A Look at US Prospectus Liability

In my forthcoming article ‘US Prospectus Liability—An Overview and Critique’ to be published in the Journal of European Tort Law, I analyze the US prospectus framework and make recommendations for improvement.  In this article, the principal statutes and Securities and Exchange Commission (SEC) rules and regulations are addressed.  Although the US prospectus regime is comprehensive, substantial gaps exist that merit correction.

In the US, prospectus liability ordinarily occurs when securities are sold pursuant to a registration statement that contains material misstatement(s) or omission(s). Section 11 of the Securities Act is the principal remedy that is invoked by investors in this context.  Nonetheless, with the difficulty that frequently arises with respect to the tracing requirement (which requires that a plaintiff acquiring securities in the secondary markets trace the shares it purchased to the allegedly deficient registration statement), claims often must be brought under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5. But because the success of a cause of action is far more challenging under Section 10(b) and Rule 10b-5, plaintiffs prefer to use the Section 11 cause of action.

A substantial gap exists in the disclosure framework of the US securities laws. Unlike other developed markets that require all material information (absent justifiable business reason) to be disclosed to investors, the US securities laws focus on specified information that must be disclosed under SEC regulations.  Provided that the information called for by these regulations is adequately provided and the issuer has not otherwise spoken on the subject, there exists no obligation to disclose.  As stated succinctly by a federal appellate court: ‘Although in the context of a public offering there is a strong affirmative duty of disclosure, it is clear that an issuer owes no absolute duty to disclose all material information.’ (Cooperman v. Individual, Inc., 171 F.3d 43, 49-50 (1st Cir. 1999)). The consequence is that material information that would impact investor decision-making and the price of the offered securities remains embargoed.  In my view, as set forth in this article and in my book Rethinking Securities Law, an issuer should be required to disclose (absent adequate business justification) all material information concerning the corporation and its securities. The same principle should apply in the US secondary trading markets—namely, with the narrow exception if a justifiable business reason exists for nondisclosure, a publicly-traded company must promptly disclose all material information.   

With respect to an action seeking relief under Section 11 of the Securities Act, a principal defense invoked is the due diligence defense (with the exception of the issuer, which has no due diligence defense). The successful use of this defense is problematic for outside directors and underwriters in the integrated disclosure system (whereby Exchange Act SEC periodic reports are incorporated by reference into an issuer’s registration statement).  This challenge is exacerbated in the shelf offering setting.  In such offerings, securities may be brought to market within a few hours. Pursuant to the due diligence defense, directors, executive officers, and underwriters have the burden of proving with respect to the non-expertised portion of the registration statement (namely, all portions of the registration statement other than those based  on the authority of experts, such as audited financial statements) that a reasonable investigation was made and, after such reasonable investigation, there was a reasonable belief that the registration statement did not contain a material misrepresentation or omission. 

To help satisfy this defense, the article and the book Rethinking Securities Law make several recommendations.  First, that a publicly-traded company should be obligated to establish a disclosure committee consisting solely of outside directors.  The committee would have the authority to retain separate legal counsel.  The committee would meet with corporate employees, the auditors, and other appropriate persons on a regular basis to review relevant disclosure matters, including past and forthcoming filings with the SEC.  The effective operation of this committee should enhance the outside directors’ access to internal corporate information and lessen their dependence on insiders for the receipt of such information.  The implementation of a competent disclosure committee thus should improve the disclosure undertaking and provide a key means for outside directors to satisfy their Section 11 due diligence defense.   Second, in the integrated disclosure framework, and particularly with respect to shelf registered offerings of equity securities, an issuer’s audit committee or other board committee consisting solely of outside directors should be required to retain legal counsel for the prospective underwriters—with the appointment, fee arrangement, and decision to terminate such law firm being within the purview of the independent committee.  The retention of competent legal counsel performing continuous due diligence for the prospective underwriters should greatly enhance the underwriters’ invocation of the Section 11 due diligence defense, improve the quality of the disclosure process, and provide greater investor protection.

As the article discusses, prospectus liability may be incurred under other US securities statutes and in a number of contexts.  For example, Section 12(a)(2) of the Securities Act and state securities laws provide investors with a right of action when a free writing prospectus (namely, a prospectus that is not part of a registration statement filed with the SEC) contains a materially false or misleading statement.  In addition, the SEC has authority to bring an enforcement action when the disclosure in a prospectus is deficient or when the use of a prospectus contravenes applicable statutory or regulatory directives.

The article concludes with several recommendations that should be implemented.  Some of these recommendations are discussed above.  Other proposals include: relaxing the onerous Section 11 tracing requirement; applying the same liability standards irrespective of whether the alleged disclosure violation occurs in a registration statement or in a SEC filed periodic report (such as the annual Form 10-K); authorizing incorporation by reference of information only for those issuers whose securities in fact trade in an efficient market; eliminating strict liability for issuers; and placing a cap on damages in specified situations. 

Marc I. Steinberg is Radford Chair in Law and Professor of Law, Southern Methodist University Dedman School of Law.