Statutory Sellers in the Age of Social Media

Section 12 of the Securities Act gives a right of rescission to purchasers of illegally unregistered securities, and purchasers of securities sold by means of a false prospectus. See 15 U.S.C. § 77l.  Although the right of action has existed since 1933, its exact contours have always been somewhat hazy.  But now, in the age of social media – with the potential for widespread promotion of unregistered and/or fraudulent investments (lately, cryptocurrencies) – interpretations of Section 12 are getting a work out, and the legal ground may be shifting.

So, the background.  Section 12 provides:

(a)In general

Any person who—

(1) offers or sells a security [without meeting registration requirements]

(2) offers or sells a security (… by the use of any means or instruments of transportation or communication in interstate commerce or of the mails, 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, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission,

shall be liable… to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, 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.

In Pinter v. Dahl, 486 U.S. 622 (1988), the Supreme Court addressed what it means to be a “seller” under Section 12, such that one can be held liable.  First, one is a seller if one actually passes title to the subject security in a transaction with the plaintiff.  Remote sellers, i.e., persons who passed title back in a chain of sales that led to the sale to the plaintiff, are not liable.

Second, one is a seller if one “solicits” the sale to the plaintiff, even if the soliciting person did not actually pass title.  The Court explained that brokers, for example, or agents of the seller, can be held liable under Section 12, and the critical question is whether the soliciting person acted for his own financial gain, or the financial gain of the seller.  If the soliciting person was merely offering gratuitous advice to the buyer, however, he would not come within the scope of Section 12.  The Court rejected a test that would make liability turn on whether the defendant’s “participation in the buy-sell transaction is a substantial factor in causing the transaction to take place.”  As the Court put it, “§ 12's failure to impose express liability for mere participation in unlawful sales transactions suggests that Congress did not intend that the section impose liability on participants' collateral to the offer or sale.”  The Court further elaborated, “The ‘purchase from’ requirement of § 12 focuses on the defendant's relationship with the plaintiff-purchaser. The substantial-factor test, on the other hand, focuses on the defendant's degree of involvement in the securities transaction and its surrounding circumstances.”

This test for “seller” status under Section 12 is now known as the “statutory seller” requirement, and in the aftermath of Pinter, all courts agree that whether a plaintiff proceeds under Section 12(a)(1) – for unregistered securities – or 12(a)(2) – for false prospectuses, the seller requirement remains the same.

So, two routes to liability under Section 12.  Transfer of title – which is usually easy to spot – or solicitation.  But what is a solicitation?  In a bunch of cases interpreting Pinter, courts latched on to the “defendant's relationship with the plaintiff-purchaser” language to hold that statutory sellers must have direct contact with the plaintiff, or at least some kind of active relationship with the plaintiff, to become liable.  See, e.g., Holsworth v. BProtocol Foundation, 2021 WL 706549 (Feb. 22, 2021). This often came up in the context of registered offerings, where plaintiffs suing for false prospectuses were informed that participation in the preparation of offering materials is not “solicitation” for Section 12 purposes, unless there was some kind of direct relationship between the preparer and a particular purchaser.  Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996); Mass. Mut. Life Ins. Co. v. Residential Funding Co., LLC, 843 F. Supp. 2d 191 (D. Mass. 2012); Braun v. Ontrak, 2022 WL 5265052 (Cal. Super. Oct. 4, 2022); Citiline Holdings v. iStar Fin., 701 F. Supp. 2d 506 (S.D.N.Y. 2010); Rosenzweig v. Azurix Corp., 332 F.3d 854, 871 (5th Cir. 2003); Baker v. SeaWorld Entertainment, 2016 WL 2993481 (S.D. Cal. Mar. 31, 2016); In re Westinghouse Sec. Litig., 90 F.3d 696 (3d Cir. 1996); Freeland v. Iridium World Comms., 2006 WL 8427320 (D.D.C. Sept. 15, 2006); In re Deutsche Telekom AG Sec. Litig., 2002 WL 244597 (S.D.N.Y. Feb. 20, 2002).

But now we have social media!  And more and more investment opportunities are being advertised through mass communications (sometimes, in Regulation A offerings, which are subject to Section 12 liability for false communications).  A bunch of these are, of course, cryptocurrencies, where the issue isn’t just false prospectus communications, but unregistered sales.  All of which makes a flat rule of personal communication somewhat unsatisfying.

Recently, the Ninth and Eleventh Circuit reversed district court rulings that direct communication was necessary.  Both Circuits held that mass social media communications that urge particular investments can trigger Section 12 liability to all affected purchasers.  See Wildes v. Bitconnect, 25 F.4th 1341 (11th Cir. 2022); Pino v. Cardone Capital, 55 F.4th 1253 (9th Cir. 2022); see also Owen v. Elastos Foundation, 2021 WL 5868171 (S.D.N.Y. Dec. 9, 2021); Balestra v. ATBCoin LLC, 380 F. Supp. 3d 340 (S.D.N.Y. 2019).

Notice the shift, then.  For some courts, preparing a prospectus for a registered offering was not deemed to involve sufficient solicitation to trigger Section 12 liability - but now other courts are saying that urging purchases on social media is sufficient.  Someone’s got to give.

And even on the internet, what kind of communications qualify?  That part’s still not entirely clear.  In the social media cases, the defendants created and sold particular investments and hawked them relentlessly, and that was found to be a solicitation.  Which brings us to Underwood v. Coinbase Global, Inc., 2023 U.S. Dist. LEXIS 17201 (S.D.N.Y. Feb. 1, 2023).

There, a class of plaintiffs alleged that many of the cryptotokens available for sale on the Coinbase exchange were, in fact, unregistered securities, and brought a battery of claims against Coinbase, including claims under Section 12 for unregistered sales.  The plaintiffs actually tried to establish liability under both of Pinter’s definitions of seller – they sued Coinbase for transferring title, and for soliciting sales.

So, let’s start with the title transfer allegations.  As we all know, in securities class actions, the original complaints are filed, consolidated, and then a notice is issued alerting other potential plaintiffs of the case.  Any plaintiffs (the original ones, or new ones) may then petition the court for “lead plaintiff” status.  The court appoints a lead, and (usually) appoints that lead’s chosen counsel as lead counsel, and a new, consolidated complaint is filed.  That consolidated complaint becomes the operative complaint for the case.  And, because the original plaintiffs may not be appointed lead, the early pleadings tend to be very sparse placeholders, in anticipation of a more detailed pleading to come after the leads are selected.

In Coinbase, however, there was no battle for lead status – after the original complaint was filed, one other plaintiff and one other law firm joined with the original plaintiffs/counsel, and they were all appointed lead together, after which they filed the amended complaint.

As is typical in these situations, the amended complaint was much longer and more detailed than the original complaint.  But, crucially, the original complaint had alleged that traders on the Coinbase exchange trade with each other, and Coinbase facilitates the exchange.  The amended complaint alleged that Coinbase acts as a market maker, buying directly from one user to sell to another, and vice versa – which would make it a statutory seller for Section 12 purposes under Pinter’s first prong.

Judge Engelmayer refused to accept the amended complaint’s allegations.  Citing circuit authority, he held that when an amended complaint contains factual allegations that contradict the facts alleged in earlier complaints, the new allegations may be rejected.  And he buttressed that holding by pointing out that the user agreement cited in the original complaint – but not the amended version – described Coinbase as merely facilitating transactions between users without trading itself.

I mean … I have no idea how Coinbase arranges its transactions, but, considering how securities class actions are organized, Judge Engelmayer’s holding is a little concerning, because the whole point is that early complaints are not drafted with the same kind of care as the consolidated complaint.  That’s not ideal, but it’s an inevitable byproduct of the lead plaintiff process, and the lead plaintiff process is – for its flaws – one of the best things to come out of the PSLRA.  And, in this case, a new plaintiff and new firm joined the action.  I don’t know the history there but it’s certainly possible neither had anything to do with the original complaint, and became part of the action because of the notice – precisely as the PSLRA intended.  It’s troubling that these new parties might be bound by mistakes – perhaps flat out errors – made by the original filers.

But let’s move on to the second prong of Pinter, concerning solicitation liability.  Plaintiffs alleged that Coinbase made money on trades – satisfying Pinter’s requirement that the solicitation be motivated by the defendant’s financial gain – and that Coinbase participated in “airdrops” of particular new token offerings, wrote news stories on price movements of particular tokens, and linked to news stories about them.

This, according to Judge Engelmayer, was not sufficient to qualify as solicitation under Pinter:

To hold a defendant liable under Section 12 as a seller, a purchaser such as plaintiffs must, therefore, demonstrate its direct and active participation in the solicitation of the immediate sale…. the AC's allegations regarding Coinbase's "solicitation" of the transactions involving the Tokens fail, because they do not describe conduct beyond the "collateral" participation that Pinter and its progeny exclude from Section 12 liability.  … These activities of an exchange are of a piece with the marketing efforts, "materials," and "services" that courts, applying Pinter’s second prong, have held insufficient to establish active solicitation by a defendant.

I’m not even saying this decision is wrong, exactly, but the line between participating in promotional “airdrops” and linking to articles about price movements, and urging purchases through YouTube and Instagram (as occurred in some of the social media cases where plaintiffs were allowed to proceed), is a fuzzy one – and that’s exactly what the Supreme Court was trying to avoid in Pinter.  See 486 U.S. at 652 (“the substantial-factor test introduces an element of uncertainty into an area that demands certainty and predictability”).

Anyway, it’s an area where the law is rapidly developing so … stay tuned.