Monday, December 14, 2009
CHAPTER FIVE: SOME OBSERVATIONS
CHAPTER FOUR: FRAUD AND CONFUSION: FRAUD BY PROXY
Eight years ago I authored an article that dealt with the Fraud by Proxy concept. The issue considered was whether the manufacturers of silicone breast implants could be held liable for misrepresenting to the physician community that their product would last a lifetime. Lawyers for these manufacturers argued that their clients made no misrepresentation directly to the patient and therefore could not be guilty of fraud. The article states: AThe argument I believe is specious for at least two reasons. First, the representations made by the manufacturer to the doctor were certainly intended to be passed on to the patient as a sales tool. Second, the doctor was clearly the agent of the manufacturer in making these representations to the patient although some courts characterize the doctor as the agent for the patient. In Barrow, Judge Fawsett states with absolute clarity: "The fact that MEC made the misrepresentations, and omitted material information in its representations, to Plaintiff's physician and not directly to plaintiff does not preclude recovery by the plaintiff against MEC for such misrepresentations and omissions." Barrow v. BMS and MEC, 1998 U.S. Dist. Lexis 23187 (M.D. Fla 1998). The court cites Albertson v. Richardson ‑ Merrell, Inc., 441 So.2d 1146 (Fla. Dist. Ct. App. 1983), in support of its conclusions, and Albertson is directly in point. There a detail man represented the safety of the product (Bendectin) to the doctor, not the patient, and the court stated that the manufacturer and the detail man could be held liable to the patient since the purpose of the misrepresentations was to encourage the physician to prescribe the drug for his pregnant patients. Id. at 1150. The Florida court in Albertson, in turn, cited with approval, Wechsler v, Hoffman ‑ La Roche, 99 N.Y.S. 2d 588 (N.Y. Sup. Ct. 1950), affirmed as modified, 108 N.Y.S. 2d 990 (N.Y. Ct of App. 1951). In that case the trial court adopted two reasons for imposing liability. First, the court said as a matter of policy the manufacturer should be liable in fraud. Second, the court said that liability would be imposed because the doctor was acting for the patient and, therefore, a fraud upon the doctor was a fraud upon the patient. The Albertson court also relied upon two Texas cases in imposing liability for fraud. Crocker v. Winthrop Laboratories, 514 S.W. 2d 429 (Tex. 1974); Bristol‑Myers Co. v. Gonzales, 561 S.W. 2d 801(Tex. 1978). Crocker, however, involved only product liability under 402A and indirect misrepresentations under 402B. Gonzales, is the same. Nevertheless, the analogy between 402B and fraud is pretty compelling. Indeed, as far back as 1890, the Supreme Court of Texas adopted the commissioners' statements: "As a general proposition, it may be correct, as contended by appellant, that a misrepresentation made to one person, and not with a view of revealing another, cannot be available to another who may have acted on it***. But it is sound doctrine that a third person to whom they were not directly made, can maintain an action for deceit, and seek cancellation of the contract made by him, if it appears that the defendant's false representations were made with a direct intent that he should act upon them in a manner which occasioned the injury." Gainesville Nat. Bank v. Bamberger, 13 S.W. 959 (Tex. 1890). While this case is cited in Tex. Jur. 3rd, it does not appear in any reported case I can find where this particular issue was involved. (**CORRECTION ** There were subsequent cases citing Bramberger for the purpose of establishing liability of a fraudfeasor to creditors for providing a false information to a credit reporting companies like Dun & Bradstreet. See Thomas v. Fitts‑Smith Dry Goods Co., 151 S.W.2d 243 (Tex Civ. App. Amarillo 1941, no writ); Schwartz v. Mittenthal, 50 S.W. 182 (Tex Civ. App. 1899, no writ); In Re J. S. Patterson & Co., 125 F. 562 (N.D. Tex. 1903). There was, however, a case involving an accounting firm providing a fraudulent audit to a county agency which was relied on by a bonding company in issuing a surety bond to that agency. See American Indemnity Co. v. Ernst & Ernst, 106 S.W. 763 (Tex Civ. App. Waco 1937, writ ref’d). But the case was decided on limitations, not on the merits. And see Hawkins v. The Upjohn Co., 890 F.Supp. 601 (E.D. Tex 1994) where false information provided the FDA was relied on by a doctor in prescribing a drug that caused harm to a patient of the doctor. Obviously, the search engine I utilized in shepardizing Bramberger was inadequate or else I was.) The spirit of the case, can be found in Cook Consultants, Inc. v. Larson, 700 S.W. 2d 231(Tex, Civ. App. ‑ Dallas 1985), where a surveyor who negligently misrepresented certain boundaries was held liable to a down the line purchaser. The court's extensive analysis of this cause of action is certainly instructive. Id. at 234 ‑ 236. Westcliff Co. v. Wall, 267 S.W.2d 544 (Tex 1954) does not hold to the contrary. There an eavesdropper brought suit for fraud, and no recovery was permitted. The court cited Cooley on Torts: "No one has a right to accept and rely upon the representations of others but those to influence whose actions they were made." Id. at 546. By implication, at least, if the misrepresentations were made for the purpose of influencing a doctor and his patient to act upon them, a cause of action will stand. On the other hand, the Dallas Court of Appeals quoted the same section of Cooley on Torts to find that a misrepresentation by an insured to obtain a life insurance policy was not a wrongful act as to an insurer which reinstated the policy after the first company was put into receivership. See First State Life Co. v. Stroud, 120 S.W. 2d 491(Tex. Civ. App.‑ Dallas 1938). That was a venue case in which no act of any kind, much less a wrongful one, occurred in the county where suit was sought to be transferred. So, I suppose, the holding was dicta, or at least an alternative holding not necessary to a decision in the case. On what finger the current Texas Supreme Court may balance the issue is debatable. But if 402B embodies a cause of action irrespective of` fault for indirect representations, it is not a leap in logic to permit the imposition of liability for grossly negligent or fraudulent conduct.” Ravkind, SCIENCE ON TRIAL ‑ THE SILICONE SYMPHONY, Toxic Reporter (Fall 1999) (Reprinted MedVersant.Com: http://www.pahealthsystems.com/archive349 2005 8 513218.html (2005))
So, let’s take a look at what finger the Supreme Court balanced the issue. The facts in Ernst & Young are a bit convoluted. In 1987 Ernst & Young audited RepublicBank’s financial statement for year ending December 31, 1986, and issued an unqualified opinion which was incorporated in RepublicBank’s 10‑K filed with the SEC. Then in June 1987 RepublicBank merged with Interfirst. The Plaintiff, Pacific Mutual, after the merger purchased, from third‑parties, $8.5M of the notes Interfirst had issued in 1982 relying on the financial strength of RepublicBank as shown in the audited financial statement. Shortly thereafter RepublicBank (now First RepublicBank) filed for bankruptcy, and the notes became virtually worthless. Pacific Mutual sued Ernst & Young asserting that the accountant intentionally and/or negligently misstated the financial position of Republic in the audit and violated GAAP by failing to reveal that it was not an independent auditor (several partners in Ernst & Young had outstanding loans from RepulicBank). The Court first holds that Texas law does not require privity between the fraudfeasor and the damaged party to support a fraud claim, citing Bramberger and American Indemnity Co v. Ernst & Ernst, 106 S.W.2d 763 (Tex.Civ.App ‑ Waco 1937, writ ref’d). So far so good. But this holding concerning privity could well open the flood gates of litigation and drown persons or companies in Ernst & Young’s position, and the Court felt it necessary to stick a finger in this hole in the dike. Thus the Court adopted the restrictive language contained in the Restatement B the fraudfeasor must intend or have reason to expect that a non‑privity party will rely on the misrepresentation and Areason to expect” means that the fraudfeasor has information that would lead a reasonable person to conclude that there is an especial likelihood that the misrepresentation will reach those persons and will influence their conduct. Ernst & Young, 51 S.W. 3d at 580. Further, the Court held that reliance must be justified and that the plaintiff must sustain a loss in a transaction the fraudfeasor intends to influence or have reason to expect such influence will occur; although the transaction need not be identical to the one contemplated by the fraudfeasor. Ibid. The Court then examined the summary judgment evidence and concluded that plaintiff’s experts provided evidence of industry knowledge or expectation but that evidence established only foreseeability which was insufficient to prove Areason to expect” in the context of fraudulent conduct. Ibid.
It is difficult to fault the Court’s reasoning except in one respect discussed later. But the question remains what type of evidence is sufficient to meet the standard. Certainly, the phrase Aespecially likely” doesn’t provide much of a clue.
Obviously the act of the accountant in intentionally misstating a company’s financial condition, as in Ernst & Young, is different from the acts of a manufacturer in misstating the characteristics of its product as in Crocker and Gonzales, but it is not all that much different from an individual giving false financial information to a credit agency as in Bramberger, and is virtually the same as an accountant providing a fraudulent audit to its client that caused a bonding company to issue a surety bond to that client as in American Indemnity Co. v. Ernst & Ernst. The issue is one of “legal cause,” which Judge Cardoza’s opinion in Palsgraf v. Long Island R.R. Co., 162 N.E. 99 (N.Y. Ct of App 1928), established as the tether holding ”negligence in the air” within reasonable boundries. The concept raises a question of law that the courts resolve in many cases, and it sets the outer limits for causation when dealing with negligent acts. “Legal cause” has seldom been an issue of interest, however, when the courts have dealt with intentional acts. Three years after Palsgraf, Cardoza authored Ultramares Corp. v. George A Touche & Co., 255 N.Y. 170 (N.Y. Ct of App), a case quite similar to American Indemnity. There the accountant had signed off on a financial statement that was relied on by a factor in extending credit to the company. Plaintiff, the factor, alleged that the audit had been conducted negligently and/or fraudulently and sought to recover the loss it suffered when the company became insolvent. The court refused to authorize the negligence claim:
The assault upon the citadel of privity is proceeding in these days apace. How far the inroads shall extend is now a favorite subject of juridical discussion (Williston, LIABILITY FOR HONEST MISREPRESENTATION, 24 Harv. L. Rev. 415, 433; Bohlen, Studies in the Law of Torts, pp. 150, 151; Bohlen, MISREPRESENTATION AS DECEIT, NEGLIGENCE OR WARRANTY, 42 Harv. L. Rev. 733; Smith, LIABILITY FOR NEGLIGENT LANGUAGE, 14 Harv. L. Rev. 184; Green, Judge and Jury, chapter Deceit, p. 280; 16 Va. Law Rev. 749). In the field of the law of contract there has been a gradual widening of the [***20] doctrine of Lawrence v. Fox (20 N. Y. 268), until today the beneficiary of a promise, clearly [*181] designated as such, is seldom left without a remedy (Seaver v. Ransom, 224 N. Y. 233, 238). Even in that field, however, the remedy is narrower where the beneficiaries of the promise are indeterminate or general. Something more must then appear than an intention that the promise shall redound to the benefit of the public or to that of a class of indefinite extension. The promise must be such as to "bespeak the assumption of a duty to make reparation directly to the individual members of the public if the benefit is lost" (Moch Co. v. Rensselaer Water Co., 247 N. Y. 160, 164; American Law Institute, Restatement of the Law of Contracts, ' 145). In the field of the law of torts a manufacturer who is negligent in the manufacture of a chattel in circumstances pointing to an unreasonable risk of serious bodily harm to those using it thereafter may be liable for negligence though privity is lacking between manufacturer and user (MacPherson v. Buick Motor Co., 217 N. Y. 382; American Law Institute, Restatement of the Law of Torts, ' 262). A force or [***21] instrument of harm having been launched with potentialities of danger manifest to the eye of prudence, the one who launches it is under a duty to keep it within bounds (Moch Co. v. Rensselaer Water Co., supra, at p. 168). Even so, the question is still open whether the potentialities of danger that will charge with liability are confined to harm to the person, or include injury to property (Pine Grove Poultry Farm v. Newton B. P. Mfg. Co., 248 N. Y. 293, 296; Robins Dry Dock & Repair Co. v. Flint, 275 U.S. 303; American Law Institute, Restatement of the Law of Torts, supra). In either view, however, what is released or set in motion is a physical force. We are now asked to say that a like liability attaches to the circulation of a thought or a release of the explosive power resident in words.
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Liability for negligence if adjudged in this case will extend to many callings other than an auditor's. Lawyers who certify their opinion as to the validity of municipal or corporate bonds with knowledge that the opinion will be brought to the notice of the public, will become liable to the investors, if they have overlooked a statute or a decision, to the same extent as if the controversy were one between client and adviser. Title companies insuring titles to a tract of land, with knowledge that at an approaching auction the fact that they have insured will be stated to the bidders, will become liable to purchasers who may wish the benefit of a policy without payment of a premium. These illustrations may seem to be extreme, but they go little, if any, farther than we are invited to go now. Negligence, moreover, will have one standard when viewed in relation to the employer, and another and at times a stricter standard when viewed in relation to the public. Explanations that might seem plausible, omissions that [***34] might be reasonable, if the duty is confined to the employer, conducting a business that presumably at least is not a fraud upon his creditors, might wear another aspect if an independent duty to be suspicious [*189] even of one's principal is owing to investors. "Every one making a promise having the quality of a contract will be under a duty to the promisee by virtue of the promise, but under another duty, apart from contract, to an indefinite number of potential beneficiaries when performance has begun. The assumption of one relation will mean the involuntary assumption of a series of new relations, inescapably hooked together" ( Moch Co. v. Rensselaer Water Co., supra, at p. 168). "The law does not spread its protection so far" (Robins Dry Dock & Repair Co. v. Flint, supra, at p. 309).” Id at 180‑189
But the court had no difficulty in authorizing the fraud claim:
Our holding does not emancipate accountants from the consequences of fraud. It does not relieve them if their audit has been so negligent as to justify a finding that they had no genuine belief in its adequacy, for this again is fraud. It does no more than say that if less than this is proved, if there has been neither reckless misstatement nor insincere profession of an [***35] opinion, but only honest blunder, the ensuing liability for negligence is one that is bounded by the contract, and is to be enforced between the parties by whom the contract has been made. We doubt whether the average business man receiving a certificate without paying for it and receiving it merely as one among a multitude of possible investors, would look for anything more.
(2) The second cause of action is yet to be considered.The defendants certified as a fact, true to their own knowledge, that the balance sheet was in accordance with the books of account. If their statement was false, they are not to be exonerated because they believed it to be true. Hadcock v. Osmer, supra; Lehigh Zinc & Iron Co. v. Bamford, 150 U.S. 665, 673; Chatham Furnace Co. v. Moffatt, 147 Mass. 403; Arnold v. Richardson, 74 App. Div. 581). We think the triers of the facts might hold it to be false. **** In this connection we are to bear in mind the principle already stated in the course of this opinion that negligence or blindness, even when not equivalent to fraud, [*191] is none the less evidence to sustain an inference of fraud.” Id at 189‑193.
As so eloquently explained by Judge Cardoza, a fraud remedy should lie if an accountant makes a fraudulent misrepresentation he knows will reach a segment of the public and affect financial decisions. Thus, while a negligent word‑tort ceases to be the Alegal cause” of damages that were remote to the initial area of impact (those in privity or nearly so), the same was not true of damages from intentional word‑torts. That was clearly the enlightened law in 1932. How the Restatement and modern decisions found it necessary to protect fraudfeasors from the foreseeable effect of their conduct is certainly beyond the scope of this article.
Even less understandable is the concept advocated by numerous scholars and adopted by many courts that damages from negligent misrepresentations should be widely available to non‑privity parties. See Comment, THE CITADEL FALLS? ‑‑ LIABILITY FOR ACCOUNTANTS IN NEGLIGENCE TO THIRD PARTIES ABSENT PRIVITY: Credit Alliance Corp. v. Arthur Anderson & Co., 59 St. John's L. Rev. 348 (1985); Pace, NEGLIGENT MISREPRESENTATION AND THE CERTIFIED PUBLIC ACCOUNTANT: AN OVERVIEW OF COMMON LAW LIABILITY TO THIRD PARTIES, 18 Suffolk U. L. Rev. 431 (1984); Wiener, COMMON LAW LIABILITY OF THE CERTIFIED PUBLIC ACCOUNTANT FOR NEGLIGENT MISREPRESENTATION, 20 San Diego L. Rev. 233 (1983); Septimus, ACCOUNTANT'S LIABILITY FOR NEGLIGENCE ‑‑ A CONTEMPORARY APPROACH FOR A MODERN PROFESSION, 48 Fordham L. Rev. 401 (1979); Miller, PUBLIC ACCOUNTANTS AND ATTORNEYS, NEGLIGENCE AND THE THIRD PARTY, 47 Notre Dame Law. 588 (1972); Marinelli, Jr., THE EXPANDING SCOPE OF ACCOUNTANT'S LIABILITY TO THIRD PARTIES, 23 Case W. Res. 113 (1971); Comment, AUDITOR'S RESPONSIBILITY, 44 Wash. L. Rev. 139 (1968); Note, POTENTIAL LIABILITY OF ACCOUNTANTS TO THIRD PARTIES FOR NEGLIGENCE, 41 St. John's L. Rev. 588 (1967); Accounting Uniformity, 30 Law & Contemp. Probs. 898 (1965). Why a negligent act should result in broader liability than a fraudulent act is also beyond the scope of this article.
Texas courts, after initially embracing this pervasive concept for negligence misrepresentations (see Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co., 715 S.W.2d 408 (Tex App Dallas 1986, writ ref’d, n.r.e.) , have apparently now adopted the requirement contained in Restatement (Second) of Torts ' 552, that the fraudfeasor have actual knowledge of the limited class of recipients which will rely on the misrepresentation. See McCamish v. F. E. Appling Interests, 991 S.W.2d 787 (Tex 1999); Abrams Ctr. Nat'l Bank v. Farmer, Fuqua & Huff, P.C., 225 S.W.3d 171 (Tex App El Paso 2005, no petition).
At all events, the courts have experienced some difficulty in applying the Aespecially likely” standard.
In Prospect High Income Fund, et al v. Grant Thornton, LLP, 203 S.W.3d 602 (Tex App B Dallas 2006, petition pending), the court found it especially likely that bond investors would rely on Grant Thornton’s audit of Epic Resorts’ financial statement in which it also certified that Epic’s bank accounts, from which interest on the bonds was paid, was fully funded. According to the Dallas court Ernst & Young was distinguishable because the plaintiffs were already investors when the audit was issued. Id. at 612.
In Exxon Corp. v. Miesch, 180 S.W.3d 299 (Tex App B C.C. 2005, petition granted), the court found it especially likely that royalty owners and a lessee, Emerald Oil & Gas Co., L.P., would rely upon false filings made by Exxon with the Railroad Commission which related to the continued economic viability of certain oil wells. The court concluded that it was irrelevant that Emerald Oil & Gas Inc. did not exist at the time the false filings were made because it was especially likely that a subsequent lessee like Emerald would rely on the filings. If Prospect High Income Fund is correctly decided then this case seems likely to avoid reversal by the Supreme Court.
In Ameristar Jet Charter, Inc. v. Signal Composites, Inc., 2001 U.S. Dist Lexis 14020 (N.D. Tex 2001), a fraud remedy was authorized where the original manufacturer of certain airline parts were misrepresented in a sale to a parts supplier which resold them to the plaintiff, a subsequent user. There was, said the Magistrate, an especial likelihood that the user would rely to its detriment on the misrepresentations from the initial sale to the parts supplier. While this might be characterized as an Aindirect reliance” case, the nature of the misrepresentations was such that they continued after the initial sale.
In Great Plains Trust Co. v. Morgan Stanley Dean Witter & Co., 313 F3d 305 (5th Cir 2002), Morgan Stanley was retained by Allwaste, Inc., to provide it with a fairness evaluation of a merger with Philip Services Corp.. The retention agreement stated that the purpose of the evaluation was to inform Allwaste’s board of directors of the financial implications (fairness) of the proposed transaction. Plaintiffs were Allwaste debenture holders who were adversely affected by the merger. The Fifth Circuit had no difficulty in affirming a dismissal of the case. First, the Plaintiffs failed to put forward any compelling reason why the contractual limitations contained in the fairness opinion concerning its restricted use should not be enforced. Second, there was nothing to suggest that it was especially likely that the debenture holders would receive and rely on the fairness opinion. The fact that it may have been foreseeable that the Plaintiffs might receive the opinion and rely upon it was insufficient to satisfy the requirements of Ernst & Young.
In Mid States Development, LLC v. Fidelity National Title Insurance Co., 2001 U.S. Dist Lexis 15448 (N.D. Tex 2001), Fidelity provide several banks (interim finance lenders) with assurances about the financial where with all of Alliance Mining, Inc., to provide permanent financing for projects being constructed by their interim borrowers like Mid States. When Alliance was unable to fund the necessary permanent financing, Mid States was forced to obtain alternative permanent financing and sustained damages in the switch. There was some evidence that Fidelity knew that interim borrowers from the banks would receive and rely on those assurances, and the court concluded that this was sufficient to satisfy the especially likely standard. This case was cited by Judge Fish in the Admiral case, discussed below, but found inapposite.
In Marshall v. Kusch, 84 S.W. 3d 781(Tex App -- Dallas 2002, petition denied), the seller of property failed to advise the purchaser that the land was infested with anthrax virus. The original purchaser then conveyed the property to the plaintiff. The original seller knew that his purchaser would resell the property, but the subsequent purchaser was not afforded a fraud remedy when anthrax infected his livestock because he did not know of or rely on the misrepresentation. This is another “indirect reliance” case that did not pass muster.
In Admiral Ins. Co v. Heath Holdings USA, Inc., 2004 U.S. Dist Lexis 9211 (N.D. Tex 2004), Heath Holdings made misrepresentations to Caliber One Indemnity Company that caused it to issue an insurance policy. Admiral was an excess carrier which issued its policy of insurance based upon the fact that Caliber One had issued a basic policy to Heath. Summary judgment was granted on the ground that Admiral did not rely on the misrepresentation itself. Of course, this was a correct result under Texas fraud law as Aindirect reliance” does not create an actionable scenario. Judge Fish nevertheless points out the difficulty a plaintiff has in satisfying the especially likely standard in a direct reliance case. Quoting from Ernst & Young, 51 S.W. 3d at 581, he observes that Aeven an obvious risk that a third person will rely on a misrepresentation is not enough to impose liability.”(Slip opinion p. 22).
The phraseology referred to by Judge Fish was adopted verbatim by our Supreme Court from the Restatement comments, and it is this element that renders Ernst & Young an enigma wrapped in a mystery. How does it impact the requirement that it be especially likely that a non‑privity party will rely on a misrepresentation from the fraudfeasor? Frankly, this language can be applied to real life situations in one of two ways. It can mean that an objective risk that anyone would recognize (a foreseeability certainty) can never satisfy the especially likely requirement, or it can mean that even a subjective risk is insufficient unless the fraudfeasor knows (not just thinks) that reliance will occur. On the other hand it may well mean that fraud by proxy is an illusion except in situations where the fraudfeasor knows the ultimate recipient, knows he will rely on the misrepresentation, and intends such a result (although intent may be inferred).
From all appearances, Ernst & Young was a compromise decision. Justice O’Neill’s opinion is thorough and well reasoned, except for the “even an obvious risk” language. It seems probable (but not necessarily especially likely) that majority support for the opinion could not be mustered without this limitation. The Court declined to adopt ' 531 but did adopt the limiting language appended to that section. Certainly, no prior Texas case used this Restatement language to define the cause of action. The Supreme Court has granted the petition in Miesch and will likely grant the petition in Prospect High Income. Can we foresee an explanation? Maybe.
CHAPTER THREE: LIABILITY OF PROFESSIONALS UNDER THE STATE AND FEDERAL SECURITIES ACTS
From a historical perspective, hucksters, con men and thieves have been the backbone of the securities fraud industry. In the 80’s, however, CEO’s, bankers, brokers, accountants and lawyers were added to this list. State and federal regulators manned the trenches to protect the public against its willingness to believe in and invest with these pitchmen, and successful administrative and criminal prosecutions under state Blue Sky Laws[x] and the federally adopted Securities Act of 1933 (33 Act) [xi] and Securities Exchange Act of 1934 (34 Act),[xii] combined with the substantial damages available through private litigation, virtually assured that violators would be dealt with harshly. Even the Supreme Court’s 1976 decision in Ernst & Ernst v. Hochfelder,[xiii] requiring proof of scienter[xiv] (intent to deceive, manipulate or defraud) to support a federal cause of action under the 34 Act for misrepresentations or omissions in the purchase or sale of a security, did little to allay the perpetrators’ fear of civil lawsuits and administrative enforcement actions. Of course, the single greatest threat to corporate America and its operatives, bankers, brokers, lawyers and accountants was the “strike suit.” That was the name given the massive class action lawsuits that asserted securities law violations filed by professional plaintiffs[xv] through lawyers specializing in this form of coercion. Such a suit was usually generated when a company revealed in reports it was required to file with the SEC that it had been negligent or inattentive or had violated some rule of the SEC, resulting in a drop in its stock price. The unparalleled success of the tactic eventually led Congress to impose tort reform on this cottage industry. The legislative history of this reform legislation shows that Congress treated the professional plaintiffs and their lawyers as opportunistic gluttons.[xvi]
Federal causes of action for securities violations began their fall from grace in 1994, although some would argue that the fall actually began in 1988 with Pinter v. Dahl.[xvii] In that case the Supreme Court rejected the “substantial factor” and “proximate cause” tests to identify the persons who could be held liable as sellers of securities under the 33 Act.[xviii] In their stead the Court announced that to be a seller the person had to successfully solicit a sale of a security motivated at least in part by a desire to serve his own financial interest.[xix] Pinter, therefore, virtually eliminated third-party professionals (bankers, accountants and lawyers) as putative sellers under the 33 Act,[xx] although they remained potentially liable as aiders and abettors.[xxi] Then in 1994, the Court in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.,[xxii] decided that Section 10b of the 34 Act, 15 USCA '78j(b), that imposed liability on those who used misrepresentations or omissions Ain connection with”[xxiii] the sale or purchase of a security, did not permit the imposition of aider and abettor liability.[xxiv] The following term the Court in Gustafson v. Alloyd Co.[xxv] determined that Section 12(a)(2) of the 33 Act, 15 USCA '77l(a)(2), that imposed strict liability for misrepresentations in prospectus materials, applied only to the public sale of a security by an issuer or controlling shareholder. Central Bank of Denver and Gustafson were decided by a 5 to 4 vote of the Justices. Federal securities law was thus set on its new course by the slimmest of margins at the highest of levels.
Congress joined the steerage in 1995 with enactment of the Private Securities Litigation Reform Act of 1995 (PSLRA), [xxvi] that had as its purpose the elimination of the “strike suit,” and it placed significant compliance requirements on class actions that were based on federal law and filed in federal court. See 15 USCA '78u-4(a) and '77z-1(a). PSLRA was not limited, however, to federal securities cases filed as class actions. It also dealt with such cases generally, imposing an automatic stay of discovery if a Motion to Dismiss[xxvii] was pending (15 USCA '78u-4(b)(3)(B)); limiting joint and several liability (15 USCA '78u-4(f)); capping damage (15 USCA '78u-4(e)(1)); creating a safe harbor for forward looking projections (15 USCA '78u-5 and '77z-2); and enhancing the standards for pleading and proving fraud (15 USCA '78u-4(b)(1) and (2)). But PSLRA did not cure the problem. “Strike suits” could still be filed in state courts as long as the securities claims were not founded on the 34 Act’s prohibitions against misrepresentations and omissions.[xxviii] Congress cured most of this oversight in 1998 by enacting the Securities Litigation Uniform Standards Act of 1998 (SLUSA).[xxix] That legislation nullified state laws that authorized class actions in state law securities cases based upon misrepresentations and omissions and vested the federal courts with original and removal jurisdiction over a “covered class action” as well as individual state court suits if there were more than 50 potential class members or 50 individual plaintiffs, respectively, asserting misrepresentations or omissions in connection with the purchase or sale of a “covered security.” See 15 USCA '77p(f)(2) and '78bb(f).[xxx] In the mean time Congress enacted the National Securities Market Improvement Act of 1996 (NSMIA),[xxxi] that further insulated most securities transactions from state registration or regulatory requirements. These securities made immune by NSMIA were called “covered securities.” See 15 USCA '77r(b). So, when SLUSA was adopted two years later, this immunity for “covered securities” was extended to include state law class actions and multi-plaintiff litigation. Thus a “strike suit” alleging 34 Act or state law violations disappeared into the fog of securities lore. Whether a “strike suit” founded on the 33 Act will meet a similar fate, remains to be seen.[xxxii]
It is not clear that this wave of court decisions and legislation was responsible for the egregious conduct of Enron, WorldCom, Just for Feet, and the others. But all of the major business failures in the passed few years appear to involve misrepresentations or omissions made or joined in by brokers, accountants, lawyers, bankers and senior company operatives. Congress’ reaction to this state of affairs was the adoption of the Sarbanes-Oxley Act (SOA).[xxxiii] That legislation is examined in the last section of this article.
As pointed out above, federal law after 1976 required proof of scienter (intent to deceive, manipulate or defraud) to recover under the 34 Act for securities misrepresentations and omissions, and by 1994 it was becoming increasingly more difficult to comply with the pleading requirements of FRCP Rule 9(b).[xxxiv] The second part of PSLRA, the part not limited in application to just class actions, put two more graves in that procedural burial ground by directing that the plaintiff must plead with particularity the false statements complained of and also explain in detail what was misleading about those statements.[xxxv] See 15 USCA '78u-4(b)(1). In addition, if the legal claim required proof of intent or the like, the plaintiff had to plead all facts that “give rise to a strong inference” of that state of mind. See 15 USCA '78u-4(b)(2). Congress also directed in PSLRA that the federal courts must stay discovery in a securities case if a Motion to Dismiss was filed and permitted the trial court little latitude to authorize further discovery.[xxxvi] See 15 USCA '78u-4(b)(3). This pleading problem was heightened by the fact that a Motion to Dismiss pursuant to FRCP, Rule 12(6) (failure to state a claim), would normally be filed and evaluated before discovery was completed or even started in some cases. If a defendant were on its toes, a plaintiff would have to discover, if he could, the facts of the wrongful conduct without any assistance from judicial processes. One court went so far as to say: “The purpose of these provisions (was) to **** (provide) protection of the corporate defendants from plaintiffs’ counsel discovering their way into facts which could allow them to amend an initially frivolous complaint so as to state a claim.” See In re Transcrypt Intn’l. Sec. Litig., 57 F.Supp2d 836, 841(D. Neb. 1999). As a consequence, a plaintiff’s knowledge, real or imputed, might well be sufficient to initiate the statute of limitations under inquiry notice because of, for example, information available in a newspaper article but insufficient to survive a Rule 12(6), Motion to Dismiss.
For all of these reasons third party professionals like Arthur Anderson & Co. no doubt believed, or at least hoped, that they were reasonably immune to civil prosecutions by damaged investors proceeding under federal law.
There should be no surprise that by 1995 non-class action relief available under Blue Sky Laws had become more popular with plaintiffs.
The Texas version of the Blue Sky Laws is investor oriented.[xxxvii] Frequently it is said that federal laws require disclosure and state laws protect investors. The Texas Securities Act (TSA) attempts, or at least attempted, to do just that. The misrepresentation portions of the Act provide: “A person who offers or sells a security (whether or not the security is exempt under Section 5 or 6 of this Act) by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statement made, in light of the circumstances under which they are made, not misleading, is liable to the person buying the security from him, who may sue either at law or in equity for rescission, or for damages if the buyer no longer owns the security. However, a person is not liable if he sustains the burden of proof that either (a) the buyer knew of the untruth or omission or (b) he (the offeror or seller) did not know and in the exercise of reasonable care could not have known, of the untruth or omission.” TSA ' 33A(2), Tex.R.Civ.Stat., Art. 581-33A(2). The statute provides protection for investors by exempting from state registration requirements securities listed on a National Securities Exchange only if they “are of ascertained, sound asset or income value.” See TSA ' 6(F)(2)(3rd). Texas further requires that a company seeking to register its securities by notification (when there is no federal registration of the security) have more than “sufficient net income to pay specified interest or dividends or have net income equal to 5% of the market capitalization of the company computed by using the offering price of the security being issued to value all issued and outstanding shares.” See TSA ' 7B(1). If a security is to be registered by coordination (when it piggybacks a federal registration) the company must prove that its business plan is “fair, just and equitable.” See TSA ' 7C(2). NSMIA rendered impotent these merit safeguards when “covered securities” were involved. See 15 USCA ' 77r(a)(3).
While recovery under TSA is restricted to out of pocket (rescission) damages[xxxviii] a plaintiff need only show a material misrepresentation, or an omission to state material facts necessary to make the facts stated not misleading. TSA remedies are available to a purchaser as well as a seller if misled by a purchaser.[xxxix] In addition the Act permits recovery of costs, interest, and attorney’s fees. See TSA ' 33(D)(3). The latter is discretionary with the court, however. A defense of “knowledge” of the true facts is available to the defendant. That is, if the plaintiff knows the true facts, he cannot recover damages based upon the untrue representation. Similarly, a “lack of knowledge” defense is available if the defendant can show that he did not know the untruth of the statement and could not have learned of the untruth by the exercise of ordinary care.[xl] Scienter need not be shown; nor is it necessary for the plaintiff to prove that he relied on the misrepresentation in making the purchase or that he might have acted differently had he known the true facts.[xli]
Plaintiff is required to plead and prove that he qualifies as a “purchaser” under the TSA. The term is not defined, but the broad definition of a “sale” [xlii] has convinced most courts to liberally construe the term “purchaser” in identifying appropriate plaintiffs. See Summers v. WellTech, Inc., 935 S.W. 2d 228, 233 (Tex.App.-Houston[1st District] 1996, no writ).
The plaintiff must also show that the defendant was a seller. Once again the term is not defined in TSA, but the same liberalism that identified a purchaser has not been universally used to identify a seller. Indeed there are conflicting decisions in the Courts of Appeals and the Supreme Court. Under vintage case law, a “seller” could be anyone who participated as “a link in the selling process.” See Brown v. Cole, 291 S.W. 2d 704, 708 (Tex. 1956). A recent decision calls into question the continued vitality of that expansive concept of seller. See Frank v. Bear, Stearns & Co., Inc., 11 S.W. 3d 380, 383 (Tex.App.CHouston[14th District] 2000, review denied). The Frank court relied on certain interpretative “Comments” to the 1977 amendments of TSA, prepared by a State Bar subcommittee that was a co-sponsor of the legislation, to reach its conclusion that only the person making the sale to the purchaser could be held liable as a seller. A more recent decision, however, restates the holding in Brown v. Cole. See Tex. Capital Securities, Inc. v. Sandefer, 58 S.W. 3d 760, 765-766 (Tex.App.-Houston[14th] 2001, pet. denied)(Sandefer 1). The Sandefer 1 court does not cite Brown v. Cole to support its conclusion. Nor does the court cite Frank. The court relies on one of its own decisions from 1976, Rio Grande Oil Co. v. State, 539 S.W. 2d 917, 922 (Tex.App.-Houston[14th District] 1976, writ ref’d, n.r.e.). According to the Frank court the expansive concept of seller was amended out of the statute in 1977 when aider, abettor and control liability were added. The particular “Comment” relied on by the Frank court does, indeed, support a narrow interpretation of the term “seller.” It states that privity is now required between seller and purchaser. But this conclusion is clearly not supported by the statutory language. The Court in Brown v. Cole, supra, 291 S.W. 2d 704, 708, relied on the expansiveness of the definition of “sale” to conclude that the term “seller” must have a very broad meaning as well, and the definition of “sale” was not altered by the 1977 amendments and has not been changed as of today. Frankly, under the usual rules of statutory construction, adding another group of potentially liable persons doesn’t diminish the liability of those already included and doesn’t mean that a “seller” should now be restricted to those in privity with the purchaser. It is true that “Comments” were provided to the legislature with the final draft bill (Draft 12-November 21, 1976, as enacted) submitted by the State Bar subcommittee, and thus might be considered as “legislative history,” but the “Comment” in question was not included with the draft bill and does not qualify as such history. See Bromberg, Civil Liability Under Texas Securities Act ' 33 (1977) and Related Claims, 32 S.W. L.J. 867, 891 (1978). I would give the “Comment” in question the same weight I would give to a legal article published without being peer reviewed -- not much. When adopted by the Texas legislature the “Comments” stated that a “seller” was to be identified by reference to federal law, and the predominate federal view at that time was that a person who “proximately caused” a sale was considered a “seller.” Bromberg, supra, at 884-85. So, the Sandefer 1 court got it right, just not for the reasons expressed.
UnderTSA, third party professionals who aid and abet a violation can be held liable to the same extent as the seller, and those who control a violator are subject to liability as well. Just as in the case of a direct violation by a seller, a control person can escape liability by showing that he did not know of the activity that gave rise to the violation and could not have known of it by exercising ordinary care. TSA ' 33F(1). The courts have not accorded the same subjective/objective (knew or should have known) defense to an aider and abettor. The reason for this seemingly inconsistent result is the language in TSA that defines “aiding” liability. That language requires that the aider and abettor act with “intent to deceive or defraud or with reckless disregard for the truth or the law (that) materially aids a seller, buyer, or issuer of a security is liable *** jointly and severally with the seller, buyer, or issuer.” TSA ' 33F(2). The Texas Supreme Court recently held that “aiding liability” requires subjective (actual) awareness of unlawful conduct on the part of the primary violator, although the aider need not know the details of that conduct. See Sterling Trust Co. v. Adderley, 168 S.W. 3d 835 (Tex. 2005). The Court found the aider’s subjective knowledge of the “Ponzi” scheme being utilized by the primary violator would be sufficient to support a finding of aider liability, if the jury were properly instructed on the aider issue. Whether that “unlawful conduct” must itself constitute a securities law violation is apparently an issue for another day.[xliii]
Little Texas case law exists on the issue of control, and no definition of “control” is contained in TSA. State regulations have been adopted by the Commission that define “control” in the same language used in the federal regulations: “Control is the power to direct or influence the direction of the management or policies of a person, directly or indirectly, through the ownership of voting securities, contract or otherwise.” TAC Title 7, Part 7, Chapter 113, Rule '113.14(b)(7). The similar federal definition is at 17 CFR 230.405. A Texas case considering the control issue purported to rely on federal law in holding that “control” exists only if the person has the power to determine the activities and direction of the corporation, in general, and the power to influence the specific activities in question. See Frank v. Bear, Stearns & Co., supra, 11 S.W.3d at 384. That interpretation or adaptation of federal law is incorrect. See Ravkind, We New Wizards of Wall Street, 66 Tex. B. J. 120 (2003). Under federal law control can exist with considerably less power or influence. For example, control is generally thought to arise if a person owns 20% of the stock of a major corporation. See Order Approving Proposed Rule Change Relating to Shareholder Approval, Exchange Act Release No. 27035 (July 18, 1989). Logically a somewhat greater percentage of stock ownership would be needed to control a smaller entity. The SEC has proposed a rule providing that a person must own 10% of the shares of a company before an issue of affiliate (control) status would arise under Rule 144. See Proposed Rules, 62 FR 9246 (Feb. 27, 1997). That proposal has languished for eight years without action. Recently the SEC did adopt regulations that use 10% ownership as a threshold for determining affiliate (control) status for persons serving on the newly prescribed audit committees. See Final Rule: Standards Relating to Listed Company Audit Committee, SEC Release Nos. 33-8220, 34-47654, and IC-26001.[xliv] A number of commentators state that 10% stock ownership raises a presumption of control. But there is no support for that assertion except prior statements by other commentators. See Ravkind, supra, 66 Tex.B.J. at 128 note 32. A few Texas cases have struggled with the control issue. In Barnes v. SWS Financial Services, Inc., 97 S.W. 3d 759 (Tex.App.-- Dallas 2003, no pet.) a registered representative working at a brokerage firm (SWS) engaged in fraudulent practices in the sale of certain church bonds. The sales were not made through SWS, the firm had no knowledge of the transactions, and, indeed, SWS did not sell this type of security nor did it receive any share of the monies earned by its representative. The court first concluded that the firm did not need to participate in the culpable conduct in order to establish control liability and rejected this requirement that had been recently imposed by the Texarkana court in Tex. Cap. Sec. Mgmt., Inc. v. Sandefer.[xlv] (Sandefer 2). The court then looked to the criteria set forth by the Houston court in Frank, supra, 11 S.W. 3d at 382-84, and found that SWS did not control the specific activity in question. Thus the court concluded that SWS was not liable as a control person. Sandefer 2 at 765. The problem with the analysis is that the court’s conclusion is based upon factual matters relevant to whether SWS knew or should have known of the activity. Those facts establish a defense, and they should not be considered part of plaintiff’s burden to show a violation. In effect the court required the plaintiff to prove the absence of the defense, and that is virtually the same requirement imposed by the Sandefer 2 court that was rejected by the Barnes court earlier in its opinion. The Barnes court should have resolved the control issue using master-servant and agency considerations.[xlvi] Particularly relevant is Judge Hudspeth’s piercing analysis in Gonzalez v. Morgan Stanley Dean Witter, Inc., 2004 U.S. Dist. Lexis 26709 (W.D. Tex. 2004). He directs attention to G.A. Thompson & Co. v. Partridge, 636 F.2d 945 (5th Cir. 1981), where a 24% shareholder who served as a director and participated in the day to day activities of the company was found to be a “control” person. Importantly, the court cites with approval Dyer v. Eastern Trust and Banking Co., 336 F.Supp. 890 (N.D. Me. 1971). There the court found prima facia control status to exist where the individual was one of the twelve directors that controlled the corporate violator. Be that as it may, this concept of control has enormous possibilities as a tool in a security-plaintiff’s arsenal useable against third party professionals if the issue of control is determined by reference to federal law. This is so because federal law recognizes “control groups” as meeting the definition of control even though most of the individual members of the control group would not have sufficient power to influence conduct if they were not a member of the group.[xlvii] The Dyer decision referred to above is an excellent example of the concept. Stock ownership and employment by the company are not prerequisites to establish control under federal law. Liability of third parties based upon control is the subject of a recent ALR annotation.The annotation provides great detail about the divergent views of the various federal courts relating to the proof necessary to impose control liability. See Liability of Officer, Director, Employee, or other Individual Associated with Seller or Issuer of Securities as >Control Person’ under '15 of the Securities Act and ' 20(A) of the Securities Exchange Act, 183 A.L.R. Fed. 141 (2003). Control liability under the 33 Act (Securities Act), 15 USCA ' 77o, is different than such liability under the 34 Act (Securities Exchange Act), 15 USCA ' 78t(a); although the definition of control is the same, the defenses are different. The Texas “control” concept is virtually the same as the one provided by the 33 Act, and the defenses are the same. The 34 Act defense requires the controlling party to exercise “good faith.” This defense also requires proof that the controlling party did not induce, directly or indirectly, the acts that constitute the violation. The defenses under the 33 Act require proof that the controlling party did not know of the facts constituting the violation and had no reasonable cause to believe the existence of those facts. The statutory defense for control liability under Texas law is proof that the defendant did not know of the violation and could not have discovered it by exercising ordinary care. TSA ' 33F(1).
Corporate activities subject to control can be specifically defined, and different persons may well control different aspects of corporate life. One set of corporate officers may have responsibility for acquisitions. Clearly such officers would have considerable influence in evaluating merger possibilities. Another set of officers may have responsibility for financial reporting. Just as clearly these officers would have the ability to influence how various financial matters are presented. This financial group within the corporation would need cooperation from third-party accountants and lawyers in order to effectively control the improper reporting of financial matters, particularly if adverse financial information is being concealed from the Board of Directors. To date at least no securities case has been found that imposes liability on the third-party bankers, lawyers or accountants because of their membership and participation in the “control group,” although there are cases imposing non-group control liability on these professionals.[xlviii] Judge Harmon’s opinion in the Enron,[xlix] contains an exhaustive analysis of the factual allegations in the case and the applicable law. While I might quarrel with one or two of her conclusions about Texas securities law, her opinion is a superb, almost text book, exposition into this complex area of law. In Enron she finds that lawyers, accountants, and bankers may be subject to liability to investors as direct violators of Section 10(b) and Rule 10(b)-5, under the allegations in the consolidate complaint. Her rationale appears to incorporate “control group” concepts. Intentional or not, her discussion of the issues demonstrates that a group of persons acting together can achieve results not possible if their actions had been separate. None of the professionals did any actual selling of Enron stock, but the court found that their alleged activities “in connection with” such sales were sufficiently egregious to impose direct liability on them. At all events, it seems inevitable that an enterprising plaintiff will assert that bankers, accountants and lawyers are, indeed, part of a control group and liable along with the involved corporate officers.
From a federal standpoint, the question of the moment is whether the Sarbanes-Oxley Act (SOA) together with PSLRA will re-establish the fear of non-compliance that once upon a time was generated by the potential of a “strike suit.” At this time the answer has to be “no.” The reason is obvious. SOA creates the possibility of administrative prosecutions and even some criminal liability, but it does not create a private civil cause of action for damages against the perpetrators,[l] and one is not likely to be implied. See Bloomenthal, Sarbanes-Oxley Act in Perspective, pp. 134-136 (1st ed. 2002).[li] SOA does refer to disgorgement and does create new and enhanced civil penalties in actions initiated by the SEC. But disgorgement and, to a large extent, civil penalties relate to the profit made by the perpetrator not to the damages caused by the illegal acts. See SEC v. Blavin, 760 F.2d 706, 713 (6th Cir. 1985). Nevertheless the statute directs the SEC to use the collected funds to benefit the victims of the violations. See SOA Section 308(a), 15 USCA '7246(a). The term “victims” is not defined, nor are there any procedures in place to set up the fund or disperse the money. Further SOA provides no clue about the priority of any particular victim. If this sounds to us like an illusory remedy, just think how it sounds to a “victim.”
In SOA Section 308(c), 15 USCA '7246(c), the SEC was directed by Congress to study disgorgement and penalty cases concluded in the passed five years and report on the success and impact of these remedies. That report was filed on January 24, 2003.[lii] Congress also directed in SOA Section 703, 15 USCA '7201 Note, that the Commission study and report which group of securities professionals had committed the most violations in the passed five years. That report was also filed on January 24, 2003.[liii] The two reports show that securities brokers committed the highest percentage of violations (60%). Accountants committed 3.5% of the violations, lawyers 2.8%, and transfer agents 1.6%. The total dollar amount of disgorgement orders was $800,000,000, and $167,000,000 had been collected. Civil penalties amounted to $226,000,000 with $77,000,000 collected. Apparently the only monies that had been transferred to benefit a victim at that time were a payment to a bankruptcy trustee and a payment into two different class action funds ($11.6MM). The Report that is responsive to SOA Section 803c states that “most of the money returned to investors comes from the successful conclusion of actions filed in federal district court. Eighty-seven district court actions involving 358 defendants were reviewed *** (and) in 34 of these cases, payments totaling a little over one billion dollars were made directly to approximately 125,000 investors.” [liv] These numbers obviously do not jibe with the specific numbers reported[lv] and most likely include the results from private litigation.
It is noteworthy that PSLRA does not permit any of the funds collected by the SEC to be used to pay attorneys’ fees of private litigants seeking participation in the disgorged monies.[lvi] The purpose of this provision may simply be a final slap at lawyers or it may be intended to discourage private litigants who seek recovery of some of the money generated in the SEC’s litigation. Either way it clearly marks Congress’s current distaste for lawyers and private litigants. We lawyers are regular whipping boys when it comes time for legislative reform. The public seems to accept without question the proposition that “if it’s bad for lawyers it’s good for the country.” Our profession has historically withstood these tactics with a winsome shrug, knowing: “What goes around comes around.” In time it seems likely that the right to recover damages will be reinvested in those who have actually been damaged by the illegal acts, and lawyers will be called upon to render services to remedy the harm. Remember, the call for reform came from those committing fraud not those damaged by it, and those committing fraud are never disappointed that the imposed remedy is only modestly effective. The complaints about strike suits, professional plaintiffs, and their lawyers came from the companies that had committed violations and were being terrorized by that litigation. These bleeding hearts convinced Congress that strike suit allegations were without merit, but they had to cough up big money or else spend millions in defense. The premise that these companies would rather pay a large ransom than respond to discovery is, in a word, poppycock. Not one example of an innocent company being damaged by a strike suit can be found in the public record. Truth is that the companies paid the money to settle a case because their internal documents were so damning. Had unaltered Texas law applied to the DotCom IPO’s marketed in the late 90’s that generated such enormous profits for the issuers, affiliates, brokers, and investment bankers, not to mention the enormous losses suffered by the investing public, those frauds would have never left the starting gate.
ENDNOTES
[i]. The only successful SEC action that involves allegations against lawyers for their legal work is the 2DoTrade, Inc., scam. SEC-SAR Release 51218. However, Vinson & Elkins has been seriously implicated in the Enron civil lawsuits.
[ii]. See In re Enron Corporation Securities, Derivative & ERISA Litigation, 235 F.Supp.2d 549, 694-703 (S.D. Tex. 2002).
[iii]. See WorldCom’s Sworn Statement Pursuant to Section 21(a)(1). (www.sec.gov/news/wcresponse.html).
[iv]. SEC News Release 03-54. (www.sec.gov/news/press/2003-54.html)
[v]. D0J Release #283
[vi]. News.morningstar.com/news/DJ/M02/D25/200402251608DOWJONESDJONLINE001075.html
[vii]. SEC News Release 03-123. (www.sec.gov/news/press/2003-123.html).
[viii]. SEC News Release 03-16 (www.sec.gov/news/press/2003-16.html).
[ix]. See In re Enron Litigation, supra, 235 F.Supp.2d at 673 and at 676 Note 108.
[x]. Texas’ Blue Sky Law is Tex.Rev.Civ.Stat. Article 581-1, et seq.
[xi]. 15 USCA '77a, et seq.
[xii]. 15 USCA '78a, et seq.
[xiii]. 425 U.S. 185 (1976)
[xiv]. Section 10b of the 34 Act, 15 USCA '78j(b), and SEC Rule 10b-5, 17 CFR '240.10b(5), make no mention of scienter.
[xv]. See S. Rep. 104-98, 1995 USCCAN 679 at 683. The term is now defined by the limitations placed on a person who is a plaintiff in multiple class action cases. A person can act as lead plaintiff in no more than five federal class action cases in any three year time span. See 15 USCA '78u-4(a)(3)(B)(vi)
[xvi]. See S. Rep. 104-98, 1995 USCCA 679 at 687-689.
[xvii]. 486 U.S. 622 (1988)
[xviii]. These were clearly the tests used by of a great majority of the lower federal courts to identify a seller. See Hines v. Data Line Sys., Inc., 766 P.2d 1109 (Wash.App. 1989).
[xix]. 486 U.S. at 647.
[xx]. See Ackerman v. Schwartz, 947 F.2d 841, 845-846 (7th Cir. 1991).
[xxi]. E.g. W.O. Akin v. Q-L Investments, Inc., 959 F.2d 521 (5th Cir. 1992); Hines v. Data Line Sys., Inc., 766 P2d 1109 (Wash.App. 1989).
[xxii]. 511 U.S. 164 (1994).
[xxiii]. The phrase Ain connection with a sale” distinguishes and broadens liability under the 34 Act. The operative phrase in the 33 Act is Aa sale.” See McGann v. Ernst & Young, 102 F.3d 390 (9th Cir. 1996).
[xxiv]. The same rationale excludes aider and abettor liability under the strict liability provisions of the 33 Act. Aiding and abetting liability was revived in 1995 in PSLRA, but only in actions brought by the SEC or DOJ. No private remedy is authorized. See 15 USCA '78t(f)
[xxv]. 513 U.S. 561 (1995).
[xxvi]. PL 104-67, 1995 HR 1058.
[xxvii].The statute even provides its own Motion to Dismiss. See 15 USCA '78u-4(b)(3)(A). In addition the federal courts were authorized to enjoin discovery in any state court case if necessary to aid or protect its jurisdiction. See 15 USCA '78u-4(b)(3)(D).
[xxviii]. Claims under Section 10(b) of the 34 Act or Rule 10b-5 can only be pursued in federal court. See 15 USCA '78aa. Anomalously, claims under the 33 Act are not even removable to federal court. 15 USCA ' 77v(a).
[xxix]. PL 105-353, 1998 S. 1260.
[xxx]. SLUSA does not apply to class actions filed in the state of incorporation of the target company. See 15 USCA '78bb(f)(3)(A)(i).
[xxxi]. PL 104-290, 1996 HR 3005.
[xxxii]. See Zia v. Network, Inc., 336 F.Supp.2d 1306 (S.D. Fla. 2004); In re Tyco International Sec. Litig., 322 F.Supp.2d 116 (D. N.H. 2004); In re Waste Mgmt., Inc., Sec. Litig., 194 F.Supp.2d 590 (S.D. Tex. 2002). These cases hold that a 33 Act Astrike suit” is not removable. But see In re King Pharmaceuticals, Inc., 2004 U.S. Dist. Lexis 20222 (E.D. Tenn. 2004); Alkow v. TXU Corp., 2003 U.S. Dist. Lexis 7900 (N.D. Tex. 2003). These hold just the opposite.
[xxxiii]. PL 107-204 (2002).
[xxxiv]. This rule requires that fraud be pleaded with particularity. The pleading must state specifically the what, when, where, and by whom concerning the misrepresentation, and must explain why it is fraudulent. A failure to satisfy this pleading requirement makes the pleading subject to a FRCP, Rule 12(6), Motion to Dismiss. See e.g. Shields v. CityTrust Bancorp, Inc., 25 F3d 1124, 1127-1128 (2nd Cir. 1994).
[xxxv]. These requirements did not actually make the plaintiff’s burden more onerous than it already was.
[xxxvi]. The court can permit discovery only when Aparticularized discovery is necessary to preserve evidence or to prevent undue prejudice.” 15 USCA '78u-4(b)(3)(B). In Faulkner v. Verizon Comm., Inc., 156 F.Supp.2d 384 (S.D.N.Y. 2001), the court observed: AThe sole example proffered by Congress as to what justifies lifting the stay is the terminal illness of an important witness which might necessitate the deposition of the witness prior to ruling on the motion to dismiss.” Id at 402.
[xxxvii]. See Flowers v. Dempsey-Tegeler & Co., Inc., 472 S.W. 2d 112, 115 (Tex. 1971).
[xxxviii]. See TSA ' 33D.
[xxxix]. Texas is one of the few states that allows a recovery to a seller if he is duped by a purchaser. See TSA '33B.
[xl]. Only a buyers knowledge of the Atruth” is a defense available to an issuer if the misrepresentation appears in prospectus materials filed with the state commissioner or the SEC. See TSA '33C.
[xli]. See Duperier v. Texas State Bank, 28 S.W. 3d 740, 754 (Tex.App-C.C. 2000, pet. dism’d by agreement); Anheuser-Busch Companies, Inc. v. Summit Coffee Co., 858 S.W. 2d 928, 936 (Tex.App.-Dallas 1993, writ denied).
[xlii]. Sale is defined by TSA '4E: AThe terms >sale’ or >offer for sale’ or >sell’ shall include every disposition, or attempt to dispose of a security for value. The term >sale’ means and includes contracts and agreements whereby securities are sold, traded or exchanged for money, property or other thing of value, or any transfer or agreement to transfer in trust or otherwise. ****.”
[xliii]. The inference one may draw from the opinion is that the Aunlawful conduct” need not itself constitute a securities law violation since a “Ponzi” scheme may not always involve the sale of a security. It might be better practice to make no such assumption at this point in time.
[xliv]. See www.sec.gov/rules/final/33-8220.html.
[xlv]. Tex. Cap. Sec. Mgmt., Inc. v. Sandefer, 80 S.W. 3d 260, 267 (Tex.App.CTexarkana 2002, no pet.)(Sandefer 2).
[xlvi]. See Paul F. Newton & Co. v. Tex. Comm. Bank, 620 F.2d 1111, 1120 (5th Cir. 1980).
[xlvii]. There is little federal case law defining Acontrol groups.” The SEC has discussed the control group concept primarily in its “no action” letters. These are letters stating that the staff will not recommend adverse action by the Commission under particular circumstances. Sometimes, of course, the staff would advise in its letter that it can not agree to take no action under the particular circumstances. The staff has uniformly declined to agree to take no action where the facts show family or business relationships that suggested a control group. See Carnation Company, 1980 WL 17775 (SEC No-Action Letter)(Publicly Available Feb. 3, 1980); Commodore Corporation, 1978 WL 13693 (SEC No-Action Letter)(Publicly Available Oct. 6, 1978); Perini Corporation, 1972 WL 11257 (SEC No-Action Letter)(Publicly Available Oct. 23, 1972); Power Dyne Vehicles, Incorporated, 1972 WL 11204 (SEC No-Action Letter)(Publicly Available Aug. 21, 1972); Bishop Graphics, Incorporated, 1972 WL 8980 (SEC No-Action Letter)(Publicly Available June 7, 1972); Glosser Brothers Incorporated, 1972 WL 8810 (SEC No-Action Letter)(Publicly Available May 8, 1972).
[xlviii]. But see, Kalnit v. Eichler, 85 F.Supp. 2d 232 (S.D. N.Y. 1999). There the court confuses an already confusing issue in holding that control allegations against directors are inappropriate because the directors are alleged to have directly violated the 34 Act. In my view the court misses the point. The corporation may certainly be considered the direct violator and the directors control the corporation. The importance of the issue in a federal setting cannot be overstated. Unlike allegations of direct violations control liability does not raise the specter of Rule 9(b). This decision highlights another perplexing issue. The court appropriately states the definition of materiality applicable to 34 Act cases that Athere be 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 available” and Aassumed actual significance” in the deliberations of the reasonable investor to invest. Because the 34 Act requires scienter, proximate cause and reliance this definition makes sense. It doesn’t make sense in a 33 Act case or a case under TSA. All that is required by the statute is a demonstration of control.
[xlix].In re Enron Corporation Securities, Derivative & ERISA Litigation, supra, 235 F.Supp.2d 549.
[l]. SOA Section 804(c), 28 USCA '1658 Note.
[li]. Mr. Bloomenthal has authored a great many articles and books dealing with securities issues. This one is essential reading for any serious student of securities law.
[lii]. Report Pursuant to Section 308c. (www.sec.gov/news/stories.shtml).
[liii]. Report Pursuant to Section 703. (www.sec.gov/news/stories.shtml).
[liv]. Report p. 10.
[lv]. The SEC recently announced that it would be setting up a fund to compensate investors harmed by the broker misconduct referred to in News Release cited in Note 3. The amount for distribution is said to be $399,000,000. One would have to speculate that the penalties collected by the SEC ($487,500,000) will not find their way to investors.
[lvi]. See 15 USCA '78t(f)
CHAPTER TWO: A PRACTICAL GUIDE TO THE TEXAS SECURITIES ACT
I. The Sale of Unregistered Securities.
A. TSA ' 33A(1) prohibits the sale of securities in this state unless they are registered or exempt from registration: TSA ' 33A(1) provides in part: “A person who offers or sells a security in violation of Section 7 *** of this Act is liable to the person buying the security from him, who may sue in law or in equity for rescission or for damages if the buyer no longer owns the security.” Section 7 prohibits the sale of an unregistered security unless there is an available exemption from registration. Liability based on this type of claim is not dependent on fault or even causation in the traditional sense.
B. Definition of Securities. The term “securities” is broadly defined by TSA ' 4A:
“The term security or securities shall include any limited partner interest in a limited partnership, share, stock, treasury stock, stock certificate under a voting trust agreement, collateral trust certificate, equipment trust certificate, pre‑organization certificate or receipt, subscription or reorganization certificate, note, bond, debenture, mortgage certificate or other evidence of indebtedness, any form of commercial paper, certificate in or under a profit sharing or participation agreement, certificate or other evidence of indebtedness, certificate or any instrument representing any interest in or under an oil, gas or mining lease, fee or title, or any certificate or interest representing or secured by an interest in any or all of the capital, property, assets, profits or earnings of any company, investment contract or any other instrument commonly known as a security, whether similar to those herein referred to or not.”
C. Required Proof.
- A sale by the defendant. The requirement in ' 7 that the prohibited sale be made by a “dealer or agent” has been effectively read out of the statute by a broad interpretation of the term “dealer.” See I E 1(b), infra.
- To the plaintiff
- Of a security
- That is not registered
- And not exempt from registration.
D. Authorities. These required elements of proof are stated or implied in the following: TSA '33A(1) as applied to Section 7; Searcy v. Commercial Trading Corp., 560 S.W.2d 637, 639 (Tex.1978); Brown v. Cole, 291 S.W.2d 704, 707 (Tex.1956); Busse v. Pacific Cattle Feeding Fund #1, Ltd., 896 S.W.2d 807, 814 (Tex.App. -Texarkana 1995, writ denied); Jones v. Latham, 671 S.W.2d 612, 614 (Tex.Civ.App. -Eastland 1984, writ ref’d n.r.e.); Lintz v. Eastmam Dillon, et al, 568 S.W.2d 147, 151 (Tex.Civ.App. -Beaumont 1978, reversed on other grounds, 582 S.W.2d 394 (Tex.1979)); Ladd v. Knowles, 505 S.W.2d 662, 666‑667 (Tex.Civ.App.-Amarillo 1974, writ ref’d n.r.e.)(This case adds a non‑statutory defense of knowledge discussed in I H 2(b), infra.)
E. Plaintiff's Elements.
- Plaintiff must prove a purchase of an unregistered security from the defendant.
(a). Plaintiff must prove that he purchased a security from the defendant. This element can usually be proven by financial records. Plaintiff must also establish that the security was not registered with the Commission. This fact may be established by the records of the Commission and is seldom contested. The term “purchaser” is broadly interpreted by the courts to accomplish the remedial purposes of the Act. It is not uncommon in the sale of a security for someone other that the person who provided the funds for the purchase to be shown as the owner, such as a stock‑broker or other type of agent or nominee. A purchaser does not necessarily have to show that he is the record owner of the security after the sale in order to have standing to pursue a claim under TSA. Indeed, under the Act, an agent may also qualify as a purchaser. A good example of this dichotomy is where stock is purchased and held by a clearing house for the account of the broker‑dealer, commonly referred to as being held in “street name.” The transfer records of the company will show the broker‑dealer or Cede (the custodian for DTC, the largest clearing house) as the owner. Records kept by the broker‑dealer, however, will identify the true owner. In Summers v. WellTech, Inc., 935 S.W.2d 228, 233 (Tex.App.-Houston [1st Dist.] 1996, no writ), the purchase was paid for by someone other than the record owner; nevertheless, the record owner qualified as the purchaser. The court relied on federal case law to reach this conclusion, citing Lewis v. Walston & Co., 487 F.2d 617, 622 (5th Cir. 1973) and Monetary Mgmt. Group v. Kidder, Peabody & Co., 604 F.Supp. 764, 768 (E.D. Mo. 1985).
(b). Defendant must be a seller. This element will usually require proof from the plaintiff that identifies the person or persons he dealt with in the purchasing process. Although the prohibition in TSA ' 7 is directed at Adealers and agents,” the statutory definition of the term “dealer” is sufficiently broad that any person (or entity) selling an unregistered security will be subject to liability under this section of TSA. See Busse v. Pacific Cattle Feeding Fund #1, Ltd., 896 S.W.2d 807, 814 (Tex.App.-Texarkana 1995, writ den’d); Brown v. Cole, 291 S.W.2d 704, 707 (Tex. 1956); Cosner v. Hancock, 149 S.W.2d 239, 243 (Tex.Civ.App.-El Paso 1941, writ dism’d). But see Stone v. Enstam, 541 S.W.2d 473, 479 (Tex.Civ.App.-Dallas 1976, no writ). A vendor selling his own securities, however, may have an exemption if the circumstances satisfy TSA ' 5C(1)(limited sales by a non‑issuer). The federal definition of “dealer” includes a requirement that the dealer be in the business of selling securities. See 15 USCA ' 77b(c)(12). The Texas definition does not. See TSA ' 4
(c). At all events, under vintage case law, a seller could be anyone who participated as “a link in the selling process.” See Brown v. Cole, 291 S.W.2d 704, 708 (Tex.1956). In that case the Court held that a promoter‑investor was a “link in the selling process” and deemed to be a seller. In 1992, that holding was applied in Lutheran Brotherhood v. Kidder, Peabody & Co., Inc., 829 S.W.2d 300, 306 (Tex.App.‑‑Texarkana 1992, writ granted by agreement), 840 S.W.2d 384 (Tex. 1992) (court of appeals decision overturned without consideration of the merits). In Texas Capital Securities, Inc. v. Sandefer, 58 S.W.3d 760, 765‑766 (Tex.App.-Houston [1st District] 2001, petition denied), the latest case to consider this issue, the principles stated in Cole were applied to render a remote promoter liable for the sale of unregistered securities.
A sale is defined by TSA ' 4E as follows:
“The terms 'sale' or 'offer for sale' or 'sell' shall include every disposition, or attempt to dispose of a security for value. The term 'sale' means and includes contracts and agreements whereby securities are sold, traded or exchanged for money, property or other thing of value, or any transfer or agreement to transfer, in trust or otherwise. Any security given or delivered with or as a bonus on account of any purchase of securities or other thing of value, shall be conclusively presumed to constitute a part of the subject of such purchase and presumed to have been sold for value. The term 'sell' means any act by which a sale is made, and the term 'sale' or 'offer for sale' shall include a subscription, an option for sale, a solicitation of sale, a solicitation of an offer to buy, an attempt to sell, directly or by an agent, by a circular, letter, or advertisement or otherwise, including the deposit in the United States Post Office or mail box or in any manner in the United States mails within this State of a letter, circular or other advertising matter. Nothing herein shall limit or diminish the full meaning of the terms 'sale,' 'sell' or 'offer for sale' as used by or accepted in courts of law or equity.”
An issue inquiring whether the defendant “was a person who made a sale of a security to the plaintiff” or an inquiry “did defendant sell a security to the plaintiff,” satisfies the statutory requirements if the terms are properly defined. A decision from the Houston Court calls into question this expansive concept of “seller.” See Frank v. Bear, Stearns & Co., Inc., 11 S.W.3d 380, 383 (Tex.App.-Houston [14th Dist.] 2000, review denied). The Frank court held that, in addition to the actual seller who passes title to the plaintiff (privity), only those who control the seller or aid the seller, as those terms are defined in TSA ' 33F(1) and ' 33F(2), can be held liable on the same basis as a seller, relying on the Comments to the 1977 amendments to TSA. In this respect, however, the Comments inaccurately state the legislative history. Indeed, the Comment relied on by the Frank court was not submitted to the legislature with the proposed bill. See TSA '33, Draft 12‑November 21, 1976 (final‑as‑enacted). The accurate legislative history shows that the identification of a seller was to be determined by reference to federal law, and in 1977 the most widely utilized federal standard for determining seller status was a proximate cause or substantial factor test. See Bromberg, Civil Liability Under Texas Securities Act ' 33 (1977) and Related Claims, 32 S.W. L. J. 867, 884‑885 (1978); Huddleston v. Herman & MacLean, 640 F.2d 534, 551 (5th Cir. 1981). Frank is wrongly decided, but its progeny just growed and growed. See Millcreek Associates, L.P. v. Bear Stearns & Co., Inc., 205 F.Supp.2d 665, 676 (W.D. Tex. 2002).
(c). Security. As shown by the statutory definition this term potentially includes every type of monetary transaction in which the purchaser acquires a passive interest in an investment opportunity. A written document is not necessary to prove the existence of a “security.” See Tex Civ. Stat. Art. 581‑4 (Supp. 2003). The term includes items not commonly thought to be a security.
(1). What is a security?
(i). Stock is a security. In common parlance a traditional security is an investment medium where the purchase money for an ownership interest in an enterprise is used by the enterprise to make money without significant participation by the purchaser. See Busse v. Pacific Cattle Feeding Fund #1 Ltd., 896 S.W.2d 807, 814 (Tex.App.-Texarkana 1995, writ denied). Included are mineral interests and any certificate or interest representing or secured by any or all of the capital, assets, property, profits or earnings, of any company.
(ii). Investment contracts are securities. The existence of an “investment contract” is dependent on whether the efforts made by those other than the investor are significant and are “the managerial efforts which affect the failure or success of the enterprise.” See Searsy v. Commercial Trading Corp., 560 S.W. 2d 637, 641. (Tex. 1978). A limited partnership interest falls in this category.
(iii). Evidence of indebtedness is a security. The Searcy court defined “evidence of indebtedness” as “all contractual obligations to pay in the future for consideration presently received,” relying on the language in United States v. Austin, 642 F.2d 724, 736 (10th Cir. 1972). Id. at 641‑642. Included in this category are bonds, notes, mortgages, commercial paper, and debentures.(iv). Catch all. Any other instrument commonly known as a security is included whether similar to any of the listed items, or not.
(v). Most of the specific items listed in the definition of a security can usually be identified, and a sale of an interest in one of them will be considered the sale of a security. The exception to this generality is the determination whether a note or bill of exchange is a security. There is a presumption that notes and bills of exchange are securities. A contest on this issue will involve the use of the “family resemblance” test, which requires application of criteria developed by the federal courts to assist in the determination. See Grotjohn Precise Connexiones Int'l v. JEM Fin., Inc., 12 S.W.3d 859, 868 (Tex.App.‑‑Texarkana 2000, no petition) (citing Reeves v. Ernst & Young, 494 U.S. 56 (1990)).
(2). What isn’t a security?
(i) Joint venture is not a security. A joint venture interest or agreement is not a security. See Russell v. French & Assocs., Inc., 709 S.W.2d 312, 314 (Tex.App. Texarkana 1986, writ ref’d n.r.e.)
(ii). General partnership interest is not a security. A general partnership interest or agreement is not a security. Ibid.
(iii). Specific exclusions that are not securities. TSA ' 4(A), specifically excludes insurance policies, annuity contracts, endowment policies, and optional annuity contract, issued by a state supervised insurance company.
(d). Registration. Defendant did not register the security before selling it. This fact may be proven by records of the Commissioner. See McQueen v. Belcher, 366 S.W.2d 670, 672 (Tex.Civ.App.‑‑Amar. 1963, no writ). Indeed there is a specific provision in TSA permitting such proof. See TSA ' 30. There are three different ways to obtain authorization to sell a security in Texas: Qualification: TSA ' 7A, requires the filing with the Commissioner of substantial financial data and the company’s business plan. A prospectus must be provided to the purchaser. If the commissioner is satisfied with the provided documents, a permit will be issued. Notification: TSA ' 7B, is used by companies that have been in business for more than 3 years and show an operating profit. After reviewing the submitted data, the Commissioner will, if satisfied, enter an Order approving the registration, and the security will be deemed registered. Coordination: TSA ' 7C, is available to companies whose securities have been approved or submitted for approval by the SEC. This type of registration becomes effective on the date the SEC approves the federal registration.
(e). Exemption. The party claiming an exemption from registration has the burden of proof on the issue. The defendant, therefore will be put to proof of an exemption after plaintiff establishes items 1‑4. See Brown v. Cole, 291 S.W.2d 704, 711‑712 (Tex. 1956); Tex. Capital Securities, Inc. v. Sandefer, 58 S.W.3d 760, 777‑778 (Tex.App.‑‑Houston [1st Dist.] 2001, review denied). But see Dean v. State, 433 S.W.2d 173, 178 (C.C.A. 1968). The securities that must be registered with the Commissioner are those not exempt under state law and not “covered” under federal law.
(1). What securities are “covered” under federal law.
(i). Listed securities are covered by federal law and are not subject to state registration or regulation requirements. All securities listed on a National Securities Exchange or on a Regional Exchange having listing requirements equivalent to those imposed by the National Exchanges are “covered” securities. See 15 USCA ' 77r(b)(1).
(ii). Exempt Securities are covered by federal law and are not subject to state registration or regulatory requirements. Securities exempt from federal registration by a federal exemption (excluding sales to accredited investors authorized by ' 77d(6)) granted under Section 3 or Section 4 of the Securities Act of 1933, 15 USCA ' 77c and ' 77d, are “covered” securities. See 15 USCA '77r(b)(4).
(iii). Any sale to a qualified purchaser or a registered investment company involves a covered security and is not subject to state registration or regulatory requirements. From a transaction standpoint any sale to a “qualified” purchaser involves a “covered” security as does any sale of securities to a registered Investment Company. See 15 USCA '77r(b)(3) and (b)(2), respectively. Securities exempt under '77d(6) (limited sales to accredited investors) are not “covered” securities under ' 77r. The recently proposed definition of “qualified purchaser” uses the same criteria that identify an accredited investor, and no significant expansion of federal immunity would occur. See Proposed Rule, SEC Release No.33‑8041, File No.87‑23‑01. This is so because sales by an issuer to sophisticated investors (a classification that, for all practical purposes, includes accredited investors) are already “covered” transactions if there is no public solicitation. See Section 4(2) of the 33 Act, 15 USCA ' 77d(2). If the SEC were to adopt a more expansive definition of “qualified purchaser” federal preemption could be dramatically increased.
(iv). These preemptive rules do not apply to remedies provided by the company’s state of incorporation. See 15 USCA ' 77r(a)(2)(13).
(2). What's left for the state to regulate? What is left for state regulation or registration requirements, from a federal exclusory standpoint, are securities sold under limited offering exemptions authorized by ' 77c(b) and intrastate sales under ' 77c(a)(11). These are securities marketed under Regulation A (17 CFR ' 230.251‑263); Regulation D (17 CFR ' 230.501‑508) (except Rule 506); and intrastate sales under Section 3(a)(11) of the 33 Act, 15 USCA ' 77c(a)(11). Federal law does not restrict state regulation of fraudulent conduct. See 15 USCA 77r(c)(1)
(f). State exemptions. Exemptions for types of transactions and types of securities are provided by the Act. See TSA ' 5 and ' 6. An in depth analysis of these state exemptions is reported elsewhere. See Crawford, Exemptions Update Under Texas Law, 35‑WRT Tex.J.Bus.Law 1 (1999) ( Ms. Crawford has been the Texas Securities Commissioner for more than ten years.). There is, however, considerable confusion over the registration requirements for private sales that do not involve the issuer. The exemption for private sales of this type under federal law is ' 4(1) and 4(12) of the 33 Act, although the latter section is a fictitious reference. The existing federal provision, Section 4(1), states that registration is not required for sales of securities by persons who are not issuers, brokers, or underwriters. See 15 USCA ' 77d(1). And see, Schneider, ' 4(12), Private Resales of Restricted or Controlled Securities, 49 Ohio St. L. Rev. 501 (1988), for a detailed review of the federal provisions. Texas does not have a similar exemption. Texas case law involving private sales by independent investors is sparse. One court has said that the Act is intended to cover the private sale of all of the stock in a corporation to an investor or investors. See Anheuser‑Busch Cos. v. Summit Coffee Co., 858 S.W.2d 928, 940‑41 (Tex.App.-Dallas 1993, review denied)(remanded for reconsideration, 514 U.S. 1001 (1995)(holding reaffirmed, 934 S.W.2d 705 (Tex.App.-Dallas 1996, writ dism’d by agreement). The Houston court indicated otherwise in Joachim v. Magids, 737 S.W.2d 852, 855 (Tex.App.‑‑Houston [1st ] 1987, writ denied). The fact is, however,that the only exemptions available to a typical owner of securities are TSA '' 5C, 5H, and 6F. But there is no reason why Texas could not use the same sensible approach used under the federal system. It is at least noteworthy that State Securities Board has adopted by regualtion an exemption for the sale of securiteis by an owner who is not an issuer. See TAC Title 7, Part 7, Chapter 139, Rule ' 139.14. This regulation is said to be authorized by TSA ' 5T, and it permits 15 sales by an owner during any 12 month period. I cannot think of any good reason why the regulation might be considered invalid, although I have found no reference to it in the court cases.
(g). While unlikely, it is possible that the non‑statutory defense recognized in Ladd v. Knowles, supra, 505 S.W.2d at 668, will be canonized in this state. If so there will be an additional issue whether the plaintiff knew or should have known that the securities had not been registered.
F. Remedies:
1. Actual damages. The Act permits rescission or damages based on rescission if the security is no longer owned by the purchaser, sometimes referred to as “out of pocket” damages. No recovery is authorized under the Act for “benefit of the bargain” damages. TSA ' 33D. The “benefit of the bargain” issue arises in a registration case only when a TSA claim is joined with a common law or statutory claim that does authorize such a recovery. Necessarily the misrepresentation or omission would relate to the registration or exemption of the security. If the buyer prevails on both damage theories, he will be required to elect between them. See, e.g., Formosa Plastics Corp. v. Presidio, 941 S.W.2d 138, 151 (Tex.1995).
2. No exemplary damage. The Act permits the recovery of exemplary damages only if provided by some other applicable remedy, like fraud. TSA ' 33M.
3. Equitable remedies other than rescission. A private litigant can not obtain injunctive or similar relief. Those remedies are available only to the Attorney General or the Commissioner acting on his own. See TSA ' 32A and B.
4. Interest. Recovery or payment (in the instance where money is owed to the defendant in the rescission process) of interest at the legal rate is authorized by the Act. TSA ' 33D. This legal rate is set by ' 302.002, Texas Finance Code. Currently the rate is 6% per annum.
5. Costs. Court costs are recoverable. TSA ' 33D(6).
6. Attorney fees. Attorney fees may be recovered if the court determines that such an award would be equitable. TSA '33D(7). These fees must be allocated appropriately as is required in other situations. See Geodyne Energy, etc. v. The Newton Corp., 97 S.W.3d 779, 883 (Tex.App.-Dallas 2003, petition denied).
7. Criminal conduct. Violations of TSA can lead to serious criminal charges. See TSA ' 29.
G. Jury Charge. There is no pattern jury charge for this cause of action, but there are only six possible inquiries under the statute. (1). Did Defendant sell (2) to Plaintiff (3) a security? If so, (4) was the security registered with the Commission? If not, (5) was the security exempt from registration? If not, (6) what damages did Plaintiff sustain? There is always a possibility that a defendant will dispute the plaintiff's underlying factual allegation that are evidentiary of a sale. In that event a jury issue may be necessary to resolve the conflict. For example, if the defendant denies that there was any solicitation involved in the transaction, an issue could be submitted to resolve that dispute. In the usual case where one or more elements of each of these ultimate facts is contested, the jury issues would be:
Issue No. 1: Did Defendant sell a security to the Plaintiff? “Sell” and “security” would be defined by the statutory definitions.
Issue No. 2: Was the security, if you have so found, registered with the Commissioner and a permit issued?
Issue No. 3: Has the Defendant proved that the security, if you have so found, was exempt from registration?
Issue No. 4: What are Plaintiff's damages? “Damages” would be defined in accordance with the statute.
See Bromberg, Civil Liability Under Texas Securities Act ' 33 (1977) and Related Claims, 32 S.W. L. J. 867, 901‑902 (1978). In a Registration case these issues should normally be questions of law.
H. Defenses.
1. Statutory:
(a). Limitations. Three years. A plaintiff has three years from the date of sale of the unregistered security to file suit if no offer of rescission is made. TSA ' 33H(1)(a).
(b). Offer of rescission. TSA contains provisions that are truly a trap for the unwary plaintiff. If the defendant makes an offer to rescind the transaction complying with TSA ' 33I or ' 33J, a plaintiff must reject the offer in writing within 30 days of its receipt, and the rejection must expressly state that the right to sue is reserved. Failure to do so terminates the plaintiff’s right to pursue a legal claim. If this occurs the sole remedy is to accept the offer. TSA ' 33H(1)(b). Even if rejected in writing the rejection of the offer initiates a one year limitation period for filing suit.TSA ' 33H(1)(c).
2. Non Statutory.
(a). Standing. While technically not a defense, a plaintiff must nevertheless qualify as a purchaser from the defendant or defendants (who must be a “sellers”) to have a cause of action under this part of TSA. In other words only the first wave of buyers may sue the seller or sellers. This “privity” requirement has been criticized but remains the only viable means to reduce a defendant’s potentially unlimited strict liability. See Goode, The Reduction of Seller Liability Under the Securities Act of 1933, Good News for Securities Professionals, 46 Wash. & Lee L. Rev. 627 (1989). The privity required is that between the purchaser and those who are “links in the selling process.”
(b). Plaintiff's Knowledge. Plaintiff's knowledge or sophistication is irrelevant. See Lintz v. Eastman Dillon et al, supra, 458 S.W.2d at 151. State securities laws are patterned after the federal securities laws that seek to establish and maintain an orderly market for securities and that require disclosure of material risks. The primary purpose of TSA, however, is to protect the investor by regulating the purchases and sales of securities in this State and to punish the defendant for violating the Act. See TSA ' 10(1)(b); Anheuser‑Busch Cos. v. Summit Coffee Co., supra, 858 S.W.2d at 940‑41. Thus, the purchaser’s knowledge that the securities were not registered or his failure to investigate to determine the registration status is irrelevant. See e.g., Stinner, Estoppel and in Pari Delicto Defenses to Civil Blue Sky Actions, 73 Cornell L.Rev. 448 (1988). Nevertheless, the court in Ladd v. Knowles, 505 S.W.2d 662, 668 (Tex.Civ.App. -Amarillo 1974, writ ref’d n.r.e.) held that actual knowledge, or knowledge that could have been acquired by the exercise of ordinary care, of the unregistered status of the security put plaintiff in pari delicto with the defendant and that disqualified him from relief under the Act. This was an alternative holding, and most other courts considering this issue have concluded otherwise. See Lintz v. Eastman Dillon et al, supra, 458 S.W.2d at 151. See Stinner, supra, 73 Cornell L.Rev. at p. 462. Stinner analyzes reported decisions from various states and concludes that knowledge of the violation without additional participation in management is, or should be, insufficient to defeat the claim. Id. at 462‑467. A case directly in point is Dunn v. Bemire Petroleum, Inc., 680 S.W.2d 304, 306‑307 (Mo.App.1984) (Defendant should not evade liability by simply telling the purchaser that the stock is not registered). E.g. Southwestern Drilling v. Parr, 1987 U.D. Dist. Lexis 16054 (W.D. Okla. 1987); Hall v. Johnston, 758 F.2d 421 (9th Cir. 1985); Caldwell v. Trans‑Gulf Petroleum Corp., 311 So.2d 80 (La App. 1975). Federal law is also inconsistent with Ladd v. Knowles. See e.g. Pinter v. Dahl, 486 U.S. 622, 639 (1988) (“[E]ven where a plaintiff actively participates in the distribution of unregistered securities, his suit should not be barred where his promotional efforts are incidental to his role as an investor.”) Be that as it may this decision by the Amarillo court has not been questioned by any later Texas case. But it has not been cited on this point either. There is a specific provision in TSA that could, if applicable, support the Ladd decision. The Ladd court in fact refers to it. TSA ' 33K makes unenforceable any contract that the person asserting contract rights knew would violate a provision of the Act. This provision, however, does not negate the statutory remedy. See Bromberg, supra, 32 S.W.L.J. at 911. It impacts only contract rights. Thus the purchaser could not force the seller to part with the unregistered security. The actual purpose of ' 33K appears to be to prevent enforcement of an underwriter's agreement to distribute the unregistered security or some similar contractual arrangement. The Ladd court cites this provision but fails to analyse it.
(c). Waiver. Substantive rights under the Act cannot be waived. TSA ' 33L.
I. Secondary Liability.
1. Control. The Act contains specific provisions for “control” liability. TSA ' 33F(1) states:
“A person who directly or indirectly controls a seller, buyer, or issuer of a security is liable under Section 33A, 33B, or 33C jointly and severally with the seller, buyer, or issuer, and to the same extent as if he were the seller, buyer, or issuer, unless the controlling person sustains the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of the existence of the facts by reason of which the liability is alleged to exist.”
No definition is provided by TSA for the term “control” although a regulation has been adopted by the Commissioner defining it in the same way as the federal counterpart: “Control‑‑ The power to direct or influence the direction of the management or policies of a person, directly or indirectly, through the ownership of voting securities, by contract , or otherwise.” See TAC Title 7, Part 7, Chapter 113, Rule '113.14(b)(7). Compare the federal version at 17 CFR 230.405. In Busse v. Pacific Cattle Feeding Fund #1, Ltd., supra, 896 S.W.2d at 815, the court purported to apply federal law and held that there is a three‑part test to determine control. The first relates to the general power to control of the business entity. The second is the power to control the specific activity involved in the violation. The third requires that the defendant participate in the conduct that is the basis of the violation. All three must exist, said the court, for control to be found as a fact. The Busse court appears to have gone a little too far in characterizing the elements of control required by federal case law. See Ravkind, We New Wizards of Wall Street, 66 Tex.B.J. 120, 121‑129 (2003). An exhaustive analysis of the federal court decisions is provided by Bromberg. See Bromberg and Lowenfels on Securities Fraud & Commodities Fraud, ' 8:8.5(800), et seq. (2nd ed. 2002). Both the Houston and the Dallas Courts of Appeals have held that participation in the wrongful conduct is unnecessary for control liability to attach. See Barnes v. SWS Financial Services, Inc., 97 S.W.3d 759, 763 (Tex.App.-Dallas 2003, petition denied); Frank v. Bear, Sterns & Co., 11 S.W.2d 380, 384 (Tex.App.-Houston [14th Dist.] 2000, petition denied).
2. Aiding and Abetting. TSA ' 33F(2) provides:
“A person who directly or indirectly with intent to deceive or defraud or with reckless disregard for the truth or the law materially aids a seller, buyer, or issuer of a security is liable under Section 33A, 33B, or 33C jointly and severally with the seller, buyer, or issuer, and to the same extent as if he were the seller, buyer, or issuer.”
This section is the only one in TSA requiring proof of scienter for civil liability to attach, and the Supreme Court has recently addressed this section of TSA. In Sterling Trust Co. v. Adderley, 168 S.W.3d 835 (Tex. 2005), the Court reversed the Ft Worth court’s holding that knowledge of the underlying activity was not a necessary element for “aider” liability to attach. The Supreme Court reasoned that “general awareness” of some illegal conduct by the primary violator was necessary for the imposition of “aider” liability. And the Court further explained that the “aider” need not know of the specific wrong being perpetrated, but must subjectively realize that some character of wrongful conduct was being engaged in. Id. at 837. It is unclear whether the “aider” must realize that he is actually aiding a securities law violation; although it is clear that the conduct aided must be a violation of the securities law. Otherwise, of course, if there was no securities violation by the principal, the “aiding” provision would be inapplicable. In addition, there is a separate line of cases holding that the person providing the aid must be generally aware of his role in the violation. See Goldstein v. Mortenson, 113 S.W.3d 769, 776 (Tex.App.-Austin 2003, no petition.); Frank, supra, 11 S.W.3d at 384. That requirement was also disputed by the Ft Worth court in Sterling Trust Company v. Adderley, 119 S.W.3d 312, 318‑319 (Tex.App. Ft Worth 2003), reversed on other grounds, 160 S.W.3d 835 (Tex. 2005). The Court’s language doesn’t actually reject that concept:
“We therefore hold that the TSA's >reckless disregard for the truth or the law’ standard means that an alleged aider can only be held liable if it rendered assistance >in the face of a perceived risk’ that its assistance would facilitate untruthful or illegal activity by the primary violator. TEX. REV. CIV. STAT. ANN. art. 581‑33F(2); Kolstad, 527 U.S. at 536. In order to perceive such a risk, the alleged aider must possess a >general awareness that his role was part of an overall activity that is improper.' Gould, 535 F.2d at 780.”
Sterling Trust, supra, 168 S.W.3d at 842.
This language suggests that an “aider” need only know that the primary violator is engaging in some character of unwholesome conduct and that his (the “aider’s”) activity is assisting that conduct.
J. Related Matters.
1. Federal Case Law. Federal law also prohiits the sale of unregistered securities. See Section 12(1) of the 33 Act, 15 USCA ' 77l1). Aiding and abetting, however, is not an available private remedy. See Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994). Central Bank actually involves Section 12(2), but there is no question about the applicability of its rationale to a registration case. See Bromberg and Lowenfels on Securities Fraud & Commodities Fraud, supra, at '8.5(600).
2. Federal Statutory Law. In the mid to late 90’s Congress enacted a number of statutes that restricted available state class action remedies for securities violations. SLUSA (Securities Litigation Uniform Standards Act), PL 104‑353; PSLRA (Private Securities Litigation Reform Act), PL 104‑67; NSMIA (National Securities Market Improvement Act), PL 104‑290.
II. Sale of Securities by Means of Misrepresentations or Omissions.
A. TSA ' 33A(2) prohibits the use of misrepresentations or omissions of material facts in the sale of securities:
“Untruth or Omission. A person who offers or sells a security (whether or not the security or transaction is exempt under Section 5 or 6 of this Act) by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they are made, not misleading, is liable to the person buying the security from him, who may sue either at law or in equity for rescission, or for damages if the buyer no longer owns the security.”
B. Required Proof.
1. Defendant sells
2. To plaintiff
3. A security
4. By means of a misrepresentation or omission
5. Of a material fact
C. Authorities. These elements of proof are stated or implied in Tex.Rev.Civ. Stat. art. 581‑33A(2)(TSA ' 33A(2); Geodyne Energy Income Production PartnershipI‑E v. Newton Corp., 97 S.W.3d 779 (Tex.App. Dallas 2003, petition denied); Tex. Capital Securities, Inc. v. Sandefer, 58 S.W.3d 760, 776 (Tex.App.-Houston [1st] 2001, review dism’d); Duperier v. Tex. State Bank, 28 S.W.3d 740, 753 (Tex.App.-Corpus Christi 2000, petition dism’d); Hendricks v. Thornton, 973 S.W.2d 348, 360 (Tex.App.-Beaumont 1998, petition denied); Weatherly v. Deloitte & Bache, 905 S.W.2d 642, 649‑650 (Tex.App.-Houston [14th Dist.] 1995, writ dism’d w.o.j.); Anheuser‑Busch Cos., Inc. v. Summit Coffee Co., 858 S.W.2d 928, 936 (Tex.App.-Dallas 1993, writ denied), remanded for reconsideration 514 U.S. 100 (1995), reaffirmed 934 S.W.2d 705 (Tex.App.-Dallas 1993, writ dism’d by agreement).
D. Jury charge. There is no pattern jury charge for this cause of action. In Duperier v. Texas State Bank, 28 S.W.3d 740 Tex.App.-Corpus Christi 2000, writ dism’d by agreement), the trial court charged the jury as follows:
“Special Question No.1: Did the defendants violate the Texas Securities Act in the sale of the World Bank Notes to Texas State Bank? A person or entity violates the Texas Securities Act by offering or selling a security by means of either: (a) an untrue statement of material fact; or (b) an omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they are made, not misleading. A prediction in connection with a sale of a security may constitute a material fact if: (a) the speaker does not genuinely believe the statement is accurate; (b) there is no reasonable basis for the speaker’s belief that the statement is accurate; or (c) the speaker is aware of any undisclosed facts that would tend seriously to undermine the accuracy of the statement.” Id. at 746.
The last portion of this instruction relates to fraudulent intent. See TSA ' 4F. And fraudulent intent is relevant only with respect to criminal violations. See TSA ' 29C(1). The application of that standard to a civil violation is inappropriate.
The trial court in Duperier also instructed the jury:
“A fact is material if there is a substantial likelihood that it would have assumed actual significance in the deliberations of a reasonable investor, in that it would have been viewed by the reasonable investor as significantly altering the total mix of information made available. No violation *** occurred if (defendant) has proved by a preponderance of the evidence that (plaintiff) knew of the untruths or omissions or *** (defendant) did not know, and in the exercise of reasonable care could not have known, of any such untruths or omissions.” Ibid.
This instruction mirrors the one used by the federal courts. See Granader v. McBee, 23 F.3d 120, 123 (5th Cir. 1994). The federal definition, however, was developed to apply in cases where reliance, foreseeability and proximate cause are necessary elements of proof. Texas law does not require these elements for liability to attach. E.g., Geodyne, supra, 97 S.W.3d at 783‑785. In Geodyne, in Texas Capital Securities, Inc. v. Sandefer, supra, 58 S.W.3d at 776, and in Weatherly v. Deloitte & Touche, supra, 905 S.W.2d at 649, the courts held that reliance was not an element of proof in a TSA case and approved an instruction of material fact that is perhaps easier for a jury to interpret: “A fact is material if a reasonably prudent investor would want to know about it in making an investment decision.” In Anheuser‑Busch Companies, Inc. v. Summit Coffee Co., 858 S.W.2d 928 (Tex.App.‑‑Dallas 1993, writ denied), the court stated: “An omission or misrepresentation is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding to invest.” Id. at 936. The language approved in Duperier could be misinterpreted as suggesting that foreseeability or causation are elements of this cause of action.
E. Plaintiff's elements.
1. Plaintiff purchased a security from the defendant. To prove an action for violation of TSA ' 33A(2) plaintiff must establish that he purchased a security from the defendant and that the defendant used misrepresentations or omissions in the selling process. (a). Plaintiff. As in a registration case, the plaintiff must purchase a security from the defendant, and the same criteria discussed in part I, above, will satisfy the plaintiff’s burden to establish his status as a purchaser. This relationship is sometimes loosely referred to as the parties being “in privity.”
(b). Defendant. The Plaintiff must prove that the defendant was a seller of the security. That could include any person (or entity) who was a link in the selling process or there could be a more stringent standard applied depending on the outcome of the disagreement described in part I H 2(b), above.
(c). Security. Plaintiff must prove that the transaction involved the sale of a security. The same broad definition of a security applicable in a Registration case is applicable to this cause of action.
(d). Misrepresentations or omissions. Plaintiff must prove that the sale involved the use of misrepresentations or omissions of material facts by the defendant.
(1). What is a “fact?” When the subject matter is an existing circumstance it is reasonable easy to distinguish a fact from opinion or puffery. When the subject matter relates to a future event or circumstance the distinguishing features between fact, opinion and puffery become more obscure. The specificity of the statement (can the statement be determined as true or false) and the relative knowledge of the parties (does the defendant have superior knowledge or has she pretended to have superior knowledge) are the two most referenced criteria for differentiating fact from opinion or puffery. See Marshall v. Kusch, 84 S.W.3d 781, 785 (Tex.App.‑‑Dallas 2002, rev. denied).
(2). What is a material fact? A material fact is one that a reasonable investor would want to know before investing. The applied standard is an objective one, and it is based on what a reasonable investor would want to know.
(e). Must the plaintiff prove scienter, reliance or proximate cause. The short answer is “no.” Case law establishes that the plaintiff need not show that he would have acted differently had he known the true facts. See Summers v. WellTech, Inc., supra, 935 S.W.2d at 235; Anheuser‑Busch Companies, Inc. v. Summit Coffee Co., supra, 858 S.W.2d at 936. Scienter is not required. See Busse v. Pacific Cattle Feeding Fund # 1, LTD., supra, 896 S.W.2d at 815. Nor is reliance a required event. See Weatherly v. Deloitte & Touche, supra, 905 S.W.2d at 649. In Geodyne, supra, 97 S.W.3d at 783‑785, the court discusses all of these issues. There are a few Texas cases stating that the misrepresentation must induce the sale of the security. See Crescendo Investments, Inc. v. Brice, 61 S.W.3d 465, 475‑76 (Tex.App.-San Antonio 2001, no petition). These cases are wrongly decided. Liability is predicated on the misrepresentation of a material fact. And a “material fact” is one that a reasonably prudent investor would want to know. Causation is, therefore, subsumed in the finding of materiality.
F. Remedies. The same remedies available in a registration case are available for this type of claim.
G. Defenses.
1. Statutory.
(a). Plaintiff's knowledge. The defendant can escape liability by showing that the plaintiff knew the true facts. If the purchaser has actual knowledge of the true facts that are being misrepresented or omitted her recovery is barred. See TSA ' 33A(2). Imputed knowledge will not suffice. Plaintiff has no duty to investigate the representations or the omissions. See Duperier v. Tex. State Bank, 28 S.W.2d 740, 745 (Tex.App.-Corpus Christi 2000, review dism’d by agreement). This same statement can be found in fraud cases. See, e.g., West v. Carter, 712 S.W.2d 569, 755 (Tex.App.-Houston [14th Dist.] 1986, writ ref’d n.r.e.). At the same time, however, the courts in fraud cases have required a plaintiff to exercise ordinary care after completion of the transaction to uncover the fraud for limitations purposes. See Little v. Smith, 943 S.W.2d 414, 420 (Tex.1997). These differing duties are not inconsistent, however. The language in TSA’s limitations provisions applicable to misrepresentation cases embodies the requirement that plaintiff exercise reasonable care to discover the wrong. See TSA ' 33H(2)(a). But this diligence requirement is applicable only to the limitations issue and comes into play only after the sale or purchase has occurred. See Geodyne, supra, 97 S.W.3d at 786 n. 6; Summer v. WellTech, Inc., supra, 935 S.W.2d at 234.
(b). Defendant's lack of knowledge. The defendant can escape liability if he can show that he did not know the statements made were false and could not have known of their falsity by exercising ordinary care. See TSA ' 33A(2) (c). Limitations. Three or five years. Suit must be brought within three years of discovering the misrepresentation or omission and ordinary care must be used in the discovery process. Five years from the date of the sale is the maximum time period for filing suit. See TSA ' 33H(2)(a) and (b). If an Offer of Rescission is made complying with ' 33H or ' 33I, plaintiff must reject the offer in writing within 30 days of its receipt and specifically state in the written response that her right to sue is reserved in order to preserve her right to sue. See TSA ' 33H(2)(c). Suit must be initiated within twelve months of the rejection of the offer unless the general time limit sooner expires in which event the suit must be brought within the time afforded by the general time limit. See TSA ' 33H(2)(d). The Commissioner has disputed this interpretation provided by the 1977 Comments . She asserts that a plaintiff should have not less than one year to file a claim after rejection of the rescission offer. See Rowley, The Sky is Still Blue in Texas‑State Law Alternatives to Federal Securities Remedies, 50 Baylor L.Rev. 99, 204 n. 80 (1998). A number of courts have regarded the Comments as authoritative. The fact is, however, that the Comments reflect the thoughts of a subcommittee of the State Bar and represents, therefore, only the view of a lobbyist.
2. Non Statutory.
(a). Unclean hands or in pari delicto. This defense is already part of the statute. See part II G 1(a), above.
H. Secondary liability. Vicarious or secondary liability is the same here as described in part I.
I. Related matters. Indirect Fraud. A very interesting question is whether a purchaser may recover for indirect fraud or “fraud on the market” under TSA. Obviously there is no privity between the purchaser and the person commiting the fraud in these types of claims. A cause of action under TSA for indirect fraud was recognized in Texas Capital Securities, Inc. v. Sandefer, 58 S.W.3d 760 (Tex.App.‑‑Houston [1st Distr.] 2001, review denied). An exhaustive contrary view can be found in a New Jersey case. See Kaufman v. I‑Stat Corp., 754 A.2d 1188 (N.J. Sup. Ct. 2000). It may be that this type of claim should simply be viewed as a one falling under the Restatement (2nd) Torts ' 531. See Ernst & Young, LLP v. Pacific Mut. Life Ins. Co., Inc., 51 S.W.3d 573 (Tex. 2001). “Fraud on the market” is a concept announced in Basic, Inc. v. Levinson, 485 U.S. 224, 241‑242 (1988). Its primary purpose is to establish a presumption of reliance when misrepresentations occur that impact the price of a security and the substance or circumstances of the misrepresentations are of a type that the injured investor would be unaware of them. A number of state courts have declined to recognize or apply this presumption while others have responded to it more favorably. See Sanderson, A “Basic” Misunderstanding: How the United States Supreme Court Misunderstands Captial Markets, 43 S. Tex. L. Rev. 743 (2002). Sanderson fails to cite the state case in which a state court reacted somewhat favorably to the holding in the Basic case. See Gohler v. Wood, 919 P2d 561 (Utah Sup. Ct. 1996). In that case the court stated that reliance was not a necessary element of proof under Utah's Blue Sky Law so a presumption of reliance was unnecessary. That same situation exists in Texas, but our courts have not yet had occasion to rule on the issue.
III. Sale of a registered security by means of misrepresentations or omissions in registration or prospectus material provided by a non‑selling issuer.
A. TSA ' 33C prohibits the use of misrepresentations or omissions in registration or prospectus materials.
B. Elements.
1. Sale by a third party (A non‑issuer or non‑affiliate)
2. To the plaintiff
3. Of a security
4. Misrepresentations or omissions in registration or prospectus materials
5. Of material facts
6. Issuer (the company) is liable to the Plaintiff.
C. No Texas case is found that specifies the required elements.
D. Jury charge. There is no pattern jury charge for this cause of action. The language discussed in part II can be adapted to fit this cause of action.
E. Plaintiff's elements. Plaintiff must prove that he purchased a security from a third party and that there were misrepresentations or omissions of material facts in the registration or prospectus materials.
1. Plaintiff. Plaintiff must show that he was a purchaser. The same definition of a purchaser discussed above is applicable here. See part I a(1)
2. Defendant‑third party seller. Plaintiff must show that he purchased the security from someone other than the issuer or an affiliate of the issuer. It is very likely that a defendant will stipulate that he is not the issuer or an affiliate of the issuer.
3. Security. Plaintiff must prove that he purchased a security.
4. Misrepresentation or omission in the offering documents filed with the Commissioner or the SEC. Plaintiff must prove that the filed documents contained material misrepresentations or omissions.
F. Remedies. Remedies available under this cause of action are the same as those available under the causes of action discussed above.
G. Defenses.
1. Statutory:
(a). Plaintiff's knowledge of the true facts: If the plaintiff knows that the representations in the registration or prospectus materials are false or that there are omissions of material facts, he can not recover under TSA ' 33C. No defense is afforded the non‑selling issuer for lack of knowledge even if he is totally unaware of the falsity of the misrepresentation or the omission. TSA ' 33C(2).
(b). Limitations: The limitations provision applicable to a misrepresentation or omission case applies to this cause of action.
2. Non statutory. To date no non‑statutory defenses have been recognized by the courts, but, if Ladd v. Knowles is the law in Texas, it would be reasonable to assume that the plaintiff in a case under this subsection would have to exercise diligence to determine that there were no misrepresentations or omissions in the prospectus materials before making the purchase.
H. Secondary liability. Vicarious or secondary liability is the same under this cause of action as in a registration case.
I. Related matters. Section 12(2) of the 33 Act, 15 USCA 77j(2), is substantially similar to this cause of action.
IV. Purchase of a security by means of misrepresentations or omissions.
A. TSA ' 33B prohibits the purchase of a security by means of misrepresentations or omissions. Texas is one of a handful of states recognizing this cause of action.
B. Elements of proof.
1. Purchase of a security by the defendant
2. From the plaintiff
3. By means of misrepresentations or omissions
4. Of a material fact
C. In all other respects the discussion in part II is applicable here.
V. Sale of securities in this State by unregistered salespersons.
A. TSA ' 33A(1) also prohibits the sale of securities in this State by any person not registered as required by TSA ' 12.
B. Elements of proof.
1. Sale of a security
2. To a purchaser
3. By someone not registered as required byTSA ' 12
4. And the transaction is not exempt under TSA ' 5
C. These elements of proof may be found in: TSA ' 33A(1). No Texas case has been found that discusses the elements of this type of claim. Citizens Ins. Co. v. Hakim Daccach, 105 S.W.3d 712 (Tex.App.‑‑Austin 2003, petition granted), involves this cause of action, but the issues on appeal were related to the propriety of a class action certification.
D. Jury issues. There is no pattern jury charge for this cause of action. The discussion on this subject in part I, above, concerning unregistered securities is applicable here.
E. Plaintiff's elements. Plaintiff must establish that he purchased a security from a non‑registered seller.
1. Plaintiff. Plaintiff must prove that he was a purchaser. The same considerations stated in part I, above, are applicable here.
2. Defendant. Plaintiff must prove that the defendant was the seller or sellers. See part I.
3. Security. Plaintiff must prove that he purchased a security. See part I.
4. Unregistered Seller. Plaintiff must prove that the defendant was not registered to sell securities in this state. This fact can be proved by the records of the Commissioner.
5. Exemption. Once plaintiff has proved items 1 through 4, the defendant will need to prove that an exemption existed and that registration was not required. Otherwise, the seller or sellers will be liable for damages.
F. Remedies. The same remedies discussed above are available for this cause of action.
G. Defenses.
1. Statutory.
(a). Limitations. The same limitations provision applicable to a registration case are applicable here.
(b). Exemptions provided by TSA ' 5. The transaction exemptions are the same as for registration cases. However, the registration exemptions provided by TSA ' 6 for particular types of securities are not available to the seller as a defense to this cause of action.
2. Non statutory. The court's decision in Ladd v. Knowles, supra, 505 S.W.2d at 662, authorizing a defense of plaintiff's knowledge, actual or constructive, in a registration case could be applicable here.
H. Secondary liability. Secondary liability is the same here as is provided for the other causes of action contained in TSA.
VI. Sales in violation of orders issued by the Commissioner or violation of the restrictions on expenses incurred in an offering.
The other causes of action provided by TSA ' 33A(1) relate to violations of '' 9, 23A, 23C and 23‑1. These sections involve special orders entered by the Commissioner that suspend the sale of a registered security or impose escrow requirements for the funds collected in the offering. TSA ' 9 also imposes a ceiling on the costs incurred in the offering. In all respects a cause of action for violation of one of these orders would be the same as is provided for the sale of an unregistered security.