CHAPTER § 11.02 Private Liability Under Federal Securities Laws

• Jurisdiction: United States

§ 11.02 Private Liability Under Federal Securities Laws

Most private damages actions brought by aggrieved investors assert claims alleging breach of one or more of the following provisions of the federal securities laws: (i) Section 11 of the Securities Act of 1933 (the "Securities Act")¹⁰ (relating to false and misleading statements or omissions in a registration statement); (ii) Section 12(a) of the Securities Act¹¹ (false or misleading statements or omissions in a prospectus or other "communication"); or (iii) Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act")¹² and SEC Rule 10b-5 promulgated thereunder¹³ (relating broadly to fraudulent conduct in connection with any purchase or sale of any security). Those provisions are discussed below.

[1] Section 11 of the Securities Act—Civil Liabilities on Account of a False Registration Statement

Section 11 of the Securities Act establishes a private right of action for persons injured by a false or misleading statement of material fact or material omission in a registration statement. A registration statement is a document that must be filed with the SEC before the security to which it relates may be offered for public sale.¹⁴ The registration statement must contain specified information about the entity issuing the security, its business, its current financial condition, and its past performance (if applicable). The registration statement must be signed by the issuer, its principal executive officer(s), its principal financial officer(s), its comptroller or principal accounting officer, and the majority of its board of directors (or persons performing equivalent functions).¹⁵

[a] Overview of a Section 11 Claim

[i] Elements of the Claim

To prevail on a Section 11 claim, a plaintiff must establish that one or more statements included in a registration statement were false or misleading as to a material fact or that the registration statement omitted material information required to be included therein.¹⁶ A "material" fact is one that "would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."¹⁷ The inquiry is typically fact-driven.¹⁸ Notably, a plaintiff need not prove that the defendants acted with a culpable mental state (scienter) when making the misstatement or omission. Thus, an innocent, but erroneous, filing may give rise to Section 11 liability.

In addition, purchasers who acquire a security directly from its issuer or from an underwriter in an initial offering need not prove that they actually relied on the registration statement. However, those purchasers who acquire a security after the security's issuer has published an earnings statement covering a period of at least 12 months from the effective date of the registration statement must prove reliance.¹⁹

[ii] Who May Sue

Any person who purchased a registered security can bring a claim under Section 11. However, a plaintiff who did not purchase the security at the time of its initial offering from the issuer, but instead later purchased the security on the open market, must present evidence tracing the shares purchased back to the offering made pursuant to the registration statement.²⁰ Where the issuer has made only one registered public offering of securities and only shares registered in connection with that offering have entered the market, the stock may be presumed to be traceable to the registered offering.²¹ In cases in which an issuer has made more than one public offering of shares or where shares not subject to the offering registration statement have entered the market, the burden to demonstrate that shares purchased on the open market were initially sold in the registered offering in question presents a serious hurdle for open-market purchaser plaintiffs.²²

[iii] Who May be Sued

A Section 11 claim can be asserted against: (1) every person who signed the registration statement; (2) every person who was a director or partner of the issuer or performed functions similar to a director or partner at the time the registration statement was filed; (3) every person who is named in the registration statement as being or about to become a director, partner, or person performing similar functions; (4) any expert named as responsible for a portion of the registration statement (such as an issuer's auditor);²³ and (5) underwriters. Furthermore, a claim can be asserted against any person who controls any of the foregoing persons, including controlling shareholders who might otherwise escape liability.²⁴

[iv] Prescribed Remedy

The measure of damages available to a plaintiff who succeeds in establishing liability under Section 11 depends upon whether the plaintiff has sold the securities at issue before judgment. Where a plaintiff has retained ownership of the securities through judgment, damages are calculated as the difference between the amount paid for the security (provided that such price was not greater than the price at which the market was offered to the public at the time of the purchase) and the value of the security at the time of filing of the lawsuit.²⁵ If the plaintiff sold the securities at issue before filing suit, the damages will be the difference between the amount paid for the security (again, capped at the price at which the security was offered to the public) and the price at which the security was sold.²⁶ The third possible measure of damages comes into play in cases where a plaintiff retains ownership of the securities at the time of filing the lawsuit, but then sells before judgment is rendered. In that situation, the plaintiff's damages will be the difference between the amount paid for the security (capped at the price at which the security was offered to the public) and the sale price, so long as that amount is less than the difference between the price paid for the security and the security's value at the time that the lawsuit was filed.²⁷

[b] Defenses to Liability Under Section 11

[i] Issuer's Defenses

There are relatively few defenses that an issuer may assert to claims of misrepresentation or omission relating to facts existing at or before the time of the registration statement at issue. As to such claims, the issuer avoids liability only if:

1. The challenged statements were not false or misleading and no information required to be included in the statement was omitted;
2. Any false or misleading statement or omission was not material;
3. The plaintiff knew at the time of purchase that the challenged statements were false or misleading or that material facts were omitted; or
4. The issuer can prove that plaintiff's claimed damages were not caused by the challenged statements or omissions.²⁸

Where, on the other hand, the challenged representation is a forward-looking statement within the meaning of the safe-harbor provisions of the Reform Act,²⁹ additional defenses are available. First, if the forward-looking statement is accompanied by appropriate cautionary language identifying risk factors that could cause actual results to differ materially from those predicted, the claim is barred.³⁰ Second, where the forward-looking statement is not accompanied by cautionary language, the plaintiff must plead and prove that the statement was made or authorized by an executive officer who actually knew that the statement was false or misleading.³¹

[ii] Defenses Available to Non-Issuer Defendants

Section 11(b) sets forth additional defenses available to defendants other than issuers. Defendants bear the burden of proof as to each of those defenses.³² A non-issuer defendant will avoid Section 11 liability if he or she can prove: (1) that prior to the effective date of the registration statement at issue, he/she had resigned from or ceased to act in the office, capacity, or relationship as described in the registration statement and had so advised the SEC; or (2) that the false or misleading portion of the registration statement became effective without his/her knowledge, and that, upon becoming aware that the registration statement had become effective, he/she gave public notice that the registration statement had become effective without his/ her knowledge.³³ Additionally, any defendant may avoid liability upon proof that he/ she reasonably believed, after appropriate investigation, that the statements in the challenged registration statement were indeed true and accurate and did not omit any material information.³⁴ Where the challenged part of the registration statement was made on the authority of an expert (such as an accountant), a defendant (other than the person on whose authority the statement was made) will avoid liability upon proving that "he had no reasonable ground to believe and did not believe, at the time such part of the registration statement became effective, that the statements therein were untrue, or that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading."³⁵ The standard of reasonableness required for the Section 11(b)(3) defenses is "that required of a prudent man in the management of his own property."³⁶

[2] Section 12(a)(2) of the Securities Act—Civil Liabilities Arising in Connection with Prospectuses and Communications

Section 12(a)(2) of the Securities Act³⁷ permits a purchaser of a security to seek damages and other relief from the seller where the purchase and sale were procured by means of a prospectus or oral communication that contains an untrue statement of material fact or omits a material fact.³⁸

[a] Overview of a Section 12(a)(2) Claim

As with claims under Section 11 relating to false and misleading statements or omissions in a registration statement, a Section 12(a)(2) plaintiff must prove that the challenged prospectus contains a false or misleading statement of material fact or that it omits a material fact necessary to make a statement not misleading. A plaintiff need not...