Several years ago, the Securities and Exchange Commission’s (SEC) Enforcement Division announced its intention to pursue claims against issuers under Section 17(a) of the Securities Act, utilizing the “negligence standard” contemplated by that provision. In claims against issuers, the SEC generally pleads Section 17(a) claims by alleging that the defendant should have known that its statements were false or misleading.1 In this article, we summarize this standard.
The Statute and Its Interpretation
Section 17(a) provides:
“[I]t shall be unlawful for any person in the offer or sale of any securities (including security-based swaps) or any securitybased swap agreement (as defined in section 78c(a)(78)  of this title) by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly—
- to employ any device, scheme, or artifice to defraud, or
- to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
- to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.”
Section 17(a) does not explicitly set forth a negligence standard. However, under relevant case law, the provision has been determined to require a defendant to act in the manner that a reasonably prudent person in its position would have acted under the circumstances. In short, a firm would be expected to “exercise . . . reasonable care in obtaining and communicating information,” including undertaking “an appropriate investigation before . . . making statements to investors or prospective investors.” SEC v. Shanahan, 646 F.3d 536, 545-46 (8th Cir. 2011).
How has this standard been interpreted by courts? In the trial of a Section 17(a) claim against a trader in the case of SEC v. Stoker, Judge Rakoff of the Southern District of New York instructed the jury that, in considering whether the defendant acted negligently, the jury could consider “any evidence of industry practice, custom, or standards as they pertained to a reasonably prudent person in Mr. Stoker’s position at the time [the applicable security] was being marketed.” However, the instructions noted that “while such industry practices and the like are relevant, they are not controlling.” Instructions of Law to the Jury at 13, SEC v. Stoker, No. 1:11-cv-7388 (S.D.N.Y. July 31, 2012), ECF No. 89.
Similarly, in SEC v. Shanahan, the Eighth Circuit affirmed a decision to grant defendant judgment as a matter of law following trial on Section 17(a) claims. Here, the SEC “presented no evidence, through expert or lay testimony, documentary evidence or otherwise with respect to the degree of care that an ordinarily careful person would use under the same or similar circumstances, whether [the defendant] exercised reasonable care in obtaining and communicating information, or whether he undertook an appropriate investigation before allegedly making statements to investors or prospective investors.” In particular, the court noted that “the SEC offered absolutely no evidence regarding [the defendant’s] duties as a member of [the company’s] Board of Directors and as a member of the Compensation Committee.” Shanahan, 646 F.3d at 545-46.
Additional Considerations Relating to Section 17(a)
No Private Right of Action. Only the SEC may bring a claim under Section 17(a). In this regard, the provision differs from Section 10(b) of the Exchange Act and Section 11 of the Securities Act, each of which provide a private right of action to purchasers of the relevant securities.
Offer or Sale Requirement. Unlike Section 10(b) of the Exchange Act, which applies to securities transactions more generally, Section 17(a) only applies to the offer or sale of securities. In other words, the SEC may only bring a Section 17(a) claim based on misstatements made in connection with an offer or sale. In contrast, if an executive of a public company makes a misstatement about the company and an investor reasonably relies on that statement in a transaction on the secondary market, the investor may bring a claim against the executive under Section 10(b), even though the company was not a party to the transaction.
Potential Defendants. Section 17(a) arguably applies to a broader class of defendants than does Section 10(b). Under the Supreme Court’s Janus decision, only the “maker” of the statement—the “person with ultimate authority over the statement”—is liable for a misstatement under Section 10(b). Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2302 (2011). And, under Janus, ‘‘[o]ne who prepares or publishes a statement on behalf of another is not its maker,” and is not liable under Section 10(b). Id. However, most courts have held that Janus does not apply to Section 17 claims. See, e.g., SEC v. Daifotis, No. C11-137, 2011 BL 199412, at *5-6 (N.D. Cal. Aug. 1, 2011).
As a result, a broker-dealer who negligently “uses” an issuer’s misstatement to sell a security may be liable under Section 17(a). See SEC v. Tambone, 550 F.3d 106, 127-28 (1st Cir. 2008) (“The statute prohibits an individual from ‘obtain[ing] money or property by means of any untrue statement.’ It does not state, however, that the seller must himself make that untrue statement. Indeed, the text suggests that the opposite is true—that it is irrelevant for purposes of liability whether the seller uses his own false statement or one made by another individual. Liability attaches so long as the statement is used ‘to obtain money or property,’ regardless of its source.”).