Control Person Liability: Tips For Investment Firms

First published in Law360, September 21, 2011

Law360, New York (September 21, 2011, 12:19 PM ET) -- Investment firms face an ever-expanding range of legal risks associated with making and managing their portfolio company investments. One area of liability that has seen an expansion is "control person" liability under the federal securities laws. This theory is traditionally used against officers and directors of companies alleged to have violated the securities laws, the premise being that these individuals "control" the primary violator.

But recent decisions and U.S. Securities and Exchange Commission actions have expanded the scope of control person liability to expose entities and individuals with more peripheral involvement with the primary violator. In light of this increased exposure, investment firms need to pay close attention to potential control person liability issues in connection with their investments. This article explores the implications of control person liability as it relates to investment firms and their personnel, offering practical steps to limit risks associated with such exposure.

Standards for Control Person Liability

Section 15 of the Securities Act of 1933 ("Securities Act") and Section 20(a) of the Securities and Exchange Act of 1934 ("Exchange Act") provide that one who "controls" a person liable under another provision of the Securities Act or Exchange Act is liable to the same extent as the controlled person (i.e., the primary violator). Section 15 and Section 20(a) generally have been interpreted in the same manner. To plead a claim for control person liability, the plaintiff must establish (1) a primary violation of the securities laws and (2) control over the primary violator by the alleged control person.

Pleading Standards

District courts essentially have applied two distinct standards in determining whether a plaintiff has pled control. The U.S. Supreme Court has yet to resolve this split in authority.

Under the "culpable participation" standard, which is the law in the Second, Third and Fourth Circuits, a plaintiff must plead and prove that "the control person was in some meaningful sense a culpable participant in the primary violation."1

By contrast, under the "potential control" standard, which is the law (with varying permutations) in the Fifth, Sixth, Seventh, Eighth, Ninth, Tenth and Eleventh Circuits, a plaintiff must show "the power to control the transaction underlying the alleged securities violation and not the exercise of that power."2 In other words, the "potential control" standard requires a plaintiff to allege that the defendant "had the power to direct or cause the direction of the management and policies" of the company, regardless of whether he or she exercised such control.

Affirmative Defense

Even if a defendant is found to have controlled the primary violator, that defendant will not be liable if it can establish the "good faith" affirmative defense. To prove good...