Securities Laws Protect Even Sophisticated Investors

Even the most wealthy and experienced investors can fall prey to an investment swindle when fraud is involved. If you find yourself in this predicament, you may fear that your road to recovery is blocked by the “sophisticated investor” doctrine that supposedly prevents investors with knowledge of the financial world from prevailing in a securities action. But this fear is unfounded. Let’s explore why.

Federal Securities Laws

Although arbitrators are often convinced otherwise, commentators argue and many courts (and the SEC) agree that there is no basis in federal securities law for treating sophisticated investors any differently from unsophisticated ones. Consider the elements of a fraud action under Rule 10b-5. That rule says that a person is liable for damages if, in connection with the purchase or sale of a securities, they:

1. employ any device, scheme, or artifice to defraud;
2. make any misstatements or omissions of material fact; or
3. engage in any act, practice, or course of business that operates as a fraud or deceit on any person.

To prove a Rule 10b-5 claim, the claimant must prove:

1. that the respondent made misstatements of material fact, or failed to disclose material facts;
2. that the claimant reasonably relied on these misstatements or omissions of fact;
3. that the claimant would not have made the investment at issue without the misrepresentations/omissions; and
4. that the respondent intended to deceive the claimant (a state of mind referred to as “scienter”).

Nothing about an investor’s sophistication, familiarity with the markets, or ability to absorb a loss, right? So where does the “sophisticated investor doctrine” fit in? Respondents rely on it as a defense to negate the element of reasonable reliance. The argument goes that, because the claimant is a “sophisticated investor,” it was unreasonable of her to rely on respondent’s misrepresentations. In effect, a sophisticated investor is apparently someone who should know better than to rely on anything a seller might say to her. But that doesn’t make for a very good rule at all.

For years, courts have pointed out that “sophisticated investors, like all others, are entitled to the truth.” (Stier v. Smith, 473 F.2d 1205, 1207 (5th Cir. 1973).) In fact, nowhere does the language of the relevant statutes and rules distinguish among investors on the basis of sophistication. As you surely know, having wealth, investment experience or market knowledge is no help when you’re being lied to – especially if the lies are deliberate and intended to keep you from getting to the truth. Moreover, “sophistication” is an unclear standard and court decisions that consider it are all over the map. Generally, the factors courts look at include an investor’s:

• wealth;
• age;
• education;
• professional status;
• investment experience; and
• business background.

Of course, a person can be wealthy with no investment experience at all. It’s also possible to have lots of experience with certain kinds of business or investments, but know little to nothing about others. Here are some investors that the SEC concluded were not sophisticated:

• an investor who owned his own roofing company, had a degree in business administration, and maintained a $3 million brokerage account;
• a city finance manager;
• an investor who studied economics in college and was able to access online investment information; and
• an investor with a Harvard business degree. (See Giants and Pygmies: The Fallacies of the Sophisticated Investor Doctrine, Lawrence C. Melton, PIABA Bar Journal, Winter 2006.)

Despite all of this, however, arbitrators sometimes seem to fall prey to accepting the sophisticated investor doctrine as a defense to claims brought under federal securities law. That’s where the Texas Securities Act comes in.

The Texas Securities Act

Texas, like most other states, has its own securities laws that supplement federal laws. The Texas Securities Act (TSA) casts a broader net than the federal securities acts, and can offer a claimant an easier road to recovery. Here’s why.

The TSA, like federal law, prohibits the sale of securities by misrepresentation of, or failure to disclose, a material fact. To prove a fraud claim under the TSA, the claimant has to prove:

1. that the respondent sold claimant a security; and
2. that the respondent misrepresented, or failed to disclose, a material fact in connection with the sale.

Proving a case under the TSA does not require a claimant to prove that he reasonably relied on the seller’s misrepresentation. Nor does the claimant have to show that without the misrepresentation, he would not have purchased the security. Therefore, the sophisticated investor doctrine is completely irrelevant to a TSA fraud claim. In his defense, the respondent must prove that the claimant actually knew that the misrepresentation was false – and the claimant is under no duty to investigate the truth of the respondent’s claims.

What About Private Placements?

When you consider fraud in the context of private security offerings, the inherent incoherence of the sophisticated investor doctrine becomes plain. In these sales, of course, the securities being sold are exempt from registration and cannot be offered to the general public. Under both federal law and the TSA, purchasers who can participate in a private offering must be sophisticated or well-informed, at least as to the securities issue under consideration. Rule 109.13 of the Texas Administrative Code says that these factors at least must be considered in assessing sophistication:

1. the investor’s financial capacity;
2. the investor’s knowledge of finance, securities, and investments generally; and
3. the investor’s experience and skill in investments based on actual participation.

So, by law, the investors in a private offering are sophisticated. Does this mean they cannot be defrauded? Of course not! It’s hard to make an informed decision when you’re being lied to, no matter how much knowledge, experience, or skill you may possess. For this reason, there is no provision in the law exempting private placements from the prohibition against misrepresentation. If it were true that a sophisticated investor could not reasonably rely on a seller’s misrepresentations, then sellers in private placements could defraud investors essentially with impunity. But this is not the law.

If you are a successful, experienced investor, you are entitled to protection from fraud just as much as a financial novice. Anyone can be victimized by fraudulent misrepresentations, or by a deliberate failure to disclose material facts. The sophisticated investor doctrine should not bar recovery under federal law. And even if an arbitrator accepts the idea that a so-called sophisticated investor cannot reasonably rely on misrepresentations, under the TSA it doesn’t matter because a claimant doesn’t have to prove reasonable reliance to recover. If you have been the victim of investment fraud, whether through public or private securities, you have the right to bring a claim regardless of your investment experience. Contact my office today at 866-597-2221, or via our website’s contact form, to discuss your situation.