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I'm Jeff Sonn, an attorney concentrating on securities fraud and consumer class actions. I use this blog to bring attention to regulatory filings involving financial advisors, current events in securities and cases in the financial services industry, and to help investors understand their rights and options for financial recovery. Questions? Contact me online or call anytime at 844-689-5754

Common Remedies and Claims in Ponzi Cases

Theories of liability in Ponzi cases normally include a claim for the sale of unregistered securities.1 The Securities Act of 1933 and the Securities Exchange Act of 1934 both define the term “security” as including the catch-all term “investment contracts.”2 The phrase “investment contract” is not defined in either statute. In Securities & Exchange Commission v. W.J. Howey Co.,3 the Supreme Court provided a flexible test for determining whether a particular transaction qualified as an “investment contract.” “[A]n investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party ….”4

The Court stated that this approach “embodies a flexible rather than a static principle, one that is capable of adaption to meet the countless and variable schemes devised by those who seek the use of the money of others on the promises of profits.”

In Securities & Exchange Commission v. Edwards,5, the Supreme Court reaffirmed the definition enunciated in Howey. The Court reiterated that “ ‘Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.’ To that end, it enacted a broad definition of ‘security,’ sufficient ‘to encompass virtually any instrument that might be sold as an investment.’ ”6

Courts will normally broadly apply the securities laws under the Security Acts of 1933 and 1934 under Howey and reiterated in Edwards to all “schemes devised by those who seek the use of the money of others on the promise of profits.”7 As the Supreme Court once commented in Tcherepnin v. Knight,8 “[I]n searching for the meaning and scope of the word ‘security’ in the Act[s], form should be disregarded for substance and the emphasis should be on economic reality.”.

The second theory common to suits involving Ponzi schemes is a claim for fraud by misrepresentation or omission under Section 10(b)(5).9 Section 10(b) of the Securities Exchange Act makes it, “unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange … [t]o use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.”10

The SEC, pursuant to this section, promulgated Rule 10b-5, which makes it unlawful

“(a) To employ any device, scheme, or artifice to defraud,
“(b) To make any untrue statement of a material fact or to omit to state a material fact necessary
in order to make the statements made, in the light of the circumstances under which they were
made, not misleading, or“(c) To engage in any act, practice, or course of business which operates
or would operate as a fraud or deceit upon any person,“in connection with the purchase or sale of
any security.11

Rule 10b-5 encompasses only conduct already prohibited by § 10(b).12 Though the text of the Securities Exchange Act does not provide for a private cause of action for § 10(b) violations, the Courts have found a right of action implied in the words of the statute and its implementing regulation.13 In a typical § 10(b) private action a plaintiff must prove (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.14

Unfortunately, in Central Bank, the Supreme Court of the United States determined that § 10(b) liability did not extend to aiders and abettors.15 The Court found the scope of § 10(b) to be limited by the text, which makes no mention of aiding and abetting liability.16 The Court doubted the implied § 10(b) action should extend to aiders and abettors when none of the express causes of action in the securities Acts included that liability. Id., at 180, 114 S.Ct. 1439.17

Another common claim brought in Ponzi scheme cases is liability under the “control person” statute under the Securities and Exchange Act of 1934.18 The Act imposes liability not only on the person who actually commits a securities law violation, but also on an entity or individual that controls the violator. Section 20(a) provides:

Every person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.

15 U.S.C. § 78t(a) (emphasis added).

The text of section 20(a) unambiguously imposes derivative liability on persons that control primary violators of the Act. Under section 20(a), a controlling person is liable to the plaintiff jointly and severally with and to the same extent as a controlled person for the controlled person’s acts, unless the controlling person can establish the affirmative defense of good faith and non-inducement.

The legislative purpose in enacting a control person liability provision was to prevent people and entities from using straw parties, subsidiaries, or other agents acting on their behalf to accomplish ends that would be forbidden directly by the securities laws.19 In congressional hearings preceding the passage of the Act, Congress referred to correcting the “dangerous and unreliable system of depending upon dummy directors” that lacked any accountability or responsibility.20

The House of Representatives Report accompanying the Act summarized section 20(a) and clarified that Congress intended to achieve its purpose by making “a person *722 who controls a person subject to the act … liable to the same extent as the person controlled unless the controlling person acted in good faith.”21

Control person liability is essentially a claim for vicarious liability. In the Eleventh Circuit, “a defendant is liable as a controlling person … if he or she ‘had the power to control the general affairs of the entity primarily liable at the time the entity violated the securities laws …[and] had the requisite power to directly or indirectly control or influence the specific corporate policy which resulted in the primary liability.’ “22

Thus, under controlling law, any person who “controls” a person or entity that violates a provision of the Securities Act or the Exchange Act is jointly and severally liable for the violation. The SEC’s implementing regulations define “control” as “the possession, direct or indirect, or the power to direct or cause the direction of the management policies of a person.”23

The derivative nature of section 20(a) liability has caused courts to disagree over the extent and nature of the burden that the plaintiff must bear to prove section 20(a) liability. In Brown v. Enstar Group, Inc., 84 F.3d 393, 396 (11th Cir.1996), the Court held that a plaintiff alleging controlling person liability under section 20(a) must allege that (1) the defendant had the power to control the general affairs of the primary violator, and (2) the defendant had the power to control the specific corporate policy that resulted in the primary violation.

However, the Court in Enstar Group, Inc. noted an important distinction between the test it adopted and the Eighth Circuit’s test requiring a plaintiff to prove that a defendant actually exercised power over the entity primarily liable.24 Because the Court found that the defendant in Enstar Group, Inc neither possessed nor exercised power over the entity primarily liable at the relevant time, it did not decide whether the power to control the general affairs of the entity primarily liable means “simply abstract power to control, or actual exercise of the power to control.”25

Other Courts have required pleading and proof of some “culpable conduct” on the part of the controlling person, along with the power to control the policies that resulted in the primary liability.26

Still other claims that are commonly brought in Ponzi scheme cases are tort and contract claims under the common law. Claims for fraud, breach of fiduciary duty, state blue sky laws, common law aiding and abetting, negligence and even breach of contract are also common in Ponzi cases.27 Since the elements of these claims would likely vary from state to state, it is beyond the scope of this article, but the practitioner would be wise to explore each of these claims.

1. Normally referred to as “Sale of Unregistered Securities in Violation of Sections 5(a) and 5(c) of the Securities Act, ”15 U.S.C. §§ 77e( a) and 77e[c].

2. 15 U.S.C. § 77b(a)(1); 15 U.S.C. § 78c(a)(10).

3. 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946).

4. 328 U.S. at 298-99, 66 S.Ct. at 1103.

5. 540 U.S. 389, 124 S.Ct. 892, 157 L.Ed.2d 813 (2004).

6. 540 U.S. at 393, 124 S.Ct. at 896 (quoting Reves v. Ernst & Young, 494 U.S. 56, 110 S.Ct.945, 108 L.Ed.2d 47 (1990)).

7. S.E.C. v. Mutual Benefits Corp., 408 F.3d 737, (11th Cir.2005); Howey, 328 U.S. at 299, 66 S.Ct. at 1103; see also Tcherepnin v. Knight, 389 U.S. 332, 336, 88 S.Ct. 548, 553, 19 L.Ed.2d 564 (1967).

8. 389 U.S. 332, 336, 88 S.Ct. 548, 553, 19 L.Ed.2d 564 (1967).

9. See 15 U .S.C. § 78j(b), and Rul e 10b-5, 17 C .F.R. § 240.10b-5.

10. ” 15 U.S.C. § 78j.

11. ” 17 CFR § 240.10b-5.

12. United States v. O’Hagan, 521 U.S. 642, 651, 117 S.Ct. 2199, 138 L.Ed.2d 724 (1997).

13. Superintendent of Ins. of N.Y. v. Bankers Life & Casualty Co., 404 U.S. 6, 13, n. 9, 92 S.Ct.165, 30 L.Ed.2d 128 (1971).

14. See Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 341-342, 125 S.Ct. 1627, 161 L.Ed.2d 577 (2005).

15. Central Bank of Denver vs. First Interstate Bank of Denver, 511 U.S., at 177, 114 S.Ct. 1439 (1994).

16. Id.

17. The Court added the following: “Were we to allow the aiding and abetting action proposed in this case, the defendant could be liable without any showing that the plaintiff relied upon the aider and abettor’s statements or actions. See also Chiarella [ v. United States, 445 U.S. 222, 228, 100 S.Ct. 1108, 63 L.Ed.2d 348 (1980) ]. Allowing plaintiffs to circumvent the reliance requirement would disregard the careful limits on 10b-5 recovery mandated by our earlier cases.” Ibid. The decision in Central Bank led to calls for Congress to create an express cause of action for aiding and abetting within the Securities Exchange Act. Then-SEC Chairman Arthur Levitt, testifying before the Senate Securities Subcommittee, cited Central Bank and recommended that aiding and abetting liability in private claims be established. S. Hearing No. 103-759, pp. 13-14 (1994). Congress did not follow this course. Instead, in § 104 of the Private Securities Litigation Reform Act of 1995 (PSLRA), 109 Stat. 757, it directed prosecution of aiders and abettors by the SEC. 15 U.S.C. § 78t(e).

18. Section 20(a) of the Exchange Act, 15 U .S.C. § 78t(a). Section 15 of the Securities Act of 1933 also imposes liability on controlling persons. See 15 U.S.C. § 77o (West 20007).

19. H.R.Rep. No. 73-152, at 12 (1933); see generally William O. Douglas, Directors Who Do Not Direct, 47 Harv. L.Rev. 1305 (1934); Loftus C. Carson II, The Liability of Controlling Persons Under the Federal Securities Acts, 72 Notre Dame L.Rev. 263, 266 (1997).

20. S.Rep. No. 73-47, at 5-6 (1933); see also H.R.Rep. No. 73-152, at 12 (1933); Stock Exchange Practices: Hearing on S. Res. 84 (72nd Cong.) and S. Res. 56 and 97 (73rd Cong.) Before the Senate Comm. on Banking and Currency, 73rd Cong., 1st Sess. 6556 (1934) (remark of Sen. Barkley).

21. H.R.Rep. No. 73-1383, at 26 (1934) (emphasis added).

22. Brown v. Enstar Group, Inc., 84 F.3d 393, 396 (11th Cir.1996) (citations omitted).See also Hoffend v. Villa (In re Villa), 261 F.3d 1148 (11th Cir. 2001)(Under this Court’s interpretation of the term “controlling person” under § 20(a), a “controlling person” may include not only partners or principals under agency law, but also any person who has the power to control the conduct of another person who has violated securities laws.); Davidco Investors, LLC v. Anchor Glass Containers, 2006 U.S. Dist. LEXIS 11527, Fed. Sec. L. Rep. (CCH) P93,732 (M.D.Fla. 2006)(A defendant is liable as a controlling person if he “had the power to control the general affairs of the entity primarily liable at the time the entity violated the securities laws . . . [and] had the requisite power to directly or indirectly control or influence the specific corporate policy which resulted in the primary liability.””).

23. 17 C.F.R. § 230.405.

24. See Sheinkopf, 927 F.2d at 1270. “For [defendant] to be liable … there must be ‘significantly probative’ evidence that the [defendant] exercised, directly or indirectly, meaningful hegemony over” the controlled person.) (citation omitted); Harrison v. Dean Witter Reynolds, Inc., 974 F.2d 873, 880-881 (7th Cir.1992) (describing a similar requirement for plaintiff); Metge v. Baehler, 762 F.2d 621, 631 (8th Cir.1985) (holding that control person merely must possess, not necessarily exercise, the power to determine the acts or omissions upon which the underlying violation is predicated); San Francisco-Okla. Petroleum Exploration Corp. v. Carstan Oil Co., 765 F.2d 962, 964 (10th Cir.1985) (stating that a plaintiff establishes a prima facie case of controlling person liability “when the … defendant [is] shown to be a controlling person”); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1572 (9th Cir.1990) (same).

25. Enstar Group, Inc., 84 F.3d at 397 n. 6.; see also G.A. Thompson & Co., Inc., 636 F.2d at 958.

26. See Boguslavsky v. Kaplan, 159 F.3d 718, 720 (2d Cir. 1998) (“§ 20(a) liability requires an individualized determination of a defendant’s control of the primary violator as well as a defendant’s particular culpability”) (emphasis added); see also Ganino v. Citizens Utilities Co., 228 F.3d 154, 170 (2d Cir. 2000) (“To make out a prima facie case under § 20(a)…plaintiff ‘must… show that the controlling person was in some meaningful sense a culpable participant’ ”); First Jersey Sec., 101 F.3d at 1472 (plaintiff must “show that the controlling person was ‘in some meaningful sense [a] culpable participant’ ”); Hollin v. Scholastic Corp., 252 F.3d 63, 77-78 (2d Cir. 2001) (emphasis added). Gurfein v. Ameritrade, Inc., 411 F. Supp. 2d 416, 427 (S.D.N.Y. 2006).

27. See e.g. See Complaint, Scheck Investments LP vs. MBC et al. Case no. 04-21160 (S.D. FL 2004).

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