Pennsylvania Supreme Court Rules That A Showing Of Fraudulent Intent Is Not Required To Establish A Violation For Misrepresentation Under Pennsylvania Securities Act
July 31, 2023
By: Carl L. Engel
On July 19, 2023, the Pennsylvania Supreme Court, in the case Mimi Investors LLC v. Tufano, addressed for the first time whether a showing of intent was required to establish liability for a misrepresentation under the Pennsylvania Securities Act (the “Act”). An investor had brought a lawsuit against a data-storage company from which it had purchased promissory notes based on statements that the company recently had received hundreds of new customer orders. After the investor purchased the notes, the company soon stopped making payments thereon, stating that the customer orders had never actually materialized. The investor filed a lawsuit against the company’s officers for violating the Act’s prohibition on false statements. The officers argued that they could not be liable under the Act, because they were not accused of attempting to perpetrate a fraud against the investor. However, both the Supreme Court and lower courts agreed that the Act provides for two separate violations, one for fraud and another for misrepresentation, and a claim for misrepresentation did not also require a showing of intent to fraud. Accordingly, the investor is allowed to proceed with his lawsuit against the company’s officers based on their false statements about new customer orders.
In 2016, Mimi Investors LLC sued several officers of ORCA Steel LLC, a data-storage company, alleging that the officers had made material misrepresentations of fact in violation of the Act. In their complaint, Mimi Investors described a meeting held in February of 2014 during which the ORCA officers had told Mimi Investors that they had received 400 orders for computer-data-storage space at a new data-storage facility that they had planned. To secure financing to construct the facility and service the orders, the ORCA officers sought to sell promissory notes to increase available capital. As a result of the meeting, Mimi Investors purchased promissory notes from ORCA Steel in the amount of $500,000. In October of 2014, ORCA Steel stopped making payments on the notes.
Mimi Investors alleged that on October 21, 2014, the ORCA officers had told it that they “had known for months” that a construction loan was not available because the data-storage orders “were not investment grade.” Mimi Investors claimed that the statements made in February of 2014 had violated Section 1-401(b) of the Act, which prohibits “mak[ing] any untrue statement of a material fact” in connection with the sale of a security. The ORCA officers asked the court to dismiss the complaint based on an argument that Section 1-401(b) required “scienter,” i.e. the intent to defraud. The trial court declined the ORCA officers’ request, and they immediately petitioned the Superior Court to review the decision, which was granted.
The Superior Court observed that there was no prior appellate decision in Pennsylvania interpreting Section 1-401 of the Act. It found, however, that Mimi Investors’s complaint had included at least some allegations that the ORCA officers had acted with intent to defraud, and affirmed the trial court on that basis. The Superior Court did not resolve whether Section 1-401 actually requires a plaintiff to show that the defendants acted with scienter. The ORCA officers petitioned the Pennsylvania Supreme Court to review the issue.
The Supreme Court granted the petition only in part, and solely as to the issue of whether the Act “requires a plaintiff to plead and prove scienter by clear and convincing evidence in connection with an alleged violation of 70 P.S. § 1-401 regulating the purchase and sale of securities in the Commonwealth.”
To begin its analysis, the Supreme Court observed that, although there were no appellate cases addressing scienter under the Act, the U.S. Supreme Court has held that a showing of scienter is required to impose liability under SEC Rule 10b-5, which is the federal analog of 70 P.S. § 1-401. As a result, federal courts interpreting 70 P.S. § 1-401 consistently had held that a showing of scienter was required. Mimi Investors argued, on the other hand, that Section 1-401 does not expressly include scienter as an element, and the assumption that it mirrors SEC Rule 10b-5 “undermines federalism.”
The Supreme Court next observed that “there are no terms in Section 1-401(b) related to scienter.” The court reasoned that, absent an ambiguity in the Act, there was no basis for turning to other devices of statutory interpretation, such an analysis of federal decisions on SEC regulations. The court noted that had the Pennsylvania General Assembly wanted to include an element of scienter in Section 1-401(b), it could have. Indeed, in Section 1-401(a) it had done so by prohibiting “any device, scheme or artifice to defraud.” “Conversely,” the court observed, “language describing scienter is glaringly absent from Section 1-401(b).” The court recognized that “the General assembly was free to recognize that such misstatements might cause significant economic harms warranting redress, regardless of intentionality.” Therefore, it affirmed the Superior Court’s decision not to dismiss Mimi Investors’s claim for violation of Section 1-401(b).
The Supreme Court’s decision benefits Pennsylvania investors, because it makes clear that misrepresentations of fact per se and frauds are both illegal when made in the connection with the sale or purchase of securities, and give rise to separate violations. Had the Supreme Court agreed with the ORCA officers by reading a scienter element into Section 1-401(b), Pennsylvania investors effectively would be protected against only fraud, as a misrepresentation of fact would have to be made in connection with a fraud for there to be liability under the Act. Instead, to obtain protection under Section 1-401(b), investors need only show that they were given false information on which they relied.