Securities Litigation under the Securities Act of 1933 and the Securities Exchange Act of 1934 - Venture Capital

• Author: Sundeep Patel
• Position: Business litigation associate with Colley Godward Kronish LLP
• Pages: 07

Sundeep Patel is a business litigation associate with Colley Godward Kronish LLP. Mr. Patel received his J.D. magna cum laude from American University Washington College of Law.

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Introduction

Venture capital is a type of private equity capital typically provided to smaller, high-potential, companies in the interest of generating a large return through an eventual realization event such as an initial public offering (“IPO”) or sale of the company.¹ Venture capital investments generally exchange cash for shares in the invested company.²

The venture capital industry has played a significant role in the growth of the U.S. economy.³ Venture capital is widely accepted as an important process in the nurturing of entrepreneurs and the establishment and growth of start-up firms.⁴ Venture capital provides enterprises with a life-line—the cash that they need to grow.⁵ Because so many of these companies offer innovative products and services, venture capitalists perform a vital function for the economy: allocating funds, through expert selection and management, in order to bring the most promising inventions to life.⁶ Since start-up companies lack an established operating record, standard commercial sources of financing are typically unavailable.⁷ Because of this, entrepreneurs seek the assistance of venture capital to obtain financing for their start-up companies.⁸

… venture capitalists perform a vital function for the economy: allocating funds, through expert selection and management, in order to bring the most promising inventions to life.

The primary objectives of U.S. securities laws, as administered by the Securities and Exchange Commission (“SEC”), “are to protect investors and ensure that securities markets are fair, efficient, and transparent.”⁹ The Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”) allow the SEC to create rules to protect investors.¹⁰ The primary purpose of both the Securities Act and the Exchange Act is to ensure that institutions that offer securities provide full and fair disclosure to the investing public.¹¹ The Securities Act requires that such disclosure be made in the registration statement that a company must file with the SEC as part of the company’s public offering process.¹² Pursuant to Section 5 of the Securities Act, it is unlawful to sell or offer to sell any security unless a registration statement has been filed with and declared effective by the SEC or unless the transaction is exempt from the registration requirements.¹³ The Exchange Act requires full and fair disclosure for companies engaged in securities trading and requires periodic reporting by registered companies.¹⁴ Such companies are traditionally ones that are publicly traded on exchange markets like the New York Stock Exchange and the NASDAQ.¹⁵

Litigation

Securities laws govern the methods of raising capital for business purposes. The federal securities laws, specifically the Securities Act and the Exchange Act, have traditionally been problematic for established public companies and their major institutional investors.¹⁶ Once considered untouchable, venture capitalists are finding themselves increasingly embroiled in litigation relating toPage 24 their business activities. Plaintiffs’ lawyers are increasingly using the federal securities laws to go after venture capital funds. This is usually because of the increased participation of venture capital funds in financing public companies, and the increased importance of private transactions in the financial marketplace.¹⁷ Venture capital firms and their general partners have been sued for fraud, breach of contract and securities law violations relating to their firm’s investments in, or dealings with, portfolio companies. This article offers examples of the types of emerging litigation involving venture capital firms brought under the Securities Act and Exchange Act.

The Exchange Act requires full and fair disclosure for companies engaged in securities trading and requires periodic reporting by registered companies.

Securities Act Liability

One of the most common lawsuits relating to the Securities Act is the allegation that a company and its directors have made material misstatements in the company’s prospectus and registration statement. A venture capital manager who served as a director of a company at the time the company went public may be liable for material misstatements included in the company’s prospectus and registration statement. In Warman v. Overland Data,¹⁸ several venture capital funds that had representatives serving on the board of Overland faced allegations in a class action that alleged that the company’s IPO prospectus and registration statement were false and misleading. The court denied the defendants’ motion to dismiss because the court did not believe the funds were in substantial control of the company through their representatives.¹⁹ In In re Stac Elec. Sec. Litig.,²⁰ several members of the Stac board faced allegations that Stac did not...