U.S. SECURITIES EXCHANGE COMMISSION v. BROWN

. In light of this specific statutory authority, the Court concludes that the SEC's claim to enforce Rule 13a-14 states a valid cause of action. Defendant Brown's Motion to Dismiss Count IV under Rule 12(b)(6) is therefore denied. 3. Count V, Alleging Violations of Exchange Act § 14(a) and Rule 14a-9

Defendant Brown next contends that Count V, which alleges that she aided and abetted violations of Exchange Act § 14(a) and Rule 14a-9, should be dismissed under Rule 12(b)(6) for failure to allege necessary elements of the claims. Section 14(a) makes it unlawful "for any person . . . in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors, to solicit or to permit the use of his name to solicit any proxy. . . ." 15 U.S.C. § 78n(a). Rule 14a-9 states that "no solicitation subject to this regulation shall be made by means of any proxy statement . . . containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading." 17 C.F.R. § 240.14a-9. Count V alleges that Brown and Prince aided and abetted violations

of § 14(a) and Rule 14a-9 when they prepared, reviewed, and approved materials in seven proxy statements filed by Integral Systems between March 2000 and March 2006 which failed to disclose Prince as an executive officer.

First, Brown argues that the SEC has failed to allege (1) an essential link between the purpose of the proxy statements and the alleged omission and (2) that the omission was material. Second, Brown argues that the SEC has failed to allege which material information concerning Prince was omitted from the proxy statements, as well as which materials Brown prepared, reviewed, and approved. Def. Brown's Mot. to Dismiss at 31-32; Compl. ¶ 35.

Brown relies on the arguments advanced in Defendant Chamberlain's Motion to Dismiss. As noted earlier, Defendant Chamberlain was dismissed as a party in this case on February 18, 2010. Although Chamberlain's Motion to Dismiss was denied as moot by minute order dated August 11, 2010, the Court will consider the arguments concerning Count V in deciding Brown's Motion to Dismiss. See Def. Chamberlain's Mot. to Dismiss at 13-20 [Dkt. No. 11].

It is well settled that a private plaintiff bringing a claim under § 14(a) or Rule 14a-9 must allege that "(1) a proxy statement contained a material misrepresentation or omission which (2) caused the plaintiff injury and (3) that the proxy solicitation . . . was an essential link in the accomplishment of the transaction." Bender v. Jordan, 439 F.Supp.2d 139, 163 (D.D.C. 2006). Brown argues that the facts pled do not allege an "essential link" between the alleged misrepresentation or omission and "the subject of the proxy solicitation." Def. Chamberlain's Reply at 8; see also Def. Chamberlain's Mot. to Dismiss at 14-15 ("There must be a clear connection, that is — an `essential link' between the alleged fraud in the proxy statement and the corporate transaction authorized by the proxy solicitation."); Def. Brown's Mot. to Dismiss at 32 (describing argument as concerning "the lack of an essential link between the purpose of a proxy and the alleged omission").

No court appears to have addressed the specific issue of whether the SEC, as opposed to a private plaintiff, must prove injury when bringing a § 14(a) claim. The SEC argues that it is not required to do so because its enforcement actions are meant to protect the public interest in enforcing the securities laws, and so a showing of reliance or injury to private individuals is "legally irrelevant." Berko v. SEC, 316 F.2d 137, 143 (2d Cir. 1963) (finding reliance and injury to private shareholders "legally irrelevant" to Commission's Section 10(b) claim); see also United States v. Haddy, 143 F.3d 542 (3d Cir. 1998) (concluding that securities laws did not require proof of reliance in § 10b action brought by government); SEC v. Lucent Techs., Inc., 610 F.Supp.2d 349, 349 (D.N.J. 2009) ("Unlike a private litigant, the SEC need not prove either reliance or damages" in a § 10b and Rule 10b-5 action).
In response, Defendant Brown relies on two cases in which courts applied the test for private actions brought under § 14(a) and Rule 14a-9 to actions brought by the Commission. Def. Chamberlain's Reply at 9 (citing SEC v. Mercury Interactive LLC, No. C 07-2822, 2009 WL 2984769 (N.D. Cal. Sept. 15, 2009), andBlack, 2008 WL 4394891, at *13). However, both Mercury and Black assumed without question that the elements for proxy violations applied in private actions would apply equally in actions brought by the SEC. As discussed, the question whether the SEC must prove injury in a § 14(a) action is not actually raised by Brown, and so it is not considered.

As the Supreme Court has explained, "[s]o long as the misstatement or omission was material, the causal relation between violation and injury is sufficiently established . . . if `the proxy solicitation itself . . . was an essential link in the accomplishment of the transaction.'" TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 444, 96 S.Ct. 2126, 2130, 48 L.Ed.2d 757 (1976) (quoting Mills v. Electric Auto-Lite Co., 396 U.S. 375, 385, 90 S.Ct. 616, 622, 24 L.Ed.2d 593 (1970)). Thus, in a private action, the essential link element requires a causal connection between the proxy solicitation and the transaction that resulted in injury to the plaintiff. However, Defendant Brown does not argue that the Complaint fails to allege this causal connection. Instead, Brown incorrectly characterizes the connection between the alleged fraud and the subject of the proxy solicitation, which is the focus of her argument, as a required showing under the essential link element. In reality, the connection between the alleged omission and the subject or purpose of the proxy solicitation is essentially a question of materiality.

Brown's first argument is therefore reduced to the single question of whether the SEC has pled sufficient facts that the omission was material to the transactions which were the subject of the proxy solicitations. Under § 14(a), "[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote" on the proxy solicitation. Id. at 449. Under Rule 12(b)(6), a complaint may not be dismissed on the ground that the alleged omission is not material "unless [it is] so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of [its] importance." Ganino v. Citizens Utility Co., 228 F.3d 154, 162 (2d Cir. 2000) (citation omitted).

The Complaint alleges that "[f]rom 2000 through mid-2006, Integral Systems filed seven proxy statements to give notice of Integral Systems's annual meetings and to solicit for the election of directors." Compl. ¶ 35. Certainly, reasonable minds could differ as to whether Prince's officer status and legal background is "obviously unimportant" to shareholders who must decide whether or not to vote for Chamberlain or other directors involved in the decision to re-hire him. Ganino, 228 F.3d at 162. The Court is therefore satisfied that Count V alleges a material omission under § 14(a) and Rule 14a-9.

Brown relies on In re Browning-Ferris Industries Shareholder Derivative Litigation, 830 F. Supp. 361, 370 (S.D. Tex. 1993), which held that the prior criminal investigation of a corporate officer was not material to a proxy soliciting an election for the board of directors because there was no indictment or criminal conviction. In this case, Prince was convicted in a criminal proceeding. Brown's reliance on a separate portion of the opinion holding that pending civil lawsuits against directors facing re-election were not material because the lawsuits were not brought against those specific directors is distinguishable from the facts of this case. Moreover, the Browning-Ferris court also ruled that plaintiffs failed to allege any relationship between the pending civil lawsuits and the directors elected to the board during the relevant period of time. Id. at 367.

Next, Brown argues that the SEC fails to allege specific facts in Count V regarding her role in aiding and abetting the alleged violations of § 14(a) and Rule 14a-9. The Complaint states that "Defendant[] Brown [] prepared, reviewed, and approved materials in the proxy statements, including the incorporated periodic reports, knowing that they did not identify Prince or disclose any of the required information concerning him," thereby providing "substantial assistance to . . . Integral Systems's and Chamberlain's violations of Section 14 and Exchange Act Rule 14a-9." Compl. ¶ 57. Brown's argument is that this allegation (1) fails to specify which information concerning Prince was required; (2) fails to specify which materials were prepared, reviewed, and approved by Brown; and (3) erroneously states that the periodic reports were incorporated into the proxy statements, when in fact they were merely included with them.

Liability for aiding and abetting a violation of the securities laws requires proof of "(1) a securities violation by a primary wrongdoer; (2) knowledge of the violation by the aider and abettor; and (3) substantial assistance by the aider and abettor in the primary violation." Treadway, 430 F.Supp.2d at 323; see also SEC v. DiBella, 587 F.3d 553, 565 (2d. Cir. 2009). Even assuming that the periodic reports were not incorporated into the proxy statements, the allegations in Count V specify that certain information regarding Prince, including his identity, were material and therefore were required to be disclosed in the proxy statements, and that Defendant Brown prepared, reviewed, and approved materials for use in the proxy statements with the knowledge that this required information was omitted. This suffices to state a claim for aiding and abetting violations of § 14(a) and Rule 14a-9. Defendant Brown's Motion to Dismiss Count V is therefore denied.

4. Failure to State a Claim for Primary Liability

Finally, Defendant Prince moves to dismiss Counts I and II against him on the basis that the SEC has failed to allege his primary liability for violations of the securities laws. Because Count I, alleging violations of § 17(a), is dismissed in its entirety for failure to allege that an offer or sale of Integral Systems's securities ever occurred, the Court will only consider Defendant Prince's arguments as they relate to Count II, alleging violations of § 10(b) and Rule 10b-5.

Section 10(b) "prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act"; it does not provide a cause of action against those who only aid and abet such acts. Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 177, 114 S.Ct. 1439, 1448, 128 L.Ed.2d 119 (1994). Primary liability under § 10(b) may be found for any person who:

The SEC could have brought an action against Prince as a secondary actor for aiding and abetting violations of § 10b and Rule 10b-5 under 15 U.S.C. § 78t(e). See Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148, 166, 128 S.Ct. 761, 773-74, 169 L.Ed.2d 627 (2008) (discussing SEC's power to enforce securities laws against secondary actors). However, it failed to do so; Count II only alleges primary violations of § 10b and Rule 10b-5. Compl. ¶¶ 43-45.

directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . use[s] or employ[s], in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

15 U.S.C. § 78j. On the basis of this statute, the SEC promulgated Rule 10b-5, which makes it unlawful for:

any person, directly or indirectly, . . . (a) [t]o employ any device, scheme, or artifice to defraud, (b) [t]o make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) [t]o engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

17 C.F.R. § 240.10b-5.

First, Prince argues that any claim under Rule 10b-5(b) must fail because the Complaint fails to allege that he "made" any material misstatement or omission or, alternatively, that he had a duty to disclose or clarify any alleged material omission made by Integral Systems. Second, Prince argues that the Complaint fails to state a claim for "scheme liability" under Rule 10b-5(a) and (c) because there are no allegations that Prince committed any manipulative or deceptive acts.

a. Rule 10b-5(b)

The Complaint alleges that Prince was responsible for drafting and preparing the Management Discussion and Analysis section of Integral Systems's periodic reports filed with the SEC, addressing the company's financial results for that period. Compl. ¶ 39. Prince is also alleged to have created and prepared internal quarterly financial results and forecasts which were incorporated into the periodic reports. Id. Finally, Prince allegedly reviewed, commented on, and approved Integral Systems's draft annual reports and proxy statements. Id. ¶ 35. Prince argues that these allegations fail to state a claim for primary liability under Rule 10b-5(b) because they do not show (1) that he made any material misstatement or omission or (2) that he had a duty to disclose or clarify any material omission by Integral.

Three tests for primary liability have emerged in different circuits. The "bright-line approach" is the most demanding of the three approaches. See SEC v. May, 648 F.Supp.2d 70, 77 (D.D.C. 2009) (discussing approaches to primary liability under securities laws). Under the bright-line approach, a defendant in a private action may be held primarily liable under § 10b and Rule 10b-5 only if he or she actually makes a false or misleading statement and the statement is attributed to the defendant at the time of its dissemination. Id. The least demanding approach is called the "substantial participation" approach, which requires a showing that a defendant substantially participated or was intricately involved in making a material misstatement or omission. See Howard v. Everex Sys., Inc., 228 F.3d 1057, 1061 n. 5 (9th Cir. 2000). The middle approach — called the "creation" test — requires a secondary actor to have "created" the misrepresentation or omission. SEC v. Wolfson, 539 F.3d 1249, 1259 n. 16 (10th Cir. 2008). This Circuit has not yet adopted one of the three approaches to primary liability for the securities laws.

Prince urges this Court to adopt the "bright-line" approach to determining primary liability, which, as noted, is the strictest of the three approaches. See Wright v. Ernst Young, LLP, 152 F.3d 169, 175 (2d Cir. 1998). Prince argues that, under the "bright-line" approach, the SEC must plead that Prince made a statement or omission, and that the statement or omission was attributed to him at the time of its dissemination to the public.

Attribution is required under the "bright-line" approach in private actions because a private plaintiff, unlike the SEC, must prove that he or she relied on the defendant's statements in order to state a claim. See id. at 175; May, 648 F.Supp.2d at 77. The Second Circuit, which introduced the attribution requirement, has not directly addressed whether it should apply in actions brought by the SEC. However, other Circuits have rejected the attribution requirement in SEC actions as irrelevant because reliance need not be proven. See, e.g., SEC v. Tambone, 597 F.3d 436, 447 n. 9 (1st Cir. 2010); Wolfson, 539 F.3d at 1260.

In addition, as the SEC points out, even the Second Circuit has not consistently required in suits by a private plaintiff that misstatements be attributed to the defendant for primary liability to attach. See, e.g., In re Scholastic Corp. Sec. Litig., 252 F.3d 63, 75-76 (2d Cir. 2001) (finding primary liability for corporate insider who was "involved in drafting, producing, reviewing and/or disseminating of the false and misleading statements," even though statements not specifically attributed to him).

However, district courts in the Second Circuit have directly addressed the issue, and have rejected the attribution requirement in actions brought by the SEC. In one such case, the court explained that "in an SEC enforcement action, there appears to be no reason to impose a requirement that a misstatement have been publicly attributed to a defendant for liability to attach, at least so long as the SEC is able to show that the defendant was sufficiently responsible for the statement — in effect, caused the statement to be made — and knew or had reason to know that the statement would be disseminated to investors." SEC v. KPMG, LLP, 412 F.Supp.2d 349, 375 (S.D.N.Y. 2006); see also SEC v. Richitelli, No. 3:09-cv-361, 2010 WL 2802911, at *5 (D. Conn. July 12, 2010); SEC v. Collins Aikman Corp., 524 F.Supp.2d 477, 490 (S.D.N.Y. 2007); SEC v. Forman, No. 07-cv-11151, 2008 WL 2704554, at *2 n. 3 (D. Mass. July 7, 2008) (unreported opinion); SEC v. Hopper, No. Civ.A. H-04 — 1054, 2006 WL 778640, at *9 (S.D. Tex. March 24, 2006) (unreported opinion).

Thus, the majority of courts which have directly addressed the issue have concluded that attribution is not required under the "bright-line" approach in actions brought by the SEC. Even assuming the application of the strictest approach is proper, the SEC, as plaintiff, need only show that Prince was sufficiently responsible for the statement and knew or had reason to know the statement would be disseminated to investors. KPMG, LLP, 412 F.Supp.2d at 375.

The only exception cited by Prince is Lucent Technologies, 610 F.Supp.2d 342. However, the court in Lucent Technologies was tasked with determining whether it should depart from the law of the case by rejecting the attribution requirement, which it had previously applied in the case at bar. The court ultimately refused to impose primary liability for violations of the securities laws on the basis that the defendants did not draft or sign the filings, and so could not be said to have "made" the misstatements allegedly contained within them. Lucent Techs., 610 F.Supp.2d at 355-58.

As discussed above, the Complaint alleges that Prince was responsible for drafting and preparing portions of Integral Systems's periodic reports dealing with the company's financial results and forecasts, and that he also reviewed, commented on, and approved the company's draft annual reports and proxy statements. Compl. ¶¶ 35, 39. Prince correctly argues that the allegations that he prepared or drafted Integral Systems's internal financial results and forecasts fail to state a claim for primary liability, even if those forecasts were later incorporated into the company's periodic filings, because the SEC does not allege that there were any misstatements concerning the company's finances. Prince's Mot. to Dismiss at 11.

However, the Complaint also alleges that Prince generally reviewed, commented on, and approved Integral Systems's periodic filings and proxy statements but failed to correct the omission of his status as an officer of the company and of his holdings and transactions in the company's securities. This allegation, if proven, would establish that Prince was sufficiently responsible for the omission under the "bright-line" approach. Because the allegations state a claim under the "bright-line" approach, which requires a showing that the defendant actually made a statement or

In SEC v. Berry, 580 F.Supp.2d 911, 922 (N.D. Cal. 2008), the district court found similar conclusory pleadings that the defendant corporate officer "reviewed," "discussed," and "finalized" various filings insufficient to plead primary liability for the defendant's role in the misstatement made in the filings. In this case, however, the SEC alleges that Prince "approved" Integral Systems's periodic filings despite the omissions contained therein, in addition to merely reviewing and commenting on them. This additional allegation indicates more substantial responsibility for preparing the filings. See id. (recognizing that substantial involvement in preparing a fraudulent statement supports a claim for securities fraud); cf. Howard v. Everex Systems, Inc., 228 F.3d 1057, 1061 (9th Cir. 2000) (fact that defendant signed document containing fraudulent statement is sufficient to conclude that defendant "made" misstatement, even if he was not involved in drafting the document).

omission, they also state a claim under the less strict "substantial participation" or "creation" approaches. Prince's Motion to Dismiss therefore fails under all three approaches. Consequently, the Court need not decide which standard applies in this Circuit.

Prince argues that Count II still fails to state a claim, however, because the SEC has failed to allege that he had a duty to disclose the omitted information. As discussed, the facts alleged in the Complaint establish that Prince "made" a statement under Rule 10b-5 when he reviewed, commented on, and approved Integral Systems's periodic filings. Under Rule 10b-5, an individual who "makes" a statement has a duty to correct "any omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading." 17 C.F.R. § 240.10b-5. Thus, Prince had a duty to correct the omissions in the periodic reports and proxy statements which he was substantially involved in preparing. See also SEC v. Druffner, 353 F.Supp.2d 141, 148 (D.Mass. 2005) ("[T]he securities laws give rise to a duty to disclose any information necessary to make an individual's voluntary statements not misleading.").

Prince relies on SEC v. Tambone, 417 F.Supp.2d 127, 135 (D.Mass. 2006), a case decided under the "bright-line" approach for primary liability, as authority for the principle that an individual only owes a duty to correct an omission if the statement containing the omission is attributed to the individual. However, the court in Tambone concluded that the defendants had no duty to correct the omission because the statement — prospectuses which were prepared by a separate entity — had not been made by them, and not because the statement was made by them but not publicly attributed to them.

In summary, the Complaint alleges sufficient facts to establish that Prince made a statement and, therefore, that he had a duty to correct any misleading omissions in that statement. Prince's Motion to Dismiss the SEC's Rule 10b-5(b) claim is therefore denied.

b. Rule 10b-5(a) and (c)

In addition to the Rule 10b-5(b) claim for Prince's alleged omissions, the SEC argues that Prince is liable under Rule 10b-5(a) and (c) for, respectively, employing a "device, scheme or artifice to defraud," and engaging in an "act, practice, or course of business which operates or would operate as a fraud or deceit upon any person." 17 C.F.R. § 240.10b-5. Prince argues that the SEC has failed to state a claim for such "scheme liability" under Rule 10b-5(a) and (c) because (1) it has not alleged that he engaged in a manipulative device or contrivance; and (2) the scheme allegations merely reiterate the omissions underlying the Rule 10b-5(b) claim. Prince's Mot. to Dismiss at 14-15.

It is certainly true, as Prince argues, that Section 10(b) "prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act." Central Bank, 511 U.S. at 177. However, an individual's participation in a scheme to defraud may result in primary liability even in the absence of a misstatement or manipulative act if the individual "engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme." Simpson v. AOL Time Warner Inc., 452 F.3d 1040, 1048 (9th Cir. 2006),vacated on other grounds, Avis Budget Group, Inc. v. Cal. State Teachers' Ret. Sys., 552 U.S. 1162, 128 S.Ct. 1119, 169 L.Ed.2d 945 (2008).

However, to establish primary liability under Rule 10b-5(a) or (c), the alleged conduct must be more than a reiteration of the misrepresentations underlying the Rule 10b-5(b) misstatement claims. Lucent Techs., 610 F.Supp.2d at 361. Primary liability may arise out of the same set of facts under all three subsections "where the plaintiffs allege both that the defendants made misrepresentations in violations of Rule 10b-5(b), as well as that the defendants undertook a deceptive scheme or course of conduct that went beyond the misrepresentations." In re Alstom SA, 406 F.Supp.2d 433, 475 (S.D.N.Y. 2005).

The Complaint's sole allegation that Prince engaged in deceptive conduct, apart from his alleged involvement in the filing of fraudulent and misleading annual reports and proxy statements, is that he violated § 16(a) of the Exchange Act, 15 U.S.C. § 78p(a), by failing to file the statements required under that section. Section 16(a) requires anyone "who is a director or an officer of the issuer of [any equity] security" to file a statement concerning any holdings and transactions of the issuer's securities. 15 U.S.C. § 78p(a).

As Prince points out, in order to prove this claim, the SEC must first establish that he was, in fact, an officer of Integral Systems. Assuming as we must in a Motion to Dismiss that the SEC does establish that Prince did act as an officer of Integral Systems with scienter, a reasonable fact finder could conclude that his failure to file the reports required under § 16(a) was done with the purpose and effect of concealing his officer status from the public. See In re Alstom SA, 406 F.Supp.2d at 474 ("[S]ubsections (a) and (c) of Rule 10b-5 encompass a wide range of activities and are not limited to the prohibition of market manipulation."). The SEC's allegations therefore state a claim under Rule 10b-5(a) and (c) for scheme liability, and Prince's Motion to Dismiss is denied.

CONCLUSION

For the reasons set forth above, Defendant Brown's Motion to Dismiss Count I is granted, and the remainder of her Motion to Dismiss is denied in all other respects. Brown's Motion to Dismiss under the statute of limitations in 28 U.S.C. § 2462 is denied without prejudice. Defendant Prince's Motion to Dismiss is denied in its entirety. An Order will accompany this Memorandum Opinion.