What Is Control Person Liability?
Section 20(a) of the Securities Exchange Act of 1934 establishes a federal financial fraud doctrine that imposes liability on corporate executives and shareholders for the acts of the companies they oversee.
In the world of government enforcement, terms like “liability” and “culpability” are typically reserved for those who directly commit a statutory offense. The term “vicarious liability” applies, and “aiding and abetting” can be charged under certain circumstances, but for the most part, parties that do not have a direct role in a statutory offense cannot be held responsible, either criminally or civilly.
However, when it comes to federal financial fraud, the law is different. Under federal law, corporate officers and major shareholders can be held responsible for the acts of their companies—even if they had nothing to do with the fraudulent act in question.
This is due to the fact that, back in 1934, Congress adopted the Securities Exchange Act. Under Section 20(a) of the Securities Exchange Act, a party that exercises “control” over a party that commits securities fraud can be held liable for the fraud—and this liability can exist regardless of whether the control party (i.e., the corporate executive or shareholder) had any involvement in the securities fraud at issue.
5 Key Takeaways About Control Person Liability Under Section 20(a) of the Securities Exchange Act
With this in mind, what do corporate executives and major shareholders need to know about control person liability under Section 20(a) of the Securities Exchange Act?
Here are five key takeaways from our federal securities fraud defense lawyers:
1. “Control Person” is Broadly Defined Under the Securities Exchange Act
The U.S. Securities and Exchange Commission (SEC) and federal courts have defined the term “control person” broadly under the Securities Exchange Act. As a result, corporate executives and major shareholders can face substantial exposure to federal liability.
As the SEC explains, “control” and “control person” are defined as follows:
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Control. The term ‘control’ (including the terms ‘controlling,’ ‘controlled by’ and ‘under common control with’) 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.
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Control person. The term ‘control person’ means any person that is a director, general partner, member, manager (or managing member if member-managed), or officer exercising executive responsibility (or, if the [issuer] is managed by a board or equivalent body, has the power to direct or cause the direction of the management or policies of the [issuer] through any means) or any other person who exercises similar power and authority for the [issuer].
As you can see, with the “management and policies” language in the definition of control and the “cause the direction” language in the definition of control person, these definitions are extremely broad, and they can potentially encompass a wide range of corporate executives and major shareholders.
2. Control Person Liability Extends to Corporate Executives and Major Shareholders
Under the definitions of “control” and “control person” above, corporate executives (i.e., directors and officers) and major shareholders can incur vicarious liability for securities fraud committed by their companies. For example, a director or officer who is found to have directed or caused the direction of the management or policies of a company that commits securities fraud can potentially be held personally accountable for the company’s violation of federal law.
In reality, however, the SEC often brings cases against corporate executives and major shareholders without specific evidence of direction or control. Instead, when a company commits securities fraud, the SEC will often aggressively pursue charges against the company’s senior executives and major shareholders as well. This means that it will often be necessary to argue in defense that the individual defendant did not have direction or control in order to avoid unnecessary exposure to civil or criminal penalties.
3. Liability for Control Persons Extends to ALL Securities Law Violations
Another key point to note is that Section 20(a) of the Securities Exchange Act is not limited to certain types of violations. Rather, control person liability extends to all securities law violations, whether civil or criminal in nature. This means that control person liability can extend to securities fraud as well as insider trading, accounting fraud, and other offenses.
As a result, even if a corporate executive or major shareholder is not concerned about securities fraud liability, there is still a risk of facing federal scrutiny. When investigating a company’s finances, the SEC (and federal prosecutors working with the DOJ) will thoroughly assess all aspects of the company’s compliance and regulatory obligations. Any violations that are found (or even suspected) can lead to additional inquiries and charges—and this includes charges against individuals in their personal capacities.
4. There is a “Good Faith” Defense to Control Person Liability
While control person liability can be broad, it is not absolute. Section 20(a) of the Securities Exchange Act establishes a “good faith” defense, stating:
Every person who, directly or indirectly, controls any person liable under any provision of [the Securities Exchange Act] or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person . . . 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.
So, if a corporate executive or major shareholder is accused of having control over a company that commits a violation of the Securities Exchange Act, it will be necessary to assert the good faith defense in order to avoid the risk of federal penalties. In order to do so effectively, the corporate executive or major shareholder will need to be able to affirmatively demonstrate that he or she did not directly or indirectly cause the company’s violation. This requires a proactive approach, and it involves presenting specific evidence that a corporate executive or major shareholder did not have control over the company at the time the violation was committed.
5. Control Person Liability Can Lead to Both Civil and Criminal Prosecution
Finally, even though Section 20(a) establishes a good faith defense, corporate executives and major shareholders should not assume that the defense will be successful if they did not know about their company’s violation. This is not the intended purpose of the good faith defense, and the SEC and DOJ will both aggressively pursue charges against individual defendants who are accused of causing or allowing their companies to violate the Securities Exchange Act. At the same time, as we discuss here and here, while the SEC’s enforcement jurisdiction is generally limited to civil enforcement, the DOJ can pursue criminal charges under the Securities Exchange Act when warranted in the DOJ’s view.
FAQs: Defending Corporate and Shareholder Control Person Liability
Can Corporate Executives Face Personal Liability for Securities Fraud?
Yes, corporate executives can face personal liability for securities fraud. Under Section 20(a) of the Securities Exchange Act, corporate executives can be held personally liable for securities law violations committed by their companies. In these cases, corporate executives must be prepared to present evidence of the “good faith” defense established by Section 20(a).
Can Shareholders Face Personal Liability for Securities Fraud?
Yes, shareholders can face personal liability for securities fraud as well. If a shareholder’s holdings are significant enough to provide direction or control, the shareholder can face personal liability for the company’s securities law violations in addition to the company’s corporate liability. The SEC takes an aggressive approach to enforcing violations of the Securities Exchange Act, and it will not hesitate to pursue charges against corporate executives and major shareholders in appropriate cases.
Can Corporate Executives and Shareholders Be Held Civilly and Criminally Liable for Securities Fraud?
Yes, in appropriate cases, corporate executives and shareholders can face both civil and criminal liability for securities fraud. If the SEC uncovers evidence of a willful violation of the Securities Exchange Act (or if it uncovers evidence of other federal crimes during the course of its investigation), it will work with the DOJ to ensure that the culpable parties are held fully accountable.
What Is the Good Faith Defense Under Section 20(a) of the Securities Exchange Act?
The good faith defense under Section 20(a) of the Securities Exchange Act provides that corporate executives and major shareholders can avoid personal liability for their companies’ securities law violations if they can prove that they did not facilitate or allow the violations to occur. As a result, facing charges under Section 20(a) involves asserting an affirmative defense—however, corporate executives and major shareholders should not rely on this defense to protect them against penalties in the event of an SEC investigation or enforcement action.
What Are the Penalties for Securities Fraud Under Section 20(a) of the Securities Exchange Act?
The penalties for securities fraud under Section 20(a) of the Securities Exchange Act depend on whether the SEC pursues civil or criminal enforcement. In civil enforcement cases, the penalties can include disgorgement, fines, loss of public company status, and other sanctions. In criminal enforcement cases prosecuted by the U.S. Department of Justice (DOJ), corporate executives and major shareholders can face additional fines and the potential for years, if not decades, of federal imprisonment.
