Two opposing legal trends involving investors seem destined to collide in a train wreck of expanded risk and liability.
On one track, you have the U.S. Supreme Court decision in SEC v. Lorenzo, which vastly expanded liability under subsections (a) and (c) of Rule 10b-5 of the Exchange Act of 1934, for those who are implicated in the distribution of misleading offering materials.
And the regulatory train is warming up its engines, with the SEC’s expression of its intention to greatly expand the universe of investors who are legally allowed to invest in risky offerings.
The Supreme Court sent the first engine down the track with Lorenzo. That decision upended well-established precedent, Janus Capital Group v. First Derivative Traders (2011), that only the “maker” or author of a statement was liable for fraudulent or misleading statements under subsection 10b-5(b), and that the other subdivisions of Section 10(b) only applied to conduct, not written or oral statements.
In Lorenzo, the Supreme Court held that, even if disseminating the statements of another would not establish liability under subsection 10b-5(b), it would constitute a “device, scheme or artifice to defraud” under 10b-5(a) (and under Section 17(a)(1) of the Securities Act as well) in addition to as engaging in “an act, practice or course of business” that operates “as a fraud or deceit” under Rule 10b-5(c).
In doing so it expanded liability to include those who are involved in disseminating misrepresentations even if they are not the authors or originators of them. As a result, more people in the financial services industry will be exposed to liability for misleading materials, not just those who author them.
SEC Regulatory Train Coming on the Other Track
On the other track, barreling in the opposite direction, is planned regulatory easing that would permit less sophisticated investors with fewer financial resources to invest in riskier investment funds.
On June 18, the SEC requested public comment on a far-reaching proposal to “harmonize” private securities offering exemptions. The request runs over 200 pages, and seeks (among other things) to realize a long-standing vision of several commissioners to open up venture capital funds and private equity funds to more “mom and pop” investors.
Essentially, the proposal reflect the SEC’s emphasis under Chairman Jay Clayton on the centrality of “capital formation” to the mission of the SEC, and the belief that the current regulatory regime precludes too many investors from participating in the growth of more speculative companies.
It also reflects the belief that access to a greater pool of capital, including from less sophisticated investors, is necessary if more companies are to grow. The deadline for commenting has since passed, and approximately 140 comments have been submitted.
It is extremely likely that a majority of the current commission will vote to relax current thresholds for accredited investors, either on the basis of net worth, current income, the amount of investments, or otherwise (such as passing a test on financial sophistication).
Chairman Clayton has repeatedly stressed his belief that:
- liberalizing access lets more people enjoy the allegedly above-average returns generated by such funds; and
- increasing the pool of capital available to investment funds is good for the economy.
Commissioner Elad L. Roisman echoes these views, such as in comments at SEC Speaks on April 8.
Commissioner Hester M. Peirce believes in limited regulation even more strongly, and has expressed the view that less government intervention in the capital formation process is better.
One can quibble as to whether smaller investors will be able to obtain increased returns by making riskier investments, or whether, in an era where SoftBank and its Vision Fund throw billions around to companies losing money at epic paces, there is a need for increased access to the capital of small investors.
What is likely is that less sophisticated investors will not be the ones granted access to the more highly regarded investment opportunities.
Increased Litigation Risks
Instead, what is most likely is that newer investors will be targeted by those that (1) seek capital for riskier ventures that (2) have been rejected by more professional investors. It is also possible, if not likely, that less ethical investment managers will target newly accredited investors, especially if professional investors reject them.
When you combine the likelihood of inexperienced investors getting targeted by riskier managers, the risk of significant losses is present. When you add to that an expansion of liability thanks to Lorenzo, it is nigh inevitable that there will be a train wreck in the form of significantly increased litigation risk—both in the form of private claims as well as in SEC enforcement cases.
Not only has Lorenzo expanded the pool of potential defendants, but it is also more likely that less sophisticated investors will sue over investment losses suffered by exposure to riskier investments. Counsel would be well-advised to be cognizant of this impending crash, for be sure that both plaintiff’s counsel and the SEC are lurking at the station, ready to punch your ticket.
What will be a train wreck for some will be a gravy train for others.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Howard Fischer is a partner in the litigation and white collar departments of Moses & Singer LLP. As a former senior trial counsel at the SEC, he was lead counsel in the litigation against Wing Chau and Harding Advisory LLC (relating to CDO asset selection in the run-up to the financial crisis) resulting in a major victory against one of the characters lampooned in the film “The Big Short.” He also led the SEC litigation involving the infamous London Whale, arising from JPMorgan Chase trader Bruno Iksil’s multi-billion dollar loss in its credit derivatives book.