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Managing risk
8.1 Liability standards
Cleary Gottlieb Steen & Hamilton LLP
Sources of liability: The main potential
sources of liability for public companies
and their officers, directors and other
employees are the federal securities laws,
state securities laws and state corporate
law of fiduciary duty.
The principal areas under which
liability may arise under the federal
securities laws are as follows:
• Disclosure liability provisions—
Several specific provisions of the
federal securities laws impose liability
for written or oral statements about
the company or its securities that
contain a material misstatement or
make a material omission. Certain of
these provisions apply to registration
statements and prospectuses (including
the IPO registration statement and
prospectus); others apply to the
company’s periodic and other reports
filed with the SEC. The precise
liability standard and burdens of
proof vary among statutes, as do
the available defenses based on the
defendant’s exercise of reasonable care
or the plaintiff’s nonreliance on the
disclosure. Depending on the specific
provision, the SEC may bring criminal
or civil penalties against the company,
its directors and officers; and in some
cases, private parties may also rely on
these laws to assert claims for damages
or rescission.
• Antifraud provisions—The company
and others may face liability
under broadly worded statutes and
regulations addressing fraud in
the securities markets. The most
important of these are Section 10(b)
of the Exchange Act and Rule 10b-5
thereunder, which apply in connection
with purchases and sales of securities.
Rule 10b-5 broadly prohibits fraudulent
and deceptive practices and untrue
statements or omissions, both
written and oral, of material fact in
connection with the purchase and sale
of any security. Under Rule 10b-5, the
issuer and its employees or agents
may be liable whether or not any of
them actually purchased or sold any
securities. Liability requires proof
that the defendant engaged in willful
misconduct or at least acted recklessly
and can be based on information
contained in a document filed with the
SEC (including a registration statement
or a periodic or other report), as well
as any information released to the
public by the company, including
press releases and annual reports to
shareholders. This catchall antifraud
provision has been widely used in
securities litigation by private parties
and the SEC alike. The geographic
reach of liability under Rule 10b-5 has
been the subject of extensive litigation
and some legislative changes in recent
years, as discussed in Section 9.8.
• Failure to register—As described in
Section 3.2, the U.S. securities laws
establish a framework for public
offerings of securities. This framework
requires the registration of every
offer and sale of a security with the
SEC unless a specific exemption from
registration applies. As discussed in
Section 3.2, the terms offer and sale
have been very broadly construed.
Both private parties and the SEC may
bring suit against the company or other
offering participants for violations of
these rules.
• “Books and records” requirements—
Under the Exchange Act, the
company is required to make and
keep books, records and accounts
that, in reasonable detail, accurately
and fairly reflect the transactions
and dispositions of its assets. The
SEC regularly uses this as a basis for
enforcement proceedings, and the
company, its officers and directors
and other parties who control the
company may be subject to civil or
criminal penalties, including fines and
imprisonment, if they are found to
have violated this provision.
• Market manipulation—Transactions
in the company’s own securities could
raise concerns about the possible
manipulation of the market price.
Manipulation would expose the
company to a variety of civil and
potentially criminal liabilities.
The individual states have securities
statutes that are analogous to the federal
securities law statutes. Federal law
preempts state law to a degree in certain
areas (e.g., registration of offers and sales,
class actions) but generally not with regard
to securities fraud or misrepresentation.
All U.S. states (other than New York)
have statutes that allow investors to
sue to rescind transactions or recover
damages when securities are sold by
means of materially misleading offering
documents. In approximately 35 states,
including a number with a significant
investor base, sellers must show they
exercised reasonable care to avoid liability.
However, state securities laws are unlikely
to provide a basis for the nationwide class
actions or other large-scale proceedings
that have marked securities litigation
under the federal securities laws.
Finally, the corporate laws of the
individual states impose basic “fiduciary”
duties on directors and officers of
companies organized under those laws,
with these duties being owed to the
company itself and its shareholders.
Directors have two fundamental fiduciary
duties: the duty of care and the duty of
loyalty. Directors must act in good faith,
with the care of a prudent person, and in
the best interest of the company. They
must refrain from self-dealing, usurping
corporate opportunities and receiving
improper personal benefits. Decisions
made on an informed basis, in good
faith and in the honest belief that the
action was taken in the best interests of
the company, will be protected by the
“business judgment rule.” Generally,
officers owe fiduciary duties similar to
those of directors. Officers also may owe a
duty to keep the board informed. Officers
with greater knowledge and involvement
may be subject to a higher standard of
scrutiny and liability.
Directors and officers can be held
liable to the company for violations of
these duties. The shareholder derivative
suit provides a means by which a private
litigant can enforce duties on behalf of the
company.
Types of proceedings: Remedies and
sanctions for improper securities activities
can be sought in three basic ways:
• Civil (including class actions and
derivative suits)—Private parties seek
to recover losses allegedly suffered as
a result of the defendant’s conduct
or request relief to compel or to stop
84 NYSE IPO Guide