A. Who may be sued.-The company issuing the stock, those who have signed the registration statement (by sec. 6(a) a principal executive officer or officers), the directors, experts such as accountants, and the underwriters.

B. Privity of contract.-The purchaser of the stock can sue any underwriter who helped distribute the issue, even though that particular one did not sell to the purchaser. In other words, under section 11 privity of contract is not required. The buyer has no claim if he knew of the misstatement when purchasing. That fact must be proved by the person being sued. But short of that, the purchaser need not claim that he has read, or even heard of, the registration statement containing the untruth, filed with the SEC in Washington. Nor must he prove reliance on it. In order to sue the issuer, the buyer merely needs to have bought the stock. At the time of final purchase, however, he has a prospectus with much the same information.

C. Defenses to the issuer, directors, etc.-How else may the defendants escape liability besides showing that the buyer knew of the untruth when purchasing? There are no defenses for the company which issued the stock. In contrast to the common law, it may not plead either the fact that the mistake was made in good faith or after a reasonable investigation.

Other defendants who may be sued, such as the directors, officers, experts, and underwriters described above, do have certain defenses available to them. For instance, a director could prove that he had after reasonable investigation reasonable grounds for believing that the facts in the registration statement were true. In substituting a standard of negligence for the older one of fraud, the act once more rejects a defense of good faith. Where such a defendant draws on the report of an expert, he is not liable if he had no knowledge of any inaccuracy, or no reasonable grounds for believing it inaccurate. The expert must have made a reasonable investigation giving him reasonable grounds to believe the statements were true.

The burden of proof to establish these defenses is on the defendants and not the buyer.

II. PRESENT LAW: CIVIL LIABILITIES OF COMPANIES EXEMPT FROM REGISTRATION TO BUYERS UNDER SECTION 12 (2) OF THE 1933 ACT

Section 12 (2) is applicable as between any buyer and any seller to him, whether the stock is registered or not. The seller under the section is liable to his immediate purchaser for damages in any sale effected by the means of interstate commerce or the mails by means of a prospectus or oral communication, which includes a material misstatement. The omission of a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading, is also prohibited.

Generally, then, the buyer may sue the issuer or the dealer (if either sold to him), where the misstatement was in the prospectus or made orally in interstate commerce (over the telephone). This is the section that is usually used by the buyer to sue the fraudulent dealer.

A. Who may be sued.-Section 12 (2) allows suit only against the seller of the stock, the issuer, underwriter, or dealer as the case may be. Yet section 11 in the registration area specifies not only the seller, but also the issuer's principal officers, directors, experts, and so forth. Thus if the selling dealer or issuing company is insolvent, those persons in control of it responsible for the misleading statements cannot be reached.

B. Privity of contract.—If the issuing company sells to a dealer, who in turn sells to the buyer, the latter cannot go beyond his immediate seller and recover from the issuer, the one who may be guilty.

As with the provision under section 11, the buyer may not recover if he knew of the untruth. Presumably such knowledge on his part must be proved by the seller.

C. Defenses. This section makes defenses more readily available to a seller than did section 11 to the issuing company. He may plead (somewhat as may the directors under the former section) the excuse of no knowledge, and after exercising reasonable care the impossibility of getting knowledge of the misstatement. Good faith is still not an excuse under this section.

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III. THE POSITION OF THE BENNETT BILL, H.R. 4744

The wide latitude of suit allowed the buyer under section 11 registration in contrast to the narrower coverage allowed him under section 12 (2) has prompted varying attempts to impose more liability on the companies and sellers in the exempted area.

Basically, the purpose is to protect the investor who buys stock in the area exempted to $300,000. The danger to him is that it may be primarily new companies with small capital that will take advantage of regulation A. If these companies fail, he cannot always reach their assets in bankruptcy. And the evils of high pressure salesmanship and of selling on the basis of inadequate information allegedly exist to a large degree in small issues. Presumably, on account of these fears the House has refused in the past to increase the exemptive limit. On the other hand, small business needs access to capital without the heavy cost of full registration. This inspires the proposed lifting of the exemptive limit from $300,000 to $500,000. The question now for decision is how much additional protection, if any, must be granted the investor in the form of new civil and criminal remedies.

H.R. 4744, 85th Congress, known as the Bennett bill, sought to afford the additional protection by imposing most of the strict registration penalties of section 11 to similar persons who were exempt under regulation A.

From the examination of section 11, it should be plain that under H.R. 4744 the same persons could be sued with the same defenses by a buyer who bought a registered or an exempted stock. Therefore, the SEC opposed this bill on the ground that it would require the equivalent of full registration for small issues and thus indirectly repeal the exemption.

IV. PROPOSED LAW SECTION 5 PROVIDES NEW BUT LESS SEVERE LIABILITIES An intermediate position on protection has been proposed in section 5 of S. 1178, one that enlarges the present civil and criminal liabilities of exempt offerings, but does not go as far as H.R. 4744. This amendment would add a new subsection (b) to section 12 (the one now relating to sellers) which may be applied to exempted stocks. It says that a company (and certain others) submitting any statement or document to the SEC (the offering circular and letter of notification) under the small issue exemption containing a material untruth may be sued by a buyer who gets or sees a copy of the statement, or who relies directly or indirectly on the misstatement.

A. Proposed law: When the buyer may sue. In addition to old section 12(2), under new section 12(b), the buyer who receives or is shown a copy of the offering circular with an untruth could sue the issuer and certain others. The company's offering circular (in addition to being submitted to the SEC) must be sent to the buyer as well before the sale (SEC rule 256 (a) (2)). Thus in the ordinary course of events, the buyer should get the same information in the circular as is submitted to the SEC. The proposed section merely spells out liability if there is a misstatement in it.

To win, the buyer would probably have to prove he got the document but does not have to prove he read it. This is very similar to the burden of proof under section 11, applying to full registration. There the buyer may sue even though he never read the registration statement in Washington. Ordinarily, however, he has to receive a prospectus by the time of final sale, containing much the same information. In general, then, the receipt of the circular under the small issue exemption is similar to getting the prospectus under full registration. Therefore the first part of the amendment to section 12 in effect gives the buyer a comparable remedy to sue the issuer, etc., for a material misstatement in the exempted area as previously existed in the registration field.

The NASD believes that the buyer must read and rely on the statement to

recover.

B. Propose law: Burden of proof on the plaintiff.-The second part of the new provision for liability states that the buyer may sue if he relies directly or indirectly on the untrue statement in connection with his purchase of the stock (whether he got the offering circular or not). For instance, suppose a dealer states a certain fact to the buyer in person or over the telephone. Under section 11's registration provisions, if he bought the stock (presumably after having received a prospectus), there is no necessity for the buyer to prove reliance on the misstatement. Thus the hurdle of recovery appears to be slightly higher upon the buyer of a small issue who does not get a copy of the offering circular.

The buyer has no claim if he knew of the untruth or of the omission, but the burden of proving it is upon the defendant sellers of stock.

C. Proposed law: Who may be sued.-In the case of full registration under section 11, it was the issuing company, the signers of the statement (principal officer), the directors, experts and underwriters.

But in a small issue suit under section 12 (2) the only defendant was the immediate seller, whether issuing company or dealer, not their officers or directors, etc. And suit by a remote buyer may be blocked by privity requirements.

The effect, then, of the proposed section 12(b) is to import some of section 11's wider coverage. It would entitle the buyer to sue the issuing company, the signers of the circular, and anyone who made or caused the misstatement to be made.

D. Proposed law: Privity of contract.-Privity would no longer be a necessity since a remote buyer could sue the issuing company even though it did not sell to him. This would cure the deficiency mentioned above.

Yet the board of directors, officers, and underwriters are not directly included in the liability. Obviously those who make the misstatement or cause it to be made are included under the wording of the new section; those who did not escape liability. But it has been argued that not only the directors and officers who cause the untruth but all of them as a group should be proper subjects for suit as in the case of section 11's full registration. In answer, the SEC insists that such extension would deter public financing of small business.

Underwriters could still be sued under section 12 (2) as sellers. They rarely are involved in small issues under regulation A.

Experts and dealers would probably be included by the clause, "made such untrue statement."

In the opinion of the Commission, the new section will allow the buyer the practical remedy he seeks, the right to reach the issuer's assets in bankruptcy. E. Defenses.-Aside from proving that the buyer knows of the missstatement at the time of purchase, the issuing company has no defenses (as in section 11). However, the section goes on to provide ready defenses for the few other defendants, the signers and perhaps directors or others who cause the misstatement. They need merely claim and prove that they did not know of the untruth in the document or statement submitted to the Commission or that they acted in good faith in making the mistake. Such an excuse means that a director escapes liability because of his ignorance. To exempt from civil liability a person who in good faith makes a misstatement would destroy the effect of the entire section, because it is practically impossible to deny a "claim" of good faith. (Hearings before Senate Committee on Banking and Currency on S. 875, 73d Cong., 1st sess. (1933) p. 205.) In neither section 11 or 12 was the claim of good faith allowed.

However, it is argued by the SEC that since the defendant will be liable under this section only if he caused the misstatement, it will be difficult for him on those facts to insist he did not know of it or made it in good faith. This will suffice to reach the fraudulent promoter or engineer.

Any judgment on increased civil liability must consider the addition of criminal liability. The discussion follows:

SECTION 10. CRIMINAL LIABILITY ADDED TO SMALL ISSUE AREA

Section 24 of the act makes it a criminal offense for any person in a registration statement filed with the SEC willfully to make a misstatement of a material fact. The penalty is fine or imprisonment. This section does not apply now to misleading applications, reports, or documents not part of a registration statement. Thus it does not include small companies applying under regulation A. Proposed section 10 of S. 1178 would cover small companies by adding that applications, reports or documents filed under the act or any rule or regulation thereunder would incur the existing criminal penalties in case of misstatement. The word "documents" would include the offering circular and letter of notification.

The SEC maintains that the addition of such penalties to small issuers will not discourage novice companies from raising capital. The reasoning is that to apply the criminal penalties an element of willfulness must be proved-that is, knowledge of the falsity. In its opinion it is just to place small issuers on an equal footing for willful misstatements with companies who fully register.

The New York Stock Exchange believes that the new penalty should be limited only to the exempt offering documents, rather than apply to all reports.

F. Contribution to the defendant from other guilty parties.-Section 5 of S. 1178 also provides for contribution to the defendant from other guilty parties. The last sentence of the proposed 12(b) says that any person who is found liable and is not primarily at fault may get contribution (as in cases of contract) from any other guilty party who if sued separately would have been liable to make the same payment.

This provision for contribution somewhat parallels the one for full registration in section 11 (f) of the 1933 act, and section 18(b) of the Exchange Act of 1934. Both contribution sections are in harmony with the modern theory of contribution among joint tortfeasors, abolishing the common law doctrine where there was none. The phrase, "as in cases of contract," means that parties liable on the statements filed may equitably recover from one another.

The question of who is "primarily at fault" may bring more complication into the second suit than intended, says the National Association of Securities Dealers. If the defendant does not avail himself of third-party practice under the Federal rules, his separate suit for contribution may raise the issue of primary fault, properly the issue of the first suit.

G. Vagueness of "Any document filed."-The new section speaks of any statement or document filed with the SEC in connection with exempt stock offerings containing an untrue statement of a material fact. Objection of the industry is to the vagueness of "any statement or document filed." For under section 11, liability exists in regard to only one document, the registration statement. It is feared that later regulations may include too many documents. Under present regulations, there must be filed a notification, an offering circular and amendments, newspaper and radio advertisements, and semiannual reports during the offering. The industry insists that the exemption of regulation A is hardly preferable to full registration because there are so many requirements; therefore, in the opinion of the NASD, the liability should cover only the offering circular.

In response the Commission answers that it would be unduly restricted if obliged to name each document which is "required." And the proposed language gives the Agency some of the power it has under full registration. For under section 7 it may alter some of the requirements for registration statements.

Due to the increased liability to companies offering small issues, the Small Business Administration, the NYSE, and the NASD oppose this amendment.

SECTION 7: CREATION OF POWER TO GRANT AN INJUNCTION FOR PAST VIOLATION OF THE ACT

An injunction has been traditionally granted to prohibit a person from continuing an unlawful activity. The defendant is enjoined because a criminal penalty for his past offenses may not stop future ones. Indeed he may pay a fine for the past offenses while being presently enjoined from committing the same one in the future. Thus an injunction is in no way a criminal sanction. (U.S. v. Oregon State Medical Society, 343 U.S. 327, 333 (1952).)

However, though the offense is no longer being committed, an injunction may also issue when there exists a likelihood of repetition. This likelihood is proved by the facts existing at the time of seeking the injunction—not necessarily the amount of time which has elapsed since the last violation. For example, voluntary discontinuance of itself may not suffice (SEC v. Lawson, 24 F. Supp. 360 (1938)). Nor is it forestalled merely because the threat of SEC investigation induces cessation of violation (SEC v. Torr, 87 F. 2d 446, 449 (1937)). Other circumstances might be the willful or careless nature of defendant's misdeeds. A district court has added that a statutory injunction should be granted not only in terms of defendant's cessation, but in terms of protection of the public (Lawson, supra); in regard to proving future repetition under another statute, see Ring v. Authors' League of America, 186 F. 2d 637 (1951).

Historically, one could not get an injunction from the court as a matter of right. As a matter of equity, the court issued it in its discretion, taking into account the above-named circumstances (U.S. v. W. T. Grant Co., 345 U.S. 629, 633 (1953)).

Following these concepts, the 1933 act in section 20 (b) allows the SEC to seek an injunction when the defendant "is engaged" or "about to engage" in a violation of the act. These words refer to present activity and include likelihood of repetition. In 1940 the Investment Company Act and the Investment Advisers

Act added the words "has engaged" (sec. 42(d) and sec. 208(d), respectively). In the suggested amendment, section 7 of S. 1178, the Commission proposes to change the earlier Securities Act to conform with the later acts it administers. The words "has engaged" in a violation or "has failed to comply" with the act, would be added. The justification for conformity is that defendants have argued that Congress intended in the later acts to allow an injunction for past violations related to likelihood of repetition; therefore, the absence of "has engaged" in the earlier Securities Act meant it did not so intend therein. No cases have been cited adopting the argument.

The industry, however, insists the change would have the drastic effect of allowing the issuance of an injunction for a past violation without a showing of likely repetition.

Although the statute says an injunction "shall be granted" when certain facts are proved, the Supreme Court has construed a similar statute to mean that the discretion of the Court was not changed by such language. Thus, the issuance is not automatic. (Hecht v. Bowles, 321 U.S. 321 (1944).)

Nevertheless, even though a court retains its equity jurisdiction, the industry feels a judge may believe himself justified under the new language in issuing an injunction unrelated to any showing of future violation (see latter part of Bowles case, p. 331).

Throughout the SEC has recognized that equity jurisdiction exists and in a conference with the industry on March 7 it gave assurance that there was no desire to change this basis. Therefore, it may be objected that the Commission does not need this amendment. That is, it may now obtain an injunction any time it can show the danger of repetitive violations (SEC v. Torr, supra, p. 449; SEC v. Franklin Atlas Corp., 154 F. Supp. 395 (1957), p. 401)). To recapitulate, industry argues that if the agency really seeks to use the injunction as a preventive remedy, it has all the power needed at present. The danger is felt that it seeks to use the injunction as a punitive remedy. If punitive remedies are needed, under section 24 the agency may ask for a fine or an imprisonment for a willful violation of the act. Fraudulent bucketshop operators may be rapidly indicted when it can be proved they have infringed the law.

It may be asked why the SEC uses an injunction as a punitive remedy rather than resort to its criminal remedies. The reason is that an injunction is much swifter than the cumbersome administrative procedures which may also be applicable. For instance, in the case of a broker-dealer who violates the act by selling unregistered stock, an injunction is more expeditious than revocation of his license. The latter requires notice to the dealer, opportunity for hearing, and a finding of violation.

For

In support of its request, the Commission points out that an injunction only forbids illegal selling. But, industry responds, the adverse publicity of an injunction practically puts a broker out of business in the stock market. the adverse effects of publicity under the OPA statute, see Brown, Price Ad., O.P.A. v. Purvin, 52 F. Supp. 348 (1943). Under the pressure of the market to sell stock, an injunction may be consented to, rather than contested.

Moreover it is not clear whether the defendant can contest the validity of an agency order in a suit for injunction based on an alleged past failure to comply. Acquiescence in the order may be less burdensome than contesting it at the administrative level or through the courts in a direct proceeding to test its validity. If, thereafter, it is claimed that the order was not complied with and an injunction is sought on the basis of the past failure to comply, ordinarily, the defense of invalidity of the order would be met by a claim that the defendant had failed to exhaust his administrative remedies. NASD urges that consideration should be given to including in this section a provision that would suspend the doctrine of exhaustion of administrative remedies, to permit the defendant to contest the validity of the order in the injunction proceeding; and that the language of this section directing that the court "shall" grant the injunction or restraining order, should be changed to "may."

More important, once an injunction is granted, it is grounds for revocation or denial of various privileges under the other SEC Acts. For example, a broker or dealer's registration may be denied or revoked if he is enjoined from a practice in connection with the purchase or sale of any security (sec. 15(b) (2) (C), Securities Exchange Act of 1934). And under the proposed amendments to the 1934 act, the SEC seeks the same power when an injunction relates to conduct of business of a broker, dealer, or investment adviser (sec. 13 of S. 1179). An investment adviser's registration may now be denied or revoked if he has been enjoined in the same way (sec. 203 (d) (2), Investment Advisers Act of 1940).