(Article from Securities Law Alert, July 2019)
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On July 23, 2019, the Third Circuit held that “a nonvoting board observer affiliated with an issuer’s placement agent” is not subject to liability under Section 11 of the Securities Act of 1933 as a person who “‘perform[s] similar functions’” to a “‘director.’” Obasi Inv. Ltd. v. Tibet Pharm., 2019 WL 3294888 (3d Cir. 2019) (Hardiman, J.) (quoting 15 U.S.C. § 77k(a)(3)).
Background
Plaintiffs brought Section 11 claims against two nonvoting board observers who were chosen by the placement agent and named with their consent in a registration statement. The registration statement noted that although the board observers had no formal authority or responsibilities, “they may nevertheless significantly influence the outcome of matters submitted to the Board of Directors for approval.” Plaintiffs contended that defendants were subject to Section 11 liability pursuant to 15 U.S.C. § 77k(a)(3), which provides that Section 11 claims may be brought against “every person who, with his consent, is named in the registration statement as being or about to become a director, person performing similar functions, or partner.”
The district court found that there was “a genuine issue of material fact as to whether [the board observers] could be viewed as . . . people performing similar functions to a director.” Dartell v. Tibet Pharm., 2017 WL 1944106 (D.N.J. May 10, 2017). The district court noted that “[a]ccording to the description” in the registration statement, the “[b]oard [o]bservers could influence the entire board.” The district court reasoned that the “[b]oard [o]bservers arguably had more influence than any individual board member, who could only cast a single vote.” The district court subsequently certified the following question for an interlocutory appeal:
Can Defendants be potentially liable under Section 11 of the Securities Act of 1933, each as a ‘person performing similar functions’ to a director, in light of Defendants’ role as board observers who could (but did not necessarily have to) significantly influence the outcome of matters submitted to the board of directors for approval?
Obasi, 2019 WL 3294888.
Third Circuit Holds Nonvoting Board Members Affiliated With an Issuer’s Placement Agent Do Not Perform “Similar Functions” to Directors as a Matter of Law
On appeal, the Third Circuit held that “deciding whether a person is a proper § 77k(a)(3) defendant . . . is a question of law for the court, not a question of fact for the jury.” The court further held that the inquiry is limited to a review of “the description provided” in the registration statement of the person’s role, and does not extend to extrinsic evidence concerning the person’s actual functions. The Third Circuit found that holding otherwise “would excise the phrase ‘named in the registration statement as’ altogether and rewrite § 77k(a)(3) to say ‘every person who, with his consent, is or is about to become a director [or] person performing similar functions.” The court further reasoned that “the requirement of consent to be named . . . confirms that [the court’s] inquiry stops at the text of the registration statement.” The court noted that “[i]t is hard to see how this consent could be informed if a person’s status (and potential liability) were speculative and mutable based on facts and events beyond the text of the registration statement.”
Turning to the question of whether the nonvoting board members affiliated with the issuer’s placement agent could face Section 11 liability pursuant to § 77k(a)(3), the Third Circuit held that defendants were not “performing similar functions” to directors based on the description of their role in the registration statement. The court emphasized that defendants “cannot vote for board action” and thus have no “ability to manage the company’s affairs,” which is the “directors’ most basic power.” The court also found it significant that defendants were “aligned with the placement agent” rather than the company. The court explained that defendants’ “loyalties aren’t with [the company’s] shareholders—and loyalty to the shareholders is as vital to directorship as the power to manage.” Finally, the court noted that defendants’ “tenures are set to end automatically, with no opportunity [for shareholders] to vote them out.” The court found that these “[t]hree features differentiate [defendants] from directors.”
The Third Circuit deemed defendants’ “influence” insufficient to render them similar to directors. The court observed that a well-regarded analyst “might also enjoy special access to the issuer’s board and management,” and may also have the “power to influence the issuer’s board.” The court explained that “no one would argue that [this] hypothetical analyst is any meaningful way ‘similar’ to a board member.”
The Third Circuit also rejected plaintiffs’ contention that “a broad construction” of § 77k(a)(3) “is necessary to hold wrongdoers accountable.” The court noted that “Section 11 imposes near-strict liability for untruths and omissions made in a registration statement,” as “a § 11 plaintiff need not allege scienter, reliance, or loss causation.” The court explained that “[b]ecause § 11 is such strong medicine, . . . it applies only to limited and enumerated categories of defendants.” The court pointed out that “Section 11 is but one part of an overlapping web of civil liability provisions,” many of which could be used to seek redress against nonvoting board members appointed by the issuer’s placement agent.
In a dissenting opinion, Judge Robert Cowen expressed his view that the majority had applied an unduly narrow definition of the term “similar,” and failed to adhere to the Supreme Court’s instruction that federal securities fraud laws “should be construed . . . flexibly to effectuate their remedial purposes.” Id. (quoting Herman & MacLean v. Huddleston, 459 U.S. 375 (1983)). Judge Cowen opined that “a person may be named as performing similar functions to a director even if he or she does not possess the directors’ formal power to direct and manage a corporation, and the responsibilities and duties that accompany those powers.”