10(b), it can bring claims of aiding and abetting or conspiring to make such offerings, unlike private plaintiffs. Section 17(a) is also an important part of the SEC’s toolbox, largely for the reasons given above.

The SEC also has the power to impose substantial penalties for securities violations. Pursuant to section 8A of the Securities Act, 15 U.S.C. § 77h-1, it can enter a cease and desist order against any person it finds has violated, is violating, or is about to violate its rules. It may also impose a civil penalty if doing so would serve the public interest. See 15 U.S.C. §§ 77h-1(g) & 78u(d)(3).

State common laws and “blue sky” laws. In addition to the federal securities laws, every state has its own set of securities laws—commonly referred to as “blue sky laws”—that are designed to protect investors against fraudulent or misleading sales practices and activities in the offer and sale of securities to, from, or within their borders.

In Massachusetts, for example, the blue-sky law provision, Mass. Gen. Laws ch. 110A, § 410(a)(2), prohibits the offering or sale of securities through either a false statement or omission of  information needed to prevent the offering from being misleading, where the buyer is unaware of the false statement or omission. The Massachusetts Supreme Judicial Court has drawn several plaintiff-friendly conclusions from General Laws Chapter 110A, section 410(a)(2). First, a plaintiff need not establish—or even plead—the elements of scienter or negligence in order to sustain a claim under section  410(a)(2). A plaintiff also does not need to prove that he or she relied on the alleged misrepresentation in deciding to purchase securities, and his or her status as a sophisticated investor (or lack thereof) is wholly irrelevant. See Marram v. Kobrick Offshore Fund, Ltd., 809 N.E.2d 1017 (Mass. 2004). To sustain a claim under the statute, a plaintiff need only establish a lack of knowledge of the misleading statement or omission. Of course, a plaintiff also must show that the statement or omission concerned a material fact, whether or not it was relied on. In general, the statement or omission must concern a fact—not an opinion or belief of the issuer—unless that opinion or belief is inconsistent with the facts surrounding the offering. Omnicare Inc. v. Laborers Dist. Council Constr. Indus. Pension Fund, No. 13-435, 135 S. Ct. 1318 (2015). In addition, Chapter 110A, section 410(g) of the Massachusetts General Laws prohibits any waiver of compliance with any provision of the act. This limitation on the basic right to contract freely is consistent with the blue-sky laws in a number of other jurisdictions.

Beyond any applicable blue-sky laws, a number of other remedies may exist for aggrieved plaintiffs at the state level. For instance, a plaintiff can potentially bring a claim for the common-law torts of fraud or negligent misrepresentation, as well as for breach of fiduciary duty and breach of contract. A consumer protection claim may also be possible. For example, the Massachusetts consumer protection statute, Mass. Gen. Laws ch. 93A, § 2, prohibits unfair or deceptive practices in “trade or commerce.” Section 1 of Chapter 93A defines “trade” and “commerce” as including securities, giving rise to a state cause of action for relief from deceptive actions by a seller in the offering of securities.

Suits Against Attorneys
In addition to sellers and issuers, attorneys can be sued under many of the above-referenced statutes, especially by the SEC. Attorneys typically draft materials relating to all offerings of securities, including private placement offerings. Thus, if those materials are materially misleading, the preparing attorney can be sued under section 12(a)(1) or Rule 10b-5.

For example, the SEC instituted an administrative proceeding seeking a permanent bar against an attorney from practicing before the commission. Matter of Carl N. Duncan, Securities Exchange Act Release No. 34-68501 (Dec. 20, 2012). The SEC had also instituted a suit against the attorney in federal district court in which the SEC had alleged that the defendant attorney prepared and issued false legal opinions and letters in connection with a scheme to inflate trading volume in the common shares of a company’s stock, in violation of sections 5(a), 5(c), and 17(a)(2) of the Securities Act. The U.S. District Court for the Southern District of New York had entered a final judgment by consent against the attorney, permanently enjoining him from future violations of the 1933 Act. The court also

  • prohibited the attorney from participating in the preparation or issuance of any opinion letter in connection with the offer or sale of securities pursuant to the Securities Act,

  • permanently barred him from participating in an offering of penny stock, and

  • required him to pay disgorgement and prejudgment interest thereon in the amount of $16,094.98 and a civil money penalty in the amount of $25,000.00.

Attorneys are also open to so-called gatekeeper exposure. See, e.g., Complaint, SEC v. Treaty Energy et al., No. 4:14-cv-812 (E.D. Tex. filed Dec. 15, 2014) (alleging violations of sections 5(a) and 5(c) of the Securities Act by the outside counsel for the defendant company for registration violations and aiding and abetting such violations; seeking a permanent injunction barring him from providing legal services to any person or entity in connection with the offer or sale of securities exempt from registration or with filing Form S-8 with the SEC; also seeking civil penalties and disgorgement)

While private placement offerings are unregistered, certain aspects of both federal securities laws and state laws apply. Further, lawyers must be aware of potential personal exposure relating to their involvement in private placement offerings. Thus, when representing a potential plaintiff in connection with a claim arising out of an unregistered private placement investment, one should be aware of not only the possible claims that can be asserted but also the restrictions that some of these claims may encounter.

Keywords: litigation, securities, private placement offering, unregistered security, blue sky law, Securities and Exchange Commission, SEC

Peter M. Saparoff, John F. Nucci, and Joel D. Rothman are with Mintz Levin Cohn Ferris Glovsky and Popeo, P.C., in Boston, Massachusetts.

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