Securities Act - Liability

Section 12(a)(2)• Due care defense• “by means of prospectus”

(last updated 16 Feb 11)

What is liability for deception outside RS?

§ 12(a)(2)

Any person who … offers or sells a security

(whether or not exempted by the provisions of  section 3 of this act, other than paragraph (2) of subsection (a) of said  section), …

by means of a prospectus or oral communication,

which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading 

(the purchaser not knowing of such untruth or omission),

and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission, ....

shall be liable, subject to subsection (b) of this section, to the person  purchasing such security from him [for rescission] ...

Compare this to 10b-5, §11 and §12(a)(1) liability …

Rule 10b-5 §11 §12(a)(1) §12(a)(2)

Transactional nexus

“icw” purch/ sale security

Part of RSViolation of

§5“by means of prospectus”

PlaintiffPurchaser or

sellerPurchaser (tracing)

Purchaser Purchaser

Defendant Primary violatorList (I, Ds, Os, UWs, expert)

“statutory seller”

“statutory seller”

(1) Material misrepresentation

Pl BOP (or duty to speak)

Pl BOP (or omission)

n/aPl BOP (or omission)

(2) ScienterPl BOP (facts /

strong E)Def BOP (“due

diligence”)n/a

Def BOP (not know, due care)

(3) ReliancePl BOP (unless

FOM)Def BOP (Pl

“knew”) *n/a !!!

“by means” / Pl not know

(4) CausationPl BOP (prox

cause)Def BOP

(“other than”)n/a

Def BOP (“other than”)

(5) DamagesPl BOP (O/P or

rescission)Rescission (up to offering $)

Rescission Rescission

Court FederalFederal or

stateFederal or

stateFederal or

state

Limitations 2 yrs + 5yrs 1 yr + 3 yrs 1 yr 1 yr + 3 yrs

Sanders v. John Nuveen & Co (7th Cir 1980)

Your client John Nuveen & Co. is an established securities firm in Chicago that often underwrites offerings of commercial paper -- short-term, promissory notes issued by solid companies.

Nuveen is considering selling commercial paper of Winter & Hirsch, a consumer finance company.

Does “paper” issue have to be registered?

John Nuveen & Co.(underwriter)

Winter & Hirsch(Issuer)

Commpaper

Investors

§ 3 Classes of Securities under Title

(a) Exempted securities. Except as hereinafter expressly provided, the provisions of this title shall not apply to any of the following classes of securities: …

(3) Any note, draft, bill of exchange, or banker's acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited;

What about reliance/causation and culpability?

§ 12(a)(2)

Any person who … offers or sells a security (whether or not exempted by the provisions of  section 3 of this act, other than paragraph (2) of subsection (a) of said  section), … by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission, ....

shall be liable, subject to subsection (b) of this section, to the person  purchasing such security from him [for rescission] ...

W&H defaults - its financials were wrong. What does "by means of a prospectus or oral communication" mean?

(1)  Is it relevant that John Nuveen issued commercial paper reports that repeated much of the false W&H financial information?

(2)  Is it relevant that many of the purchasers of the W&H paper had never read these reports?

How might causation be shown?

John Nuveen & Co.(underwriter)

Winter & Hirsch(Issuer)

Commpaper

Investors

Your client says it has some info on Winter & Hirsch -- enough to establish a "due care" defense?

(1)  Banks have extended W&H lines of credit -- indicating they believe the finance company is solid.

(2)  W&H's financial were audited by a reputable accounting firm and showed healthy accounts receivables, low debt.

What would be required under Section 11 due diligence?

John Nuveen & Co.(underwriter)

Winter & Hirsch(Issuer)

Commpaper

Investors

What is “by means of prospectus or oral communication”?

Gustafson v. Alloyd Inc. (US 1995)

The Gustafsons own Alloyd Inc and sells all their shares to a venture capital company, Wind Point Partners. 

Wind Point paid Gustafsons $18 million, plus another $2 million subject to adjustment in light of actual earnings during the current year. When actual earnings are figured, Wind Point is owed $800,000.

What does Wind Point ask for?

GustafsonWind Point

Partners

Alloyd Inc

K

100%owner

§ 12(a)(2)

Any person who … offers or sells a security (whether or not exempted by the provisions of  section 3 of this act, other than paragraph (2) of subsection (a) of said  section), … by means of a prospectus or oral communication, which includes an untrue statement of a material fact … shall be liable, subject to subsection (b) of this section, to the person  purchasing such security from him [for rescission] ...

Meaning?

§ 10 Information required in prospectus

   (a) Information required in registration statement; documents not required.

(1) a prospectus relating to a security … shall contain the information contained in the registration statement …

§ 2 Definitions

(a) Definitions. When used in this subchapter, unless the context otherwise requires--

  (10) The term "prospectus" means any prospectus, notice, circular, advertisement, letter, or communication, written or by radio or television, which offers any security for sale …

“We begin with § 10. … Section 10 does not provide that some prospectuses must contain the information contained in the registration statement. Save for the explicit and well-defined exemptions for securities listed under § 3 (exempting certain classes of securities from the coverage of the Act), its mandate is unqualified: "a prospectus ... shall contain the information contained in the registration statement."

Justice AnthonyKennedy

On the other hand, accepting Alloyd's argument that any written offer is a prospectus under § 12 would require us to hold that the word "prospectus" in § 12 refers to a broader set of communications than the same term in § 10. …

In the name of a plain meaning approach to statutory interpretation, the dissents discover in the Act two different species of prospectuses: formal (also called § 10) prospectuses, subject to both §§ 10 and 12, and informal prospectuses, subject only to § 12 but not to § 10. Justice Anthony

Kennedy

Alloyd's contrary argument rests to a significant extent on § 2(10), …. The word "communication," however, on which Alloyd's entire argument rests, is but one word in a list, a word Alloyd reads altogether out of context. … The constructional problem is resolved by the second principle Alloyd overlooks, which is that a word is known by the company it keeps (the doctrine of noscitur a sociis).

In sum, the word "prospectus" is a term of art referring to a document that describes a public offering of securities by an issuer or controlling shareholder. The contract of sale, and its recitations, were not held out to the public and were not a prospectus as the term is used in the 1933 Act.

Justice AnthonyKennedy

Your grade of

the majority opinion …

Gustafson v. Alloyd Inc. (US 1995)The dissenters …

Justice StephenBreyer

Justice Ruth Bader Ginsburg

Justice AntoninScalia

Justice ClarenceThomas

Hypothetical #1

Gertrude wants to sell her company. She distributes a private placement memorandum to many potential buyers -- it contains all the data of a typical public offering "prospectus."  

Gertrude finds a buyer (or many buyers), who find inaccuracies in the memo. Can they rescind under § 12(a)(2)?  What if the offering is an exempt “small offering” under Reg A?

Buyer

Buyer

Buyer

Buyer

Buyer

Buyer

Gertrude(seller)

Hypothetical #2

Allyne Corp., a reporting public company, issues new common shares to the public.  It files a 1933 Act registration statement.

• Its underwriter White & Watson sends customers a favorable (but false) newspaper clipping about Allyne – a “free writing prospectus.”  § 12(a)(2) liability?

• White & Watson sales reps call customers and quote the same favorable (but false) newspaper clipping about Allyne.  § 12(a)(2) liability?

Public offering

Underwriter

Customers

Falseoral

statement

False free

writing

Allyne(issuer)

The end