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Control Person Liability

Control person liability claims in the realm of broker-dealers are typically brought under §20(a) of the Securities Exchange Act. Interestingly, in a recently settled case brought by the SEC against Nature Sunshine Product’s, the SEC named individual executives of the company under §20(a) and did not alleged that the executives had personal knowledge of the underlying Foreign Corrupt Practices Act (“FCPA”)) violations.

This is noteworthy because there is somewhat of a split among the courts about what needs to be alleged under §20(a ) to bring a control person into a case or arbitration. Generally, the courts are divided between one standard that requires some level of participation on the part of the control person, and another that maintains that participation is not required. Thus, it will be interesting to see if plaintiffs’ attorneys, who advocate for the broadest of standards, will try to use the SEC’s decision not to allege knowledge as support for their control liability claims. Although it is plausible that they will try to do so, that fact remains that such an argument would be without merit because the FCPA is an entirely different animal than the typical violations brought against brokers.

Control person liability is defined under §20(a) as:

“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).

Because the statute itself does not define what it means to “control any person,” the SEC provided clarification: “control means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.”

The definition provided in the Uniform Application for Broker-Dealer Registration also sheds some light on “control.”

The power, directly or indirectly, to direct the management or policies of a company, whether through ownership of securities, by contract, or otherwise. Any person that (i) is a director, general partner or officer exercising executive responsibility (or having similar status or functions); (ii) directly or indirectly has the right to vote 25% or more of a class of a voting security or has the power to sell or direct the sale of 25% or more of a class of voting securities; or (iii) in the case of a partnership, has the right to receive upon dissolution, or has contributed, 25% or more of the capital, is presumed to control that company. (This definition is used solely for the purpose of Form BD.)

The practical application of the control person liability theory typically results in senior executives (CEOs, CFOs, CCOs, etc.), board members, and owners of broker-dealers being named individually in lawsuits and arbitrations. Often, senior executives and the like are brought into cases primarily as a means to add another pocket to the potential settlement pool. In practice, although there are various defenses against control person liability claims, the costs of having senior executives and senior management tied up in a trial or arbitration hearing can force them to settle otherwise meritless claims.

The Courts’ Interpretations of §20(a)

Describing the disagreements among the circuit courts as a “circuit split” is understating what is more accurately described as complete disarray. Indeed, it seems that the only thing the courts agree on is that under any test for control person liability, there must be an underlying violation of a securities law. The divergent standards set forth by the circuits can be generally divided into two main categories: 1) the “potential control” standard (followed by the First, Fifth, Sixth, Seventh, Eighth, Ninth, Tenth, and Eleventh Circuits) and 2) the “culpable participation” standard (followed by the Second, Third, and Fourth Circuits).

The circuits that have adopted the potential control standard subscribe to very broad definitions of control that are susceptible to abuse by litigious claimants who bring claims against control persons based on dubious grounds. On the other hand, the circuits that subscribe to the culpable participation test have a comparatively stricter standard for control liability that discourages frivolous claims by requiring plaintiffs to allege some level of conduct or participation on the part of those control persons named in the matter.

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About the Author

David Welch, Winget, Spadafora, & Schwartzberg, LLC
New York, NY 10022

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