Secondary Liability of Financial Advisers for Materially Aiding the Sale of Unregistered Non-Exempt Securities Under the Uniform Securities Act (2002)

Secondary Liability of Financial Advisers for Materially Aiding the Sale of Unregistered Non-Exempt Securities Under the Uniform Securities Act (2002)

Secondary Liability of Financial Advisers for Materially Aiding the Sale of Unregistered Non-Exempt Securities Under the Uniform Securities Act (2002)

Subsection 509(2) of the Uniform Securities Act (2002) (the “USA”) provides the purchaser of an unregistered non-exempt security with a cause of action against the seller of the security. [1]
Subsection 509(8)(d) of the USA provides the purchaser of an unregistered non-exempt security with a cause of action against a broker-dealer, and/or an agent of a broker-dealer or issuer, who materially aids the seller in effecting the sale.

Who is a Broker?

A “broker-dealer” is defined under the USA as “a person engaged in the business of effecting transactions in securities for the account of others or for the person’s own account.”
“[A]n entity that receives commissions or other transaction-related compensation in connection with securities-based activities generally would be viewed as a broker-dealer.” PLI Broker Dealer Regulation, § 2:2-6; accord Heligman v Otto, 161 Mich App 735, 741; 411 NW2d 844 (1987) (“question of whether or not [a person] receives compensation” for effecting transactions in securities has a “significant bearing” on  person’s status as broker under Michigan USA) (quoting 69 Am Jur 2d, Securities Regulation – State, § 16, p 1076); SEC v Gagnon, 2012 US Dist LEXIS 38818, at *11 (ED Mich, Mar 22, 2012) (holding that person who acted as “the link between the issuer and the investor” and received “transaction-based compensation” was broker). [2]
“When coupled with transaction-based compensation, any activity facilitating the offer and sale of securities will trigger [broker-dealer registration] requirements.” 2 Blue Sky Regulation § 11.02. Such activities include “soliciting investors,” “advising customers,” and “arranging for delivery and payment.” SEC, Study on Investment Advisers and Broker-Dealers, pp 50, 103 (Jan 2011); accord SEC v George, 426 F3d 786, 797 (CA 6, 2005) (summary judgment on claim that defendant acted as an unregistered broker upheld where defendant “was regularly involved in communications with and recruitment of investors for the purchase of securities.”); SEC v Bravata, 763 F Supp 2d 891, 918-919 (ED Mich, 2011) (payment of commissions together with evidence of solicitation supported finding that defendants were acting as unregistered brokers in violation of the Securities Act); SEC v National Executive Planners, Ltd, 503 F Supp 1066, 1073 (MDNC, 1980) (defendant’s solicitation of investors and receipt of commissions supported summary judgment on count alleging defendant acted as an unregistered broker); SEC v StratoComm Corp, 2 F Supp 3d 240, 263 (NDNY, 2014) (granting summary judgment against a defendant who solicited investors, “relayed terms of the transactions and handled related paperwork,” and received transaction-based compensation).
Solicitation occurs when a broker recommends a specific security to a customer. Securities Exchange Act Release No. 34-24852, 1987 SEC LEXIS 3879 (1987) (“Clearly, if a broker were to call a customer and specifically recommend the purchase or sale of a particular security, the resulting order” should be considered “solicited.”). “[A] transaction will be considered to be “recommended” when the broker “brings a specific security to the attention of the customer through any means, including, but not limited to, direct telephone communication, the delivery of promotional material through the mail, or the transmission of electronic messages.” NASD Notice to Members 96-60 (emphasis added); see also Hicks, 7B Exempted Transactions Under the Securities Act of 1933 § 16:81 (2003) (solicitation of a sale occurs if broker uses issuer’s disclosure documents in communications with offerees and presents offerees with the information needed to finalize the sale).

Who is an Agent?

An agent is defined under the USA as “an individual other than a broker-dealer who represents a broker-dealer in effecting or attempting to effect purchases or sales of securities or represents an issuer in effecting or attempting to effect purchases or sales of the issuer’s securities.”
“Persons who promote, market and participate in sales for compensation invariably face participant liability as agents” of either the issuer or a broker-dealer. 2 Blue Sky Regulation § 15.03 (citing Moss v Kroner, 197 Cal App 4th 860, 129 Cal Rptr 3d 220 (Cal App 2011) (“working relationship” between defendants and the issuer by which they promoted and marketed sales of securities for compensation made defendants agents of the issuer for purposes of joint and several liability)).

What Constitutes Material Aid?

Some courts have defined “material aid” as aid which has a natural tendency to influence, or is capable of influencing, an investor’s decision to purchase the securities at issue. Connecticut Nat Bank v Giacomi, 242 Conn 17, 52-53; 699 A2d 101 (1997); Foster v Jesup & Lamont Securities Co, 482 So2d 1201, 1207 (Ala, 1986).
Other courts have adopted a “but for” test for distinguishing material from immaterial aid. Black & Co v Nova-Tech, 333 F Supp 468, 472 (D Or, 1971); Adamson v Lang, 236 Or 511, 515; 389 P2d 39 (Or 1964) (en banc); Fakhrdai v Mason, 72 Or App 861, 868; 696 P2d 1164 (1985). These courts hold that if the illegal sale would not have occurred without the defendant’s aid, the defendant’s aid is material. Id.
A person’s conduct need not be a substantial factor in effecting a sale of a security in order for it to be said that the person’s conduct “materially aids” the sale. Foster, 482 So2d at 1207. For example, personal liability has been found against an agent licensed to sell securities whose only participation was to introduce the plaintiff to a representative of the seller and inform the plaintiff that he had invested his own money in the securities and believed he had made a good investment. Gonia v E I Hagen Co, 251 Or 1, 3-7; 443 P2d 634 (1968). The court found that the purchasers substantially relied on the agent’s statements and such statements were decisive factors in inducing the sales. The fact that the agent did not know the securities were unregistered was immaterial. Id. at 7.

Are there Any Defenses?

Section 509(8)(d) of the USA provides an affirmative defense to a “person [who] did not know and, in the exercise of reasonable care could not have known, of the existence of the conduct by reason of which liability is alleged to exist.”
This defense has been narrowly construed. It does not encompass situations where the broker or agent was simply unaware that the investment was a security. [1]
In Rzepka v Farm Estates, 83 Mich App 702, 708-709; 269 NW2d 270 (1978), the Michigan court of appeals addressed this issue as follows:
Although no evidence exists that Refior knew of the stock’s unregistered status, likewise no evidence appears that he “could not have known” of this fact. Since the individual defendants have clearly failed to establish their lack of knowledge, actual or constructive, we find them liable under MCL 451.810(b); MSA 19.776(410)(b) in their positions of directors and officers of the corporation. Their ignorance of blue sky laws is irrelevant for purposes of this statute, as the exception only speaks of the lack of knowledge of “the existence of the facts by reason of which the liability is alleged to exist”. Clearly, under the statute, ignorance of the law is no excuse.
Id. (emphasis added).[2]
In Hayden v McDonald, 742 F2d 423, 438-39 (CA 8, 1984), overruled on other grounds, Austin v Loftsgaarden, 768 F2d 949 (CA 8, 1985), the U.S. Court of Appeals for the Eight Circuit addressed the issue as follows:
While not raising any dispute regarding the facts of Orison McDonald’s participation in their operations, the defendants assert that he did not and could not reasonably  know that the interests sold by the defendants were securities which had to be registered in Minnesota. The Minnesota Blue Sky Act provides an exception for primary and controlling person liability in nonregistration actions where the defendant “shall sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of the existence of facts by reason of which the liability is alleged to exist.” Id. § 80A.23(4). This exception does not apply to the present action.
The defendants do not allege that Orison McDonald was ignorant or could not learn that his company was selling interests in oil and gas operations which in fact were not registered under the Minnesota Blue Sky Act. The failure to register and the sale of unregistered interests were the “facts” establishing liability. Orison McDonald’s alleged good faith and reasonable belief that the interests were not securities which needed to be registered addresses a legal conclusion, not a matter of fact. He knew all the facts necessary for liability, so we agree with the district court that he was liable as a controlling person for the nonregistration of securities herein.
(Emphasis added).
In Robertson v White, 635 F Supp 851, 865-66 (WD Ark, 1986), rev’d in part on other grounds sub nom, Arthur Young & Co v Reves, 856 F2d 52 (CA 8, 1988), rev’d sub nom Reves v Ernst & Young, 494 US 56, 58 (1990), the court addressed the issue as follows:
[T]his court is prepared to find for purposes of this motion that they were indeed ignorant of the legal characterization of the demand notes as securities.  In the view of the court, that is irrelevant. Ignorance of the law, and of its characterization of a given transaction, is no excuse. The plaintiffs do not have to prove that the directors knowingly and willfully trespassed the law, only that the Co-op sold unregistered securities. That alone makes a prima facie case against the directors. As long as the directors knew that the Co-op was selling demand notes, and they unanimously admit that they knew that, they cannot plead ignorance of the facts upon which liability is predicated.
That is to say, ignorance of a duty to register securities, or to procure their exemption, can in no way excuse the failure to do so. The only conceivable excuse under the “lack of knowledge” defense would be if the director affirmatively believed that the securities were registered. In such a case, the director, believing the securities to be duly registered, would conclude that his duty had been discharged. Even then, the statute demands that such mistaken knowledge be not the product of negligence, and that the director bears the burden of proving that he was not so negligent.
(Emphasis added).

What Damages Can Be Recovered?

The USA provides for recovery of the amount of the plaintiff’s investments, less income received under the investment, together with costs, reasonable attorneys’ fees, and pre- and post-judgment interest.
Section 509(8) of the USA imposes joint and several liability on brokers and dealers who aid a seller of an unregistered non-exempt security. This means that there is no apportionment of fault and that the seller and the broker or agent are each liable for the whole amount of the judgment, such that the plaintiff has the choice of collecting the whole amount of the judgment from either defendant, or of collecting some from one defendant and some from the other.

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[1] Michigan is one of 20 states that have enacted the Uniform Securities Act (2002). The other states are Alaska, Wyoming, New Hampshire, Mississippi, New Mexico, Georgia, Wisconsin, Indiana, Minnesota, Hawaii, Vermont, Maine, South Carolina, Kansas, Iowa, Idaho, South Dakota, Missouri, Oklahoma.
[2] The SEC has identified transaction-based compensation as the primary hallmark of broker-dealer activity because such compensation is triggered by the “effecting” of a sale. Herbruck, Alder & Co, SEC No-Action Letter, 2002 WL 1290291 (June 4, 2002); 1st  Global, Inc., SEC No-Action Letter, 2001 WL 499080 (May 7, 2001) (recognizing that customer protection standards are served when one with a “salesman’s stake” in a securities transaction is required to register); Wirthlin, SEC No-Action Letter, 1999 WL 34898 (Jan 19, 1999) (recognizing transaction-based compensation as being a hallmark of broker-dealer status when fee is based on consummation of transaction).