Wednesday, April 30, 2014

Defending a Control Person in Claims Made Under Section 20(a) of the Securities Exchange Act of 1934

By John A. Schifino

Section 20(a) of the Securities Exchange Act of 1934 states as follows:

(a)    Joint and several liability; good faith defense

Every person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable ... unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.

15 U.S.C. § 78t(a). The scope of Section 20(a) is significant – any “control” person, such as an officer or director of a securities firm, can be held liable jointly and severally for the bad acts of a controlled person, e.g., an employee. It appears from the statute that the mere allegation of control person status would sufficiently state a claim for Section 20(a) liability and survive a motion to dismiss. 

In In re Digital Island Securities Litigation, 223 F.Supp.2d 546 (D. Del. 2002), District Court Judge Gregory M. Sleet considered Section 20(a) and provided a detailed opinion about a plaintiff’s obligation to state a claim thereunder. Judge Sleet’s decision is regularly cited as one of the seminal decisions on control person liability under the Securities Exchange Act.

Judge Sleet held that in order to maintain a cause of action for control person liability, a plaintiff must establish: (1) an underlying violation by a controlled person or entity; (2) that the defendant is a “controlling person;” and (3) that the defendant was in some meaningful sense a culpable participant in the fraud.  In re Digital Island, 223 F.Supp.2d at 560.   

In considering the first element of plaintiff’s Section 20(a) claim, Judge Sleet held that the court should do so with the Private Securities Litigation Reform Act (“PSLRA”) in mind. The PSLRA raised Federal Rule of Civil Procedure 9(b)’s pleading requirements in securities fraud actions to discourage frivolous, speculative lawsuits. Oran v. Stafford, 226 F.3d 275, 288 (3d Cir. 2000). The PSLRA changed the pleading requirements in private securities fraud litigation by requiring that a complaint plead both falsity and scienter with particularity. In re Digital Island, 223 F.Supp.2d at 551. 

As to the second element of a Section 20(a) claim, Judge Sleet noted that the plaintiff’s legal conclusions that the individual defendant qualifies as a “controlling person” under Section 20(a) may not be accepted as true absent factual support. Id. at 561. Thus, the heightened pleading standard of PSLRA requires that a claim for control person liability state with particularity the circumstances of both the defendant’s control of the primary violator, as well as of the defendant’s culpability as a controlling person. Id.

This third element of a Section 20(a) claim is the most significant of the three. This element establishes a critical principle – a control person cannot be held liable under Section 20(a) without proof of some personal fault.