Minimizing Personal Liability Exposures Under State Securities Laws

In a case potentially affecting businesses throughout the country, the Indiana Supreme Court ruled in late 2007 in the case of Lean v Reed that an outside director of an out-of-state company was personally liable to Indiana residents who had invested in the company’s stock, even though the director had no personal role in the transaction, because he admitted that Indiana securities law compliance was not the subject of director discussion when the directors authorized the stock to be sold. As a result, directors, officers, general partners, or controlling persons of companies buying or selling securities (especially if those securities are being sold into or from Indiana) should consider improving the manner by which securities law compliance is considered by their top decision-makers and documented in the company records.

The Facts and Holding of Lean v. Reed

Lean v. Reed arose out of a tech bubble acquisition. Galaxy Online, Inc. (GOLI) was a corporation organized under the laws of Yukon Territory, Canada that started in gold mining, failed, and shifted its focus to the Internet business. As part of its efforts to expand its Internet service provider business (ISP) in 2000, GOLI negotiated to buy Abacus Computer Services, Inc., an Indianapolis-based corporation. GOLI paid for Abacus with its own stock. Ultimately, GOLI's ISP business failed, and GOLI's stock apparently became worthless. Two of Abacus's shareholders sued GOLI, its Internet subsidiary and ten other individuals who were the officers, directors and other controlling people with GOLI, including director Ralph Lean, under the Indiana Securities Law.

This case involved only Mr. Lean. The first meeting of the board of directors of GOLI that Mr. Lean attended shortly after joining the board was the meeting at which the Abacus acquisition was discussed and approved. The Plaintiffs sued Mr. Lean under Section 19 of the Indiana Securities Law (Ind. Code § 23-2-1-19), which creates a civil remedy in favor of buyers of securities in transactions that violated the Indiana Securities Law not only against their sellers but also against, among others, any partner, officer, or director of the seller and any person who directly or indirectly controls the seller. Subsection (d), however, provides such persons with a defense that “the person did not know, and in the exercise of reasonable care could not have known, of the existence of the facts by reason of which the liability is alleged to exist.”

The plaintiffs claimed, and Mr. Lean conceded, that the issuance of GOLI’s stock to the shareholders of Abacus was not registered in Indiana in violation of the Indiana Securities Law and that there were material omissions in the disclosures to the Abacus shareholders that also violated the Indiana Securities Law. However, Mr. Lean argued that he should not be held liable because he did not know, and in the exercise of reasonable care, could not have known, of these violations of the Indiana Securities Law. The trial court judge disagreed, and granted summary judgment in favor of the plaintiffs. Both an appeals court and the Indiana Supreme Court affirmed the trial court's ruling.

At heart, Lean v. Reed is about what a director must do to be protected by the affirmative defense in Section 19(d). Mr. Lean, an attorney living in Toronto, Ontario, testified that he did not ask or otherwise inquire of management or the other members of the board of directors whether the Abacus transaction was registered with the Indiana Securities Commissioner or whether GOLI's disclosures violated the Indiana Securities Law. Instead, Mr. Lean contended that such matters were properly left to GOLI's management and attorneys to ensure that such matters were addressed. In support of this position, Mr. Lean offered a deposition by a business school professor, as an expert on corporate governance, that such questions would not normally rise to the board of directors and they would not have been discussed in the ordinary course of a board meeting, even board meetings in which there were securities to be issued in a transaction. Therefore, Mr. Lean argued, he deserved an opportunity to present his case to a jury so that he could demonstrate that he did not know of, and under all of these facts and circumstances he had exercised reasonable care to discover, the violations of the Indiana Securities Law.

The Supreme Court concluded, as a matter of law, that Mr. Lean was liable to the Indiana purchasers of GOLI’s stock because his mere assumption, based on blind trust in the competence and integrity of management and GOLI counsel, that Indiana securities laws were being obeyed meant that he failed to exercise reasonable care to learn of any violations. The Supreme Court suggested that a director might in an appropriate case "reasonably rely on assertions made directly by counsel or on reasonable assurances that competent counsel have reviewed and approved the transaction." In the case at hand, however, the Supreme Court was obviously troubled by the facts that should have been obvious to Mr. Lean at the time, namely, that "GOLI had no operating history, was converting from gold mining to an internet service provider, and had issued shares and options at substantially different prices in transactions that were virtually simultaneous with the Abacus transaction. These rudimentary facts bear multiple indicia of a problematic investment." Therefore, particularly "in the face of a number of facts that raise obvious points of inquiry," the Supreme Court was unwilling to conclude that it was a sufficient defense for the outside director in the position of Mr. Lean simply to assume compliance with all applicable laws "with no explicit assurance from anyone [and] no documentation."

Governance Changes Suggested by Lean v Reed

This case raises several concerns for businesses nationwide. Indiana securities law can reach the controlling persons of businesses outside Indiana (such as the Canadian company in this case) because the Indiana Securities Law applies to any transaction that involves an offer or sale of a "security" and that falls within the jurisdictional requirements of the Indiana Securities Law (such as an issuance of securities to an Indiana investor or offers or sales made from an Indiana business to out-of-state residents). Moreover, many other states have securities laws that are similar to those of Indiana, and therefore the courts of other states could follow this Indiana precedent in interpreting their own laws.

Lean v. Reed also has troubling implications for businesses that are not organized in corporate form. Although this case involved the potential personal liability of a director of a corporation under Section 19(d), that statutory provision equally reaches other types of persons, such as partners, officers and employees that materially aid in the acts giving rise to liability are equally exposed to this potential liability. In addition, Section 19(d) imposes this potential liability upon persons that are "occupying a similar status or performing similar functions" to any of the foregoing. This language would likely cover, for example, managers of limited liability companies. Indeed, the control persons behind any type of business entity could potentially be liable under Section 19(d) for breaches of the Indiana Securities Law by their companies.

In light of this case, businesses, wherever located and however organized, that are engaging in securities transactions should consider taking additional steps and implementing additional procedures to assist their directors, officers and other control persons in establishing defenses to their personal liability. If Mr. Lean could have shown that a presentation regarding compliance with the Indiana Securities Law was made at the board meeting at which the Abacus transaction was approved, he presumably would at least have been entitled to have the reasonableness of his reliance upon that advice considered by a jury, rather than having been held liable as a matter of law without a trial. The making of written or oral reports from counsel concerning securities law compliance, if timely communicated to the decision makers and appropriately documented in minutes or other corporate records, would assist persons who are potentially liable in establishing their affirmative defenses to personal liability under the Indiana Securities Law and potentially other states' securities law.

For more information on how businesses might better protect their directors, officers, partners and controlling persons from personal liability for securities violations, please contact Ice Miller LLP.

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.