Recent Changes to California Securities Law Add Teeth to Investor Protection Under Cal. Corp. Code Sections 25501 and 25503
Governor Newsom signed A.B. 511 into law on October 7, 2021, amending California’s Corporate Securities Law of 1968 (“California Securities Law”) and adding a powerful recovery arrow to the quivers of aggrieved investors.[1] A.B. 511 amends the civil liability provisions of Cal. Corp. Code §§ 25501 and 25503. The amendments mandate an award of reasonable attorney’s fees to investors who prevail against sellers of securities who: (1) made a material misrepresentation or omission of a material fact in violation of Cal. Corp. Code § 25401;[2] or (2) sold unregistered securities in violation of the statutory investor qualification requirements of Cal. Corp. Code §§ 25110[3] or 25130[4] (or who sold securities in violation of an order suspending trading[5]). These changes take effect on January 1, 2022.
The amendments are not mutual and do not allow a prevailing defendant to recover its attorney’s fees. The new provisions only benefit a prevailing investor plaintiff. If a purchaser brings a claim under Cal. Corp. Code §§ 25501 or 25503 but fails to prove an underlying violation of either statute, the prevailing defendant cannot recover its defense fees and each party bears its own fees and costs.[6]
Civil Liability for Misrepresentations or Omissions Under Cal. Corp. Code § 25501
To prevail under Cal. Corp. Code § 25501,[7] a purchaser (or seller) of securities must prove an underlying violation of Cal. Corp. Code § 25401. Section 25401 prohibits a seller of securities from: (i) making untrue statements of material fact; or (ii) omitting to disclose a material fact necessary to make the statements made not misleading. Under both federal and state law, a fact is “material” if there is a substantial likelihood that “a reasonable investor would consider it important in reaching an investment decision.” People v. Butler, 212 Cal. App. 4th 404, 421 (2012).
Cal. Corp. Code §§ 25401 and 25501 already offer significant advantages to plaintiffs. Unlike federal Rule 10b-5 or common law fraud or negligent misrepresentation claims, the California Securities Law does not require: (1) proof of reliance; or (2) proof of intent, usually known as “scienter.”[8] Under Cal. Corp. Code §§ 25401 and 25501, all an investor must prove is (i) he or she was not given all the material facts a reasonable investor should be given; or (ii) he or she was given material facts that were not true. The seller’s intent (scienter), or lack thereof, is irrelevant.[9] The investor need only establish the misrepresentation or failure to disclose was of a “material fact.”[10] That is why the California Corporation Law is the recommended cause of action if applicable. It avoids the need to prove any intent on the part of the defendant.
Assuming a plaintiff successfully proves a violation of Cal. Corp. Code § 25401, he or she is entitled to either recession, if the securities are still owned, or damages, if the securities were sold. The measure of recovery for rescission is: (1) the consideration paid for the security; plus (2) interest at the “legal rate” (described below); and less (3) the amount of income, if any, received on the security.[11] If the purchaser previously disposed of the security, the amount of damages recoverable is: (1) (a) the price at which the security was bought; plus (b) interest at the “legal rate” from the date of purchase; less (2) (a) the proceeds received on disposition of the security or the value of the security at the time of disposition; plus (b) any income received on the security while held.[12]
The recent amendments add real teeth to these damage calculations. The amendments mandate an award of reasonable attorney’s fees and costs to a plaintiff prevailing under Cal. Corp. Code §§ 25401 and 25501, whether for rescission or damages. Specifically, Cal. Corp. Code § 25501, as amended, states that “[i]n addition to the relief described above, the court shall award reasonable attorney’s fees and costs to a prevailing purchaser or seller who succeeds in establishing a right to the relief provided by this section.”[13]
Civil Liability for Non-Registration of Securities Under Cal. Corp. Code § 25503
Under existing law, Cal. Corp. Code § 25503[14] makes anyone selling unregistered securities in California liable for rescission or damages to the purchaser of the securities, unless the seller, who has the burden of proof,[15] can establish the securities were sold under a valid exemption from registration.[16] If the seller cannot establish an applicable registration exemption, the seller is liable to the purchaser for the amount paid for the securities plus “interest at the legal rate” and less any income received. If the purchaser previously sold the securities, the measure of damages is: (1) the amount paid for the securities; (2) plus interest at the “legal rate”; and (3) minus the amount received from the sale of the securities, as well as any income. Under A.B. 511, effective January 1, 2022, the seller also is liable to the prevailing purchaser for “reasonable attorney’s fees.”
The New Crowdfunding Exemption
Along with the attorney’s fees provisions, A.B. 511 also adds a new crowdfunding exemption to the qualification requirement when certain criteria are met.[17] The relevant statute amended is Cal. Corp. Code § 25102 (which lists the issuer transactions exempted from Cal. Corp. Code § 25110). To be eligible for the crowdfunding exemption, the following criteria, among others, must be met: (i) the issuer must be a California corporation or a foreign corporation doing a majority of its business in California; (ii) the offering must follow the requirements of Regulation CF[18] (except that aggregate amount of securities sold by the issuer during the 12-month period preceding the date of offering, including the securities offered in such transaction, must not exceed $300,000, and offerings of less than $300,000 may include accounting statements certified by management rather than an independent public accountant); (iii) the issuer must take reasonable steps to ensure that each purchaser who is a natural person and not an accredited investor is able to evaluate the merits and risks of the prospective investment; (iv) the issuer must give the purchaser a three-day right to rescind any investment; and (v) the issuer must not, itself or through any third party not licensed as a broker-dealer, conduct any direct solicitation of the securities.[19] In addition, those offering securities under the new crowdfunding exemption are prohibited from requiring investors to (i) waive jury trials; (ii) be bound by law other than California; and (iii) file or resolve a claim or dispute in a forum other than California.[20]
What is the “Legal Rate” of Interest Under Cal. Corp. Code §§ 25501 and 25503?
It is now well-established an award of “interest at the legal rate” to a plaintiff successful in a claim under Cal. Corp. Code § 25401 is mandatory and not discretionary. Boam v. Trident Fin. Corp., 6 Cal. App. 4th 738 (1992). In Boam, investors in a limited partnership received a jury verdict in their favor on claims brought against the general partner under Cal. Corp. Code §§ 25401 and 25501.[21] The jury awarded plaintiffs rescission damages equal to the amount of their principal investment (less earnings) but did not award statutory interest.[22] Plaintiff investors successfully appealed, arguing the jury erroneously failed to include interest on the damages.[23] The Court of Appeal held the statute’s language leaves no room for discretion and relief must be calculated based on that language: “‘Consideration’ + ‘interest’ – ‘income’ = recovery.”[24] “Interest at the legal rate” is not 10%, as one might presume based on the 10% rate applied to prejudgment interest. Instead, to calculate damages for California Securities Law violations, “interest at the legal rate” is 7%.[25]
Thus, as of January 1, 2022, a prevailing party under Cal. Corp. Code §§ 25501 or 25503 may recover both interest at the annual rate of 7% plus reasonable attorney’s fees – a very favorable sword to hold over the head of defendants in these cases.[26]
Sales and Offers of Securities Made in California
The new (and previously existing) remedies afforded investors under the California Securities Law apply to sales and offers of securities made in the state.[27] Under Cal. Corp. Code § 25008, this includes offers made within California as well as offers accepted in this state. “Thus, a sale occurs ‘in this state’ even if the purchaser is in, and communicates acceptance of the offer to sell from, New York.” Diamon Multimedia Sys., Inc. v. Superior Court, 19 Cal. 4th 1036, 1050-51 (Cal. S. Ct. 1999); cf. In re Activision Sec. Litig., 621 F. Supp. 415, 431-32 (N.D. Cal. 1985) (excluding certain purchasers from class certification “unless they purchased the stock in California.”).
[1] A.B. 511, 2021-2022 Leg., Reg. Sess. (Cal. 2021).
[2] Cal. Corp. Code § 25401 makes it unlawful for anyone “to offer or sell a security in this state, or to buy or offer to buy a security in this state, or to buy or offer to buy a security in this state, by means of any written or oral communication that includes an untrue statement of material fact or omits to state a material fact necessary to make the statements made, in like of the circumstances under which the statements were made, not misleading.”
[3] Cal. Corp. Code § 25110 makes it unlawful for anyone “to offer or sell in this state any security in an issuer transaction (other than in a transaction subject to Section 25120) … unless such sale has been qualified under Section 25111, 25112 or 25113 … or unless such security or transaction is exempted or not subject to qualification under Chapter 1 (commencing with Section 25100) of this part.”
[4] Cal. Corp. Code § 25130 makes it unlawful for anyone “to offer or sell a security in this state in any nonissuer transaction unless it is qualified for such sale under this chapter or under Section 25111 or 25113 … or unless such security or transaction is exempted or not subject to qualification under Chapter 1 (commencing with Section 25100) of this part.”
[5] Cal. Corp. Code § 25219 empowers the commissioner to suspend trading for 90 days and prohibits broker-dealers and agents from selling or inducing purchases of securities suspended under the section.
[6] Securities transactions: qualification requirements, exemptions, and liability: Hearing on A.B. 511 Before the S. Judiciary Comm., 2021-2022 Leg., Reg. Sess. (Cal. 2021) (statement of Sen. Thomas Umberg, Chair, S. Judiciary Comm.) (“[A] purchaser who proves that a seller committed fraud is entitled to attorney fees from the seller, and a seller who proves that a purchaser committed fraud is entitled to attorney fees from the purchaser. In either type of suit, if the seller or purchaser alleging fraud does not prevail in the lawsuit, there is no fee-shifting – the parties simply pay their own fees.”).
[7] Cal. Corp. Code § 25501 (amendments in bold) states, in part: Any person who violates Section 25401 shall be liable to the person who purchases a security from ***, or sells a security to ***, that person, who may sue either for rescission or for damages (if the plaintiff or the defendant, as the case may be, no longer owns the security), unless the defendant proves that the plaintiff knew the facts concerning the untruth or omission or that the defendant exercised reasonable care and did not know (or if *** the defendant had exercised reasonable care, would not have known) of the untruth or omission.
[8] “The purpose of the [California Securities Law] in this regard is to create statutory liability that eliminates some of the elements of common law fraud, but balances this expansion of liability by placing other restrictions on recovery.” California Amplifier, Inc. v. RLI Ins. Co., 94 Cal. App. 4th 102, 108 (2001).
[9] Bowden v. Robinson, 67 Cal. App. 3d 705, 712 (1977) (“Sections 25110, 25130 and 25503 …. [do not] require scienter, negligence, or plaintiff’s reliance.”).
[10] The violator, however, may avoid liability by proving either: (1) the plaintiff knew of the facts about the untruth or omission; or (2) the defendant had exercised reasonable care and did not know (or in the exercise of reasonable care would not have known) of the untruth or omission. Cal. Corp. Code § 25401; Bowden v. Robinson, 67 Cal. App. 3d 705, 715 (1977).
[11] “Upon rescission, a purchaser may recover the consideration paid for the security, plus interest at the legal rate, less the amount of any income received on the security, upon tender of the security. Upon rescission, a seller may recover the security, upon tender of the consideration paid for the security plus interest at the legal rate, less the amount of any income received by the defendant on the security.” Cal. Corp. Code § 25501. Thus, if a seller sues for recession, he or she may recover the security, on tender of the consideration paid for the security plus interest at the legal rate, less the amount of any income received by the defendant on the security.
[12] “Damages recoverable under this section by a purchaser shall be an amount equal to the difference between (a) the price at which the security was bought plus interest at the legal rate from the date of purchase and (b) the value of the security at the time it was disposed of by the plaintiff plus the amount of any income received on the security by the plaintiff. Damages recoverable under this section by a seller shall be an amount equal to the difference between (1) the value of the security at the time of the filing of the complaint plus the amount of any income received by the defendant on the security and (2) the price at which the security was sold plus interest at the legal rate from the date of sale.” Cal. Corp. Code § 25501.
[13] Cal. Corp. Code § 25501 (emphasis added).
[14] Cal. Corp. Code § 25503 (amendments in bold) states, in part: Any person who violates Section 25110, 25130, or 25133, or a condition of qualification under Chapter 2 (commencing with Section 25110) of this part, imposed pursuant to Section 25141, or an order suspending trading issued pursuant to Section 25219, shall be liable to any person acquiring from them the security sold in violation of that section, who may sue to recover the consideration they paid for that security with interest thereon at the legal rate, and reasonable attorney’s fees, less the amount of any income received therefrom, upon the tender of that security, or for damages, if they no longer own the security, or if the consideration given for the security is not capable of being returned. Damages, if the plaintiff no longer owns the security, shall be equal to the difference between (a) the purchase price plus interest at the legal rate from the date of purchase, plus reasonable attorney’s fees, and (b) the value of the security at the time it was disposed of by the plaintiff plus the amount of any income received therefrom by the plaintiff.
[15] Apollo Cap. Fund, LLC v. Roth Capital Partners, LLC, 158 Cal. App. 4th 226, 251 (2007) (maintaining defendants have the burden of proof of establishing an applicable exemption).
[16] Cal. Corp. Code § 25102, for example, exempts various transactions from the issuer qualification provisions of Cal. Corp. Code § 25110, including, among others, certain offers and sales to institutional investors, certain private placements, and certain transactions or agreements between underwriters.
[17] Small Business California (the sponsor of A.B. 511) tried several times over the past decade to ease the costs of offering shares by reducing or eliminating disclosure requirements and other prohibitions in state securities law. These previous efforts include A.B. 2081 (Allen, 2012), A.B. 2096 (Muratsuchi, 2014), A.B. 722 (Perea, 2015), and A.B. 2178 (Chiu, 2016). Each of these bills, however, brought opposition from the Public Investors Advocate Bar Association (PIABA) and failed to pass both houses of the Legislature. To improve concerns that halted previous efforts and in exchange for the crowdfunding exemption, A.B. 511 included several “investor protections” such as the attorney’s fees provisions discussed above.
[18] In 2012, the federal government authorized the United States Securities and Exchange Commission (SEC) to adopt regulations governing crowdfunding offerings. Regulation CF, the resulting regulations promulgated by the SEC, took effect in 2016 and exempt certain crowdfunding offerings from the registration requirement provided that, among other things, the aggregate offering amount does not exceed $5,000,000 and the offering is made exclusively through an intermediary that complies with SEC requirements. Before the enactment of A.B. 511, California law did not have any crowdfunding-specific provisions. As a result, California companies seeking to raise capital within the state were held to the qualification requirements of an outdated California Corporations Code.
[19] A.B. 511, 2021-2022 Leg., Reg. Sess. (Cal. 2021); Cal. Corp. Code § 25102.
[20] Id.
[21] Boam v. Trident Fin. Corp., 6 Cal. App. 4th 738, 740-41 (1992).
[22] Id. at 743.
[23] Id. at 741, 746.
[24] Id. at 744.
[25] Cal. Const., art. XV, § 1; Boam v. Trident Fin. Corp., 6 Cal. App. 4th 738, 742-43, n. 4 (1992) (noting the jury’s instruction to calculate “[i]nterest at the legal rate of 10% per annum” was erroneous because “[t]he correct rate is 7 percent.”).
[26] Another California Securities Law provision for which attorney’s fees are recoverable by a prevailing plaintiff is Cal. Corp. Code § 25501.5. Section 25501.5, also known as the “Finders Law,” establishes civil liability for sales of securities by unlicensed broker-dealers. Under that section, a person who purchases a security from or sells a security to an uncertificated broker-dealer may sue for rescission, or for damages if the person or broker-dealer no longer owns the security. In addition, “[t]he court, in its discretion, may award reasonable attorney’s fees and costs to a prevailing plaintiff under this section.” Cal. Corp. Code § 25501.5, subd. (d).
[27] Cal. Corp. Code. § 25008.
