Chapter 15 - § 15.4 •SECTION 12(A)(2)

• Jurisdiction: Colorado

§ 15.4 •SECTION 12(A)(2)

Section 12(a)(2) of the 1933 Act provides a cause of action against any person who offers or sells a security using the jurisdictional means "of a prospectus or oral communication" that includes a material misstatement or omission. The elements for a claim against a plaintiff that allegedly violated § 12(a)(2), other than the required jurisdictional allegations, are:

• Plaintiff purchased a security, and
• Defendant offered or sold a security
• By means of a prospectus or oral communication,
• Which included an untrue statement of a material fact or omitted 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.¹²

Section 12(a)(2) applies only to offers and sales of securities "by means of a prospectus" and does not require scienter or fraudulent intent. Investors who purchase stock on the secondary market cannot state an actionable claim,¹³ even when the sellers on the secondary market are principal shareholders of the issuer.¹⁴ Also, unlike 10b-5 claims, § 12(a)(2) does not require reasonable reliance by the purchaser.

§ 15.4.1—There Must Be A Seller

The term "seller" is not restricted to the persons who directly pass title to the purchasers. The U.S. Supreme Court applied this interpretation under § 12(a)(1) in Pinter v. Dahl,¹⁵ discussed above. The Southern District of New York applied the same interpretation to § 12(a)(2) in In re Chaus Securities Litigation.¹⁶ There, the court said that "seller" under a firm commitment underwriting not only included the underwriter, but also the issuer and other principals participating in the offering. The court said, however, "[M]ere collateral participants who sign a registration statement, and thus would be proper § 11 defendants, could not be liable under § 12 unless they also satisfied the definition for statutory seller."¹⁷

In Cortec Industries, Inc. v. Sum Holding, L.P.,¹⁸ the court held that § 12(a)(2) liability can fall on parties who successfully solicit a purchase motivated by a desire to serve their own interests or those of the securities owner.

1933 Act Rule 159A (effective December 1, 2005) makes it clear that, in the SEC's view, the term "seller" in § 12(a)(2) includes the issuer when engaged in "a primary offering of securities of the issuer, regardless of the underwriting method used." This rule was adopted to address the view of a small minority of courts that required privity between the seller and the purchaser for there to be liability — meaning that the issuer in some offerings would not be liable under § 12(a)(2).¹⁹ While the SEC's view as expressed in Rule 159A is not binding on the courts, it is likely to be persuasive in most, if not all, cases.

§ 15.4.2—A Lender As A Seller

There are circumstances in which plaintiffs have brought a legal action under § 12(a)(2) against the person that loaned the funds necessary to make the investment. When the investment failed, the plaintiff found that it had to repay the loan, and sought to void the obligation by alleging securities fraud against the lender. In Davis v. Avco Financial Services, Inc.,²⁰ an agent for the lender introduced customers to the investment opportunity. The court found the lender liable when it adopted the "proximate cause" theory of § 12(a)(2) liability — i.e., when § 12(a)(2) includes as potential defendants not only the actual seller of securities, but also those people "whose efforts were a 'substantial factor' in the sale of the securities" or when the lender was a "driving force" in the offering.²¹

On the other hand, when the lender merely performs as a lender, there likely will be no primary or secondary liability.²² A bank that financed an allegedly fraudulent limited partnership formed to engage in oil and gas exploration was not held liable as a seller under § 12(a)(2); in that case, the bank did not actively participate in the solicitation of investors.²³ In Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Penner & Smith, Inc.,²⁴ investors issued promissory notes to a general partner, and those notes were used to secure loans. The general partner assigned its rights under the notes to a third party who guaranteed the loans. When the investor defaulted on the notes because of allegations of fraud in the investment, the guarantor sued on the notes and the investors defended, alleging violations of §§ 12(a)(2) and 10(b) of the 1934 Act. The court found no evidence of any control or agency relationship between the guarantor and the general partner and, therefore, denied the investors' defenses.

In Ryder International Corp. v. First American National Bank,²⁵ the Eleventh Circuit denied liability when the bank did not solicit purchases of commercial paper, but merely acted as agent for the plaintiff who purchased the paper. The court expressly rejected the plaintiffs' argument that the bank was a "substantial factor" in the transaction and, therefore, should be held liable. The same district court has held that an underwriter, or an entity that controls the immediate seller of the security, may be liable as a seller under § 12(a)(2).²⁶

§ 15.4.3—Were The Securities Offered And Sold By A Prospectus?

Before Gustafson v. Alloyd Co., Inc.,²⁷ most courts had determined that § 12(a)(2) applied to private offerings as well as to public offerings.²⁸ In Gustafson, however, the U.S. Supreme Court held that the plaintiffs could not sue under § 12(a)(2) because the private sales contract did not qualify as a prospectus, and § 12(a)(2) liability "cannot attach unless there is an obligation to distribute the prospectus in the first place (or unless there is an exemption)."²⁹ Gustafson points out that there is no prospectus delivery obligation in private placements or secondary transactions because "the word 'prospectus' is a term of art referring to a document that describes a public offering of securities."³⁰ The Supreme Court concluded that "[t]he intent of Congress and the design of the statute require that 12(a)(2) liability be limited to public offerings."³¹ As a result of Gustafson, it is clear that § 12(a)(2) does not apply to private offerings of securities.³²

In Anegada Master Fund, Ltd. v. PXRE Group Ltd.,³³ qualified institutional buyers (QIBS) (as defined in Rule 144A) purchased securities in a private placement offering from PXRE Group, a reinsurance company that suffered substantial losses as a result of Hurricane Katrina. The plaintiffs alleged that PXRE Group made misleading statements about the Katrina losses in the private placement documents, and that the private placement documents constituted a prospectus for the purposes of 1933 Act § 12(a)(2). In an effort to avoid the Gustafson analysis, the plaintiffs noted that PXRE has completed a simultaneous public offering of a different security, and that the public and private offerings should be integrated — thereby causing the private placement documents to be considered a "prospectus" notwithstanding Gustafson. The court found integration to be inappropriate in this case because of the limited number and sophisticated nature of the QIBs and the different securities involved (common stock to the public and non-voting preferred to the QIBs). Because the offerings were not integrated and a prospectus was not involved, the court dismissed the § 12(a)(2) claim.

§ 15.4.4—There Must Be A Material Misstatement Or Omission

One of the elements of § 12(a)(2) is that the offer and sale of a security must have been accomplished with an untrue statement of a material fact or an 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. Rule 159(a)³⁴ makes it clear that, for the purposes of § 12(a)(2), in determining whether the offering documents contain a material misstatement or omission, information provided after the time of sale of the security will not be taken into account. Rule 159(c) goes on to provide that "knowing of such untruth or omission in respect of a sale" means the person knowing the relevant facts at the time of the sale — not based on subsequent information.

Allegations under § 12(a)(2) must be pled with particularity,³⁵ and the Second Circuit holds that the PSLRA pleading standards apply: the complaint must plead facts resulting in a strong inference that the alleged false or misleading statements were made with actual knowledge of their falsity.³⁶

In order to maintain a cause of action under § 12(a)(2), plaintiffs reliance on the fraudulent statement is not necessary. In Sanders v. John Nuveen & Co., Inc.,³⁷ the court held that the plaintiff could maintain a § 12(a)(2) action even though he may have never seen the challenged communication. There must, however, be a causal relationship between the fraudulent misstatement or omission and the transaction. Examples of this "causal relationship" include when dissemination of the statements in question affects the market or offering price...