Saturday, July 27, 2019

An odd little Section 11 problem

I’m intrigued by this unusual Section 11 decision out of the Third Circuit, Obasi Investment LTD v. Tibet Pharmaceuticals, Inc, 2019 WL 3294888 (3d Cir. 2019).   A company called Tibet held an IPO, but the registration statement failed to identify financial troubles at its operating subsidiary.  Eventually the subsidiary’s assets were seized, Tibet’s stock price plunged, and trading was halted.

A class of plaintiffs brought a Section 11 claim against, you know, everyone they could get their hands on, including two individual defendants: Hayden Zou and L. McCarthy Downs.  Zou was a Tibet shareholder who had come up with the idea for an IPO in the first place, and approached Downs, who was a managing director for an investment bank called Anderson & Strudwick (“A&S”).  A&S ended up underwriting the offering, and for reasons that are not explained, A&S agreed with Tibet that after the IPO, two A&S designees would serve as nonvoting Board observers for the foreseeable future.  Those designees were Zou and Downs, and the registration statement explained that even without votes “they may nevertheless significantly influence the outcome of matters submitted to the Board of Directors for approval.”

When the plaintiffs sued, they argued that Zou and Downs were proper Section 11 defendants, because that statute imposes liability on “every person who, with his consent, is named in the registration statement as being or about to become a director, person performing similar functions, or partner.” 15 U.S.C. §77k(a)(3). 

The Third Circuit, in a 2-1 split, held that Zou and Downs were not named in the registration statement as performing functions similar to those of directors.

And honestly this is sort of a stream of consciousness about the decision, which got very very long, so behind a cut it goes:

[More under the jump]

So I’m reading this and the first thing that comes to mind is – wouldn’t it be easier to just call them underwriters?  After all, Section 2 of the Securities Act defines an underwriter to mean:

any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking...

That certainly sounds like what both Zou and Downs did, considering they were the ones who came up with the idea of an IPO in the first place and apparently personally worked to make it happen.  And it turns out the plaintiffs did, in fact, argue that Downs was a statutory underwriter, and the district court rejected that argument. See Dartell v. Tibet Pharm., Inc., 2017 WL 1944106 (D.N.J. May 10, 2017). The court held:

Notwithstanding Downs clear participation in the underwriting process as an employee of A&S, Plaintiffs fail to provide the Court with a single case in which a court determined that an individual employee of an underwriter was personally liable under Section 11, in addition to the underwriter itself. Nor has the Court's own research revealed such an expansive interpretation….

Plaintiffs here also brought suit against the underwriter, A&S, itself and have already entered into a settlement agreement regarding those claims. Plaintiffs are not seeking to assert claims against a different entity that was involved in the underwriting process, but instead are seeking to hold a second person liable for the same actions and conduct as A&S because Downs worked for A&S on the underwriting process. The Court will not extend the underwriter category of Section 11 defendants in such a manner.

On the one hand, the District Court is right: when we hold underwriters liable in Section 11 cases, no one looks through to the individual employees who work for the underwriter, even though they might fit the statutory definition.  And it’s by now pretty clear that despite the capacious statutory definition of underwriter, courts tend to employ a somewhat flexible reading depending on circumstances, and they aren’t terribly inclined to extend broad liability in private Section 11 cases.  See, e.g., In re Lehman Brothers Mortgage-Backed Sec. Litig., 650 F.3d 167 (2d Cir 2011).

On the other hand, most investment banks that perform an underwriter role don’t name individual employees in the registration statement – they only include the firm name.  And while that technically doesn’t matter under Section 11 (some types of Section 11 liability depend on being named, but not underwriter liability), it matters in the broader sense that underwriters serve an important signaling function to the market.  Their decision to underwrite is supposed to communicate to investors that they stand behind the offering and attest to its quality.  That’s clear not only in practical effect – see, e.g., Lily H. Fang, Investment Bank Reputation and the Price and Quality of Underwriting Services, 60 J. Fin. 2729 (2005) – but also in the legislative history.  For example, the legislative history of Section 11 (as amended in 1934), says:

When an issue of securities is proposed, a banking house will investigate the financial statement of the corporation. Based upon the statements contained in the registration statement of the corporation, a banking house will offer the securities at a certain price. Therefore, the market value is fixed by the false statement of the corporation. The individual investor relies upon the investigation made by the banker.

78 Cong. Rec. 10186 (1934) (emphasis added).  So one could argue that the choice to name names should matter in the underwriter-liability calculus, because name is a signal that the person vouches for the issue.

But on the third hand, the Third Circuit, at least, has been markedly cynical about the role underwriters play and any potential signaling function.  In Malack v. BDO Seidman LLP, 617 F.3d 743 (3d Cir. 2010), which rejected a fraud-created-the-market theory of reliance, the court held:

Yet the entities most commonly involved in bringing a security to market do not imbue the security with any guarantee against fraud.

The security's promoter and other entities involved in the issuance, such as the underwriter, the auditor, and legal counsel—the very entities often charged with fraud—cannot be reasonably relied upon to prevent fraud….

If we were to credit the fraud-created-the-market theory based on the entities involved in the issuance we would have to believe that an initial investor may reasonably rely on clearly self-interested (perhaps dishonest) parties to make decisions that are at least burdensome and at most economically irrational.  Such a belief runs counter to common sense.

(quotations and alterations omitted).  So it’s a mixed bag, is what I’m saying here.

But none of that has to do with the actual Third Circuit opinion, because on appeal, the plaintiffs focused only on their alternative claim that Zou and Downs should be liable for being “named in the registration statement as being or about to become” directors or persons performing similar functions, which the Third Circuit rejected. 

The majority read the provision only to include persons who “exercise formal power similar to directors.”  Further, the majority held that this is a question to be determined from the face of the registration itself, because statutory phrasing suggests that it’s the description in the registration statements that counts for the purposes of triggering liability under 77k(a)(3).

It strikes me that this is an unusual situation – feel free to drop a comment if this is more common than I realize – so I don’t know that the Third Circuit’s decision here has broad implications for the future, but a couple of things stand out.

First, there’s the battle over formal control versus functional control.  It’s clear that Zou and Downs probably have a lot of influence over Tibet, especially Zou, who had some other roles in Tibet’s governance.  The majority felt only formal control should matter, and the dissent felt that the statute’s language about functions “similar” to those of directors was sufficiently broad to capture the kind of practical control present here.  Now, in a way, this feels very like one of those securities law versus corporate law debates – because the securities laws tend to operate in a space of brighter, clearer lines than the fuzzier standards used in a lot of (Delaware) common law.  Delaware, of course, would look to functional control (<plug>cf: my essay After Corwin: Down the Controlling Shareholder Rabbit Hole</plug>), but Section 11 is a very specific sort of statute.

On the other hand, when we talk about the defenses available under Section 11 – basically, good faith and reasonable investigation defenses – what little caselaw exists suggests that the inquiry looks very much to the particular circumstances of the defendant, rather than his or her formal role in the company.  Think Escott v. BarChris Construction Co., 283 F. Supp. 643 (S.D.N.Y. 1968), for example, where Grant was held to a higher standard because in addition to being a director (the sole basis for potential liability under Section 11) he was also the company’s lawyer and had worked on the registration statement, and the court took that fact into account while expressly noting that he wasn’t being sued for his legal work.

Second, the Third Circuit relies on the face of the registration statement (rather than the defendant’s real-world actions) to determine whether the functions performed are similar to those of directors.  Basically, the test under 15 U.S.C. §77k(a)(3) is whether the description in the registration statement matches directorial functions - not whether someone named in the registration statement behind the scenes functioned, or was about to function, as a director.  Part of the Third Circuit’s reasoning was that the statutory reference to naming with consent suggests that defendants need to be on notice of their potential liability – they need to be able to see the exact text describing their role so they know if they’re vulnerable to Section 11 claims.  And that’s fine as far as it goes – that’s the reason for the “consent” requirement – but there is a separate provision that straight up imposes liability for people who are performing director-like functions, named in the registration statement or not. See 15 U.S.C. §77k(a)(2).  So it seems to me that the provision imposing liability for those persons who are not directors, but who are named as performing - or about to perform - director-like functions is also about ensuring that investors understand who they can rely upon to oversee the company and the offering.  I.e., if they are specifically named in the document and their duties described, it is another way of offering them up as a guarantor of quality.  So, there’s liability for persons who actually take on a director-like role and therefore assume responsibility for the offering - that’s 15 U.S.C. §77k(a)(2) - and there’s liability for persons who hold themselves out as taking on a director-like role and therefore induce investor reliance on their presence, and that’s 15 U.S.C. §77k(a)(3), dealing with persons named in the document.

Which means, when asking about whether the functions performed are “similar” to those of directors, we want to ask what kind of reliance investors would place on their role.

And that brings me to the third point, which is, the Third Circuit highlighted out that corporate directors owe fiduciary duties to the company, but Zou and Downs, as designees of the underwriter, were there to protect the underwriter’s interests, and not the shareholders’.  Should that matter in terms of whether they should be liable as directors under Section 11?  Maybe, if we think of directors as “standing behind” the offering due to their special relationship with the company.  But again, that mixes the apples of securities law with the oranges of corporate – we’d certainly hold managers of an LLC liable under Section 11 as performing functions similar to those of directors, even if the organizing documents waived fiduciary obligations.  (And fwiw, Tibet is incorporated in BVI, not Delaware; its directors have duties to act in the corporation’s best interests but they aren’t quite the same as Delaware duties).  Maybe all of this just tells us something about the nature of the influence Zou and Downs exercised: they could advise the board, but the board, knowing Zou and Downs had no duties to the company, would take that into account when deciding how much weight to place on their counsel.

Anyhoo, it’s an interesting little case.  The specific holding may not have wide application in the long run, but it touches upon a lot of issues.

Ann Lipton | Permalink


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