Written by David Welch, Esq.
...Continued from Control Person Liability Post on September 21, 2009:
The success or failure of a pre-hearing Motion to Dismiss a control person liability claim may at times depend on which standard the arbitrators or judge choose to adopt: the “culpable participation” standard or the “potential control standard.” Although some courts are bound by precedential case law to apply a certain standard, many jurisdictions have not definitely selected an appropriate standard and arbitrators, after all, are free to apply whichever standard they deem appropriate.
Thus, parties involved in control person liability disputes often commit significant efforts to advocating the standard that best suits their needs. Although defective control person liability claims can be dismissed under the “potential control” standard, as discussed below, it generally behooves control persons to advocate in favor of the application of the “culpable participation” standard.
The “Culpable Participation” Standard
In order to survive dismissal, under the “culpable participation” standard, plaintiffs must state with particularly facts giving rise to a strong inference that the controlling person in some meaningful sense culpably participated in the controlled person’s primary violation of the securities laws. Thus, in addition to the essential underlying violation, a claim for control liability must have two elements: (1) the Respondent must have exercised control over the primary violator, and (2) the controlling person must have “culpably participated” in the violation.
The courts that have adopted this standard maintain that the language of the control person liability statutes clearly require some participation beyond mere potential to control. See e.g., Lanza v. Drexel & Co., 479 F.2d 1277, 1299 (2d Cir. 1973). In that regard, the “culpable participation” standard includes an element of control person liability that the “potential to control” test ignores, which is Congress’ intent that control persons possess the same requisite scienter as the primary violator. See Rochez Bros., Inc. v. Rhoades, 527 F.2d 880, 885 (3d Cir. 1975); Cromer Finance Ltd., et al. v. Berger, et al., 137 F. Supp. 2d 452, 484 (S.D.N.Y. 2001) (holding that controlling person must be in some meaningful sense a culpable participant in the primary violation) (citing Boguslavsky v. Kaplan, 159 F.3d 715, 720 (2d Cir. 1998); Ellison v. American Image Motor Co., Inc., 36 F.Supp.2d 628, 642 (S.D.N.Y. 1999); In re Livent, 78 F. Supp. 2d 194, 221 (S.D.N.Y. 1999); Burstyn v. Worldwide Xceed Group, Inc., 2002 U.S. Dist. LEXIS 18555 (S.D.N.Y. Sept. 30, 2002).
The “culpable participation” standard is grounded in the United States Supreme Court’s decision in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), in which the Supreme Court stated:
Each of the provisions of the 1934 Act that expressly create civil liability…contains a state-of-mind condition requiring something more than negligence. [Section] 20, which imposes liability upon “controlling person[s]” for violations of the Act by those they control, exculpates a defendant who “acted in good faith and did not… induce the act… constituting the violation [.] 425 U.S. 211 n.28.
In Kohn v. American Metal Climax, the court evaluated the legislative history of Rule 10b-5 and concluded that Congress, through the use of words such as “lack of good faith,” intended that liability would not attach unless the element of culpability was present. Kohn, 458 F.2d 255, 280 (3d Cir. 1972). Referring to Kohn, the court in Rochez Bros., Inc. v. Rhoades, 527 F.2d 880, 885 (3d Cir. Pa. 1975) stated:
[s]ince the standard of culpability is ever-present in the securities laws, it is reasonable that the same standard should be included in Section 20(a). Section 20(a) also provides a good faith defense. If we were to apply respondeat superior, the availability of this good faith defense would be bypassed. Therefore, to use respondeat superior for imposing secondary liability would not advance the legislative purpose of the 1934 Act and in fact would also undermine the Congressional intent by emasculating Section 20(a).
In essence, courts that have adopted the “culpable participation” test reason that, since the control liability statute relate to claims of securities fraud -- which, after all, is the true nature of a suitability or churning claim -- Claimants should be required to show scienter on the part of the control person respondent in a manner similar to what they must plead in a § 10(b) claim against the primary actor. Burstyn v. Worldwide Xceed Group, Inc., 2002 U.S. Dist. LEXIS 18555 (S.D.N.Y. Sept. 30, 2002); In re Bayer AG Sec. Litig., No. 03 Civ. 1546 (WHP), 2004 U.S. Dist. LEXIS 19593, at *49 (S.D.N.Y. 2004).
The “Potential Control” Standard
The various “potential control” standards that have been applied by the federal courts all differ from the “culpable participation” standard in that they seemingly do not require the claimant to prove scienter on the part of the controlling person. Beyond that, there does not appear to be much uniformity among the various different iterations of the “potential control” test. For example, some courts adhere to a “potential control” standard that requires allegations far greater than the mere potential to control. See e.g., Pirelli Armstrong Tire Corp. Retiree Med. Bens. Trust v. Dynegy, Inc., 339 F. Supp. 2d 804, 828 (S.D. Tex. 2004) (holding that a plaintiff needs to allege some facts beyond a defendant’s position or title to show that the defendant had actual power or control over the controlled person).
In Metge v. Baehler, 762 F.2d 621 (8th Cir. 1985), the Eighth Circuit articulated what is regarded as the most widely accepted interpretation of control person liability under Section 20(a). Similar to the Fifth Circuit test described above, the mere potential to control the company does not suffice for control person liability because some ability to control the specific violative transaction must be shown. Under the Eighth Circuit test, the allegations must set forth specific allegations demonstrating that the control person 1) “actually participated in (i.e. exercised control over) the operations of the corporation [or person] in general” and 2) possessed the potential to control the specific transaction upon which the primary violation is predicated.” Metge, 762 F.2d 621, 630-31; Martin v. Shearson Lehman Hutton, Inc., 986 F.2d 242, 244 (8th Cir. 1993) (quoting Myzel v. Fields, 386 F.2d 718, 738 (8th Cir. 1967)). See also Harrison v. Dean Witter Reynolds, Inc., 974 F.2d 873, 881 (7th Cir. 1992); Donohoe v. Consol. Operating & Prod. Corp., 982 F.2d 1130, 1138 n.7 (7th Cir. 1992).
The Tenth Circuit applies a test requiring a role in the day-to-day operations of the company. For example, in Adams v. Kinder-Morgan, Inc., 340 F.3d 1083 (10th Cir. 2003), the allegations against the defendant corporation’s CEO were found to be sufficient to state a claim for control person liability, however, they were inadequate to state a claim against the directors. The operative difference, according to the court, was that the CEO managed day-to-day operations, while the directors did not. Significantly, the Court of Appeals held that mere allegations that a control person has the ability to acquire control are patently inadequate and insufficient to withstand a motion for summary judgment. Id. See also Aldridge v. A.T. Cross Corp., 284 F.3d 72 (1st Cir. 2002) (holding that the controlling person must have the general power to control the company and actually exercise control over the company); Brown v. Enstar Group, Inc., 84 F.3d 393, 396-97 (11th Cir. 1996) (requiring that an individual named as a controlling person must have had the power to control the general affairs of the entity primarily liable at the time the entity violated the securities law and the requisite power to directly or indirectly control or influence the specific corporate policy which resulted in the primary liability); Brody v. Stone & Webster, Inc., 414 F.3d 187, 193 (1st Cir. 2005).
The above is just a sampling of the different versions of the “potential control” standard. Although each of these tests require more than just a conclusory allegation that the named executive is a control person, they do not impose the more stringent elements required by the “culpable participation” standard.