The U.S. Court of Appeals for the Third Circuit has ruled that nonvoting observers on Tibet Pharmaceuticals' board of directors cannot be held liable by shareholders for omissions in the company's registration statement.

The appeals court reversed a decision by a federal judge in New Jersey finding Hayden Zou and L. McCarthy Downs III liable under Section 11 of the Securities Act for omitting negative financial information about Tibet Pharmaceuticals from its registration statement.

Although Zou and Downs had no formal powers or duties with Tibet, and were assigned to the board by the company's placement agent, the registration statement said they might “significantly influence the outcome of matters submitted to the board of directors for approval.” U.S. District Judge John Michael Vazquez said that power to “influence” meant Zou and Downs “arguably had more influence than any individual board member, who could only cast a single vote.”

But the appeals court, by a 2-1 margin, reversed that ruling. Judge Thomas Hardiman, joined by Judge Anthony Scirica, noted that Section 11 imposes near-strict liability for untruths and omissions in a registration statement, and that a plaintiff bringing a Section 11 claim need not allege scienter, reliance or loss causation. Because it is such a powerful measure, Section 11 applies to limited and enumerated categories of defendants, Hardiman and Scirica said. They include any person who, with his consent, is named in the registration as being or about to become a director, a person performing similar functions, or a partner.

Zou was an early investor in Tibet and the sole director of one of its subsidiaries. He recruited Downs, a managing director at investment bank Anderson & Strudwick, in 2009 to help him take Tibet public. They were not signatories to Tibet's registration statement nor named as directors of Tibet. Instead, they are listed as nonvoting board observers chosen by A&S.

Hardiman wrote that Zou and Downs are different from corporate directors in three ways: They cannot vote for board action, they are aligned with the placement agent, A&S, not Tibet; their tenures end automatically, with no opportunity to vote them out; and as agents of the placement agent, their loyalties are not with Tibet's shareholders, and loyalty to shareholders is vital to directorship.

The plaintiffs argued on appeal that the registration statement contains “clear grant of limitless power” to Zou and Downs to “significantly influence the outcomes of the highest-level corporate decision-making.” But Hardiman disagreed, saying the “face of the registration statement confers no actual power upon Zou or Downs.”

Judge Robert Cowen, in his dissent, pointed to language in the registration statement giving Zou and Downs “powers of abilities that are of a like nature or kind as the directors' power to direct or manage the affairs of the corporation.” He said the nonvoting observers may “significantly influence” the outcome of matters submitted to the board of directors and therefore should be liable under Section 11.

Tibet, a British Virgin Islands corporation, develops and manufactures traditional Tibetan medicines in China. Tibet's registration statement, issued in 2010, omitted negative information about a subsidiary, Yunnan Shangri-La Tibetan Pharmaceutical Group Ltd., which defaulted on a loan from the Chinese government. Shortly before Tibet's IPO, the Chinese government froze Yunnan's assets, and later they were auctioned off. That prompted Nasdaq to halt trading in Tibet's stock and its price plummeted. Plaintiffs sued Zou, Downs, Tibet, A&S and the IPO's auditor on behalf of purchasers of Tibet stock.

Michael Tremonte of Sher Tremonte in New York, the lawyer for Zou, said in a statement, “We are pleased that the Third Circuit reached the right result in a thorough and well-reasoned decision. It's a victory not only for our client, but also for the broader class of non-voting board observers and outside advisers. We are also gratified that the court agreed that the question of who is covered by Section 11(a)(3) of the Securities Act of 1933 should be decided as a matter of law, based solely on the text of the registration statement and without reference to extrinsic factors. This decision provides welcome clarity in an area of law that previously lacked judicial guidance.”

A. Neil Hartzell of Freeman, Mathis & Gary in Boston, representing Downs, said, “The plaintiffs were arguing an overexpansive reading of Section 11 to include board observers as persons who were strictly liable under the statute, when they simply don't have the same responsibilities and duties as directors. We're glad that the Third Circuit provided clarity on this issue.”

Laurence Rosen of the Rosen Law Firm in South Orange, representing the plaintiff investors, did not respond to requests for comment.