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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
Managing risk certain actions. Government agencies, such as the SEC, may also bring civil actions to force the defendant to give up illegally obtained profits or pay monetary penalties or to compel or stop certain actions. • Administrative—Government agencies bring administrative proceedings before administrative judges, who follow the rules promulgated by the applicable agency. For certain violations of the federal securities laws, the SEC may bring administrative proceedings to impose civil penalties or an order to bring immediate halt to allegedly improper conduct. • Criminal—Only the U.S. Department of Justice can institute federal criminal proceedings. Defendants who are convicted in criminal proceedings face substantial fines and, in the case of individuals, terms of imprisonment. None of these mechanisms is exclusive and a party may be forced to defend against more than one type of proceeding. Liability for corporate disclosures: The securities laws do not impose a general duty to disclose material information about the company. Rather, such disclosure is required only when there is a legal duty to do so. This duty arises in connection with the purchase and sale of securities, whether in registered or private offerings or in secondary market trading. The company and its directors and officers can be liable for material misstatements and omissions in public disclosures. This liability risk is mitigated by conducting appropriate due diligence prior to the IPO and establishing robust internal reporting and disclosure controls and procedures in connection with ongoing reporting obligations. Liability relating to insider trading: Insider trading liability arises under Rule 10b-5 when a party trades the company’s securities (or “tips” others to do so) while aware of material nonpublic information. The number of insider trading enforcement actions by the SEC has increased steadily over the last five years, and it is expected that this aggressive enforcement trend will continue. To reduce the risk that trading by those parties in its securities may be claimed to violate the prohibition against insider trading, the company should observe the following guidelines: • Only trade during “window periods” tied to the release of the company’s interim and annual earnings reports and other material information and the public filing of such information with the SEC and the relevant securities exchange. • Develop and promote a written policy and code of ethics with clear guidelines prohibiting insider trading and addressing general standards of conduct, protection of confidential information and whistleblowing. • Develop robust compliance programs. • Conduct periodic training on contemporary regulations, requirements and developments for all employees, including directors, officers and other management. Meanwhile, directors, officers and employees should observe the following guidelines: • Do not trade when aware that a material event or trend is developing or will occur but is not yet ripe for disclosure. • Do not selectively disclose material nonpublic information to others. • Trade only in “window periods” in compliance with any internal procedures, after all important corporate developments have been disclosed to the market. • Trade pursuant to a Rule 10b5-1 plan (see Section 6.3). Sarbanes-Oxley provisions: The Sarbanes-Oxley Act enhanced the SEC’s enforcement powers, expanded areas of personal exposure for directors and executive officers and created new criminal provisions. These provisions include: • giving the SEC the authority to freeze possible “extraordinary payments” to directors, officers, agents and employees during the course of an investigation involving “possible” violations of the federal securities laws; • mandating forfeiture of certain CEO and CFO bonuses and profits in connection with restatements; • giving the SEC the authority to seek equitable relief for the benefit of investors, which it has invoked to seek disgorgement of all compensation received after alleged occurrence of fraud, not just bonuses and incentive compensation; • giving the SEC the authority to bar persons from serving as directors or officers of public companies in cease and desist proceedings; and • creating civil and criminal penalties for false certifications by officers of periodic reports. Corporate compliance programs: A corporate compliance program is a written and operational commitment to companywide compliance with all applicable laws. A compliance program protects the company and management in three major ways: • It reduces the chance that employees will engage in criminal misconduct. • If employees do break the law, it can help mitigate the consequences for the company. The U.S. Department of Justice, the SEC and many other agencies are more lenient on companies with effective compliance programs when making charging decisions and assessing penalties. • It establishes behavioral and professional expectations for employees, allowing the company to set standards in advance and facilitating termination of employees for misconduct when rules are not followed. 8.2 Class action and derivative lawsuits Marsh Imagine the shock if the newly public company were to be served with a federal securities class action lawsuit within three days following the IPO. This happened to a significant new issuer in 2012. In fact, most securities claims are filed within three years of an IPO and there is a significantly higher probability that a securities class action will arise if an IPO is involved. As such, when managing risk in a newly public company, it is critical to understand the primary civil liability exposures faced by directors and officers. Direct class actions: The primary exposure for directors and officers of U.S.-listed companies continues to come from federal NYSE IPO Guide 85
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