AN OUTSIDE DIRECTOR’S IGNORANCE IS NOT

BLISS UNDER STATE SECURITIES LAWS

Serving a Company, Private or Public, That Sells Securities May be Hazardous to Your Financial Health

On September 19, 2006, an Indiana appeals court affirmed a trial court judgment assessing personal liability upon a Toronto resident, Ralph Lean, who served as an outside director of a Canadian company. Mr. Lean, at his very first board meeting, was asked to approve management’s proposal that the company acquire a private Indiana company by a stock-for-stock exchange; the acquisition closed three days after the board meeting. When their investment in the Canadian company soured, the Indiana shareholders alleged that the securities were “sold” by the Canadian company in violation of the registration requirements of the Indiana securities law, and that the Canadian company had not disclosed certain information that was material in violation of disclosure requirements of the Indiana securities law. The trial court, granting summary judgment to the Indiana stockholders without holding a trial, held Mr. Lean personally liable for the corporation’s violations, even though he had no participation in the transactions other than as an outside director, because he admitted that he did not inquire at the board meeting about Indiana securities law compliance.

Upon appeal, Mr. Lean contended that outside directors typically assume that management, legal counsel, and the due diligence process have taken care of any issues regarding securities compliance. He presented testimony of an expert that state securities registration or exemption is a detail that would not normally rise to the level of inquiry by the board of directors in the ordinary course of conducting a board meeting. In any event, Mr. Lean contended, he was entitled to have a jury decide whether it was reasonable for him, under these particular facts, not to have known of the alleged violations.

Rebuffing these contentions, the Appeals Court held that the Indiana statute permits an outside director to avoid personal liability for company violations of the registration and disclosure requirements of the Indiana securities law only if the director can

show that in the exercise of reasonable care he could not have known of the lack of registration and the undisclosed information. In other words … Lean’s ignorance will be bliss only to the extent that he can prove that even by the exercise of reasonable care he would have remained ignorant of the true state of affairs. By Lean’s admission, a single question to other directors would have provided Lean with salient knowledge about the transaction, and we conclude as a matter of law that Lean has failed to meet the burden set forth by statute.

The Lean decision follows a 2005 decision by another court that a national board of outside directors of a non-profit church fund could be held personally liable under Indiana securities law for the fund’s disclosure violations in connection with a debt offering made from Indiana, without any showing that the fund had intended to mislead investors. The ability of directors and officers to assert that there was no violation of the disclosure requirements of state securities law by their organizations solely on good faith grounds is substantially limited by that 2005 decision.

These two interpretations of Indiana’s securities law might apply to the securities laws of many other states, since many states’ laws are based on the same uniform state securities law. For example, in reaching its interpretation of Indiana law, the Lean court discussed precedent established more than a decade ago under the state securities laws of Washington, Arkansas and Oregon. Frequently the securities laws of more than one state will apply to a multi-state offer and sale, including not just where the purchasers are located or the closing occurs, but also the laws of the state of the corporate headquarters from where the offer originates.

Due to these multi-state dimensions of state securities regulation, the Lean decision greatly increases the risk of ultimate personal liability for directors (and officers, partners, and others serving in similar capacities or functions, and control persons) of organizations (public or private) that issue securities. Security issuances include not only common and preferred stocks and notes or other debt instruments, but also many limited liability company and limited partnership interests and other types of participations. Transactions in which securities liability might arise include not only sales of debt or equity instruments or participation interests for cash but also issuances in connection with acquisitions, recapitalizations, refinancings, stock option plans, and warrant offerings.

Directors (and others who are potentially liable) who seek to escape an unintended role as guarantor of their company’s securities issuances can bolster their ability to claim that they exercised “reasonable care,” by asking questions of management and counsel regarding securities law compliance and documenting the responses that they receive in the minutes of board meetings and otherwise. Areas of inquiry include such matters as whether:

the company’s offers or sales have been (or will be) registered under federal and all applicable states’ securities laws;
if no registration of such offer and sale has been made or is proposed to be made under one or more of such laws, whether all offerees have been advised, in writing, of the absence of registration, and why the company believes that no registration is required under each applicable securities law;
what information has been given to the offerees concerning the company and its securities, and whether the delivery of such information has been documented; and
whether all recent developments and risk factors have been communicated to the potential purchasers.

For more information concerning the implications of the Lean case, please contact an attorney in our Litigation or Corporate and Business Services Groups or Jim Petersen (Litigation).

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.