Until the 1930s, securities purchasers looked solely to state securities laws—so-called Blue Sky Laws—for protection against securities fraud. That all changed after the Crash of 1929, when the federal securities laws were enacted and came to dominate the field in the ensuing decades. But state securities laws have made a bit of comeback in recent years, and an April 2017 decision out of a California federal court may continue to fuel their rise. Colman v. Theranos, Inc. The Theranos court found that indirect purchasers of securities—those who invest in a fund that in turn purchases securities from a company—can sue that company. The decision raises a number of important questions for both issuers of securities—especially large private companies—and the many funds that buy directly into them.
A brief review of the facts will set the stage. Theranos is a privately held life sciences company recently thrust into the national spotlight over questions about the legitimacy of its business. Plaintiffs in the case had invested money in two different private funds expressly formed to invest in the company. One fund acquired stock directly from Theranos; the other acquired its stock on the secondary market. Plaintiffs’ purchases came amid a publicity campaign about Theranos that, allegedly, was designed to raise capital from private investors, including plaintiffs. After news broke questioning the viability of Theranos’s technology, the indirect purchaser plaintiffs sued the company for fraud, asserting securities claims under various provisions of California law.
Ruling on Theranos’s motion to dismiss, Magistrate Judge Nathanael Cousins of the Northern District of California held that the indirect purchasers had standing to sue under California law. In pertinent part, the California provisions at issue make it unlawful for “a broker-dealer or other person selling or offering” a security to willfully make, “directly or indirectly,” a false or misleading statement “for the purpose of inducing the purchase or sale of such security.” Unlike most of the federal securities laws, notably Section 10(b), this statute does not require a plaintiff to prove actual reliance; rather, a plaintiff need only prove that defendant intended the plaintiff to rely on his statement. And, now, if the Theranos court’s ruling is accepted by other courts, the statute also will not require “privity,” or a buy-sell relationship, between indirect purchasers and the issuing company. Defendants unsuccessfully pressed the court to impose such a requirement, but the court disagreed, noting the statute “focuses on the actions of the seller of the securities, not the relationship between seller and buyer.”
So, did the court get it right? The answer is both yes and no, with a bit of history explaining why. The California statute at issue was modeled after and closely resembles Section 9 of the Securities Act of 1934, which was specifically aimed at prohibiting the manipulative market conduct prevalent in the 1920s. As numerous state and federal courts have noted, including those in California, “market manipulation” is a term of art that covers some artifice or scheme where a defendant enters the market and alters the natural forces of supply and demand. Some of that fraudulent conduct—such as a “wash sale,” where the defendant buys and sells from himself to create the appearance of demand, or a “matched order,” where he buys and sells to co-conspirators for similar purposes—involves trading that occurs solely between one or more co-conspirators. The court is thus right that privity is not universally required; if it were, a defendant trading solely with himself or his scheming confederates could never be liable.
But the court’s analysis failed to see the full picture. Like Section 9, the California statute at issue was never intended to reach false or misleading oral or written statements like those Theranos made to the market. Rather, it is focused on specific schemes, in the market, that artificially alter the natural forces of supply and demand. Nowhere is Theranos alleged to have engaged in any such conduct. The result, then, is to allow an indirect purchaser to repackage a traditional misstatements case—which does require privity under California law—into a manipulative conduct case that does not. Courts have rejected this strategy for years.
The consequences of this approach are potentially far reaching for private companies and the funds that invest in them. For private companies, the decision poses concerns about raising money from institutional investors and publicly traded companies, which have become a significant source of financing. The court’s ruling could give disappointed investors in those entities standing to sue the private companies in which they invest. Since the universe of those investors under the reasoning of Theranos is much broader than those who participate in private offerings—and since those investors may only be able to rely on general statements in the public domain—the court’s ruling raises the possibility that retail investors could sue private companies without ever having directly invested in them.
For private funds that invest in private companies, the decision also raises a number of serious questions, especially as to who controls claims that belong to the fund. For instance, what recourse, if any, does a fund and its other investors have if they believe a lawsuit is frivolous or would distract management and thereby harm their investment? Without an express waiver of the indirect purchasers’ claims, it would seem very little. And would an investor further down the investment chain, say in a fund-of-funds, also have standing to bring a claim against the private company? The court seemed to take comfort that the universe of potential plaintiffs was limited to those the company “intended” to defraud. But drawing the line based on something so subjective provides little comfort to companies and the funds that invest in them.
It is worth emphasizing that there are ways to read the court’s ruling as limited to its unique set of facts. The funds at issue were set up for the express purpose of investing in Theranos stock, not to invest in multiple securities. What’s more, Theranos has been accused of misrepresenting the viability of its business as a whole, something different in kind and degree from an allegedly misleading statement about a discrete event or fact. Nor is it clear that the indirect purchasers had been provided any documents upon which to base their indirect investment in Theranos.
If limited to these facts, the court’s decision could be understood. But if future courts look beyond the facts to the general proposition for which Theranos stands—that indirect purchasers may sue a private company for plain vanilla securities fraud without having to prove privity—the prominence of state securities laws like those in California may only grow.