Due Diligence Defense:
Securities Act of 1933 - Sections 11 and 12(a)(2)

by Stuart A. Ober, CFE, AIFA ®

The Practising Law Institute's ("PLI") "Conducting Due Diligence 2006" seminar, held on April 6 and 7, 2006 in New York City, and the following is largely taken directly from the section of the PLI text submitted by Jonathan K. Youngwood and Steven Frankel, of Simpson Thacher & Bartlett LLP and from In Re Worldcom, Inc. Securities Litigation (02 Civ. 3288 (DLC)).

Who may use a due diligence defense and what protections are available?

he Securities Act of 1933 (the "Securities Act") Sections 11 and 12(a)(2) provide the primary legal authority that buyers of registered securities which contained false or misleading statements may turn to provide civil remedies. In order to have a viable claim, the test for liability under Sections 11 and 12 would be to prove a material misstatement or omission of a material fact. Section 11 liability flows from the requirements for filing a registration statement. Section 12(a)(2) liability flows from the requirement to distribute prospectuses.

Section 11.

Section 11 of the Securities Act "was designed to assure compliance with the disclosure provisions of the Securities Act by imposing a stringent standard of liability on the parties who play a direct role in a registered offering."

Who may be liable?

If there is a material misstatement or omission the following may be liable:

1. the issuer;
2. every person who signed the registration statement;
3. every person who was a director or partner in the issuer;
4. every person who is named (with their consent) as a director or "future" director;
5. every accountant, engineer, appraiser, or other "expert" whose profession gives authority to his statement, who is named as having prepared or certified any part of the registration statement; and
6. every underwriter of the security.

What is a material fact?

In determining whether a registration statement is materially misleading, the "central inquiry" is "whether defendants' representations, taken together and in context, would have misled a reasonable investor about the nature of the investment." I. Meyer Pincus, 936 F.2d at 761 (citation omitted). A material fact is one that "would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." DeMaria, 318 F.3d at 180 (citation omitted). See also Ganino v. Citizens Util. Co., 228 F.3d 154, 162 (2d Cir. 2000).

What is an omitted material fact?

An omitted fact may be immaterial if it is "trivial," or "so basic that any investor could be expected to know it." Ganino, 228 F.3d at 162 (citation omitted). Materiality remains, however, "a mixed question of law and fact." Ganino, 228 F.3d at 162. Since materiality is necessarily a "fact specific inquiry," Basic, Inc. v. Levinson, 485 U.S. 224, 240 (1988), courts within the Second Circuit have "consistently rejected a formulaic approach to assessing the materiality" of misrepresentations. Ganino, 228 F.3d at 162.

What are the due diligences defenses under Section 11?

An omitted fact may be immaterial if it is "trivial," or "so basic that any investor could be expected to know it." Ganino, 228 F.3d at 162 (citation omitted). Materiality remains, however, "a mixed question of law and fact." Ganino, 228 F.3d at 162. Since materiality is necessarily a "fact specific inquiry," Basic, Inc. v. Levinson, 485 U.S. 224, 240 (1988), courts within the Second Circuit have "consistently rejected a formulaic approach to assessing the materiality" of misrepresentations. Ganino, 228 F.3d at 162.

1. Non-Expert Regarding Non-Expertised Portion. Section 11(b)(3)(A) provides that a defendant will not be liable regarding "any part of the registration statement not purporting to be made on the authority of an expert" upon demonstrating "he had, after reasonable investigations, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading."
2. Expert Regarding Expertised Portion. Section 11(b)(3)(B) provides that an expert will not be liable regarding "any portion of the registration statement purporting to be made upon his authority as an expert" upon proving "he had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statement therein not misleading."
3. Non-Expert Relying Upon Expertised Portion - Section 11(b)(3(C) provides that regarding "any part of the registration statement purporting to be made on the authority of an expert" a defendant other than the expert will not be liable upon proving "he had no reasonable ground to believe and did not believe, at the time such part of the registration statement became effective, that the statements therein were untrue or that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading."
4. Any Person Relying upon Official Statement - Section 11(b)(3)(D) further provides a defense for persons who rely upon "any part of the registration statement purporting to be a statement made by an official person or purporting to be a copy of or extract from a public document.

What is the standard of reasonableness?

Section 11(c) states that the standard of "reasonableness" is that "of a prudent man in the management of his own property."

Section 12

Who is liable under Section 12?

Section 12(a)(2) of the Securities Act (formerly Section 12(2)) allows a purchaser of a security to bring a private action against a seller that "offers or sells a security . . . by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements... not misleading." 15 U.S.C. § 771(a)(2). The section entitles the buyer to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security. Id.; Commercial Union Assurance Co. v. Milken, 17 F.3d 608, 615 (2d Cir. 1994); see also Randall v. Loftsgaarden, 478 U.S. 647, 655 (1986) ("§ 12(2) prescribes the remedy of rescission except where the plaintiff no longer owns the security."). Section 12 turns on status, not scienter: It imposes liability without requiring "proof of either fraud or reliance." Gustafson, 513 U.S. at 582; see also Rombach, 355 F.3d at 164. A plaintiff need only show "some causal connection between the alleged communication and the sale, even if not decisive." Metromedia Co. v. Fugazy, 983 F.2d 350, 361 (2d Cir. 1992) (citation omitted). "Reliance by the buyer need not be shown, for § 12(2) is a broad anti-fraud measure and imposes liability whether or not the purchaser actually relied on the misstatement." Id. (citation omitted). Defendants may be liable under Section 12(a)(2) either for selling a security or for soliciting its purchase.

Section 12(a)(2) provides affirmative defenses that parallel those available for a Section 11 claim. First, the statute prohibits recovery to the extent that the person who offered or sold such security proves that any portion or all of the amount recoverable . . . represents other than the depreciation in value of the subject security resulting from such part of the prospectus or oral communications, with respect to which liability of that person is asserted. . . . 15 U.S.C. § 77l(b). In addition, Section 12(a)(2) provides an affirmative defense of reasonable care. See Royal Am. Managers, Inc. v. IRC Holding Corp., 885 F.2d 1011, 1019 (2d Cir. 1989).

What are the differences (and similarities between Sections 11 and 12(a)(2)?

While Section 11 contemplates liability only for the issuer, signers, directors, experts and underwriters involved in the registration statement, Section 12 imposes liability upon persons who sell or solicit purchases of securities.

Actionable Statements: Section 11 deals only with registration statement, while Section 12(a)(2) includes prospectus or oral communications.

Privity: (the doctrine that provides that a contract cannot confer rights or impose obligations arising under it on any person or agent except the parties to it). While Section 11 more broadly "provides a remedy for 'any person' who acquires a security" that contains false or misleading statements, Section 12 has requirement of "privity between the purchaser and the seller." Demaria, 318 F.3d at 178. It has been held, however, that even "persons who are not in privity with the plaintiff may be liable [under Section 12] if they 'successfully solicit[ed] the purchase, motivated at least in part by a desire to serve [their] own financial interests or those of the securities owner." WorldCom, 346 F.Supp 2d at 660 (citation omitted).

Remedy: While the remedy for a violation of Section 11 is damages, Section 12 provides remedies of both damages and rescission. In re AOL Time Warner, Inc. Securities.

Overlap: The elements for liability under Sections 11 and 12 are "essentially the same- materiality of the omission and failure to exercise reasonable care." Feit v. Leasco Data Processing Equip.Corp., 332 F.Supp. 544, 584 (E.D.N.Y. 1971). In addition, an allegation of scienter is not required in order to state a cause of action under either Section 11 or Section 12(a)(2). Tyco, 2004 WL 2348315 at *15.

Reasonable Care v. Reasonable Investigation: In WorldCom Securities Litigation (346 F. Supp. 2nd at 663), the court stated that "Section 12(1)2) has a defense of reasonable care that is less demanding than the duty of due diligence imposed under Section 11." "Thus, while Section 11 imposes a duty to conduct a reasonable investigation as to any portion of a registration statement not made on the authority of an expert, Section 12(a)(2) does not make any distinction based upon 'expertised' statements and only requires the defendant to show that it used reasonable care. Finding that the standard under Section 11 is more exacting than Section 12, the court proceeded to principally address the defenses under Section 11.

The text of "Conducting Due Diligence 2006" is available from Practising Law Institute, 810 Seventh Avenue, New York, NY 10019-5818, at http://www.pli.edu or call (800) 260-4PLI or (212) 824-5710.

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Stuart A. Ober is president of Securities Investigations, Inc., a firm specializing in due diligence and investment consulting and analysis (845 679-2300 or ober@stuartober.com).