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Plaintiffs who purchased securities in a private offering cannot have a cause of action under �12(a)(2) of the Securities Act of 1933, a federal appeals court has ruled. The 2nd U.S. Circuit Court of Appeals joined three other circuits in holding that �12(a)(2), which governs an offering “by means of prospectus,” does not include private transactions. The ruling in Yung v. Lee, 04-3139-cv, was issued by Judges Reena Raggi, Dennis Jacobs and Robert Sack, with Judge Raggi writing for the panel. In 1998 and 1999, Hong Kong residents Billy Yung and his father, Yung Yau, acquired in a series of private transactions shares in Integrated Transportation Network Group, a wholly owned subsidiary of the Dawson Science Corp. The purchases, by private subscription and letter agreements, were the culmination of a series of meetings between Yung and ITNG representatives, including a final meeting with Andrew Lee, the company’s president and director. The meetings covered the potential for expansion into the Chinese market for auto leasing and the value of taxi licenses held by the company, which was verified by audited financial statements. ITNG also gave the plaintiffs a prospectus prepared in connection with a separate offering of ITNG stock to Dawson shareholders — one that included an audit report prepared by public accountants BDO Seidman. In May 1999, the plaintiffs discovered that ITNG was in a “dire” financial position, with previously undisclosed liabilities and “major problems” with its transportation businesses and properties in China. The prospectus, they claimed, was filled with false and misleading statements and omissions that concealed just how bad the company’s finances were. Southern District Judge Deborah Batts dismissed their securities claim after concluding that �12(a)(2) of the Securities Act does not cover private securities transactions. At the 2nd Circuit, Raggi said that, prior to 1995, the 2nd Circuit and other courts had ruled that �12(a)(2) applies to private as well as public offerings of securities. But in 1995, the U.S. Supreme Court decided Gustafson v. Alloyd Co., 513 U.S. 561 (1995), holding that a private sales contract could not be considered a prospectus. The Supreme Court said �12(a)(2) liability “cannot attach unless there is an obligation to distribute the prospectus in the first place (or unless there is an exemption).” A prospectus, the Supreme Court said, “is a term of art referring to a document that describes a public offering of securities by an issuer or a controlling shareholder.” Raggi said Gustafson’s “narrow construction of the term ‘prospectus’ as used in �12(a)(2) has drawn sharp criticism.” “No matter,” she said, ” … the Supreme Court’s interpretation of a statute binds lower federal courts in their application of that statute.” And while the circuit “has not had to reach the issue of whether the rationale for decision in Gustafson, which involved a private secondary sale, necessarily precludes a �12(a)(2) claim with respect to any private securities action,” she said, district courts in the circuit have often cited Gustafson for the conclusion that purchasers in private or secondary markets cannot bring actions under the statute. And three sister circuits, the 1st, 5th and 10th, have reached the same conclusion. “We now join these courts in holding that Gustafson’s definition of a prospectus as ‘a document that describes a public offering of securities’ compels the conclusion that a �12(2)(a) action cannot be maintained by a plaintiff who acquires securities through a private transaction, whether primary or secondary,” Raggi said. The lack of an “obligation” by ITNG to publicly distribute the prospectus, she said, was fatal to the plaintiffs’ case. Steven J. Cohen of Wachtel & Masyr represented the plaintiffs. Christopher H. Lunding and Inna Reznick of Cleary, Gottlieb, Steen & Hamilton represented BDO International, which served as ITNG’s principal independent auditor, and BDO Binder, which also issued ITNG audit reports. Greg A. Danilow of Weil, Gotshal & Manges represented BDO Seidman.

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