Section 4(a)(1): The “Ordinary Trading” Exemption
Section 5 of the Securities Act makes it unlawful, directly or indirectly, to publicly offer or sell unregistered securities, unless the offering is covered by an exemption. Several potential exemptions are available to market participants, depending upon the nature of the transaction, amount of the offering, and participants involved. One of those exemptions is codified under Section 4(a)(1), sometimes known as the “ordinary trading” exemption, which states that Section 5 does not apply to transactions by any person other than an issuer, underwriter, or dealer.
Underwriter is statutorily defined in Section 2(a)(11) of the Securities Act as
any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking.
For example, an investment bank that has an arrangement with a securities issuer to facilitate the public sale of its securities is typically considered an “underwriter.”
On its face, Section 2(a)(11) defines underwriter broadly enough such that, theoretically, it could be construed to encompass persons other than the traditional investment bank that underwrites a registered securities offering. However, “while the definition is indeed broad, ‘[u]nderwriter’ is not . . . a term of unlimited applicability that includes anyone associated with a given transaction.” Courts have found that “[i]t is crucial to the definition of ‘underwriter’ that any underwriter must participate in the distribution of a security.” This participation notion was expressly contemplated by Congress, which “ma[de] clear that a person merely furnishing an underwriter money to enable him to enter into an underwriting agreement is not an underwriter. . . . The test is one of participation in the underwriting undertaking rather than that of a mere interest in it.” The rationale for subjecting underwriters to potential liability is “because they hold themselves out as professionals who are able to evaluate the financial condition of the issuer,” and “[t]he public relies on their expertise and reasonably expects that they have investigated the offering with which they are involved.”
If a holder of securities is not an issuer, underwriter, or dealer, they may sell their existing securities without registration pursuant to Section 4(a)(1). Section 4(a)(1) was “designed to exempt routine trading transactions with respect to securities already issued”—not necessarily to exempt initial distributions by issuers. Importantly, Section 4(a)(1) exempts transactions, not persons.
SEC v. Chinese Consolidated Benevolent Ass’n
In 1941, the Second Circuit seemingly expanded the statutory limitations of Section 4(a)(1), not only by construing the Section 2(a)(11) definition of underwriter broadly, but by holding that even if a defendant was not an issuer, dealer, or underwriter itself, the Section 4(a)(1) exemption would not apply if the defendant was engaged in “steps necessary” to the distribution of unregistered securities.
In Chinese Consolidated, the SEC sued a New York corporation to enjoin it from using any instruments of interstate commerce or of the mails in attempting or offering to sell or dispose of Chinese government bonds. The defendant was a benevolent association with a membership of 25,000 Chinese individuals. Without any official or contractual relationship with the Chinese government, this New York corporation urged members of Chinese communities in New York, New Jersey, and Connecticut to purchase Chinese government bonds, and offered to accept funds from prospective purchasers and deliver those funds to the Bank of China in New York. Neither the defendant nor its members were ever charged for their activities, and they did not receive any compensation. The SEC sought to enjoin the defendant from disposing of, or attempting to dispose of, these Chinese government bonds, which it alleged were unregistered securities.
The defendant was concededly neither the issuer of the Chinese government bonds nor a dealer. Accordingly, under Section 4(a)(1) of the Securities Act, the defendant would be exempt from registration requirements if it was also not an underwriter, as defined in Section 2(a)(11). The district court indeed found that the defendant was not an underwriter and was therefore exempt because the defendant did not sell or solicit offers to buy the Chinese government bonds for an issuer, as the Section 2(a)(11) definition of underwriter specifies. The district court found that the defendant’s actions in attempting to dispose of the bonds were not for the Chinese government; indeed, there was no contractual arrangement or even understanding with the Chinese government.
The Second Circuit reversed, pointing to the facts that the “defendant solicited the orders, obtained the cash from the purchasers and caused both to be forwarded so as to procure the bonds.” The court noted that “the aim of the Securities Act is to have information available for investors[,] [and] [t]his objective will be defeated if buying orders can be solicited which result in uninformed and improvident purchases.” Ultimately, the court, noting the aim of the Securities Act to furnish the public with adequate information, and the purported aim of the issuer (here, the Chinese government) to promote the distribution of the securities, broadly interpreted the plain language of the definition of underwriter. The court held that “[a]ccordingly the words ‘(sell) for an issuer in connection with the distribution of any security’ ought to be read as covering continual solicitations.” The court ultimately found that the defendant acted as an underwriter in the distribution of unregistered securities.
Crucially, the court went on to find a “further reason” for holding that the defendant’s activity was prohibited. The court noted that Section 4(a)(1) was not intended to exempt distributions by issuers, and that here,
[t]he complete transaction included not only solicitation by the defendant of offers to buy, but the offers themselves, the transmission of the offers and the purchase money through the banks to the Chinese government, the acceptance by that government of the offers and the delivery of the bonds to the purchaser or the defendant as his agent.
The court held that “[e]ven if the defendant is not itself ‘an issuer, underwriter, or dealer’ it was participating in a transaction with an issuer, to wit, the Chinese Government.” The court explained that the Section 4(a)(1) exemption does not “protect those who are engaged in steps necessary to the distribution of security issues.”
In sum, the court found that the defendant’s actions fell under the definition of underwriter under Section 2(a)(11) such that the defendant was liable for its attempts to dispose of the Chinese government bonds without registration; and, significantly, that even if the defendant was not an underwriter, it “engaged in steps necessary to the distribution” of the unregistered securities such that it did not qualify for the Section 4(a)(1) exemption. Thus, the “necessary participant” doctrine was born, making it possible for a defendant to be liable under Section 2(a)(11) even if it is not an issuer, underwriter, or dealer.
The Second Circuit’s Expansion of Necessary Participant
Stemming from Chinese Consolidated in 1941, courts have adopted and expanded the necessary participant language from that case to create myriad other tests that purportedly help explain what a “necessary participant” is—and when a person who is not an issuer, underwriter, or dealer can nevertheless be liable under Section 5.
Perhaps realizing that Chinese Consolidated was unmoored from the statute, the Second Circuit later tried to put the genie back in the bottle, but without actually overturning Chinese Consolidated. In SEC v. Kern, the Second Circuit cited the “steps necessary” language from Chinese Consolidated to hold that “underwriters . . . include any person who is ‘engaged in steps necessary to the distribution of security issues.’” But later, in SEC v. Sourlis, with somewhat cursory analysis, the Second Circuit held that Section 5 liability extends to “those who have ‘engaged in steps necessary to the distribution of [unregistered] security issues’”—quoting and relying on Chinese Consolidated without even mentioning the word underwriter.
District courts within the Second Circuit, springboarding from Chinese Consolidated’s departure from the statutory text, developed the “necessary participant” doctrine by introducing additional considerations beyond the plain language of Section 4(a)(1). Under these cases, defendants may be liable for violating Section 5 even if they do not offer or sell a security, provided that they were a “necessary participant” in the unregistered distribution.
But then how is a court to determine who is a “necessary participant”? As one court frames it, “[t]he ‘necessary participant test . . . essentially asks whether, but for the defendant’s participation, the sale transaction would not have taken place.’” This “but for” formulation significantly expands the range of whom the SEC can sue for Section 5 liability to include anyone or any entity that the SEC asserts had a necessary role in the unregistered securities transaction.
In other words, in an attempt to define limitations on what a “necessary participant” is, courts have articulated a “substantial factor” test—that is, “whether the defendants’ acts were a ‘substantial factor in the sales transaction.’” However, the concept of a “substantial factor” in a securities transaction is as ill-defined as other terms within this discussion.
And as the SEC v. Genovese court pointed out, the “but-for” test raises its own problems. It “would require finding innumerable necessary participants to every unregistered securities offering—everyone who played an intermediate role, no matter how small, in the chain of causation leading to the sale.” Indeed, “[a] strict ‘but-for’ test also is at odds with the Commission’s guidance, which provides that not every individual in the causal chain is a necessary participant.”
Ultimately, in Genovese, the court organized the defendant’s activities into two categories: (1) those showing “direct involvement” in the sale and (2) those “activities ancillary” to the sale. Examples of direct involvement, which implicate substantial participation, include where defendants “directly prepared . . . corporate resolutions and documentation”; “formed entities for use in sale, solicited investments, provided subscription agreements, communicated with buyers and sellers, and directed broker action”; and “found private parties as clients for deals, filed paperwork with regulators, served as president, CEO and director of transfer agency and handled promotion of stock.” In contrast, the Genovese court ultimately found that “activities ancillary” were “too remote from the actual sale to rise to the level of necessary or substantial participation”—creating yet another criterion for considering what “necessary participation” is.
Thus, in the Second Circuit alone, the new category of “necessary participant” created by Chinese Consolidated—explicitly described as being separate from the definition of underwriter in Section 2(a)(11)—has spawned a slew of tests, some of which appear to be attempting to shoehorn the classification back into the underwriter definition, and some of which follow Chinese Consolidated more strictly (and thus follow the statute far more loosely).
Other Circuit Courts’ Interpretation of Necessary Participant
In the wake of Chinese Consolidated, other circuit courts, including the U.S. Courts of Appeals for the Seventh and Ninth Circuits, also adopted a new, atextual “necessary participant” doctrine, often tempered by the “substantial factor” doctrine, to hold that defendants need not be issuers, underwriters, or dealers to be held liable for a Section 5 violation. These courts often recognize the risk that a party whose minimal acts assisted in the unregistered securities distribution could be held liable for registration violations, but they have found that, “in practice, the standards differ little, for no court using the ‘necessary participant’ test has found liable a defendant whose acts were not a substantial factor in the sales transaction.”
In SEC v. Holschuh, the Seventh Circuit formulated the test differently, explicitly finding that persons who were not underwriters may nevertheless be liable on the grounds that the statute refers to the transactions by people, not the people themselves. Holschuh found that the defendant “was a ‘necessary participant’ and ‘substantial factor’ in the unlawful sales transactions,” and thus liable even though not an underwriter. Thus, other circuits have used this “substantial factor” test as well—sometimes articulated somewhat differently from the Second Circuit, but still addressing the concept of a “necessary participant” rather than strictly an issuer, underwriter, or dealer.
Back to the Second Circuit: In re Lehman Brothers
After the adoption of the “but-for” test and “substantial factor” test, which both provided gloss on the “necessary participant” doctrine, the Second Circuit provided further guidance in a 2011 case, In re Lehman Brothers Mortgage-Backed Securities Litigation. There, investors brought putative class actions to hold credit ratings agencies liable under the Securities Act, in part as underwriters. The plaintiffs attempted to argue that Second Circuit precedent construed the term underwriter broadly to include any person who is “engaged in steps necessary to the distribution of security issues.” According to the plaintiffs’ logic, “any persons playing an essential role in a public offering . . . may be liable as underwriters.” The court disagreed, stating that its “prior cases do not hold that anyone taking steps that facilitate the eventual sale of a registered security fits the statutory definition of underwriter.” Rather, the court “stated that ‘underwriter’ references those who take ‘steps necessary to the distribution’ of securities.”
Further elaborating on Chinese Consolidated, Kern, and other Second Circuit progeny, the court clarified that “this precedent cannot be read to expand the definition of underwriter to those who participate only in non-distributional activities that may facilitate securities’ offering by others.” Rather,
the participation must be in the statutorily enumerated distributional activities, not in non-distributional activities that may facilitate the eventual distribution by others. This approach avoids the implausible result of transforming every lawyer, accountant, and other professional whose work is theoretically “necessary” to bringing a security to market into an “underwriter” . . . , a dramatic outcome that Congress provided no sign of intending.
In its elaboration, the court corrected a common misinterpretation of Chinese Consolidated, remarking that “we note that the ‘steps necessary to the distribution’ language relied on by plaintiffs was originally employed by this court [in Chinese Consolidated] to explain a registration exemption, not the underwriter definition.” The court noted, “[W]e stated [in Chinese Consolidated] that ‘[i]t,’ meaning the [4(a)(1)] exemption, ‘does not . . . protect those who are engaged in steps necessary to the distribution of’ securities because it is limited to transactions between individual investors.”
On the one hand, Lehman Brothers clarified that Chinese Consolidated first employed the “steps necessary” language to carve out “necessary participants” from the Section 4(a)(1) exemption. On the other, Lehman Brothers clarified that underwriter references those who take “steps necessary to the distribution” of securities, despite that language not existing in the Section 2(a)(11) statutory definition of underwriter. In doing so, Lehman Brothers reconfirmed the departure from the text first set out in Chinese Consolidated: under these cases, a “necessary participant” is not just a type of underwriter; it’s a new category entirely—one that does not exist in the text of the 1933 Securities Act.
Where to, from Here?
The rationale of the Securities Act was to provide the public accurate and complete information by the people or entities responsible for distributing securities to the public. Yet, despite Congress’s circumscribed application of registration requirements to issuers, dealers, and underwriters, the Second Circuit expanded the group responsible for registration requirements to include “necessary participants” to the distribution of securities, even if they are not underwriters.
That expansion, initiated in a few lines in Chinese Consolidated in 1941 and expounded on over a period of decades by multiple circuit and district courts, stretches the plain language of Section 4(a)(1). Not only can the Section 2(a)(11) definition of underwriter include those who indirectly participate in the distribution of securities (already, arguably, at the outer reaches of Section 2(a)(11)), but even those who are not underwriters may not fall under the Section 4(a)(1) exemption if they are “necessary participants” and take “steps necessary” to the distribution of unregistered securities.
Chinese Consolidated opened the door for a nebulous “necessary participant” to include myriad individuals or entities other than issuers, underwriters, or dealers in the chain of a securities distribution. The Ninth Circuit’s discussion in Murphy raised the concern that “this broader standard could encompass a party whose acts in furtherance of the distribution were de minimis and who should not be held liable for registration violations.”
In the era of digital assets trading over complex and interconnected computer networks, it might be a struggle to draw the appropriate limiting principle on who could be deemed a “necessary participant,” and an expansive interpretation could apply to innumerable persons and entities. No longer are we only concerned with a single newspaper editorial, as Judge Swan pointed to in his Chinese Consolidated dissent, but courts will be asked to consider: Websites that host front ends? Participants in a blockchain network, such as validators, stakers, or decentralized exchanges? Noncustodial wallet providers? Blockchains themselves?
For many (and perhaps all) of these categories, it would make no sense to hold the persons or entities creating or operating these technologies responsible for issuances of unregistered securities—not from a policy point of view, and certainly not under the plain language of the Securities Act. Indeed, given the free-flowing and permissionless nature of the internet and Web 3.0, participants may not even be aware of the role they play in the distribution chain—perhaps they simply publish software on the internet that could be used to ultimately purchase an alleged unregistered security.
Eighty years of case law has developed to suggest that a “necessary participant” is its own category, apart from issuers, underwriters, and dealers. That alone is a departure from the plain text of the Securities Act. Worse, as explained above, district courts have struggled to interpret the “necessary participant” language from Chinese Consolidated to apply some limiting principle, such that underwriter is not too broadly construed to include any person who is engaged in “steps necessary” to the distribution of securities.
Without the “necessary participant” doctrine’s advent in Chinese Consolidated, district courts would merely have to interpret the plain language of Section 4(a)(1) that applies to issuers, underwriters, and dealers—and perhaps Section 2(a)(11)—to determine who would be considered an underwriter. While some of the same analytical tools might be useful, such tools would be used within the context of Section 2(a)(11) and the rest of the underwriter definition, which—in context—might serve to limit some of the more expansive interpretations of which parties may be liable.
Ultimately, the “necessary participant” doctrine as first stated in Chinese Consolidated would be unlikely to survive a strict textualist Supreme Court review. Chinese Consolidated created a new category for liability, even if a person was not an underwriter. A textualist review would likely limit Section 4(a)(1)’s application to its plain language of only issuers, dealers, or underwriters (as defined in Section 2(a)(11)), not issuers, dealers, underwriters, or those who have engaged in “steps necessary” to the distribution of securities, as in Chinese Consolidated.
Further, a textualist review, grounded in the remainder of Section 2(a)(11) (and taking into account the context of that language), would be narrower. For example, such a review would not eliminate the words “for an issuer” from the Section 2(a)(11) definition of underwriter, meaning that an entity with no contractual arrangement or understanding with the issuer likely would not be considered an underwriter. Deeming an individual or entity integral to distributing an alleged security, and thus liable under Section 5, simply because it provides information about or access to that security, despite no relationship or understanding with the issuer, is unmoored from the plain language of Section 5.
Unless the Supreme Court, other courts of appeal not bound by prior circuit law, or Congress weighs in and ends this eighty-year-long (and counting) detour away from the plain statutory language of the Securities Act, the definition of necessary participant, and the myriad considerations that influence what a “necessary participant” is, will remain unclear for individuals and entities operating in the securities industry and beyond.
