By Michael Nordskog, Senior Writer, Practitioner Insights - Securities on WestlawNext
We often associate securities law violations with media villains like Bernie Madoff and petty fraudsters who use Ponzi schemes and other deceptions to prey on investors. But the statutes, regulations, and common law that govern a company's obligations to shareholders also have broad implications for corporations, LLCs, limited partnerships, and their principal figures.
While investor contributions to an enterprise are a key source of capital for growth and stability, along with a company's issuance of securities comes a host of obligations involving financial reporting, fiduciary duties, and disclosures of news both good and bad. Securities law claims can involve a range of players, from the Securities and Exchange Commission, hedge funds, and sprawling classes of aggrieved shareholders to rogue investors with a particular axe to grind. On the inside, the company itself, its board of directors, or key executives can be named as defendants and roped into high-stakes complex litigation that can take years of expense, effort, and distraction to resolve.
The ramifications range from civil penalties, injunctions, and bad press to multi-million-dollar class action judgments that can affect a company's bottom line or even imperil its ongoing existence by thwarting a critical merger or other strategies to move a company forward.
From simple promissory notes to complex credit-default swaps, the instruments that allow a company to raise operating funds or hedge against future risk are also formal relationships with legally protected parties on the other end. Corporate legal departments of all sizes should have a sound understanding of the key attributes of federal and state securities claims to ensure that internal policies and practices are in place to identify pitfalls and insulate a company from liability before accusations arise.
Much of the statutory authority for filing securities lawsuits derives from the Securities Act of 1933, the Securities Exchange Act of 1934, and many subsequent amendments such as those provided by 2010's Dodd-Frank Wall Street Reform and Consumer Protection Act. This Top Ten examines ten securities-related civil claims that can affect most types of companies:
1. Fraud claims under Section 10(b) of the Securities Exchange Act of 1934.
Section 10(b) gives shareholders a private right of action to seek damages for securities fraud. These cases frequently allege that a company and key figures made false statements or withheld information that, when revealed to the market, caused a significant drop in the company's stock price. Section 10(b) suits are commonly pursued as class actions to allow all similarly affected shareholders to recover for the resulting loss of value. Executives and board members can also be subject to control-person liability under Section 20(a) of the Act even if they did not themselves have direct knowledge of the fraud.
2. Fraud claims involving inadequate control of accounting practices.
A subspecies of Section 10(b) fraud claims involves investor accusations that a company falsely represented it had adequate control over its financial reporting before accounting revelations led to a revenue downgrade or other adverse development. Shareholders who suffered losses through ill-timed trades during a bumpy period in a company's stock-price history may then pursue damages while casting a broad net through the class certification process.
3. SEC charges of fraud in financial reporting.
The SEC can also take action under Sections 10(b) and 13(b) of the Exchange Act based on alleged wrongdoing such as manipulation of information submitted in 10-K filings or failing to maintain adequate internal accounting controls. In addition to civil penalties and other relief, the Commission may seek to bar individuals who are found guilty from acting in the future as officers or directors of any company that issues registered securities.
4. Insider trading claims under Section 17(a) of Securities Act of 1933.
While SEC enforcement actions generally name only those individuals accused of insider trading as defendants, the resulting scandal can adversely affect a company's reputation, remove key figures from the company roster, and lead to unwanted attention from the SEC, the U.S. Department of Justice, and the media. Allegations that a company insider used material, nonpublic information to sell or purchase stock for their own benefit or to tip off friends or associates can also be the subject of civil litigation under Section 20A of the Exchange Act by investors who purchased the same stock.
5. Claims seeking injunctions to halt proxy votes under Section 14 of the Exchange Act.
Shareholders can sue to enjoin companies from conducting shareholder votes regarding mergers and acquisitions, tender offers, executive compensation, corporate governance, stock splits, and other issues. Typical cases involve allegations that the proxy statement fails to provide adequate financial information to allow for a merger vote, unacceptably condenses complex issues into a single question or contains false representations.
6. Cases involving IPO registration statements and prospectuses under Sections 11 and 12(a)(2) of the Securities Act.
After a company goes public or issues a new class of stock, investors have a private right of action regarding allegedly untrue or misleading information provided prior to the initial public offering or a subsequent offering. These cases, frequently filed as class actions, may allege that the IPO registration statement or prospectus hid previous adverse financial information, failed to reveal negative trends, or otherwise deceived the market with material misinformation. Claims involving stock offerings frequently implicate the investment banks that underwrote the offering in addition to the issuing company.
7. SEC fraud actions under the Foreign Corrupt Practices Act of 1977.
Companies with offshore operations are subject to the FCPA through the anti-bribery provisions of Section 30A of the Exchange Act, which prohibit public companies from making, offering or promising illicit payments to foreign officials to influence their official acts or decisions. The FCPA also applies to accounting for foreign transactions under Section 13(b) of the Exchange Act, as well as foreign companies accused of making corrupt payments in the U.S. Companies accused of FCPA violations are subject to disgorgement of ill-gotten profits as well as civil and criminal fines.
8. "Derivative" actions alleging breach of fiduciary duty and other wrongs.
Derivative actions have nothing to do with the complex financial instruments that have become popular in recent decades. Rather, they are suits filed by shareholders on behalf of a company to compel certain actions from its board of directors or seek damages for the company from parties who profited at its expense. Shareholders who seek to seize the reins of a company's litigation rights must show that they demanded action from the board and were refused or that demand would have been futile due to conflicts of interest or other factors. Such cases typically allege poor oversight, self-interested dealings, or financial mismanagement, and depend on common-law claims such as breach of fiduciary duty, corporate waste or negligence. The Delaware Court of Chancery is a frequent forum for derivative actions due to the popularity of its laws of incorporation, but these cases can also arise in any other state where a company is incorporated.
9. Claims alleging inadequate consideration for shareholders in a proposed merger.
Another mainstay of the Delaware state court and another type of shareholder action typically based on the common law is claims alleging shareholders will be shortchanged in a pending merger or acquisition. These cases apply equally to companies that seek to go private through a cash buyout and those being absorbed by larger corporations through a stock swap. In addition to the target company, key executives and directors who stand to benefit from the deal, as well as an acquiring company or investment fund, can be named as defendants. Plaintiffs frequently allege that the fairness of the deal is belied by the company's growth potential or other valuation factors and also often claim that deal protection devices in the purchase agreement unfairly limit the board's ability to consider superior offers. If timely, these suits often seek an injunction to halt the deal.
10. Claims under various state's "Blue Sky" laws.
While the vast majority of securities litigation takes place in federal courts, investors and state regulators can also take action under state securities laws that protect investors from fraudulent sales practices and other activities. The colorful term is often attributed to U.S. Supreme Court Justice Joseph McKenna, who used the phrase in a 1917 opinion with respect to "speculative schemes which have no more basis than so many feet of 'blue sky.'" Most states' Blue Sky laws are based on the Uniform Securities Act of 1956 and tend to apply to brokerage firms and investment advisers, but they also generally have registration requirements for companies seeking to make offerings and sales in a particular state. To the extent that a claim could be filed as a class action, securities fraud suits under state law have been preempted by federal law.
Conclusion
This list should provide in-house counsel with a basic understanding of the risks their companies face and the legal mechanisms through which securities laws operate. Counsel should also take note that other types of claims exist and the listed examples can also apply to activities and alleged wrongdoing not contemplated by this article. Just as important, securities laws, particularly on the regulatory level, are as changeable as the seasons, and staying abreast of the finer points is the job of a dedicated securities law practitioner.
