Third-Party Liability for Securities Fraud

In some cases, a service provider associated with a business, such as an accountant, banker, broker, or lawyer, can be held liable for untruths or omissions made by the business in connection with the sale of stock (or other securities, such as LLC membership interests), even if the service provider has no ownership interest in the business. This liability is not commonly incurred, but the potential exists nonetheless. It can come about as a result of “aiding and abetting,” or it can arise as a result of a conspiracy between the business owner and the service provider to defraud investors. Whether or not the elements of aiding and abetting or conspiracy are well founded, the service provider can be stuck with the time and expense of defending against such allegations. Awareness of the potential liability may encourage service providers to take steps to weed out clients that they suspect may play fast and loose with investors.

The following is the text of an e-bulletin that I prepared that was published by the Corporations Committee of the Business Law Section of the State Bar of California. It addresses the issue of aiding and abetting in the context of California’s securities law (and to a minor extent, it addresses liability for conspiracy to commit common-law fraud).


As many lawyers know, a private cause of action for aiding and abetting a violation of the anti-fraud provisions of federal securities law ceased to be viable once the U.S. Supreme Court decided Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. (1994) 511 U.S. 164. Central Bank of Denver held that there is no private aider and abettor liability for a violation of § 10(b) of the Securities Exchange Act of 1934. What some lawyers may not realize, however, is that a section of the Corporations Code provides statutory liability for aiding and abetting a violation of the state-law analogue of § 10(b).

A recent case, AREI II Cases (May 29, 2013) 13 C.D.O.S. 5437, addresses the scope of Corp C § 25504.1, which creates liability for anyone who “materially assists” in a violation of certain sections of the Corporations Code, including § 25401, the section prohibiting fraud in the offer or sale of securities. As comment no. 1 below makes clear, this case is of interest not just to litigators but also to counsel who participate in securities transactions.

In 2005, over 30 investors purchased tenancy-in-common interests in a senior housing facility in Roseville, California from Asset & Real Estate Investment Company (AREI), investing over $17 million in the venture. The investors formed limited liability companies that invested in the Roseville property, and those LLCs were the plaintiffs.

James Koenig, the founder and sole owner of AREI, which promoted senior housing facilities to potential investors, was a convicted felon who had been sentenced in 1986 to two years in prison for fraud.

In June 2008, the California Attorney General raided AREI’s offices and shut down its operations, alleging it was a Ponzi scheme. Koenig was alleged to have embezzled funds from the venture for his own use or to fund other projects.

Morgan Keegan was an investment-banking firm that had no involvement in the sales of securities to plaintiffs; it structured joint ventures between AREI and various lenders. The investors sued Morgan Keegan for materially assisting in AREI’s violation of securities law and for fraud based upon a conspiracy, alleging that Morgan Keegan knew of Koenig’s felony conviction and also knew that AREI did not disclose the conviction to the investors. The trial court sustained Morgan Keegan’s demurrer to the complaint.

The trial court concluded that the complaint did not state a cause of action for materially assisting in a securities violation, reasoning that the only acts Morgan Keegan were alleged to have committed were to arrange the original and additional real estate financing. Playing an instrumental role in those legitimate transactions did not constitute materially assisting AREI in the securities law violation, i.e., selling or offering to sell securities by means of untrue statements or omissions of material fact. The court of appeal agreed on this issue.

Corp C § 25401 makes it unlawful to offer or sell a security by means of an untrue or misleading statement of a material fact. Section 25501 creates civil liability for a violation of § 25401, a liability that is sometimes referred to as “primary liability” because it applies to a person who is directly responsible for violating § 25401. There are two other sections of the Corporations Code that also create liability for violation of § 25401, liability that is sometimes referred to as “secondary liability” because it applies to someone other than the person directly responsible for the violation.

One section that creates secondary liability is Corp C §25504.1, which was the basis for this aspect of the investors’ lawsuit. That section provides in pertinent part:

Any person who materially assists in any violation of Section … 25401 [the section that prohibits fraud in the sale of securities]  …  with intent to deceive or defraud is jointly and severally liable with any other person liable under this chapter for such violation.

Thus, any person who, with intent to deceive or defraud, materially assists an issuer in selling securities by means of untrue or misleading statements will be liable for the securities law violation to the same extent as the issuer. This kind of liability is sometimes referred to as “aider and abettor liability.”

The question then is, What constitutes “material assistance” within the meaning of the statute?

The investors argued a “but for” test to determine whether material assistance was given. They argued that but for the participation of Morgan Keegan in structuring the overall transaction and arranging loans, the deal could never have been put together, and thus the investors would not have been defrauded. The court rejected the “but for” test as a way of determining “material assistance.”

The plain language of Corp C § 25504.1 makes it clear that a person must have materially assisted in the securities law violation. It is not enough that a person provided material assistance in a larger scheme to defraud if that person had no role or involvement in the part of the scheme that constituted a violation of Corp C § 25401.

Here, the primary violation was selling a security by means of false or misleading statements in violation of Corp C § 25401. Thus, the complaint had to include allegations demonstrating how Morgan Keegan assisted in the act of selling or offering to sell securities to the investors by means of untrue or misleading statements.

The court considered case law under the other Corporations Code section that imposes secondary liability, Corp C § 25504, which imposes secondary liability on broker-dealers (and on control persons and employees) who “materially aid in the act or transaction constituting the violation” if they have knowledge of, or reasonable grounds to know, of the facts giving rise to the statutory violation. In Apollo Capital Fund LLC v. Roth Capital Partners, LLC (2007) 158 Cal.App.4th 226, it was held that a broker-dealer’s active role in a securities offering was insufficient for purposes of the “material aid” requirement of Corp C § 25504. Apollo required as a condition to liability for “materially aid[ing]” that a broker­dealer have materially aided in the violation itself, namely, in the sales of securities by means of untrue or misleading statements. The AREI Cases court suggested that the “material assistance” section imposed a more stringent nexus requirement than the “material aid” section.

The court of appeal refused to follow federal case law on aiding and abetting federal securities law violations that was decided before Central Bank of Denver. It found the elements of aiding and abetting under federal case law were different than the elements of material assistance under the Corporations Code, and it found the federal case law unhelpful in any event.

In the present case, there were no allegations that Morgan Keegan had any involvement in selling or offering to sell the securities by untrue or misleading statements in the private placement memo or any other documents relied upon by the investors. In fact, Morgan Keegan was not alleged to have had any communications whatsoever with the investors, let alone to have made untrue or misleading statements to them. Nor was Morgan Keegan alleged to have played any role in the preparation, drafting, or distribution of the private placement memo circulated to investors. Therefore, the court held that Morgan Keegan could have no liability for materially assisting a securities violation, and the complaint as to this issue was properly dismissed.

The court of appeal also reviewed the allegations in the complaint that Morgan Keegan entered into a conspiracy with AREI to commit common law fraud by concealing Koenig’s felony conviction from investors and allowed the case to go forward on that basis.


1.  What does constitute material assistance by a person not a principal in the transaction? By way of dictum, the court said that it could take the form of aiding in the preparation of offering documents relied upon by investors, communicating misrepresentations directly to investors, or otherwise playing a material, facilitating role in the act of selling or attempting to sell the securities by means of misrepresentations or omissions of material fact. But because the holding of the court is on what does not constitute material assistance, the court’s musings on what might constitute material assistance are not precedent. In any event, material assistance must also be coupled with intent to deceive or defraud to create liability under the statute.

2.  With the benefit of hindsight, Koenig’s criminal conviction for fraud seems like a material fact, but it’s not clear that it was required to have been disclosed. The conviction itself did not cause the project to fail; the fact of the conviction was simply relevant to determining the integrity of the promoter and control person.

The SEC’s Regulation S-K sets forth instructions for registration statements and other forms to be filed under the Securities Act of 1933 and the Securities Exchange Act of 1934. Item 401 of Regulation S-K prescribes certain disclosures with respect to directors, executive officers, promoters, and control persons. Item 401(f)(2) requires disclosure of any criminal conviction that is material to an evaluation of the ability or integrity of such a person and that occurred “during the past ten years.” A conviction for fraud is material to an evaluation of the ability or integrity of a promoter and control person such as Koenig. But because Koenig’s conviction occurred in 1986, 18 years before the offering, the conviction would not have been required to be disclosed under the SEC’s rules for registration statements.

Many lawyers consider the SEC’s rules on mandatory disclosure in registration statements to take a prophylactic approach and to go further in requiring disclosure than would be required under the general anti-fraud requirements of the securities laws. Under that view, a matter expressly addressed by Regulation S-K (criminal convictions) but not required to be disclosed by Regulation S-K would not be material. On the other hand, the basic proscriptions against fraud set forth in the securities laws (Corp C § 25401 in this case) contain no provision that compliance with SEC rules excuses further disclosure.

Ultimately, whether Koenig’s conviction was a material fact that was required to be disclosed to investors will be a decision made by the finder of fact in the case.

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This e-bulletin was prepared by Richard G. Burt, Vice–Chair, Judicial Developments, Corporations Committee of the State Bar of California. Mr. Burt practices in San Jose.

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