Why Be Wary Of Section 11 Liability?
Last Friday's post discussed the possibility of avoiding potential liability under Section 11 of the Securities Act by relying on the Section 3(a)(10) exemption from registration. Eliminating Section 11 liability does not eliminate liability under other anti-fraud statutes or rules, such as SEC Rule 10b-5 and California Corporations Code Section 25401. So why be concerned about Section 11 liability?
Section 11 does not require that a plaintiff plead scienter on the part of defendant. Herman & Maclean v. Huddleston, 459 U.S. 375, 382 ("If a plaintiff purchased a security issued pursuant to a registration statement, he need only show a material misstatement or omission to establish his prima facie case."). Thus, it is essentially a strict liability statute. Liability under Rule 10b-5 in contrast requires that a plaintiff must prove that the defendant acted with scienter. Thus, requiring a plaintiff to proceed under Rule 10b-5 imposes a significant additional burden on plaintiffs.
Further, Section 27(a) of the Securities Exchange Act vests the federal courts with exclusive jurisdiction over suits to enforce the Exchange Act or the regulations thereunder. Thus, plaintiffs can not bring Rule 10b-5 actions in state courts, but may bring actions arising under the Securities Act of 1933 in state court. Cyan, Inc. v. Beaver County Employees Retirement Fund, 138 S.Ct. 1061 (2018). The reason that the forum is important is that many plaintiffs have concluded that they prefer California Superior Court to the U.S. District Court.
Like Section 11, California's statute, Section 25401, does not require that a plaintiff allege or prove scienter. Section 25401, however, was not based on Section 11. Rather, it was modeled on Section 12(a)(2) of the Securities Act which provides a "reasonable care" defense. California includes the "reasonable care" defense in Section 25501 which establishes the remedies for a violation of Section 25401. Arguably, the "due diligence" defense found in Section 11 is more difficult to establish than the "reasonable care" defense found in Section 25501. Thus, defendants should generally expect to prefer to be sued under Section 25401 rather than Section 11.