Control Person Liability Under Securities Laws.

Under Section 20(a) of the Securities Exchange Act of 1934, control-person liability applies when (i) an underlying violation of the Exchange Act (or rule promulgated thereunder) occurs and (ii) a person is “subject to” control. In most cases, the underlying violation claim is a prerequisite that must be satisfied before the plaintiff or prosecuting authority can pursue liability under Section 20(a). This is generally the case in lawsuits between private plaintiffs and defendants, in which a failed primary claim ordinarily precludes recovery under a derivative control-person claim. While this is also generally the case for the Securities and Exchange Commission (SEC), there is some authority for SEC enforcement action for liability under Section 20(a) lacking an established primary liability violation.

What Does “Control” Mean Under Section 20(a)?

The SEC defines “control” as “the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.” A key takeaway here is that “control” can mean not just acting as a controlling person, but possessing the actual power to act as a controlling person. Furthermore, “control” under Section 20(a) does not constitute a finding of criminal guilt. It is a form of civil liability.

Who Is or Can Be Considered a Controlling Person?

Control persons under Section 20(a) can be corporations, partnerships, or individuals. Control can be direct or indirect. Control is direct when the party has the power to direct or cause the direction of the management and policies of the primary violator. Control is indirect when it “operates through one or more intermediate entities.”

What are “ Control” Rules Under Section 20(a)?

SEC Rule 12b-2 defines “control” for purposes of the Securities Exchange Act. The corresponding Securities Act rule, Rule 405, contains a materially similar definition.

How do Sections 20(a) and 15 differ?

What Is the Difference Between Section 20(a) of the Exchange Act and Section 15 of the Securities Act?

A similar statutory scheme imposes control-person liability under the Securities Act. Here, a controlling person is called “a person who... actually exercises or controls the corporate officers, board of directors, or other persons that directly influence the management and policies of the company.” However, the applicable statutory sections are different. In the Exchange Act, controlling persons are governed by Section 20(a). Section 20(a) can apply to all violations of the Exchange Act, not just those that involve fraudulent statements and omissions. In the Securities Act, control-person liability is imposed under Section 15. Control-person liability under Section 15 is confined to violations involving primary liability under Sections 11 and 12. Control-person liability under Section 15 may be asserted both by private purchasers and by the SEC in its own civil and administrative enforcement proceedings.

What Primary Liability Violations Can Give Rise to Section 15 Liability?

Liability under Section 15 can stem from a violation of Section 11, 12(a)(1), or 12(a)(2). Liability under Section 11 stems from a registration statement containing untrue material statements or omitting material facts. Liability under Section 12(a)(1) is established where any person offers or sells a security in violation of Section 5, which generally requires an effective registration statement unless an exemption applies, and liability under Section 12(a)(2) stems from offering or selling securities by means of a prospectus or oral communication that includes untrue material statements of fact or omits a material fact.

While Sections 11 and 12(a)(2) implicate fraudulent statements and omissions, a violation under Section 12(a)(1) does not necessarily implicate fraudulent statements or omissions, and it can support control-person liability under Section 15. Similarly, a violation of Section 12(a)(2) does not necessarily implicate scienter (culpability), and it can also support control-person liability under Section 15.

What Types of Control Impose Section 15 Liability?

Section 15 states, “Every person who, by or through stock ownership, agency, or otherwise, or who, pursuant to or in connection with an agreement or understanding with one or more other persons by or through stock ownership, agency, or otherwise, controls any person liable under sections 77k or 77l of this title, 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 had no knowledge of or reasonable ground to believe in the existence of the facts by reason of which the liability of the controlled person is alleged to exist.” Section 15’s specific reference to control can be through a multi-person agreement. This is different from the concept of “control” under the Securities Exchange Act. While “control” under the Exchange Act is presumed to operate by way of individuals acting in a supervisory role, “control” under the Securities Act can arise from an agreement between individuals to act jointly.

What facts show someone actually controlled the primary violator?

What Facts Support a Finding of “Control” Under Section 20(a)?

Section 20(a) expressly covers both direct and indirect control. Thus, all manner of authority, contractual power, or other form of governing power that leads to a finding of control will be examined in a Section 20(a) enforcement case. This includes, but is not limited to, corporate ownership, contracts, and all other arrangements providing an individual or entity with meaningful governing power over the primary defendant in a Section 20(a) case.

Is There a Bright-Line Percentage for Establishing Control?

No. Neither Section 20(a) nor the SEC’s rules under the Securities Exchange Act create a presumption of control. Control is determined by a facts-and-circumstances approach, though minority ownership can establish control if the minority owners collectively have authority over all governing decisions at the entity. Conversely, a majority owner can avoid control-person liability if it is possible to demonstrate an affirmative defense to control-person liability.

Does an Executive Title Establish “Control” Under Section 20(a)?

An executive title alone does not conclusively establish “control” under Section 20(a). However, it is an important consideration in the facts-and-circumstances analysis. An executive title can support control, and it can also trigger an inference of control that requires a negative response.

Does Board Membership Establish “Control” Under Section 20(a)?

Board membership is relevant evidence that helps establish control. While board membership is not automatically dispositive, it is extremely powerful evidence. Conversely, while not as conclusively as board membership, membership in other governance structures can also establish control.

Does a Parent-Subsidiary Relationship Establish Control?

A parent-subsidiary relationship does not invariably establish statutory control. Control must be evaluated by looking at the relationship on a facts-and-circumstances basis. However, when a parent entity controls a subsidiary and a member of the subsidiary’s board of directors makes an illegal exchange, the parent entity may be held liable as a controlling entity.

Does Minority Ownership Establish “Control” Under Section 20(a)?

Minority ownership can establish control under Section 20(a) when it is accompanied by authority over governing decision-making processes at the entity. Many minority owner entities have the power to influence or direct the management and policies of their subsidiaries or affiliated companies, and they can be held liable under Section 20(a) if these entities commit a violation of the Securities Exchange Act or the applicable SEC rule.

Does Day-to-Day Operational Authority Establish “Control” Under Section 20(a)?

Day-to-day operational authority can establish “control” under Section 20(a) as well. This is a different form of control than the governance control that has been discussed so far. Day-to-day operational authority can support a finding of control under the Securities Exchange Act as well.

What Must Plaintiffs Plead in Different Federal Circuits to Avoid Pre-Trial Dismissal?

The Second Circuit currently requires plaintiffs to plead culpable participation in all private Section 20(a) enforcement actions. Culpable participation is an element that must be pleaded (and proven) before the defendant can raise the applicable defense. The Ninth Circuit is one of the circuits that currently does not make culpable participation a prima facie element under the Securities Exchange Act. The Supreme Court has not yet resolved this circuit split.

How Does Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act of 1995 (PSLRA) Affect Plaintiffs’ Pleading Requirements?

For fraud-based claims, plaintiffs must plead their complaints with the requisite particularity that is required under Federal Rule of Civil Procedure 9(b). In addition to Rule 9(b), the PSLRA imposes additional pleading requirements in all private litigation that brings a claim under the Securities Exchange Act.

What Are the Pleading Requirements in the Second Circuit?

In federal cases filed in the Second Circuit, plaintiffs in private Section 20(a) enforcement actions must plead (i) a violation of the Securities Exchange Act, (ii) that the alleged defendant acted in a “culpable” manner in furthering the violation, and (iii) that the alleged defendant exercised control over the controlled person’s actions. Second Circuit plaintiffs must plead particularized facts in support of all elements of their complaint, and they must plead “the alleged defendant’s culpable participation” as a prima facie element of the Section 20(a) liability claim.

What Are the Pleading Requirements in the Ninth Circuit?

In federal cases filed in the Ninth Circuit, plaintiffs in private Section 20(a) enforcement actions do not need to allege any facts that demonstrate “culpable participation.” Plaintiffs must still allege that the alleged defendant is subject to “control” under the Securities Exchange Act, and this “control” can include “actual power or influence,” and this is the same standard of proof that is required to be held as a controlling person.

What Are the Pleading Requirements in the Eleventh Circuit?

In federal cases filed in the Eleventh Circuit, plaintiffs in private Section 20(a) enforcement actions must plead that the alleged defendant both (i) had the power to control the controlled person’s “general affairs,” and (ii) had the power to control the “specific corporate policy” that resulted in the underlying violation.

Todd Spodek is the managing partner of Spodek Law Group, a second generation criminal defense firm that has been practicing since 1976.

What Defenses Can a Controlling Person Raise Under Section 20(a)?

Section 20(a) of the Securities Exchange Act provides two key elements for a controlling defendant to assert its affirmative defense to liability under Section 20(a). For a controlling defendant to be shielded from liability, the defendant must show good faith and that it did not induce the violation at issue.

Who Bears the Burden of Proof for Statutory Affirmative Defenses in Section 20(a) Cases?

The controlling defendant ordinarily bears the burden of establishing its statutory affirmative defense. However, if the plaintiff alleges culpable participation (as the current case law requires in certain federal circuits), the plaintiff will bear the burden of proving culpable participation as a prima facie element of its case.

What are the Defenses to Liability Under Section 15 of the Securities Act?

Like Section 20(a), Section 15 supplies a statutory affirmative defense, but it asks only whether the controlling person “had no knowledge of or reasonable ground to believe in the existence of the facts by reason of which the liability of the controlled person is alleged to exist.” As a result, Section 15 of the Securities Act and Section 20(a) of the Exchange Act provide materially different defenses, and a defendant’s choice of statutory controls will significantly impact the defenses available to the defendant.

Must All Controlled Companies Have Formal Compliance Programs to Assert the Good Faith Defense?

No. No statutory text requires formal compliance programs to exist. Instead, the “good faith” defense focuses on whether the defendant knew and did nothing, whether the defendant believed that a violation was ongoing and did not attempt to stop it, or whether the defendant failed to affirmatively supervise the controlled entity with reasonable care.

Can a Controlling Person Use Its Status as a Parent Entity to Establish the Good Faith Defense?

Controlling entities that use a “corporate veil” to establish the good faith defense do so at their own risk. For example, when a parent entity allows its subsidiary to operate without supervision, the parent may have “reasonable grounds to believe” that its subsidiary committed an underlying violation. When a parent company ignores red flags about its subsidiary’s operations, this can establish willful blindness and undermine its claims to assert a good-faith defense.

Can Control-Person Affirmative Defenses Establish the Good Faith Defense Based on Nonparticipation?

If the statutory language requires a controlling person to show “good faith” and “no inducement,” a controlling person’s failure to participate in the primary violation should assist in establish the “no inducement” component of its defense. However, mere nonparticipation is not likely sufficient to demonstrate good faith in a Section 20(a) case, where the defendant’s nonparticipation can lead to a finding that the defendant willfully did nothing as its subsidiary committed illegal acts.

Does the Section 20(a) Defense Require Evidence of Compliance Efforts?

Some federal courts think the answer is yes. While it is not statutory, the Second Circuit, among others, has held that “reasonable supervision” must be part of the “good faith” defense. This could include reasonable efforts to implement preventive compliance measures. Other courts rely on less-involved means of avoiding the “culpable participation” trigger.

How Do Remedies Differ in Private and SEC Control-Person Enforcement Actions?

Section 20(a) expressly provides for joint and several liability for controlling persons. Joint and several liability does not necessarily mean a loss of the causation or statutory damage-limits elements required to establish liability in Section 20(a) cases. Instead, joint and several liability applies when a controlling defendant is liable for the violation. Although Section 20(a) does not explicitly mention joint liability, Section 20(a)’s statutory framework has imposed joint and several liability in all circumstances since the Securities Exchange Act was enacted.

How Did the Private Securities Litigation Reform Act of 1995 (PSLRA) and the Dodd-Frank Wall Street Reform and Consumer Protection Act Impact Section 20(a)?

While Section 20(a) contains express language providing for joint and several liability, Section 20(a)’s statutory framework has established joint and several liability in cases involving fraudulent transactions. The PSLRA does not establish joint liability. Instead, the PSLRA reserves joint liability for knowing violations. The PSLRA does not impose joint liability on controlling defendants that have not directly participated in the primary violation’s fraudulent conduct.

The Dodd-Frank Wall Street Reform and Consumer Protection Act expressly included the SEC’s enforcement capabilities in Section 20(a) cases. This, however, also expanded the applicability of the Private Securities Litigation Reform Act of 1995 to the SEC as well.

Do the PSLRA’s Proportionate-Liability Rules Apply to SEC Enforcement Proceedings?

No. The PSLRA’s proportionate-liability rules apply to private damages actions. They do not apply to SEC enforcement actions, because SEC enforcement actions do not seek monetary damages in the sense of compensatory damages. The SEC may, however, seek injunctions and civil penalties in Section 20(a) enforcement proceedings.

How Does Section 21D(e) of the Securities Exchange Act Work in a Private Securities Enforcement Action?

Section 21D(e) limits covered damages in the event a controlling defendant is found jointly and severally liable in a private enforcement action under the Securities Exchange Act. The provision utilizes the mean price of the covered security for the 90-day period after a transaction or alleged violation was first reported publicly, minus any subsequent growth.

Joint and several liability does not, by itself, eliminate these damages limitations. Instead, a defendant can either establish an affirmative defense to liability, or it can use the PSLRA’s proportionate-liability rules to assert that it is only partially responsible for the losses in a private securities lawsuit. The PSLRA addresses the calculation of a defendant’s share of liability under the Securities Exchange Act at 15 U.S.C. § 78u-4(f).

Which Deadlines Govern Control-Person Claims in Federal and State Courts?

Under Section 20(a) of the Securities Exchange Act, an enforcement action for control-person liability must typically be brought within the same timeframe as the underlying action for a primary violation. Under Section 12(a)(2) of the Securities Exchange Act, a claim must be brought within a six-year statute of limitation that also triggers the application of federal repose periods. This limitation period may run to a longer term in circumstances involving fraud that is not readily ascertainable by the claimant. However, this limitation period usually terminates after five years. For other violations of the Securities Exchange Act, the timeframe typically begins at the date of discovery and lasts up to two years. The repose period is typically five years. Under Section 13 of the Securities Act, the statute of limitation is one year, and the repose period is three years.

Do State Statutes of Limitation for Control-Person Claims Depend on the Underlying Violation?

No. For example, under Section 509(g) of the Revised Uniform Securities Act, the statute of limitation for a claim involving control person liability is completely separate from the timeline under other provisions. Other examples of state blue-sky statutes provide for different affirmative defenses, different participants in the lawsuits (i.e. plaintiffs), and different filing periods than the federal control-person statutes.

What Are the Limitations and Repose Periods for Control-Person Claims Under the Securities Exchange Act?

For fraud-based claims under the Securities Exchange Act, the period for filing usually lasts up to two years from discovery of the alleged violation. Under the same Act’s Sections 12(a)(2) and 18(a) of the Securities Exchange Act, the period usually lasts one year, or up to two years if the information was not discoverable. The statutory repose period for most Securities Exchange Act claims is five years from the date of the violation, and this repose period starts to run even if the violation has not been discovered yet. However, in certain cases, the five-year repose period may be longer in cases where the defendant had knowledge of the violation and took steps to hide its occurrence.

What Are the Limitations and Repose Periods for Control-Person Claims Under the Securities Act?

Under Section 13 of the Securities Act, an enforcement action against a control person can usually be filed one year after the date of discovery of a violation or any resulting injury. However, the repose period is three years. According to Section 13 of the Securities Act, the repose period for fraud-based claims under the Securities Act are not subject to equitable tolling.

When Must Contribution Claims Be Filed?

In the case of contribution claims filed under the PSLRA, a plaintiff must file within six months after a final, nonappealable judgment.

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Every case turns on its own facts, and general information is no substitute for advice about yours. Todd Spodek, managing partner of Spodek Law Group, and the firm's attorneys defend federal criminal and white collar matters nationwide. Reach the firm at 212-300-5196.