DTCI: Indiana’s Uniform Security Act: An introduction

Massaro

The Indiana’s Uniform Security Act (IUSA) is a formidable weapon in the right circumstances. It is a complex statute with many nuances and applications. Its applicability can be extremely broad and the consequences for failure to adhere to its mandates extreme. This article will give the reader some insight as to when the IUSA may come into play. This article is not meant to cover all IUSA’s applications, defenses or interplay with federal law.

The IUSA is not exclusively a fraud-based statute

It is a common misconception that a heightened showing of fraud is a prerequisite to recovery under IUSA. Such a showing is not always required to recover.

The IUSA states:

It is unlawful for a person, in connection with the offer, sale, or purchase of a security, directly or indirectly:

(1) to employ a device, scheme, or artifice to defraud;

(2) to make an untrue statement of a material fact or to omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which they were made, not misleading; or

(3) to engage in an act, practice, or course of business that operates or would operate as a fraud or deceit upon another person.

I.C. 23-19-5-1.

At its most basic, the IUSA requires a showing that (1) the item sold was a “security,” (2) the transaction was directly or indirectly “in connection with the offer, sale, or purchase” of that security, and (3) one or more of the delineated elements existed at the time of that sale and purchase. As will be discussed in more detail below, subsections (1) and (3) require, inter alia, a showing of fraud while subsection (2) does not.

“Security” as defined by IUSA

Under IUSA “[s]ecurity” means a number of things, including the following:

[A] note; stock; treasury stock; security future; bond; debenture; evidence of indebtedness; certificate of interest or participation in a profit-sharing agreement; collateral trust certificate; preorganization certificate or subscription; transferable share; investment contract …

I.C. 23-19-1-2(28).

Clearly stock sold by a traditional corporation is covered by the definition. IUSA has, however, lagged behind the popularity of LLCs by failing to identify units as a security. While technically termed “units” for purposes of Indiana’s Business Flexibility Act, “units” are tantamount to stock. Given that stock is a definitional security as defined by I.C. 23-19-1-2(28), units in an LLC would certainly be covered.

Liability and damages under IUSA

Section 9 of the IUSA provides the mechanism for recovering for a violation of section 1 of IUSA. An action under IUSA must be commenced within three years after discovery by the person bringing the action. Unless a statutory or common-law defense is established by the seller of the security, a person is liable to the purchaser if the person sells a security in violation of IUSA. There are several ways to quantify damages under IUSA.

A purchaser may maintain an action to recover the consideration paid for the security, less the amount of any income received on the security, and interest at the greater of 8 percent per annum or the rate provided for in the security from the date of the purchase, costs and reasonable attorney fees upon the tender of the security or for actual damages as provided in I.C. 23-19-5-9(a)(3). Moreover, pursuant to I.C. 23-19-5-9(a)(2), a purchaser that no longer owns the security may recover actual damages as provided in I.C. 23-19-5-9(a)(3).

Section 23-19-5-9(a)(3) provides for the recovery of actual damages. Actual damages are the amount that would be recoverable upon a tender less the value of the security when the purchaser disposed of it and interest at the greater of 8 percent per annum or the rate provided for in the security from the date of the purchase, costs and reasonable attorney fees. A person liable under this or any of the above subsections has a right of contribution as in cases of contract against any other person liable under I.C. 23-19-5-9. Moreover, the rights and remedies provided by IUSA are in addition to any other rights or remedies that may exist.

The defense of in pari delicto

There are several defenses outlined in IUSA including that the person did not know — and in the exercise of reasonable care could not have known — of the violation. I.C. 23-19-5-9. Defenses also include the purchaser knowingly participating in the violation. Id. In common law, this second defense is called in pari delicto (“of equal fault”).

In general, “a purchaser of stock securities is barred from asserting that the sale was invalid, because of a state securities regulation violation, if he is found to be in pari delicto with the seller.” Thomas v. Hemmelgarn, 579 N.E.2d 1333, 1336 (Ind. App. 1991). “A purchaser is generally held to be in pari delicto with the seller if he participates in the organization or management of the issuing corporation.” Id.

In Thomas, a stockholder in a corporation sought to rescind its purchases of the company’s stock after discovering that the corporation and its directors failed to register the shares as securities in violation of the Indiana securities regulations. The court rejected the defendants’ defense holding:

Appellants did establish that [Plaintiffs] did some bookkeeping and electrical work, respectively. But that alone does not necessitate a finding that they participated in the organization or management of the issuing corporation.

***

There was ample evidence from which the trial court might properly conclude that the appellees did not participate in the organization and/or management of [the corporation]. . . . [Plaintiffs’] conduct as bookkeeper and electrician, without more, does not necessarily rise to that level.

Subsections (1) and (3) of IUSA require a showing of intent

There is little caselaw directly discussing violations under subsections (1) and (3). A literal reading of the statute, in conjunction with the definition of fraud under IUSA and limited caselaw suggest that proceeding on a claim under subsections (1) and (3) may be similar to alleging a claim of common law fraud. See, Noller v. Grubbs, No. 1:04-cv-01818-DFH-WTL, 2005 U.S. Dist. LEXIS 15473, at *15 (S.D. Ind. July 25, 2005). However, it is certain that intent to defraud is a required element under subsections (1) and (3). Manns v. Skolnik, 666 N.E.2d 1236, 1248 (Ind. Ct. App 1996). While Manns and Noller were decided under a former version of I.C. 23-19-5-1, the provisions are for all intents and purposes the same.

Under IUSA, “‘[f]raud,’ ‘fraudulent,’ ‘deceit,’ and ‘defraud’ mean a misrepresentation of a material fact, a promise, representation, or prediction not made honestly or in good faith, or the failure to disclose a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. This definition does not limit or diminish the full meaning of the terms as applied by or defined in courts of law or equity. The terms are not limited to common law deceit.” I.C 23-19-1-2(9).

Intent is irrelevant under section (2) of the Act

In an action under I.C. 23-19-5-1(2), the seller’s intent is irrelevant. Id.; Peoples State Bank v. Stifel, 2013 U.S. Dist. LEXIS 35161 at *11 (S.D. Ind. March 14, 2013). While Peoples State Bank is a federal case, it applied IUSA in its decision. Nor does such an action require proof of reliance. Instead, “the central issue for violating [Subsection (2) of the] statute is ‘whether material information is either misrepresented or omitted entirely.’” Peoples State Bank, 2013 U.S. Dist. LEXIS 35161 at *11(quoting Manns, 666 N.E.2d at 1248)). Comparing the definitions of “[f]raud,” “fraudulent,” “deceit,” and “defraud,” to the language of subsection (2), one would expect fraud, although omitted in subsection (2), to nonetheless be a requisite showing. That is not the case, however.

Furthermore, “[m]ateriality is determined under an ‘objective test’ where ‘[t]here must be a substantial likelihood that the disclosure of the [misstatement or the] omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of the information available.’” Kesling v. Kesling, 546 F. Supp. 2d 627, 635 (N.D. Ind. March 26, 2008) (quoting Manns, 666 N.E.2d at 1248). “[T]he determination of materiality requires delicate assessments of the inferences a reasonable investor would draw from a given set of facts and the significance of those inferences to him, and these assessments are peculiarly ones for the trier of fact; thus a materiality determination is rarely appropriate at the summary judgment stage, let alone on a motion to dismiss.” Lincoln Nat’l Life Ins. Co. v. Donaldson, Lufkin & Jenrette Sec. Corp., 9 F. Supp. 2d 994, 1003 (citation omitted; referring to a 7th Circuit case involving a Rule 10b-5 action). In addition, “materiality has been characterized as a mixed question of law and fact, and courts have admonished that only when the disclosures or omissions are so clearly unimportant that reasonable minds could not differ should the ultimate issue of materiality be decided as a matter of law.” Id.

Interpretation of subsection (2) substantially differs from federal securities law. The Indiana Supreme Court has said that, while federal authority is often appropriate in interpreting standards required by state securities law, “[f]ederal authority does not provide useful guidance on points where there are important differences between the state statute and its federal counterparts.” Lean v. Reed, 876 N.E.2d 1104, 1108-09 (Ind. 2007). Subsection (2) is one of those differences. As such, federal cases interpreting federal securities law to analyze subsection (2) generally provide no useful guidance.

The lack of a duty to conduct an independent investigation under subsection (2)

Subsection (2) is further differentiated in that there is no duty on the part of the buyer to conduct his own investigation in the inherent risks and actual circumstances underlying a transaction. In Peoples State Bank, 2013 U.S. Dist. LEXIS 35161, the U.S. District Court for the Southern District of Indiana clearly and succinctly discussed Kelsey v. Nagy, 410 N.E.2d 1333 (Ind. Ct. App. 1980), the seminal Indiana case on the duty to investigate under IUSA, as follows:

Kelsey involved investors alleging that the seller made several material misrepresentations and omissions in their purchase of stock. Id. at 1336. In particular, investors alleged that the seller told them they were purchasing unissued or treasury shares of stock, with the purpose of the sale to raise additional capital for expanding the company’s business. Id. In reality, they were purchasing the seller’s stock, a fact which he never disclosed. Id. The investors sued the seller to recover consideration paid for stock under the Indiana Securities Act which, at the time of the transaction, read in pertinent part:

Any person who … offers or sells a security by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading (the buyer not knowing of the untruth or omission), and who does not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of the untruth or omission, is liable to the person buying the security from him… .

Indiana Code 23-2-1-19(a)(2).

The Court found that the source of the stock was a material fact as the buyers ‘had the right to know whether the money they were paying for the stock was going into the treasury of the corporation so as to increase its working capital, or into [the seller’s] pocket where it would have no such effect.’ …

Further, the Court rejected the proposition that the buyers “had an affirmative duty to make inquiries and discover the actual circumstances underlying the transaction.” Id.

Peoples State Bank, 2013 U.S. Dist. LEXIS 35161 at *12-15. [Emphasis added.]

The Peoples Court continued that Kelsey remains good law as the Indiana state courts have yet to acknowledge any changes in this area. Id. at *35.

The Kelsey Court found that the disclosure of the source of the stock being sold would have led to further inquiries by the investor-purchaser, and that the failure to disclose was the omission of a material fact. Kelsey, 410 N.E.2d at 1336.

Conclusion

Any transaction involving the purchase or sale of an interest in a business should be made only after consideration of the potential applicability of the IUSA. It would be recommended that all such transactions be accompanied by formal agreements with specific reference to compliance with securities law as well as relevant disclosure statements. In representing buyers of small or closely held companies, one should keep IUSA in mind as a strong tool of recovery, especially attorney fees, as well as for guidance in evidentiary burdens. Moreover, subsection (2)’s modified showing may be of particular use in establishing a claim.•

Jason M. Massaro is the owner of The Massaro Legal Group in Indianapolis and is a member of the Business Litigation Section of the DTCI. For more information on the Business Litigation Section contact its chair, Pat McCrory, at [email protected]. The opinions expressed in this article are those of the author.