Let's be frank: the future direction of controlling person liability remains uncertain.

AuthorBednarz, Michael A.

"The explicit authority under Dodd-Frank to use control person liability under the Exchange Act may encourage further expansion of this theory of liability to attempt to cover those who are simply 'around' a violation or where a violation occurs within their chain of command." (1)


    In the wake of the Great Depression, Congress enacted the Securities Act of 1933 (1933 Act) and the Securities Exchange Act of 1934 (1934 Act). (2) Together, the Acts provide the Securities and Exchange Commission (SEC) with broad authority over the securities industry, and institute methods for holding those who commit securities fraud liable. (3) Section 15 of the 1933 Act and section 20(a) of the 1934 Act establish controlling person liability, a mechanism for establishing secondary liability against corporate directors and officers for securities fraud committed by their subordinates. (4) Section 15 of the 1933 Act merely permits controlling person liability to be pursued if very limited types of securities fraud have been committed. (5) As a result, pursuing a controlling person liability claim under section 20(a) of the 1934 Act has historically been both the SEC and private litigants' preferred course of action as it broadly allows for secondary liability to be attached to any underlying security claim within the Act. (6)

    While drafting both Acts, Congress consciously refrained from defining the term "control" because it believed that courts could effectively apply the term depending on the given facts of a case. (7) Therefore, varying standards of controlling person liability have evolved throughout the judicial system, including within federal circuit and district courts. (8) Recently, in continuing efforts to protect investors, Congress has enacted a substantial piece of legislation that may help shed light on the inconsistent application of controlling person liability: the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). (9)

    In recent history, circuit courts have been split as to whether the SEC has authority to utilize 1934 Act section 20(a) controlling person liability within its enforcement actions. (10) Section 929P(c) of Dodd-Frank addresses this issue, clarifying that the SEC has authority to bring actions founded on section 20(a) controlling person liability. (11) Nevertheless, the controlling person liability issue may remain at the forefront of securities litigation as the SEC seeks to hold corporate officers and directors secondarily liable under section 20(a). (12)

    This Note examines Dodd-Frank's potential effect on the current state of the law regarding controlling person liability. (13) Part II.A provides a review of the legislative history of the 1933 and 1934 Acts and their respective controlling person liability sections. (14) Part II.B discusses the varying judicial interpretations and confusion surrounding sections 15 and 20(a) controlling person liability. (15) Part II.C discusses both the implementation of Dodd-Frank and prior inconsistent views as to whether the SEC has the power to bring controlling person liability actions pursuant to section 20(a). (16) Finally, Part III examines the two controlling person liability standards--culpable participation and potential control--and suggests which of the two the SEC would likely find more equitable. (17)


    1. Statutory History of Controlling Person Liability

      In response to the stock market crash of October 1929, Congress adopted the Securities Act of 1933 and the Securities Exchange Act of 1934.18 Although the two acts serve the same general purpose--to discourage fraud and provide investors with adequate information--they regulate different activities within the securities market. (19) The 1933 Act primarily concerns the initial distribution process of securities, requiring entities seeking to issue securities to provide specific information to potential purchasers and the SEC. [20] In contrast, the 1934 Act created the SEC for the basic purposes of regulating the securities markets and affording remedies for fraud in securities trading. (21)

      The 1933 and 1934 Acts provide investors with legal recourse against persons who are primarily liable under the Acts, but Congress also expressly provided for secondary liability through the creation of section 15 of the 1933 Act and section 20(a) of the 1934 Act controlling person liability. (22) one of Congress's primary motives for providing secondary liability in the form of the controlling person provisions was to curb corporate directors from using "dummies"--employees who commit fraud at the direction of their superiors--in an effort to avoid liability. (23) A secondary violator of the securities statutes or rules either supports or assists the primary violator, or can be found liable simply due to his or her relationship with the violator. (24) Conversely, primary violators of the securities laws personally commit the act prohibited by rule or statute; however, especially in modern complex securities markets, violations rarely occur in such a simple manner. (25) Because Congress expressly provided for secondary liability in section 15 of the 1933 Act and section 20(a) of the 1934 Act, controlling person liability is the sole means of holding secondary security violators liable in private actions. (26)

      Section 15 of the 1933 Act provides:

      Every person who, by or through stock ownership, agency, or otherwise, or who, pursuant to or in connection with an agreement or understanding with one or more other persons by or through stock ownership, agency, or otherwise, controls any person liable under sections 77k or 77l of this title, shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlling person had no knowledge of or reasonable ground to believe in the existence of the facts by reason of which the liability of the controlled person is alleged to exist. (27) Further, section 20(a) of the 1934 states:

      Every person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable ... unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action. (28) Each section provides controlling persons with an affirmative defense. (29) Nevertheless, despite varying language, courts often interpret section 15 of the 1933 Act and section 20(a) of the 1934 Act interchangeably. (30)

      When drafting the controlling person provisions of the 1933 and 1934 Acts, Congress believed it undesirable to define the term "control," opting to allow courts to define it on a case-by-case basis. (31) As a result, the meaning of controlling persons and the application of its affirmative defense remains uncertain. (32) Seeking guidance, courts often look to the definition of control provided by the SEC. (33) The SEC defines control as "the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise." (34) Despite the SEC's definition of control, some courts interpret what constitutes control in their own capacity. (35)

    2. Varying Judicial Interpretations of Controlling Person Liability

      1. Potential Influence Standard

        Due to section 20(a) of the 1934 Act's broader liability purview, affirmative defense, and application to both the 1934 Act's 10(b) antifraud provision and Rule 10b-5, it is litigated more frequently than section 15 of the 1933 Act. (36) When determining whether a defendant is a controlling person, most circuits apply the two-part analysis developed by the Eighth Circuit in Metge v. Baehler. (37) Commonly referred to as the potential influence test, courts generally focus on whether the defendant had the potential to, or actually did, control the primary violator. (38) In order to label the defendant as a controlling person, the potential influence test requires the plaintiff to prove that the defendant "actually participated in ... the operations of the corporation in general ... [and] that the defendant possessed the power to control the specific transaction or activity upon which the primary violation is predicated, but he need not prove that this latter power was exercised." (39)

        The Sixth Circuit closely follows the Eighth Circuit's potential influence test established in Metge. (40) In Sanders Confectionery Products, Inc. v. Heller Financial, Inc., the Sixth Circuit found it unnecessary to choose between the different tests established in other circuits. (41) Nonetheless, Senior Circuit Judge Engel ultimately applied the two-part Metge analysis because it is the least rigorous of the controlling person standards. (42) Ultimately, the plaintiff failed to establish that the defendant met the first prong of the test because he did not demonstrate that the defendant actually exercised control over the operations of the business entity. (43)

        As evidenced in Harrison v. Dean Witter Reynolds, Inc., (44) the Seventh Circuit has also elected to apply the potential influence test provided by the Eighth Circuit in Metge. (45) Unlike many of the other circuits, the Seventh expressly rejected the minority culpable participation standard--a stricter standard requiring plaintiffs to show that the controlling person was a culpable participant in the underlying securities fraud. (46) The Seventh Circuit established that the concept of control almost always means the ability to "direct the actions of the people who issue or sell the securities." (47) The court reasoned that the culpable participation standard defied Congress's...

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