Your client, who recently raised funds for his new venture from a select group of friends and their friends, has called to say that, while he believed the projections of earnings he gave at the time were responsible, a major customer he'd counted on failed to materialize, and he's getting increasingly unfriendly calls from his investors. Or a new client has called, telling you she really trusted a friend of a friend who assured her that "women need to stick together, helping other women," so she wrote a fairly healthy check to the "fund," but now she can't get her calls returned, nor is she getting her promised "downstream income" from other women helping women. Still another called to say that a staff attorney from the State Commissioner of Corporations office has written, inquiring about his recent sales of batches of fruit trees in his orchard, accompanied by a management agreement, whereby your client, for a fee, would prune the trees and harvest and sell the oranges, remitting any profits to the "owner" of the trees.

What do these calls have in common? That they most likely have involved an offer or sale of a "security," a term defined in both the State's Corporate Securities Law (Cal. Corp. Code § 25000 et seq., herein, "the Law" ¹) and the federal laws: the Securities Act of 1933 (15 U.S.C. § 77) and the Securities Exchange Act of 1934 (15 U.S.C. § 782a-mm). Both federal and state statutory schemes set forth pre-offering registration or qualification requirements and anti-fraud provisions, the violations of which carry both civil liability and criminal penalties.

While many of the recent headline cases involving Martha Stewart, WorldCom and Enron involve mostly federal cases, a number of practitioners believe the trend for these cases is away from Federal jurisdiction in favor of state courthouses. Joe Cotchett, a leading plaintiffs' securities lawyer of Cotchett, Pitre, Simon & McCarthy, explained, "the California Securities Law does not require proving fraud in order to obtain a remedy for securities violations. Nor does an investor need to prove reliance on false statements as is required under the federal securities law. See Mirkin v. Wasserman, 5 Cal.4th 1082 (1993). Also, under the Private Securities Litigation Reform Act of 1995 (15 USC § 78u4(b), 'the PSLRA', federal securities cases have higher pleading standards than in state court."

And Boris Feldman, a leading defense lawyer with Wilson, Sonsini, Goodrich & Rosatti, believes: "Plaintiffs will almost always seek to bring derivative claims in state court rather than federal. Plaintiffs have a better chance at surviving a demurrer for failure to make a demand on the company in state court, and may be able to take discovery on the futility of making such a demand. Also, a federal court is likely to be tougher on those issues. Moreover, shareholders with large individual claims may conclude that they will get a more favorable settlement if they opt out of a federal class action and go their own way in an individual case in state court." ^{2 **}

In 1995, Congress attempted to raise the bar on securities plaintiffs' ability to get into federal court by passing the PSLRA, reinstating the requirement that the plaintiff allege and prove scienter, or intent to deceive or defraud, on the part of the defendant. First enunciated by Ernst & Ernst v. Hochfelder (1976) 425 U.S. 185, 201, the courts over time watered down such requirement, coming closer to a mere "reckless" standard of proof. Concerned that vexatious lawsuits were driving up the costs of raising money in the capital markets and/or jeopardizing many of the emerging tech companies, Congress reinstated the scienter rule. In response, many plaintiffs' lawyers brought their securities cases in state courts, which had no similar rule, only to see Congress act again in 1998, passing the Federal Securities Litigation Uniform Standards Act of 1998. This law mandates the removal to federal court any class action brought on behalf of 50 or more persons for securities fraud or market manipulation, where the securities are listed on a regulated stock exchange or a national market system such as NASDAQ. Responding again, plaintiffs' lawyers sought to avoid removal from state court by suing only on state grounds or by bringing derivative suits where shareholders sue officers, directors and others on behalf of the company.

Once in state court, the first issue usually addressed, either in a motion to dismiss or for summary judgment, is whether a "security" was sold. Section 25019 defines such as any stock, bond, note or investment contract. This last is any arrangement whereby the profits, if any, are to come primarily or solely from the efforts of others (SEC v. Howey (1946) 328 U.S. 293 [sale of trees in citrus orchard with agreement back to grow and market the fruit]) or where the investor is putting up the "risk capital" for the venture, without which it could not go forward (Silver Hills Country Club v. Sobieski (1961) 55 Cal. 2d 811 [promotional capital for golf club] and Peo. v. Wind River Mining Project (1969) 219 Cal. App. 3d 1390 [gold mine]). "Ponzi" or pyramid schemes and chain letters for money also have been held to come under the law.

Next, the offer or sale must have been made "in this state," a term defined by section 25008, meaning any offer made into or from this state, and any acceptance made either here or directed here from outside the state. As Commissioner, the author successfully prosecuted promoters who invited residents of Los Angeles to a local restaurant to hear "the pitch," then loaded them onto a bus to Las Vegas, where the agreement to purchase was signed. The court had no trouble finding the offer and sale had been made in California.

Unless exempt, before one may offer or sell securities in this state, the offeror must "qualify" the offering with the Commissioner by submitting an application, usually accompanied by an offering circular, or "prospectus," setting forth the material information about the investment. If the Commissioner's office finds that the offering would not be "unfair, unjust or inequitable," he or she will issue a permit allowing the offering to go forward. (§25140) In making this determination, the Commissioner considers the track record or experience of the persons running the business and the degree of risk in the venture. Certain offerings are exempt from this qualification requirement, such as those sold only to a relatively few, sophisticated investors and offerings of securities listed on certain national stock exchanges. (§25102, 25103) Persons making nonexempt offerings without obtaining a permit will be subject to both civil liability and criminal penalties.

State law also makes it unlawful to misrepresent any material fact, or to omit to state facts which are necessary to make true those things that are said, when offering to sell (or buy) securitiesthe "anti-fraud" provision. (§25401, 25501) The usual suspects here are faulty or misleading financial statements, overly optimistic projections of earnings and undisclosed potential or contingent liabilities. Again, unlike the federal law, no allegation or proof of scienter is required to state a cause of action for state securities fraud, only knowledge of the actual facts by the defendant. People v. Salas 14 Cal.Rptr.3d 689, review granted (Sept. 29, 2004).

As one can imagine, if the venture is going badly enough that investors are seeking return of their funds, usually neither the company nor the original promoter has sufficient funds with which to make a rescission. In that event, the plaintiff seeks others who may also be liable, such as controlling persons, associates, agents, officers, directors, partners, accounting firms (see the late Arthur Anderson), securities brokerage firms, banks and law firms. Section 25504 dispenses with privity for such persons, if the defendant "materially aided in the transaction and knew, or through reasonable inquiry could have learned, of the falsity or misleading nature of the representations." Durham v. Kelly (9th Cir. 1987) 810 F.2d 1500. Further, any person who materially assists in violating either the qualification or anti-fraud provisions with intent to defraud is jointly and severally liable with the other persons so liable. (§25504.1)

Finally, persons who "expertise" a prospectus, such as accounting firms, engineers or appraisers, whose profession gives authority to their statements, are made liable to any person relying thereon in purchasing or selling the security. (§25504.2) Note that a lawyer who prepares the prospectus will only be liable for that portion of the document that the lawyer "expertises," assuming he or she consents to the publication. Koehler v. Pulvers (S.D. Cal. 1985) 614 F. Supp. 829.

In the belief that buyers and sellers should enjoy a level playing field when it comes to having information about the investment, the Legislature has made illegal "insider trading," defined as trading by an officer or director or other person having a position giving access to inside information, on the basis of nonpublic, undisclosed, material information about the issuer of the securities. (§§25402, 25502, 25502.5) "Tippees" are generally not liable, unless they have a position in or with the company that gives them access to confidential information. Associates or clerks of the company's law firm are included; a taxicab driver who overheard discussions was not. Martha Stewart allegedly sold her Imclone stock on a tip from her stock broker who had heard that Imclone's president was selling some of his shares. In the end, however, she was not convicted for "insider trading, but for denying that that was her motive in selling, saying under oath that she was simply acting under a prearranged program to sell when the stock price reached a certain level.

With the Dow resuming an upward, if somewhat halting, course, and with fond memories of boom times in the recent past, persons offering "sure fire" investment opportunities may again find fertile fields. Additionally, even the best intentioned and planned business ventures meet unexpected challenges, especially in the early going. The well prepared lawyer and judge will be well advised, therefore, to have some cognizance of the breadth of the protections offered and liabilities imposed by the state securities laws in order to evaluate better the cases that likely will be filed in our state courts.

Judge Van Camp is a member of the Superior Court, County of Sacramento. He served as California Commissioner of Corporations from 1971 to 1974 and practiced corporate and securities law from 1974 to 1997, the year of his appointment to the bench.

1. Unless otherwise indicated, all citations are to the California Corporations Code.
2. The author extends thanks to Messers Cotchett and Feldman, with whom he had the pleasure of teaching a course on "Trying the Securities Fraud Case" for a Center on Judicial Education & Research program for judges in August, 2004.

January / February 2005