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1975

Liability for Misleading Statements Under Section 11 Liability for Misleading Statements Under Section 11

Ted J. Fiflis University of Colorado Law School

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Citation:Ted J. Fiflis, Liability for Misleading Statementsunder Section 11, 21 Prac. Law. 35, 54 (1975)Provided by: William A. Wise Law Library

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Liability forMisleading Statements

under Seetion 11

TED J. FIFLIS, Professor of Law, University of

Colorado School of Law, Boulder, Colorado

Speaking generally, § 11 of theSecurities Act of 1933 (hereafterthe "Act"), 15 U.S.C. §77K(1970), gives purchasers of regis-tered securities a cause of actionagainst several participants in aregistered offering for an untruestatement or omission of a materialfact in the final, effective registra-tion statement.

A particular registered offeringmay be subject as well to otherliability provisions, such as §10b-5of the Securities Exchange Act of1934.

The leading cases on § II havebeen Escott v. Bar Chris Construc-tion Corp., 283 F. Supp. 643(S.D.N.Y. 1968), and Feit v.Leasco Data Processing Equip-ment Corp.. 332 F. Supp. 544(E.D.N.Y. 1971). Another case(in two opinions) which presum-ably will be of importance isBeecher v. Able, [1973-1974

Transfer Binder] CCH FED. SEC.L. REP. 194,450 (S.D.N.Y. 1974),and [1974-1975 TransferBinder]CCH FED. SEC. L. REP. 95,016(S.D.N.Y. 1975).

SCOPE

The incidence of § 11 was re-cently extended as a result of theadoption of Rule 145, whichrepealed Rule 133, the "no-salerule," and made securities trans-actions in certain previously ex-empted reclassifications, mergers,and purchases of assets for stocksubject to the registration require-ments. Since adoption of Rule 145,a registration statement will berequired in a statutory merger un-less an exemption is available, andmisrepresentations or omissions inthe registration statement will besubject to §11 exposure. However,on a purchase of assets for securi-ties, Rule 145(3) requires is-

36 THE PRACTICAL LAWYER (Vol. 21--No. 7)

tration only if the transfer of assetsis part of a pre-existing plan fordistribution of the securities, orthe asset seller is dissolved or dis-tributes the securities received oradopts resolutions for dissolutionor distribution within a year of thevote of its shareholders on theasset sale.

Section II therefore relates toall the various types of registeredofferings-direct offerings by issu-ers, including corporate combina-tions, reorganizations, and sharefor share exchanges, and registeredsecondary offerings by persons ina control relationship with theissuer, including a parent corpora-tion's use of its subsidiary's securi-ties in a corporate combination,and vice versa.

Non-registered primary or sec-ondary offerings, including "Reg.A" offerings, are not covered by§ 11 but may be subject to otherliability provisions of the securitiesacts.

Even if accompanied by a pros-pectus, oral misrepresentations arenot covered by §11, although anaction may be available under§12(2) or §17(a) of the 1933Act, Rule 1Ob-5 promulgated un-der the 1934 Act, and, in certaincircumstances, §§9, 14, and 15under the 1934 Act.

PURPOSES

The general assumption is that§11 liability is not punitive in na-

ture, though its exclusive purposedoes not seem to be to make theinvestor whole. Rather, it appearsto be aimed at effectuating the twoexpressed policies stated in thepreamble to the Act: "To providefull and fair disclosure of the char-acter of securities sold in interstateand foreign commerce and throughthe mails, and to prevent frauds inthe sale thereof, and for other pur-poses."

One other matter that maythrow light on § 11 is the fact thatthe original version of the section,enacted at the nadir of businessprestige in early 1933, was amend-ed in 1934 as the result of a con-certed campaign to weaken its pro-visions. Numerous changes whichseem incompatible with the majorthrust of § 11 were adopted at thattime. Hence, these clauses are theproduct of ultimate compromiseby two antagonistic factions.

PLAINTIFFS

Linear PrivitySection 11(a), agrammar, states:

victim of poor

In case any part of the regis-tration statement, when such partbecame effective, contained an un-true statement of a material factor omitted to state a material factrequired to be stated therein ornecessary to make the statementstherein not misleading, any personacquiring such security (unless itis proved that at the time of such

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LIABILITY FOR MISLEADING STATEMENTS UNDER SECTION 11 37

acquisition he knew of such un-truth or omission) may, either atlaw or in equity, in any court ofcompetent jurisdiction, sue . . .(italics supplied).

Because the phrase, "such se-curity," is an appositive withouta referent, the issue is posedwhether only persons who acquireda security in the chain of title fromthe registered offering-linear priv-ity-may sue, or whether anyonewho acquired a security of thesame class as those registered mayalso sue.

Barnes v. Osojsky, 373 F.2d269 (2d Cir. 1967), and ColonialRealty Corp. v. Brunswick Corp.,257 F. Supp. 875 (S.D.N.Y.1966), held that a plaintiff mustprove linear privity. See also Rud-nick v. Franchard Corp., 237 F.Supp. 871 (S.D.N.Y. 1965),where an underwriter in the firstof two registered offerings was notliable to buyers in the secondoffering. Hence if the registeredoffering is of a class previouslyoutstanding, or if additional offer-ings are made, a plaintiff may beunable to recover if he cannotsustain his burden of proving linearprivity.

The proposed American LawInstitute Federal Securities Code(hereafter "ALI Code") §§1403and 1409 (T.D. No. 2, 1973),would permit recovery by all per-sons purchasing subsequent to theoffering statement, the functional

equivalent of the prospectus, but itwould prorate the recovery amongall claimants.

Class ActionsBecause the misrepresentations

and omissions actionable under§11 are all contained in or omittedfrom a single registration state-ment, one important characteristicfacilitating class actions is estab-lished. As a result, class suits arecommon under the section and arewell suited. See H. BLOOMENTHAL,SECURITIES AND FEDERAL COR-

PORATION LAW 8-98 (Clark Board-man, New York, 1975).

Actions by UnderwritersProfessor Loss has suggested

that an underwriter, being one who"acquired" the securities in a regis-tered offering, may himself havean action under §11 although heis also one of the class of defen-dants. 3 L. Loss, SECURITIES REG-ULATION 1723-24, n. 129 (LittleBrown, Boston, 2d ed. 1961).(This set and the 1969 Supple-ment, volumes 4, 5, and 6, willhearafter be cited "Loss.") But herecognizes the disruption that thisright to sue would cause in theoperation of §11(f), providing forcontribution among the defendants.6 Loss at 3844.

Priorities on InsolvencyIf the issuer is insolvent, there

may be claims against the insol-37

38 THE PRACTICAL LAW/YER (Vol. 21-No. 7)

vent estate both by equity securitypurchasers suing under §11 andother non-equity creditors, sug-gesting a question whether the §11equity holding plaintiffs shouldshare on a par with other creditorsor should be subordinated. Thisproblem arises with other pro-visions of the securities acts aswell. See Slain & Kripke, TheInterlace Between Securities Regu-lation and Bankruptcy-Allocatingthe Risk of Illegal Securities Issu-ance Between Security Holdersand the Issuer's Creditors, 48N.Y.U. L. REV. 261 (1973).

The uniform answer so far hasbeen that securities act claimantsare creditors regardless of whethertheir claims derive from someequity security, and will share ona par with other unsecured credi-tors on insolvency. Four SeasonsNursing Centers of America, Inc.,472 F.2d 747 (10th Cir. 1973);In Re Los Angeles Land & Invest-ments, Ltd., 282 F. Supp. 448(D. Hawaii 1968); SEC v. Insur-ance Investors Trust Co., [ 1971-72Transfer Binder] CCH FED. SEC.L. REP. 93,259 (W.D. Ky.1971); Carpenter v. Hall, 311 F.Supp. 1099 (S.D. Tex. 1970),petition for writ of mandamus de-nied in part and granted in partsub. nom. Ernst & Ernst v. U.S.Dist. Ct., 457 F.2d 1399 (5th Cir.1972). Cf. Oppenheimer v. Harri-man Nat. Bank & Trust Co., 301U.S. 206 (1937).

The rule has been criticized bySlain & Kripke, supra, who recom-mend subordination where anequity holder claims rescission.The proposed Bankruptcy Act of1973 §4-406, H.R. Doc. No.93-137, 93d Cong., 1st Sess.(1973), introduced as H.R. 10792and S.2565, would subordinatenot only rescission claimants buteven those whose claims are basedon a tort by non-selling defendants.The ALI Code §1602(d), T.D.No. 3 (1974), will follow what-ever provisions the Bankruptcy Actcontains.

DEFENDANTS

Section I1 also presents somedifficult problems of interpretationas to who are proper defendants,although it seems to identify veryspecifically several categories. Thequestions arise in determining whobelongs in each category.

Section 11(a) lists as possibledefendants:

* Signers of the registration state-ment;

0 Directors, partners, or near di-rectors and partners of the issuer;

* Experts who are named as hav-ing prepared or certified a part ofthe registration statement; and

0 Underwriters of the security.

SignersSection 6(a) of the Act, 15

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LIABILITY FOR MISLEADING STATEMENTS UNDER SECTION 11 39

U.S.C. §77f(a), specifies thosewho are required to sign a regis-tration statement:

[E] ach issuer, its principal exec-utive officer or officers, its principalfinancial officer, its comptroller orprincipal accounting officer, andthe majority of its board of direc-tors or persons performing similarfunctions (or if there is no boardof directors or persons performingsimilar functions, by the majorityof the persons or board having thepower of management of the is-suer), and in case the issuer is aforeign or territorial person" by itsduly authorized representative inthe United States.

Since §11(a) seems to be un-ambiguous in holding every personwho "signed," any ambiguities of§6(a) presumably will have beenresolved at the time of filing theregistration statement. Those whosigned will be liable, but not thosewho did not. But see Douglas &Bates, The Federal Securities Actof 1933, 43 YALE L. J. 171, 194(1933).

Directors and Near Directors§11(a)(2) and (3) add to the

list of possible defendants:(2) [E]very person who was a

director of (or person performingsimilar functions) or partner inthe issuer at the time of the filingof the part of the registrationstatement with respect to whichhis liability is asserted.

(3) [E]very person who, withhis consent, is named in the regis-tration statement as being or aboutto become a director, person per-forming similar functions, or part-ner.

Does a "person performing sim-ilar functions" to those performedby directors include a person whocontrols dummy directors? Thedictum in Mersay v. First RepublicCorp. of America, 43 F.R.D. 465,469 (S.D.N.Y. 1968), indicates so.More likely, only persons who di-rect non-corporate issuers, likegeneral partners, trustees, and as-sociates, are covered. See 3 Lossat 1724, n.130. The legislative his-tory of § 15 of the Act, dealingwith vicarious liability, indicatesthat it is that section that is aimedspecifically at the principal of adummy director. S. Rep. No. 47,73d Cong. 1st Sess. 5 (1933);H.R. Conf. Rep. No. 152, 73dCong. 1st Sess. 27 (1933).

Experts§ll(a)(4) makes liable:[E]very accountant, engineer, or

appraiser, or any person whoseprofession gives authority to astatement made by him, who haswith his consent been named ashaving prepared or certified anyreport or valuation which is usedin connection with the registrationstatement, with respect to thestatement in such registrationstatement, report, or valuation,

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40 THE PRACTICAL LAWYER (Vol. 21-No. 7)

which purports to have been pre-pared or certified by him.

Although ordinarily the phrase"whose profession gives authorityto a statement made by him" mightbe ambiguous, the practical ad-ministration of the registrationprocess removes any doubt, sincethe Securities and Exchange Com-mission (hereafter "Commission")requires that manually signed con-sents to be named an expert befiled with it before the registrationstatement will be made effective.See 3 Loss 1740-41.

It would seem that, as with"signers," one who signs a consentwill be considered an expert.

Unlike any of the other personsliable under §11, experts are liableonly if the portion of the registra-tion statement purporting to bemade on their authority is mis-leading. §11(a)(4).

Underwriters§11(a) concludes the list of

those liable with "every underwrit-er with respect to such security."

Because the term "underwriter"is a word of art, not only are themanaging and participating under-writers held but so too are theso-called "statutory underwriters"as defined in §2(11), as well asthe "last moment underwriter"under §11(d). SEC Securities ActRelease No. 5275 (June 26,1972), CCH FED. SEC. L. REP.

ff4506B at pp. 4056-57; Folk,

Civil Liabilities Under the FederalSecurities Acts: The Bar Chris Case(Part I1), 5 VA. L. REv. 199, 227-34 (1969).

Statutory underwriters may in-clude, for example, controllingpersons as well as lenders who takeshares from controlling persons aspledges, although the term doesnot include selling group brokersunless they receive special treat-ment from the underwriters.

Controlling PersonsIn addition to the persons

named in §11(a), liability under§11 may be imposed by §15 of theAct on certain others. Section 15,15 U.S.C. §770, reads:

Every person who, by orthrough stock ownership, agency,or otherwise, or who, pursuant toor in conjunction with an agree-ment or understanding with one ormore other persons by or throughstock ownership, agency, or other-wise, controls any person liableunder sections 11 or 12, shall alsobe liable jointly and severally withand to the same extent as suchcontrolled person to any person towhom such controlled person isliable, unless the controlling per-son had no knowledge of or rea-sonable ground to believe in theexistence of the facts by reason ofwhich the liability of the controlledperson is alleged to exist.

Because the "unless" clause,added by the 1934 amendments,

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LIABILITY FOR MISLEADING STATEMENTS UNDER SECTION 1 41

gives a special defense to controlpersons, it will often be importantto determine whether one is liableunder §15 or §11(a).

Vicarious LiabilityFurther, vicarious liability may

be imposed on persons other thanthose specified by §§11(a) and 15by operation of common law rulesof agency or aiding and abetting.See especially In re Caesar's PalaceSecurities Litigation, 360 F. Supp.366, 383 (S.D.N.Y. 1973) (aid-ing and abetting a §11 violation);SEC v. Management Dynamics,Inc., [1974-1975 Transfer Bind-er] CCH FED. SEC. L. REP.

195,017 (2d Cir. 1975) (SECenforcement proceeding, principalheld liable for agent's fraud underthe analogue to §15 and §20(a) ofthe Securities Exchange Act of1934, and Rule lOb-5; §20a heldto supplement and not restrict vi-carious liability.)

There may be some questionwhether persons who control dum-my directors are covered, not by§15, but by §11(a)(2) and (3),which imposes the same liabilitythat directors face upon "personsperforming similar functions" asdirectors.

Security Holders inControl Relationship

Conspicuous by their absencefrom §11(a) as potential defend-ants are security holders in a "con-trol relationship" with the issuer,

whose offerings may have to beregistered under §5.

Control persons are not exempt-ed from the registration require-ments of §5 if they use a §2(11)statutory underwriter to make adistribution, as those terms aredefined by the Act and Rule 144.If the sale is but a "link in a chainof transactions through which se-curities move from an issuer to thepublic," it must be registered. Pre-liminary Note to Rule 144. A per-son is in a "control relationship,"as defined in the last sentence of§2(11), if he controls an issuer,is controlled by an issuer, or isunder common control with theissuer, as in a brother-sister cor-poration relationship.

Therefore a person in a "con-trol relationship" whose sharesmust be registered under §5 willnot be subject to §11 liability un-less he is in that one type of "con-trol relationship" whereby he isthe one who is in control, because§11 itself does not list control per-sons as defendants and §15 in-cludes only the "controlling per-son" who controls someone.

ELEMENTS OF PLAINTIFF'S CLAIM

Misrepresentationsand Omissions

Misrepresentations of fact, half-truths, and omissions of facts re-quired in the registration state-ment, if material, are actionablewhen contained in or omitted from

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the effective registration statement.However, misrepresentations andomissions from other documents,such as the "red herring" prospec-tus, are not actionable under § 11.

What are "facts" and what are"material facts" are questions ofno small moment. See Schneider,Nits, Grits and Soft Informationin SEC Filings, 121 U. PA. L.REV. 254 (1972); Kripke, RulelOb-5 Liability and "Material""Facts," 46 N.Y.U. L. REv. 1061(1971). Literal-mindedness as towhat constitutes a fact is not inconsonance with recent decisions,which have held that estimates ofan insurance company's excess re-serves are facts, Feit v. LeascoData Processing Equipment Corp.,332 F. Supp. 544 (E.D.N.Y.1971), as are projections of profits,Beecher v. Able [1973-1974Transfer Binder] CCH FED. SEC.L. REP. 194,450 (S.D.N.Y.1974). But see Heller, DisclosureRequirements Under Federal Se-curities Regulation, 16 Bus. LAW-YER 300, 307-08 (1961), protest-ing that such information is not"facts."

The common law recognizedthat an utterance was actionableif misleading even though it wasan opinion, and the emphasis wason "material," not on "fact." Whileprojections were not facts underearly common law cases, an attor-ney's opinion of law could be mis-leading if, under the circumstances,

it was reasonable to rely upon it.W. PROSSER, TORTS 725 (WestPublishing, St. Paul, 4th ed. 1971).Accountants still urge in theirpleas for a "better understanding"of accounting by lawyers that audi-tors' reports are merely "opinions."The misunderstanding is on theother side.

Subsequently Discovered Factsand UpdatingBecause §11(a) speaks of mis-

representations and omissionswhen the registration statementbecame effective, two quite similarsituations receive differing treat-ment. The draftsmen, apparentlyconcerned in §11 with maximizingthe possibilities for an honest reg-istration statement, required onlythat it be true when made-i.e.,when effective.

Thus, representations that weretrue when made, but which sub-sequently become false becausecircumstances changed, are neitheractionable under §11 nor requirepost-effective amendments to theregistration statement. See I Loss293.

On the other hand, representa-tions that were false when made,although the falsity is not discov-ered until later, are actionableunder §11, and require "post-effective" amendments to the reg-istration statement. See 1 Loss219.

For other fraud sections of the

OCTOBER 15

LIABILITY FOR MISLEADING STATEMENTS UNDER SECTION 11 43

securities acts, both types of casesare treated as misleading. Fischerv. Kletz, 266 F. Supp. 180(S.D.N.Y. 1967); Fiflis, CurrentProblems of Accountants' Respon-sibilities to Third Parties, 28 VAND.L. REV. 31, 128-30 (1975). Bothtypes of cases would seem to in-voke the doctrine of SEC v. ManorNursing Centers, Inc., 458 F.2d1082, 1096-97 (2d Cir. 1972),which held that a prospectus truewhen made, but which later be-came false, is not a prospectus forpurposes of §5 requiring deliveryof a prospectus on sale of a se-curity. The case would clearly ap-ply where the prospectus was falsefrom the start but the falsity wasdiscovered belatedly. See Folk,Civil Liabilities under the FederalSecurities Acts: The Bar ChrisCase (Part II), 5 VA. L. REV 199,256-266 (1969).

Unfulfilled ProjectionsProjections frequently appear in

prospectuses. Although projectionswere specifically prohibited only inproxy solicitations under the Noteto Rule 14a-9, the Commissionhad a basic policy against any pro-jections in prospectuses until twoyears ago. Gerstle v. Gamble-Skogmo, Inc., 478 F.2d 1281 (2dCir. 1973); Thomas Bond, Inc.,5 S.E.C. 61, 71 (1939); T. FIFLIS& H. KRIPKE, ACCOUNTING FORBUSINESS LAWYERS 472 (WestPublishing, St. Paul, 1971). Theyare now permitted but not re-

quired. SEC Securities ExchangeAct Release No. 9844 (Nov. 1,1972 [1972-1973 Transfer Bind-er] CCH FED. SEC. L. REP.

79,075; Beecher v. Able (1973-1974 Transfer Binder] CCH FED.SEC. L. REP. 94,450, at p. 95,561(S.D.N.Y. 1974) (by stipulationof parties). See also the "hot is-sues" releases and other itemscited in Ruder, Disclosure of Fi-nancial Projections, FIFTH AN-NUAL INSTITUTE ON SECURITIES

REGULATION 5, 9-10 (PractisingLaw Institute, New York City,1974).

If projections are false whenmade because without foundation,they will result in liability onlywhen damages occur. Hence, mostoften suits probably will not bebrought unless the projections donot eventuate or some other fac-tors cause a decline in values. Inthe latter event, the "comparativecausation" concept of §11 (e) mayapply. On the other hand, a pro-jection may not be false eventhough it later fails to occur.

One important case involvingprojections was a §11 case, onlyrecently completed at the triallevel. Beecher v. Able [1973-1974, Transfer Binder] CCH FED.SEC. L. REP. 794,450 (S.D.N.Y.1974), and [1974-1975 TransferBinder] CCH FED. SEC. L. REP.f195,016 (S.D.N.Y. 1975). In thefirst opinion, the Court held thatpredictions in a prospectus that

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44 THE PRACTICAL LAWYER (Vol. 21---No. 7)

Douglas Aircraft would break evenfor a particular year were materi-ally false because of a failure todisclose some uncertain assump-tions underlying the forecast andthe fact that prior projections hadbeen quite inaccurate. In the sec-ond opinion, the Court considereddamages under §11(e).

On the other hand, in Dolgowv. Andersen, 53 F.R.D. 664(E.D.N.Y. 1971), afl'd, 464 F.2d437 (2d Cir. 1972), where theCourt held merely that the actioncould not proceed as a class action,it said that an unmet projectionwas probably not a misrepresenta-tion even though the underlyingassumptions were not stated. Per-haps the cases can be reconciledon the basis of the reasonablenessof the assumptions under the cir-cumstances. See generally, Com-ment, 16 B.C. IND. & COMM. L.REV. 115 (1974).

PleadingThe pleading of misrepresenta-

tions or omissions under §11 isnot regulated by Rule 9(b) of theFederal Rules of Civil Procedure,which requires pleading of fraudwith particularity. Schoenfeld v.Giant Stores Corp., F1973-1974,Transfer Binder] CCH FED. SEC.

L. REP. 94,460 (S.D.N.Y.1974).

MaterialityThe formal definitions of mate-

riality tend to use synonyms in a

circular way-e.g., a fact is mate-rial to a reasonable man if anordinary person would, or might,consider it important, or if it is amatter as to which an averageprudent investor ought reasonablyto be informed before purchasing.These definitions are not usefulexcept to begin the inquiry, whichseems to boil down to whether thetrier of fact believes that an in-vestor justifiably relied.

The determination of the courtis not always convincing. In Escottv. Bar Chris Construction Co., 283F. Supp. 643 (S.D.N.Y. 1968),the Court found a misstatement ofthe current ratio at 1.9 to I ratherthan 1.6 to 1 to be material, whilean earnings overstatement of 16per cent was not material whereactual earnings had increased from$441,103 for 1959 to $1,496,196for 1960, instead of the misrepre-sented increase to $1,742,801.

The most interesting treatmentof materiality was in Feit v. LeascoData Processing Equipment Corp.,332 F. Supp. 544 (E.D.N.Y.1971), where Judge Weinsteinarticulated several features of theconcept. Among other things, hepointed out that materiality in aformal document such as a pros-pectus is more readily establishedthan when the same words areused informally, and that it dif-fered with the various antifraudprovisions of the securities actsand with the nature of the com-

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LIABILITY FOR MISLEADING STATEMENTS UNDER SECTION nI 45

munication as an affirmative state-ment or omission.

Defendants' CulpabilityA plaintiff need not establish

the defendant's knowledge of, ornegligence concerning, the untruth,or the foreseeability of the harmor an intent to cause it, althougha defendant other than the issuerwill have certain due diligencedefenses.

CausationA plaintiff need not show that

the purchase was caused by themisrepresentation, unless he ac-quired the security after an earn-ings statement for a 12 monthperiod after the effective date ofthe registration statement wasmade generally available to theissuer's security holders. Eventhen, reliance may be establishedwithout proof of the reading ofthe registration statement. §11(a).

The possibility of reliance on anunread registration statement haspuzzled many. Doubtless, this lan-guage in §11(a), being one of the1934 amendments, was the resultof some pushing and shoving bythe antagonists and is not com-pletely clear. However, one of thedraftsmen explains it by suggestingthat the seller's claims, communi-cated to the buyer, will be basedon the registration statement. Seeletter of James M. Landis to FelixFrankfurter dated December 4,

1933, quoted extensively in R.CHATOV, THE COLLAPSE OF COR-

PORATE FINANCIAL STANDARDS

REGULATION: A STUDY OF SEC-ACCOUNTANT INTERACTION 150(Ph.D. Dissertation, U. Cal.,Berkeley, 1973).

Furthermore, reliance by an in-vestor on the unread untruth couldalso be the result of an investmentadvisor's recommendations basedon the registration statement, Rud-nick v. Franchard Corp., 237 F.Supp. 871, 873 (S.D.N.Y. 1965),as well as reliance on the marketprice as being based on legal dis-closure. Cf. Competitive Associ-ates, Inc. v. Laventhol, Krekstein,Horwath & Horwath, [1974-1975 Transfer Binder] CCH FED.

SEC. L. REP. 95,090 (2d Cir.1975); Reeder v. MastercraftElectronics Corp., 363 F. Supp.574 (S.D.N.Y. 1973).

THE MEASURE OF DAMAGES

A contract measure of damageswould give a plaintiff the differencebetween what he paid and thevalue, at that time, of what hereceived. Section 11(e), however,uses a different measure, compli-cated with variables, resulting ineight different possible combina-tions. In addition, it establishes aspecial measure for underwriters,and provides all defendants witha "comparative causation" defense.

Because of the various combina-tions, it is impossible to state the

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general measure in a simple sen-tence. The statute uses threeclauses in a compound sentence,which, when paraphrased, say:

The general measure of damagesfor all except underwriters is theamount paid by the plaintiff, or thepublic offering price, whichever isless, minus:

' The value at the time of suit, ifthe securities have not been resoldbefore judgment;

*The sale price received, if thesecurities have been resold in themarket before suit; or

• The higher of value at time ofsuit or price received on resale, ifthe securities have been resoldafter suit but before judgment.

In a recovering market, a plain-tiff's attorney must be careful totell the client that he may recoverless if he resells the security thanif he holds it.

Numerous complex questionsmay arise, making the formulaeven more difficult. For example,the "value" even of publicly tradedsecurities unsold at the time ofsuit may not be trading price. Feitv. Leasco Data Processing Equip-ment Corp., 332 F. Supp. 544(E.D.N.Y. 1971). Cf. Beecher v.Able, [1974-1975 Transfer Bind-er] CCH FED. SEC. L. REP.195,016 (S.D.N.Y. 1975). Andwhat is the value of a security soldbefore suit if the sale is a distress

sale rather than "in the market?"If the defendant is an under-

writer, his liability is further lim-ited unless he received some spe-cial benefit from the issuer. Theoutside limit for an underwriter isthe total offering price of thesecurities underwritten by him andactually distributed to the public.This outside limit is based on theprice of the securities sold, not onthe damages incurred, and shouldbe contrasted with the underwrit-er's liability under §10b-5. Chris-Craft Industries, Inc. v. Piper Air-craft Corporation, [1974-1975Transfer Binder] CCH FED. SEC.L. REP. 95,058 (2d Cir. 1975).

Regarding the measure of dam-ages generally, see Cherner v.Transitron Electronic Corp., 221F. Supp. 48 (D. Mass. 1963);Fox v. Glickman Corp., 253 F.Supp. 1005 (S.D.N.Y. 1966);Beecher v. Able, [1974-1975Transfer Binder] CCH FED. SEC.L. REP. 95,016 (S.D.N.Y.1975).

Under the ALI Code, § 1403 (h),Reporter's Revision of Text ofT.D.'s Nos. 1-3 (1974), therewould be a general $100,000 perdefendant limit of liability fornegligence on all but underwritersand issuers, except that for de-fendants whose gross revenues ex-ceed $10,000,000, the limit is 1per cent of their gross revenues,to a maximum of $1,000,000. SeeT.D. No. 2 Comment e, p. 106.

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LIABILITY FOR MISLEADING STATEMENTS UNDER SECTION 11 47

Concomitantly, recovery is to beprorated among all the potentialclaimants. ALI Code §1409.

Comparative Causation

As a result of the 1934 amend-ments, §11(e) was altered to per-mit a defendant to prove that anyportion of the damages did notresult from the untruths in the partof the registration statement uponwhich his liability is asserted.

The opponents of this amend-ment probably comforted them-selves with the thought that, as apractical matter, it could never beeffectively invoked. That was theview held by two able commenta-tors. R. JENNINGS & H. MARSH,SECURITIES REGULATION, CASES

AND MATERIALS 810 (FoundationPress, Mineola, N.Y., 2d ed.1968). But Feit vs. Leasco DataProcessing Equipment Corp., 332F. Supp. 544, 586-587 (E.D.N.Y.1971), has given the words apowerful effect.

In that decision, Judge Wein-stein reasoned that the share valueswould have declined proportion-ately to the Standard & Poor'sDaily Stock Price Index, and hetherefore diminished the measureof damages in the same proportion.In Beecher v. Able [1974-1975Transfer Binder] CCH FED. SEC.L. REP. 95,016, at p. 97,560(S.D.N.Y. 1975), Judge Motleyendorsed the Leasco technique but

found that the defendants therehad failed in their burden of proof,offering numerous items of evi-dence to show that the security'svalue probably would not havedropped. However, even in thiscase, the plaintiffs had made aconcession based on the concept of§11(e).

The ALI Code has adopted thisproviso for all kinds of cases, notlimiting it to §11 type situations.The comments refer to the conceptas "comparative causation." See§1402(f)(2)(A) and commentsthereto in T.D. No. 2 (1973).

RescissionThe 1934 amendments intro-

duced some enigmatic languageconcerning the relief available tothe plaintiff.

The words of §11 (a) permittingsuits "at law or in equity" and of§11(e) that the suits authorizedunder §11(a) "may be to recoversuch damages" leave open thequestion whether the plaintiff islimited exclusively to the defineddamage liability of §11(e) orwhether he may obtain equitablerelief such as rescission.

In certain circumstances, rescis-sion may be more favorable to aplaintiff than damages and mayinvoke equity practices and pro-cedures not otherwise applicable.Still, the infirmities of a commonlaw rescission action, described inShulman, Civil Liability and theSecurities Act, 43 YALE L. J. 227,

47

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48 THE PRACTICAL LAWYER (Vol. 21--No. 7)

231-33 (1933), would perhaps beapplicable to an action for rescis-sion based on §11.

A consideration of the historyof the 1934 amendments repealing,inter alia, an express rescissionremedy, is relevant. Section 11 (e)had originally read: "The suitauthorized under subsection (a)may be either (1) to recover theconsideration paid for such secur-ity with interest thereon, less theamount of any income receivedthereon, upon the tender of suchsecurity or (2) for damages if theperson suing no longer owns thesecurity."

Section 12(2), which now readsas the original §11(e) had read,allows, according to IndependenceShares Corporation v. Deckert, 108F.2d 51 (3d Cir. 1939), an actionmerely for money damages andnot for equitable relief. But theSupreme Court, reversing in Deck-ert v. Independence Shares Corp.,311 U.S. 282, 287-88 (1940),held that although the ultimate re-covery under §12(2) must belimited to what is permitted there-under, the form of action or theprocedure employed may includea claim for equitable relief underthe "Act as a whole" and §22(a),which permits enforcement inequity or law of all liabilities underthe Act.

Both of the same grounds applyequally under §11(e) as it nowreads. Furthermore, the plaintiff

should be able to add a count un-der §12(2) and seek rescission orother equitable relief, following theSupreme Court's decision in Deck-ert. I. 1. Case Co. v. Borak, 377U.S. 426 (1964), and Mills v. TheElectric Auto-Lite Co., 396 U.S.375 (1970), further strengthenthis view. But see Gerity v. CableFunding Corp. [1973 TransferBinder] CCH FED. SEC. L. REP.94,205, at n.4, p. 94,874 (D. Del.

1973), where the court left unre-solved the question whether liqui-dation and dissolution could bedecreed under §11.

Under the original act, "rescis-sion" presumably could be hadagainst all the defendants. Rescis-sion under the amended act mightseem to be available only againstthe petitioner's immediate seller-perhaps an underwriter or dealer.But see the recent case allowingrescission against a non-seller un-der Rule 10b-5. Gordon v. Burr,[1974-1975 Transfer Binder]CCH FED. SEC. L. REP. 94,874(2d Cir. 1974).

DEFENSESThe Issuer

The only substantive defense ofthe issuer under §11 is that theplaintiff knew of the untruth oromission at the time of his acqui-sition. Of course, any defendantwill seek to refute the affirmativeelements of the plaintiff's case orto introduce facts that require the

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LIABILITY FOR MISLEADING STATEMENTS UNDER SECTION I 49

plaintiff to go forward with evi-dence. Thus, the issuer may showthat it had issued a 12 month earn-ing statement and force the plain-tiff to prove reliance on the mis-leading facts in the registrationstatement.

Furthermore, the comparativecausation defense of §11(e) maybe established by the issuer. Per-haps if rescission or other equitablerelief is applicable, equity doctrinesof laches and unclean hands willalso be available, although thereare no cases on these matters.

The issuer has no "due dili-gence" defense of the type avail-able to all other defendants.

Non-expertsIn addition to the defenses and

opportunities to shift the burdenof going forward available to theissuer, all other defendants havecertain additional defenses under§I1(b).

WithdrawalAny defendant may prove that

he withdrew from the office andrelationship described in the regis-tration statement, and notified theCommission and the issuer inwriting before the effective date.§11(b) (1).

Due DiligenceOf more significance are the due

diligence defenses of §11(b)(3).Although non-experts are respon-sible for the entire registration

statement, their duties of diligenceare diminished for the expertisedportions, and need merely negativebelief and any reasonable groundfor believing the statements in theexpertised parts were untrue.§11(b) (3) (C).

As to the remainder of the reg-istration statement, they have aduty to investigate the facts toestablish an affirmative belief andreason to believe in the truthful-ness of the statements. §11(b)(3)(A). The standard of reason-ableness is that of the "prudentman in the management of his ownproperty." §11(c).

The facts that will establishthese defenses and the right todelegate these duties will vary withcircumstances.

Experts

Due DiligenceExperts are responsible only for

the expertised portions. §11(a).They have a duty to investigatethe facts to establish an affirmativebelief and reason to believe in thetruthfulness of these portions.§11(b) (3)(B).

Somewhat incongruously, thesame standard of reasonableness-that of "a prudent man in themanagement of his own property"-applies to experts and non-ex-perts. Does this mean that anauditor must audit as though hewere working for himself? Prob-

50 THE PRACTICAL LAWYER (Vol. 21-No. 7)

ably not. See the Bar Chris opinionrequiring auditors to follow thestandards of their profession. Butthe statutory language arguablymay permit a court to hold anexpert to a higher standard thanthat of his profession when thecustom is not supported by learnedreason. See Fiflis, Current Prob-lems of Accountants' Responsibili-ties to Third Parties, 28 VAND. L.REV. 31, 83 (1975).

An expert is any accountant,engineer, appraiser, or personwhose profession gives authorityto a statement made by him.§11 (a) (4).

An expertised portion of a reg-istration statement is any part ofthe registration statement whichwas prepared or certified or whichis copied from or extracted froma report or valuation which wasprepared or certified by an expertwhose name is mentioned with hisconsent.

Because of the holding in BarChris, supra, it has generally beenassumed that an accountant is anexpert only with respect to auditedstatements. While that is, at leastin part, a factual question, underthe typical existing practices, ad-mittedly only the audited state-ments are expertised.

Because what is "expertised" isa question of fact to some extent,the diligence duty of non-expertsis not as strong for the expertisedportions, and experts are liable

only with respect to their exper-tised portions, there may be a con-flict of interest between expertswho would seek to minimize theextent of expertised portions andthe non-experts who would wantto maximize it. An attorney shouldbe careful to note the conflictwhen the registration statement isbeing prepared.

Withdrawal

An expert has the same defenseof withdrawal and notification as anon-expert.

Controlling Persons

Controlling persons who are li-able vicariously would seem tohave the benefits of defenses es-tablished by their subordinates,although this is not entirely clear.They have a further defense under§ 15 if they show they "had noknowledge of or reasonablegrounds to believe in the existenceof the facts by reason of which theliability of the controlled person isalleged to exist."

Does this clause require thecontrolling person to make an in-vestigation? Does it merely meanthat if he knows of suspicious cir-cumstances he must inquire fur-ther? Is mere absence of evidenceof falsity a defense? Will his dutybe higher when the sale is his ownsecondary offering? Does he havea duty to supervise the controlled

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LIABILITY FOR MISLEADING STATEMENTS UNDER SECTION I1 51

person so as to become aware offacts which would have put himon notice? Will the duty vary asthe persons controlled vary fromthe issuer to underwriter to ac-counting firm? See Folk, Civil Lia-bilities under the Federal SecuritiesActs: The Bar Chris Case (PartII), 5 VA. L. REV. 199, 218-223(1969).

MULTIPLE PARTY LIABILITY

The liability of all the defend-ants, with the possible exceptionof controlling persons, is joint andseveral. §11(f). Thus, a plaintiffneed not sue all the potential de-dendants, and, for example, if theissuer is solvent, he may considersuing only the issuer to avoid es-tablishing an array of defenseattorneys against him and becausethe issuer has no due diligencedefense.

Whenever more than one personis liable, problems of contributionand indemnification arise. Theproblems are exacerbated underthe securities laws for severalreasons:

* Section 11 (f) and other sectionsprovide express rights of contribu-tion, thereby altering the normalcommon law rules concerning con-tribution among joint tortfeasors;

* Often contracts for indemnityare in existence, especially betweenissuers and underwriters and issu-ers and their officers and directors;

* Each of the defendants is likelyto have varying degrees of rela-tionship to the wrong, with theresult that those less closely re-lated will believe they should notbear the ultimate loss;

0 At times the parties may havebeen misled one by the other, thusinvoking many calls for indemni-fication; and

* Huge sums are often at stake,making the pressure to seek indem-nity or contribution great.

As a result, attorneys involvedin securities litigation face difficultproblems in this area in virtuallyevery case.

Since §11(f) permits contribu-tion "as in cases of contract," ithas been said that contributionshould be pro rata without regardto fault, though it should notbe available on behalf of or againstcontrolling persons liable under§15, and experts may not be en-titled to contribution against non-experts who establish their owndiligence as to expertised portions.Douglas & Bates, The Federal Se-curities Act of 1933, 43 YALE L.J. 171, 179, 196 (1933). But seeGould v. American-Hawaiian SSCo., 387 F. Supp. 163, 169-72(D. Del. 1974).

Some other specific problemsunder §11(f) seem worth raising:

0 Given the express grant of acontribution right, is indemnity to

52 THE PRACTICAL LAIWYER (Vol. 21-No. 7)

be denied? In a case under RulelOb-5, but following §11(f) byanalogy, contribution was allowedand indemnity denied, at leastwhere both parties were guilty ofthe fraud. Globus v. Law ResearchService, Inc., 418 F.2d 1276 (2dCir. 1969) (indemnity denied);318 F. Supp. 955 (S.D.N.Y.1970) (contribution permitted onremand). Indemnification wouldseem to work contrary to the pol-icy of the Act to deter misrepre-sentation.

* Since most issuers are corpora-tions that can perpetrate acts onlythrough directors and officers,should a corporation be entitled toindemnity from its directors andother servant-agents liable under§11? See the analogy in deHaayv. Empire Petroleum Company,286 F. Supp. 809 (D. Colo.1968).

0 Section 11(f) specifies that ifthe first person held "liable was,and the other was not, guilty offraudulent misrepresentation,"there should be no contribution.Aside from the difficulties suggest-ed in this language in the case ofcorporations that are issuers, andthe problems of defining terms,what if the only person initiallysued was guilty of mere neglectand another is guilty of fraudulentmisrepresentation? Will this for-tuitous order of events mean thatthe first person held is stuck with

part of the liability or should thefact that had he not been sued bythe victim he would have no li-ability to make contribution en-title him to sue for full indemnity?

0 If a plaintiff sues only the issuer,will the issuer have a duty to seekcontribution or indemnification? Ifthe same persons are directorswhen the liability arose and whenthe issuer pays the judgment, theywould have a conflict of interest.See the SEC brief in opposition tocorporate issuer's petition to allowit to pay the full liability in Feitv. Leasco, F1971-1972 TransferBinder] CCH FED. SEC. L. REP.f93,415.

0 If the terms of a settlementwhereby the issuer pays more thanits share of the liability are notdisclosed, is this a failure to dis-close a material fact in connectionwith a purchase or sale of a se-curity so as to be actionable under§10b-5? Perhaps disclosure itselfwill not avoid the application of§10b-5 under one aspect of Scho-enbaum v. Firstbrook, 405 F.2d215 (2d Cir. 1968) (en banc).

* If a partial settlement is made,say, with one of two defendants,what will be the liability of thesettling defendant to contribute tothe non-settling defendant?

* What is the applicable statuteof limitations for a contributionaction under § 1 (f) or for contri-

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LIABILITY FOR MISLEADING STATEMENTS UNDER SECTION 11 53

bution or indemnification actionsotherwise? When is it initiated andtolled?

0 For § 11 (f) contribution actions,the broad venue and service pro-visions of §22(a) will apply, butwhat of actions for contribution orindemnification otherwise? SeeMiller v. Hano, 8 F.R.D. 67, 71(E.D. Pa. 1947), holding that noindependent basis of subject mat-ter jurisdiction is required. Thevenue would seem to be appropri-ately identical to venue for themain action. Lyons v. Marrud,Inc., [1967-1969 Transfer Bind-er] CCH FED. SEC. L. REP.[92,307 (S.D.N.Y. 1968). Butjurisdiction over the person is adifferent matter, and must be in-dependently established. U.S. v.Rhoades, 14 F.R.D. 373 (D. Colo.1953) (involving the Housing andRent Act of 1947). See 3 Loss1739 and 6 Loss 3855 for furthertreatment.

Many of these questions havebeen addressed at least in part inseveral decisions. Many morecases will be required before clearrules can emerge.

THE STATUTE OF LIMITATIONSThe Statute of Limitations, §13

of the Act, will cause the actionto expire one year after discoveryof the misrepresentation or omis-sion should have been made andnot later than three years after a

bona fide offer to the public.The plaintiff must plead and

prove the non-expiration of thelimitations period, in accordancewith the usual federal rule forperiods of limitation that are partof the substantive cause of action.Rosenberg v. Hano, 121 F.2d 818(3d Cir. 1941).

JURISDICTION, VENUE, AND SERVICE

Under §22 of the Act, jurisdic-tion is concurrent with state andterritorial courts and removal isprohibited.

Venue is placed "in the districtwherein the defendant is found oris an inhabitant or transacts busi-ness, or in the district where theoffer or sale took place, if the de-fendant participated therein."

Process may be served in thedistrict of venue, any other districtin which the defendant is an in-habitant, or wherever the defendantmay be found.

SECURITY FOR COSTS

Under §I1(e), a court may re-quire security for costs, includingattorney's fees, from any partyunder any section of the 1933 Act,and if the suit or defense is foundto be without merit, it may taxcosts after judgment. §11(e) wasintended to avert strike suits.

The court's determination isgenerally not appealable. DonlonIndustries, Inc. v. Forte, 402 F.2d

54 THE PRACTICAL LAWYER (Vol. 21--No. 7)

935 (2d Cir. 1968). See Klein v.Adams & Peck, 436 F.2d 337 (2dCir. 1971) (not appealable sincenot a final order, and claims ofabuse of discretion are so unlikelyto succeed as not to justify theexpense of appeal).

INTERACTION WITH OTHER

SECTIONS

Section 11 may not exhaust thepossibilities of recovery for mis-representations and omissions insecurities sales. See Stewart v. Ben-nett, 359 F. Supp. 878 (D. Mass.1973), for a summary of the vary-ing views. But see Blue ChipStamps v. Manor Drug Stores, 95S. Ct. 1917, 1933, at n.15 (1975),which may renew the enthusiasmof defense attorneys to argueagainst the availability of otherprovisions.

As previously noted, in theSecond Circuit, a misleading pros-pectus is no prospectus at all forthe purpose of meeting the re-quirement of delivery of a prospec-tus on sale of a security. SEC v.Manor Nursing Centers, Inc., 458F.2d 1082 (2d Cir. 1972). Since§12(1) gives a private action fornon-delivery of a prospectus, itmay be that a plaintiff could ob-tain rescission or damages under§12(1) for a misleading prospec-tus.

Much of the law of §11 mayhave substantial effects on analo-gous requirements of diligence and

rights of contribution under othersections. See deHaas v. EmpirePetroleum Co., 286 F. Supp. 809(D. Colo. 1968); Globus v. LawResearch Service, Inc., 318 F.Supp. 955 (S.D.N.Y. 1970); andespecially Folk, Civil Liabilitiesunder the Federal Securities Acts:The Bar Chris Case (Part 11), 5VA. L. REV. 199 (1969).

This overlap is one of the prin-cipal targets of the ALI Codeproject. Avoiding overlaps is gen-erally commendable as a matterof neatness. But given the presentavailability of numerous remediesfor misleading prospectuses, inweighing the fairness of the ALICode, one cannot merely compare§11 with proposed §1403. It isnecessary to also consider the ef-fect of removal of present rightsof action under the other fraudprovisions of the Act.

CONCLUSION

Close analysis of §11 yields asurprising quantity of difficultquestions under this most explicitof the securities acts' civil liabilityprovisions. One must anticipatethat the newly perceived potencyof the section will yield a greatlyincreased flow of decisions in thenear future. In the meantime, prac-titioners would be well-advised totake a second look at what at firstglance may seem to be a simpleprovision imposing civil liabilityfor misleading registration state-ments.