(Article from Securities Law Alert, May 2023)
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On April 5, 2023, the Third Circuit resolved whether a district court erred in failing to award attorneys’ fees or impose any other sanctions in connection with determining that plaintiffs violated Rule 11 in bringing certain federal securities claims following their purchase of unregistered securities in a company’s stock offering. Scott v. Vantage Corp., 64 F.4th 462 (3d Cir. 2023) (Smith, J.). The Third Circuit affirmed the district court’s determination that certain of plaintiffs’ claims violated Rule 11 and that the company’s founder (the only defendant party to the appeal) was not entitled to attorneys’ fees. The court held, however, that the PSLRA “mandates the imposition of some form of sanctions when parties violate Rule 11 in bringing federal securities claims.”
Background and Procedural History
Plaintiffs brought federal securities claims against the defendant company, its president, and the company’s founder after they purchased stock in the company’s 2016 stock offering under SEC Rule 506(b).[1] Plaintiffs became concerned about the company’s financial condition shortly after they invested their funds but, having no right to rescind based on their stock agreements, plaintiffs sued, asserting ten counts against defendants, including three federal securities claims (an unregistered securities claim, a misrepresentation claim, and a Rule 10b-5 securities fraud claim). In 2019, the district court granted summary judgment for the company’s founder and the company’s president on the three federal securities law claims, which the Third Circuit affirmed. Before the district court’s summary judgment ruling, the company entered bankruptcy proceedings.
After performing the PSLRA-mandated Rule 11 inquiry, the district court concluded that plaintiffs had violated Rule 11 with respect to their unregistered securities claim and their misrepresentation claim against the company’s founder, but had not violated Rule 11 as to their 10b-5 securities fraud claim. Notably, the district court declined to award the company’s founder attorneys’ fees or impose any other sanction based on its conclusion that plaintiffs’ Rule 11 violations against him “were not a substantial violation under the PSLRA” because plaintiffs had a reasonable basis to believe they had factual support for their securities fraud claim, which it considered to be “the heart of the complaint.” By contrast, the district court awarded attorneys’ fees to the company’s president after determining that plaintiffs violated Rule 11 in their claims against him. The district court concluded that the claims against the company’s president were “tenuous, and that his only connection to Plaintiffs’ claims was his ‘mere status’ as a control person.” As to the company, it entered bankruptcy proceedings before the district court conducted its Rule 11 analysis.
Certain of Plaintiffs’ Federal Securities Claims Violated Rule 11
On appeal, the Third Circuit affirmed the district court’s determination that plaintiffs’ unregistered securities claim[2] and their misrepresentation claim[3] against the company’s founder violated Rule 11. The Third Circuit also held that the district court did not abuse its discretion in determining that these claims lacked factual support in violation of Rule 11(b)(3). Noting that, under Mary Ann Pensiero, Inc. v. Lingle, 847 F.2d 90 (3d Cir. 1988), courts should assess Rule 11 compliance by assessing a party’s or attorneys’ conduct based on what was reasonable to believe at the time of the complaint, the Third Circuit stated that plaintiffs made only general unregistered securities allegations in the complaint and failed to identify any specific individuals as unaccredited investors. Similarly, as to the misrepresentation claim, the Third Circuit pointed to the district court’s determination that plaintiffs’ pre-filing investigation should have revealed the lack of factual support for their allegation that the offering was public.
The Third Circuit also affirmed the district court’s determination that plaintiffs’ 10b-5 securities fraud claim did not violate Rule 11. The Third Circuit concluded that there was no abuse of discretion in the district court’s determination that plaintiffs had a reasonable basis to allege securities fraud. The Third Circuit also noted that while the district court did summarily dismiss the 10b-5 claim, “courts must ensure that Rule 11 ‘not be used as an automatic penalty against an attorney or a party advocating the losing side of a dispute.’” (quoting Gaiardo v. Ethyl Corp., 835 F.2d 479 (3d Cir. 1987)).
It Was an Abuse of Discretion Not to Impose Any Sanctions
Ultimately, the Third Circuit concluded that the district court abused its discretion in declining to impose any form of sanctions and vacated the portion of the order that declined to impose sanctions because the text of the PSLRA makes the imposition of sanctions mandatory after a court determines that a party has violated Rule 11. On remand, the Third Circuit instructed the district court to impose “some form of sanction” against plaintiffs in accordance with Rule 11, but took no position on what sanction to impose acknowledging that the district court was better situated to make that determination.
[1] Securities offerings under Rule 506(b) are exempt from registration. An issuer must still meet certain requirements, however, including that an issuer cannot engage in general solicitation or advertising, securities cannot be sold to more than 35 non-accredited investors, and that non-accredited investors must have sufficient knowledge and experience to evaluate potential risks.
[2] In their unregistered securities claim, plaintiffs alleged that defendants failed to meet registration exemption requirements and that the offering violated federal securities law because the founder sold securities to allegedly unsophisticated and unaccredited investors without providing sufficient disclosures. The district court concluded that the founder reasonably believed that both investors in question were accredited at the time of their security purchases.
[3] Plaintiffs alleged that the founder violated 15 U.S.C. § 771(a)(2) by making misrepresentations while selling company stock (for example, by misrepresenting the company’s resources). The district court found that the documentation provided to prospective investors clearly identified the offering as private and for accredited investors only and concluded that such misrepresentation claims did not apply to the private sale of securities.