The Standard for Claims of Aiding and Abetting Securities Fraud

Section 20(e) of the Securities Exchange Act of 1934 allows the SEC, but not private litigants, to bring civil actions against aiders and abettors of securities fraud. The SEC may bring such an action against “any person that knowingly or recklessly provides substantial assistance to another person in violation of a provision of this chapter." 15 U.S.C. § 78t(e). Similarly, the Missouri Securities Act provides under Section 409.6-604 that the Commissioner may bring an enforcement action against a person who has materially aided, is materially aiding, or is about to materially aid an act, practice, or course of business constituting a violation of the Act.

There are no Missouri cases addressing the aiding and abetting liability under the Missouri Securities Act. However, “Missouri courts have often looked to cases decided by courts from other jurisdictions to aid in comprehending the definitional limitations of the [Missouri Securities] Act, particularly when the language of the federal and state securities statutes involved is nearly identical.” Moses v. Carnahan, 186 S.W.3d 889, 904 (Mo. App. W.D. 2006) (finding that the Missouri Securities Commissioner was justified in looking to federal cases interpreting the federal Securities Acts in construing the meaning of the term “offer” as contained in the Missouri Uniform Securities Act).

The only Eighth Circuit case to directly address aiding and abetting liability under § 20(e) of the Securities Exchange Act is S.E.C. v. Shanahan, 646 F.3d 536 (8th Cir. 2011). In that case, the court noted that to establish aiding and abetting liability , the SEC must prove (1) a primary violation of the securities laws; (2) “knowledge” of the primary violation on the part of the alleged aider and abettor; and (3) “substantial assistance” by the alleged aider and abettor in achieving the primary violation. Id. at 547 (citing K & S P'ship v. Cont'l Bank, N.A., 952 F.2d 971, 977 (8th Cir.1991), cert. denied, 505 U.S. 1205, 112 S.Ct. 2993, 120 L.Ed.2d 870 (1992)). The court also stated that “[n]egligence ... is never sufficient,” and “a bare inference that the defendant must have had knowledge” of the primary violator's transgressions is insufficient. Id. The Eighth Circuit found that the SEC failed to make its case against an outside director of a corporation because it failed to prove “knowledge” of the corporation's alleged primary violations.

In a footnote, the court noted that Section 20(e) had recently been amended to include liability for “any person that ... recklessly provides substantial assistance to another person in violation of a provision of this chapter." See Dodd–Frank Wall Street Reform and Consumer Protection Act, Pub.L. No. 111–203, § 929O, 124 Stat. 1376, 1862 (July 21, 2010), codified at 15 U.S.C. § 78t(e). However, this amendment was not applicable to the appeal before the court.

There have been no reported cases located which have addressed the "recklessly" providing substantial assistance element of an aiding and abetting claim. However, it is generally understood that reckless conduct means that the actor realized or should have realized there was a strong probability his conduct would cause the injury. It follows that "recklessly" providing substantial assistance would, at the least, amount to providing substantial assistance in situations where the actor should have realized a primary violation of the securities laws.  This of course lowers the bar for what the SEC must plead and prove in order to make a claim for aiding and abetting.

The SEC has also been aided by recent court decisions interpreting the "substantial assistance" element of an aiding and abetting claim. In S.E.C. v. Apuzzo, 689 F.3d 204 (2d Cir. 2012) cert. denied, 133 S. Ct. 2855 (U.S. 2013), the district court had found that the SEC had not adequately alleged substantial assistance.  Specifically, the court held that “the [C]omplaint contains factual allegations which taken as true support a conclusion that there was a ‘but for’ causal relationship between Apuzzo's conduct and the primary violation, but do not support a conclusion that Apuzzo's conduct proximately caused the primary violation.” Concluding that such proximate causation was required to satisfy the “substantial assistance” component of aider and abettor liability, the district court granted the motion to dismiss.

The Second Circuit found that in the context of an enforcement action by the government, where the goal is deterrence and not compensation, proximate cause is too stringent a standard to apply.  Instead, to satisfy the substantial assistance element, the SEC must allege and prove facts sufficient to show that a defendant “in some sort associate[d] himself with the venture, that he participate[d] in it as in something that he wishe[d] to bring about, [and] that he [sought] by his action to make it succeed.”  Id. at 206.  As such, the Second Circuit reversed the decision of the district court.

The Dodd-Frank amendment and the Apuzzo decision reflect enhancements to the SEC’s ability to bring aiding and abetting claims against individuals who assist in carrying out a fraudulent scheme.  Arguably a claim can now be brought even if an individual did not have actual knowledge of the primary violation and even if the individual's actions do not result in direct harm.

North Carolina Plaintiffs and Connecticut Defendants End Up in Southern District of New York Due to Presence of New York Attorney Co-Defendant

The law firm of Cosgrove Law, LLC has already counseled one client regarding the investment adviser activities of James Tagliaferri and his TAG Virgin Islands, Inc. (“TAG”). Another TAG client, Matthew Szulik, brought a federal suit in the Eastern District of North Carolina in 2010 on behalf of a number of family trusts. The suit alleged that, among other things, TAG and Tagliaferri, as well as a TAG managing director by the name of Patricia Cornell, committed violations of the U.S. Investment Advisers Act, the North Carolina Investment Advisers Act, the 1934 Act and breach of fiduciary duty. The Complaint also included three claims against a New York attorney that advised TAG and drafted investment documents, including a civil conspiracy claim. In a nutshell, the Complaint alleged that TAG made self-serving and inappropriate investments with the Szulik's trust funds, including investments in Protein Polymer Technologies shares and a race horse through International Equine Acquisition Holdings. According to the Eastern District's opinion, 2012 WL 8 44662 (E.D. NC, March 12, 2012), the Plaintiffs also alleged that they had evidence that TAG received illegal undisclosed kickbacks for the equine investments.

The contractual advisory relationship between TAG and the Plaintiffs was based upon an Investment Management Agreement with a Connecticut choice-of-law provision executed in Connecticut and North Carolina. TAG's office was in Connecticut before it relocated to St. Thomas. None of the transactions or representations at issue took place in New York. The New York attorney and the TAG Defendants moved to dismiss the Complaint on jurisdictional, venue, and 12(b)(6) grounds.

In an opinion that I found to be an excellent, if not belated, law school refresher, Eastern District Chief Judge Dever carefully walked through a succinct analysis of the rules and principles of federal court jurisdiction and venue. In doing so, he concluded that, while the Eastern District federal court possessed personal jurisdiction over the TAG Defendants and venue in the Eastern District was proper for them as well, it lacked both general and specific personal jurisdiction over the New York attorney. But according to Judge Dever, the federal court in Manhattan possessed such jurisdiction. And venue there was proper as to all of the Defendants pursuant to the less utilized 28 USC 1391(b)(3). As such, he ordered the transfer of the entire case pursuant to 28 USC Section 1404.

So the next time your investment adviser spends your money on a race horse or uses it for loans secured by property in Mexico City—you might ask him where his attorney's office is located. Food for thought.

The Supreme Court Reaffirms Total Mix Test for Materiality

The U.S. Supreme Court adopted the position urged by the SEC’s amicus brief, affirming its traditional test of materiality in 10b-5 actions in Matrixx Initiatives, Inc., v. Siracusano on March 22, 2011. The unanimous ruling rejected the petitioner’s contention that there should be a bright-line test for materiality in a securities fraud suit, a position that the Court also previously rejected in Basic Inc. v. Levinson.

The complaint alleges that Matrixx made false statements in 2003 about a cold remedy nasal spray, Zicam. The statements publicized the success of the nasal spray, which made Matrixx increase its earning guidance based on increased Zicam sales. However, the company had information from multiple sources showing that the nasal spray could cause loss of smell.

After several product liability suits had been filed, Matrixx continued to state that Zicam was safe and that none of the clinical trials supported findings that the nasal spray caused loss of smell. After an FDA investigation report was released, Matrixx’s share price dropped.

The District Court dismissed the original complaint holding that a pharmaceutical company is not required to disclose such reports unless they are statistically significant—consistent with precedent in the Second Circuit. However, the Ninth Circuit Court of Appeals reversed concluding that the statistically significant test was contrary to the test for materiality set forth by the Supreme Court in Basic and TSC Industries, Inc v. Northway, Inc.. In TSC and Basic, the Court articulated the “total mix” test, which sets the threshold for materiality as satisfied when there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available."

The Supreme Court affirmed the Court of Appeals, holding that “the materiality of adverse event reports cannot be reduced to a bright-line rule. Although in many cases reasonable investors would not consider reports of adverse events to be material information, respondents have alleged facts plausibly suggesting that reasonable investors would have viewed these particular reports as material.” Namely, that Zicam is Matrixx’s key product.

In its reasoning, the Supreme Court again rejected adopting a bright-line approach. Arguments in favor of a bright-line rule are based on the idea that statistical significance is the only indication of causation. However, the Court stated that lack of statistically significant data does not mean that medical experts have no reliable basis for inferring a causal link between a drug and adverse events. The Court concluded that investors may utilize a similar approach: considering context, not just statistical significance for determining causation. Similarly, the question of materiality is based on a contextual inquiry.

In Matrixx, the Court held that the total mix standard for materiality was met because Matrixx received information and reports that indicated a plausible causal link between Zicam and loss of smell. The court held this is sufficient to meet materiality at the pleading stages.

THE SEC PROPOSES TO EXPAND MUNICIPAL SECURITIES DISCLOSURE

During recent years, more and more individual investors have entered into the municipal securities market. Particularly troublesome has been the noticeable discrepancy between the information disclosed to investors in municipal securities and the information available to corporate securities investors. Accordingly, on July 17, 2009, the SEC issued a proposal to amend the current municipal securities disclosure requirements provided under Rule 15c12-12 of the Securities Exchange Act of 1934.

The proposed amendments would serve five main functions, including:

(1) Requiring a broker, dealer or municipal securities dealer to reasonably determine that the issuer or obligated person has agreed to provide notice of specified events in a timely manner;

(2) Amending the list of events for which a notice is to be provided;

(3) Modifying the events that are subject to a materiality determination before triggering a notice to the MSRB;

(4) Revising an exemption from the rule for certain offerings of municipal securities with put features; and

(5) Providing interpretive guidance intended to assist municipal securities issuers, brokers, dealers and municipal securities dealers in meeting their obligations under the antifraud provisions.

Chairman Mary L. Schapiro summarized the likely impact the proposed amendments would have by explaining that they would “help investors make more knowledgeable investment decisions about municipal securities, while at the same time enabling broker-dealers to satisfy their obligations.”

Public comments on the SEC’s most recent proposal are due September 8, 2009.

CORPORATE GOVERNANCE MAY SOON GO UNDER THE MICROSCOPE

The latest in a wave of SEC proposals aimed at helping protect investors from more financial turmoil focuses on company disclosures during the proxy process. Under the SEC's newest consideration, corporate officers and directors would no longer be able to govern blindly at the risk of their shareholders. Instead, these governing bodies would be forced to disclose more detailed information in a more timely fashion to ensure that shareholders had the information necessary to make informed decisions during the proxy process.

The SEC's goal is not to provide additional disclosures, but rather to compel better disclosure in three specific proxy-related disclosure areas:

(a) Executive compensation—seeking better disclosure regarding the relationship between executive compensation policies and company risk;

(b) Director and nominee qualifications—seeking better disclosure regarding individuals' qualifications for board membership; and

(c) Board governance—seeking better disclosure as to a board's leadership structure and risk management role.

The SEC also wants to improve proxy voting disclosure by requiring more timely disclosure of annual meeting voting results. These considerations would inevitably increase transactions costs and thereby cost companies more money. However, the SEC feels that shareholders, as owners of these companies, have a right to proper disclosure by companies who are charged with managing their investments.

In addition, on July 1, 2009, the SEC issued a proposal to amend the proxy rules under the Securities and Exchange Act of 1934 to implement specific requirements for companies subject to Section 111(e) of the Emergency Economic Stabilization Act of 2008. Specifically, the proposed amendments would require that any companies receiving monetary relief under the Troubled Asset Relief Program (“TARP”) must permit a shareholder vote to approve executive compensation during the time period in which the company's TARP obligations remain outstanding. The SEC's proposal explains that “the proposed amendments are intended to provide useful, comparable and consistent information to assist an informed voting decision when registrants that are TARP recipients present to investors the advisory vote on executive compensation required pursuant to Section 111(e)(1) of the EESA.”

To read the proposed rule in its entirety, click here.