SEC Settlement in the Curt Schilling 38 Studios Matter Highlights the Section 17(a)(2) Liability of Initial Purchasers in Rule 144A High Yield Offerings

Kramer Levin Naftalis & Frankel LLP

On March 20, 2019, an agreement between Wells Fargo Securities LLC (Wells Fargo) and the Securities and Exchange Commission (SEC) to settle litigation involving failed video game company 38 Studios, LLC, headed by former Boston Red Sox pitcher Curt Schilling, was approved by the federal district court in Rhode Island. In addition to injunctions against future violations of securities laws and disgorgement of profits, Wells Fargo was ordered to pay an $812,500 civil penalty. 

In a complaint against Wells Fargo (and others) filed on March 7, 2016, the SEC alleged that Wells Fargo was aware of a funding deficit 38 Studios faced after giving effect to a private placement of $75 million of bonds for which it acted as placement agent, but nonetheless participated in the private placement notwithstanding that the funding deficit was not disclosed in the offering materials. In addition, Wells Fargo was alleged to have not disclosed all of the fees that it would be paid in connection with the private placement. The full text of the SEC’s complaint can be found here.

The SEC alleged that Wells Fargo violated, among other laws, Section 17(a)(2) of the Securities Act of 1933, as amended (the Securities Act). Section 17(a)(2) provides that “it shall be unlawful for any person in the offer or sale of any securities . . . to obtain money or property 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 light of the circumstances under which they were made, not misleading.” Section 17(a)(2) is broader than Section 10(b) and Rule 10b-5 under the Securities Exchange Act of 1934, as amended, because claims under Section 17(a)(2) may be based on negligent conduct, without proof of scienter. Section 17(a)(2) does not, however, allow for private rights of action.

Section 17(a)(2) of the Securities Act is applicable to private placements, including Rule 144A offerings (as well as to public offerings). The increased use by the SEC of Section 17(a)(2) against initial purchasers and placement agents does not appear to turn on the sophistication of the purchasers of the securities in the offering.

With the increased use of Section 17(a)(2), it is likely that increased attention by the SEC and the courts will be given to industry practice, custom and standards in Rule 144A offerings to determine what conduct of initial purchasers and placement agents constitutes negligence for purposes of Section 17(a)(2).

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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