Suing Under the Maryland Securities Act

Date: November 15, 2010

The story is all too familiar these days. Your client, a successful businessman or professional, was convinced by a friend of a friend to invest a substantial sum of money in a business which has recently gone sour. Your client tells you that initially he received a respectable return on his investment, but in the ensuing months the payments became smaller and less frequent and ultimately dried up. He reports that now there is talk that the business is having cash flow problems and may not make it. "Insiders" tell him that we just have to sit tight and wait for the economy to turn around and things will be okay. However, your client isn't buying that and wants to know whether there is any way he can get his money back.

You carefully read your client's limited partnership agreement, his limited liability company operating agreement or his loan or investment agreement. You look hard at the representations and warranties; rights to distributions; and other duties owed by the business entity or its management to your client, for any glimmer of a cause of action. Unfortunately, the language of the document is not investor friendly. There is boilerplate language about your client's complete understanding of the risks of the investment; that he has not relied on any representations which do not appear in the document; and that he, as a "qualified investor," has received all the information about the business necessary to make an informed investment decision.

Exacerbating your client's distress is his strong belief - albeit without any tangible evidence - that he was swindled and that the business insiders either "got their money out" or somehow managed to enrich themselves as the business began to sink. Despite his frustration and anger, your client does not want to throw good money after bad and wants you to advise him about his litigation options.

A major factor in your analysis is whether even a successful lawsuit against the business entity will net your client a dry hole or an unsecured creditor position in a bankruptcy proceeding. The cost of litigation and the time to obtain a final judgment will also weigh heavily on your thinking. Finally, without any hard evidence of chicanery, the likelihood of success under traditional common law claims of fraud, misrepresentation, and breach of contract is, at best, questionable. Asserting claims for breach of fiduciary duty, accounting, or bringing a derivative or class action are fraught with legal complexities which invite time consuming legal motions and appeals which drive up litigation costs, and even if successful may not achieve the goal of getting your client his money back.

Often overlooked, the Maryland Securities Act ("MSA") provides a powerful statutory weapon to help your client recover his investment provided he falls within the reach of this Act. These weapons include a cause of action for rescission of the investment and return of the investment money, plus interest and reasonable attorneys' fees. Just as important, the MSA establishes joint and several liability for each director, officer, partner, or "control person" of the business entity to the same extent as the business entity is found liable for violation of the MSA. Needless to say, this joint and several liability feature (which is not widely known or appreciated) is a potent means to recover against the "insiders" who have "gotten their money out" and are relying on the limited liability company form, the corporate form or the contractual documents to shield them from personal liability. Finally, to the extent that the business entity maintained a standard D&O policy, an action against such directors and/or officers under the MSA may be sufficient to trigger coverage and a new deep pocket.

To qualify for protection under the MSA: (1) your client's investment must be a security within the meaning of the MSA; (2) there must be a violation of the MSA by the offeror/seller of the security; and (3) your client's suit must be brought within the MSA's unique statute of limitations and other statutory requirements.

A. Did Your Client Invest In A Security?

Whether your client purchased a "security" as defined under the MSA is in many ways a vexing and confusing question. Securities are often well disguised (unintentionally or otherwise) as partnership interests, limited liability company member interests, promissory notes, investment contracts, participation interests, purchase options, warrants or other agreements which do not have the look or feel of a traditional security. However, the MSA defines a security in a very broad and elastic fashion. Moreover, the courts "look through" the form of the investment to its substance and economic reality in deciding whether a "security" was purchased. The MSA defines a security inter alia:

"Security" means any (1) note; (ii) stock; (iii) treasury stock; (iv) bond; (v) debenture; (vi) evidence of indebtedness; (vii) certificate of interest or participation in any profit sharing agreement; . . . (xi) investment contract; (xii) voting-trust certificate; (xiii) certificate of deposit for a security; . . . (xv) in general, any investment or instrument commonly known as a security; or (xvi) certificate of interest or participation in . . . or right to subscribe to or purchase any of the preceding.

Section 11-101(r) of the MSA.

The federal securities acts (The Securities Act of 1933 and the Securities Exchange Act of 1934) also define the term "security" in a manner very similar to the MSA. Since the MSA looks to the federal securities acts for authoritative guidance, it is important to recognize that the Supreme Court has repeatedly held that the definition of a security "is sufficiently broad to encompass virtually any instrument that might be sold as an investment," Reves v. Ernst & Young, 494 U.S. 56, 61 (1990), and sufficiently flexible to reach "countless and variable schemes devised by those who seek the use of the money of others on the promise of profits." Tcherepnin v. Knight, 389 U.S. 332, 338 (1967). Indeed, the form of the instrument or investment is disregarded in favor of the substance with the emphasis on the economic reality. In this context, the Supreme Court in Securities Exchange Commission v. W.J. Howey Co., 328 U.S. 293, 298-299 (1946) established the classic definition of an investment contract as an investment in a common venture; premised on a reasonable expectation of profits; to be derived from the entrepreneurial or managerial efforts of others.

The Howey formulation has been adopted by Maryland courts which have held that non-collateralized, interest bearing promissory notes, Caucus Distributors, Inc. v. Maryland Securities Comm'nr, 320 Md. 313, 316-330 (1990), and interests in limited liability companies AK'S DAKS Communications, Inc. v. Maryland Securities Comm'nr, 138 Md.App. 314, 326-333 (2001), were securities within the meaning of the MSA. Even loan instruments or other seemingly non-investment agreements which provide options or rights to obtain equity in the issuer business are likely to be securities. While the MSA generally excludes traditional, commercial loans and specifically exempts insurance and annuity products, the broad reach of the definition of "security" makes it very likely that your client's investment is actually a security which may entitle him to the rights and remedies under the MSA.

B. Does Your Client Have A Claim For Violation Of The MSA?

Section 11-703 of the MSA provides a right of action to your client (the offeree or purchaser of a security) where the offeror or issuer offers or sells a security which is not registered or is not appropriately exempted from registration or the requirements of the applicable MSA exemption are not fulfilled by the security issuer. The MSA also establishes a cause of action against any person who offers or sells a security by means of an untrue statement of a material fact or any omission to state a material fact.

1. A limited offering without registration or exemption

The Maryland securities regulation scheme generally requires a notice filing with the Maryland Division of Securities in connection with the offer or sale of certain categories of securities, including limited offerings. A limited offering is one of the most common forms by which capital is raised by start up or small businesses and is probably the general form of offering pursuant to which your client purchased his security. In a limited offering, securities are offered for sale primarily by word of mouth directly by the business issuer through its principals, directors, managers, officers or agents to a relatively small number of prospective purchasers - often to relatives, friends and friends of friends.

If the limited offering is made in more than one state, the issuer must find a federal exemption as well as an exemption in each state in which offers and sales are made. Most offerings are made under SEC Regulation D and are oftentimes referred to as "Reg D" offerings. Within Regulation D, the most common exemption relied upon is Rule 506, which permits an unlimited amount of investment money to be raised from an unlimited number of "accredited investors" (including individuals with a $1,000,000 net worth or with incomes of $200,000 or $300,000 including their spouse) and up to 35 unaccredited investors. Such offerings require a formal, public filing with the SEC. A corresponding Maryland state information filing - sometimes known as a "blue sky" filing -- must also be made with the Maryland Division of Securities.

While businesses making limited offerings sometimes secure the necessary Reg D exemption from the SEC, many times they do not. You can check on line whether the security your client purchased was federally exempted. Even if federally exempted, there is still a reasonable likelihood that the requisite Maryland filing was not made by the security issuer. You can quickly determine whether the security offering in which your client participated was properly "blue skied" in Maryland by calling the Maryland Division of Securities.

If your client's security purchase was part of a limited offering for which the business issuer failed to obtain an exemption under the MSA, your client may have a cause of action under Section 11-703 of the MSA.

2. Misrepresentation or omission to disclose a material fact

Misrepresentation is a familiar and well established legal doctrine in Maryland. However, it does not necessarily meet the practical needs of your client's situation. Most likely your client executed form documents which expressly limit the issuer/seller's factual representations to your client to the information provided in the documents. Despite what your client may describe as the issuer/seller's oral promises of "sure-fire success", the documents - which your client may not have carefully read - frequently show your client's acknowledgement of the investment risks and his receipt of full information, including his opportunity to ask any questions he wishes regarding any matters pertaining to the issuer, its business and the securities being offered for sale. Moreover, if the issuer/seller is even modestly sophisticated, the form documents your client signed were undoubtedly crafted so that any rosy promises are actually carefully labeled as "projections," "estimates," and sales puffery which will create major legal and factual obstacles to a misrepresentation action. Thus, while some factual situations may support a misrepresentation action under Section 11-703 of the MSA, your client's best litigation bet is probably a claim based on an omission to disclose material facts.

The cause of action under the MSA based on an omission to disclose a material fact is, unfortunately, expressed in pluperfect lawyer-speak. It imposes liability on one who:

[o]ffers or sells the security by means of . . . 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 if he 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 . . . omission.

MSA ยง 11-703(a)(1)(ii). In practical terms, the offeror/seller must affirmatively provide to the security purchaser full disclosure all material facts unless he, the offeror/seller, can satisfy the burden of proving that he was not aware, or could not reasonably have been aware, of the omitted material facts. A material fact, in turn, can very generally be defined as a fact about the business, including its operations, finances and management, etc., that a reasonable investor would consider important in making an investment decision.

Federal courts have found "materiality" in a very wide range of information, factors and circumstances. Suffice it to say that in many limited offerings, whether or not properly exempted under Regulation D and/or the MSA, there are likely to be material facts which were not disclosed to your client at the time your client purchased the security. This is especially true where the security is offered or sold to your client unaccompanied by financial statements, and/or a comprehensive private placement memorandum of other offering document, including "risk factors". Therefore, you should focus your client interview on what material information was not provided - i.e. detailed financial statements, compensation to "insiders," employment/retainer agreements with insiders and/or relatives, detailed descriptions of the products or services of the business, its existing customers, and the background and experience of its management. To the extent that these and/or other material facts were not disclosed when your client purchased the security, your client may have a securities claim under the MSA.

C. Does Your Client's Securities Claim Satisfy The Statute Of Limitations?

Your client's claim under the MSA must satisfy a somewhat complicated statute of limitations. First, based on a failure by the security offeror/seller to obtain registration or exemption of the security under the MSA (or other violation of Section 11-703(a)(1)(i) of the MSA), suit must be brought within the earlier of: one year from the violation or three years after the contract for the purchase/sale of the relevant security. Second, an action by your client (the offeree or buyer) against the security offeror/seller based on a material misrepresentation or omission to disclose a material fact must be brought within the earlier of: one year after the reasonable diligence discovery of the untrue statement or omission, or three years after the contract of purchase/sale of the relevant security.

The practical effect of these limitations requires your client to file suit quickly - within one year - based on the security issuer/seller's failure to secure an exemption in Maryland under the MSA. A claim for misrepresentation/omission provides more breathing room and in the case of an omission your client will probably have the full three year maximum because it is unlikely that your client discovered the omission earlier.

D. The MSA Overrides Any Contractual Provisions Which Attempt To Limit Or Waive The Provisions Of The MSA

Buried somewhere in your client's partnership agreement, LLC operating agreement, note, or investment agreement there may be a choice of law provision by which your client has agreed that the law of a state other than Maryland will govern in any lawsuit. From this you might conclude that the MSA does not apply and your client is left to the tender mercies of the securities laws of Wyoming or some other state. Coupled with a forum selection clause which requires that any suit be brought in a state other than Maryland you may be on the verge of telling your client to find another attorney.

A unique feature of the MSA specifically provides that any agreement your client may have made, pursuant to which compliance with any provision of the MSA is waived, is void. Thus, any choice of law requirement which, for example, calls for Wyoming law to be applied in any action by your client against the security issuer/seller is void because compliance with the MSA would thereby be waived. Indeed, the statutory force of this provision indicates a clear public policy by which the MSA cannot be overridden by contract.


The Maryland Securities Act provides an important cause of action in support of your client's efforts to recover monies invested in securities offered or sold in violation of the law.

This article appeared in the November 2010 issue of the Maryland Bar Journal and is reproduced by permission of the Maryland Bar Journal, which is published by the Maryland State Bar Association.