The following post comes to us from Jonathan D. Glater, Assistant Professor of Law at the University of California Irvine School of Law. It is based on his recent paper, “Hurdles of Different Heights for Securities Fraud Litigants of Different Types,” which is available here.
When investors buy securities in a private offering, it is presumed that they have the sophistication and expertise to invest in the absence of the formal disclosure requirements that apply to public offerings. When investors claim to have been victims of fraud, they assert that they have fallen victim to deceit. When investors who purchased through a private offering cry fraud, they must argue that they were sophisticated ex ante, but not so sophisticated that they could or should have detected the fraud that they complain of ex post.
In my article on post-financial crisis securities fraud litigation, I argue that the challenge facing a plaintiff who invested in a private offering is not as great as that facing one who bought in a public offering. The reason has to do with the practice of private offerings and the pleading standards that apply to securities fraud claims. In a nutshell, investor plaintiffs who bought securities in public offerings face the greatest practical difficulty gathering evidence of the defendant’s intent, or scienter, and their allegations of intent must satisfy the most demanding pleading standard. Investor plaintiffs who bought in private placements have practical advantages in gathering evidence of intent and face the most difficulty alleging that they reasonably relied on allegedly fraudulent statements, and allegations of reliance face a lower pleading standard.
Here is how this happens. First, investors who purchase in private offerings typically receive communications, including e-mail messages and sometimes presentations, in addition to deal disclosure documents; that is clear from the complaints in civil fraud suits brought in the wake of the financial crisis under section 10(b) of the Securities Exchange Act of 1934 and rule 10b-5. While these additional communications may not include a proverbial smoking gun revealing a fraudulent scheme, they do at a minimum document a seller’s interest in wooing a specific investor in a way that the disclosures associated with a public offering, for example, do not. The plaintiff who purchased in a private offering consequently has more material to sift in search of support of an allegation that the defendant seller acted with the requisite scienter.
For plaintiffs who purchase securities in public offerings, proving scienter is very difficult because prior to discovery, little evidence suggesting fraud may be available to an outsider. Regulatory filings describing risk exposure are carefully reviewed, while other, less formal communications among financial institution executives discussing a private offering may be less thoroughly vetted. Thus, the article contends, investors in private offerings have an informational advantage relative to what the article calls “outsider investors” who buy in public offerings.
Second, a plaintiff’s allegation that the defendant acted with scienter must meet a heightened standard adopted by Congress in an effort to curb potentially frivolous securities lawsuits. Where an outsider investor faces the greatest practical challenge, the law adds to the burden.
For the private offering plaintiff, the significant hurdle to overcome is establishing that reliance on a defendant’s allegedly fraudulent statement was reasonable, regardless of the plaintiff’s sophistication that enabled participation in the private offering in the first place. (In case after case, defendants in 10b-5 suits argued in their motions to dismiss that the plaintiffs had access to information that would have made plain just how risky an investment was and that any sophisticated buyer would have reviewed and understood that information.) Plaintiffs’ allegations of reliance need not satisfy the stringent standard applicable to allegations of scienter.
One possible consequence of the different pleading standards applicable to different elements of a fraud claim under 10b-5 is an incentive to invest in private offerings, thereby preserving an easier path to recovery through litigation. Of course, considering potential recovery through litigation as a factor in deciding whether to invest may go well beyond what most investors have time, energy or expertise to consider – although their lawyers might well ponder the matter.
Rationales exist for different treatment of claimants suing under the same law and under very similar facts. For example, as a matter of public policy, lawmakers and courts may wish to encourage private offerings of securities . Perhaps an easier path to recovery in cases of potential fraud follows from a tacit decision that because the private offering investor does not benefit from the disclosure regime applicable to public offerings, barriers to recovery through litigation in the wake of fraud should be lower. This seems odd reasoning, however, given that the private offering investor is not compelled to buy in, but could opt to purchase only in public offerings.
When we talk about the burdens confronting plaintiffs, we are really talking about the distribution of risk. The more difficult it is for a plaintiff to sue successfully alleging securities fraud, the more risk that plaintiff faces when investing. Such a plaintiff might have a greater incentive to investigate a transaction beforehand. Any conversation about adjusting the pleading standards should involve a discussion about the incentive effects created. Perhaps a little more introspection and caution on the part of investors in private offerings would be a good thing; on the other hand, perhaps possible delays in the raising of capital would be a bad thing. It is a debate worth having.
The article, which is based on a review of more than 100 motions to dismiss securities fraud claims filed in the Southern District of New York after the financial crisis, proposes two reforms. First, the pleading standard applicable to allegations of scienter should be lowered to be consistent with the standard for claims alleging other types of fraud. Second, to establish the reasonableness of reliance on an allegedly fraudulent statement, investors in private offerings should be required to explain to the court what steps they took to investigate the investment beforehand, the extent to which they deviated from industry norms, and the reasons for such deviations. This second requirement would compel plaintiffs who styled themselves as sophisticated before investing to justify recovery afterward. The second requirement would make concrete and consistent the longstanding rule that courts help those victims of fraud who took reasonable steps to protect themselves, not those who closed their eyes to apparent risk and took the plunge anyway.