Chapter 16 - § 16.4 • ELEMENTS OF RULE 10B-5

§ 16.4 • ELEMENTS OF RULE 10B-5

Rule 10b-5 was promulgated by the SEC under the authority granted to it in § 10. Rule 10b-5 is patterned after § 17(a) of the 1933 Act. Both are applicable to "any person," and they divide fraud into three parts in substantially identical language, although each subsection of Rule 10b-5 prohibits slightly different conduct in connection with the purchase or sale of a security.7 The rule, as a whole, is considered to be synonymous with fraud.8

The elements of a Rule 10b-5 violation, in addition to the required jurisdictional allegations, are described in the following sections.

§ 16.4.1Plaintiff Is A Purchaser Or Seller Of Securities

First, the plaintiff must be a purchaser or seller of securities, according to Blue Chip Stamps v. Manor Drug Stores.9 In Chanoff v. U.S. Surgical Corp.,10 the court upheld the trial court's dismissal of an action under Rule 10b-5 when the plaintiffs had retained securities as a result of allegedly misleading statements. The trial court stated "that because the crux of the plaintiffs' claims are for fraudulent inducement to retain shares, they are . . . not purchasers or sellers [of securities]"11 and therefore did not have a private right of action under Rule 10b-5.

Birnbaum v. Newport Steel Corp.12 pre-dated the Blue Chip Stamps case. In Birnbaum, the Second Circuit held that only the actual purchaser or seller of stock could seek relief under Rule 10b-5.

In Kinsey v. Cendant Corp.,13 the court held that a holder of stock options was not a "purchaser of securities" for the purposes of claims under § 10(b).

An oral agreement to purchase stock that is not enforceable as a result of the statute of frauds is not a "sale" for the purposes of Rule 10b-5. In Kagan v. Edison Brothers Stores, Inc.,14 the plaintiffs sued under Rule 10b-5 for damages in the amount they would have received had the sale taken place.

Securities dealers and would-be investors who were unable to buy stock in an initial public offering lacked standing to bring a Rule 10b-5 claim when the stock rose significantly in value following the offering. The dealers and prospective investors claimed that they had been promised the opportunity to purchase the shares, and the underwriter subsequently reneged.15

In Lincolnshire L.P. v. Essex LLC,16 the court found that claims by a company that it was fraudulently induced to deposit funds with a broker in anticipation of receiving preferential pricing in an upcoming public offering met the Blue Chip Stamps test and, therefore, were actionable.

Acceptance of an employment compensation package that includes a promise to create a stock option involves a "purchase" of securities within the meaning of Rule 10b-5.17

In Leisure Founders Inc. v. CUC International,18 the defendants had promised the plaintiff a consulting position and stock options in exchange for the sale of his stock; this met the "in connection with" requirement.19 In In re Leslie Fay Cos., Inc. Securities Litigation,20 a fraudulent audit report filed with the issuer's Form 10-K annual report was held to be in connection with a subsequent sale of securities (which used the Form 10-K disclosure).

In SEC v. Zandford,21 the U.S. Supreme Court held that the misappropriation of client funds by a broker occurred "in connection with" a purchase or sale of securities and, therefore, the broker involved could be held civilly liable under Rule 10b-5. In the decision, the Supreme Court rejected the Fourth Circuit's conclusion that the conduct complained of must bear some "relationship to market integrity or investor understanding" to be actionable under § 10(b).22

In In re Carter-Wallace, Inc. Securities Litigation,23 the court found that technical advertisements for a product (in this case an anti-epileptic drug) in a scientific journal forms a part of the information on which the market relies. Thus, marketing materials, according to the court, can be the basis of a Rule 10b-5 action if the plaintiff can show that the marketing information reached the stock market through analysts and other professionals. As the court found that the Carter-Wallace complaint alleged fraud-on-the-market, "a straightforward cause and effect" test applied, under which the plaintiff need only show that statements that manipulate the market are connected to resultant stock trading.24

According to the Third Circuit, the "in connection with" element of a § 10(b) claim may be established by showing that the misrepresentations in question were material and that they were disseminated to the public in a medium upon which a reasonable investor would rely.25

In Laub v. Faessel,26 the court found that a man who allegedly misrepresented his expertise as an investment adviser could not be held liable for fraud under § 10(b) because the alleged misconduct did not occur "in connection with" a securities transaction. The plaintiffs complaint did not allege that the adviser's misstatements "caused the loss incurred under any specific stock in [the plaintiffs] portfolio."27 Rather, the plaintiff alleged "that, due to [the adviser's] deceit, he paid [the adviser] for fraudulent services from which he may have been induced to purchase as he did."28 The complaint alleged no claim that the losses flowed directly from the adviser's misrepresentations.

If there is no purchase or sale of securities, then fraudulent statements, no matter how misleading, cannot support a Rule 10b-5 claim. In Production Resource Group. LLC v. Stonebridge Partners Equity Fund. L.P.,29 Stonebridge made allegedly fraudulent statements to Production in negotiations of an acquisition by Production, which was never completed. The court dismissed the securities fraud claims.

The plaintiff's purchase or sale must have been "contemporaneous" with the transaction by the defendant. When insider trading is involved, the court in Wilson v. Comtech Telecommunications Corp.30 held that the duty of disclosure on the part of inside traders in the open market is owed only to those investors trading contemporaneously. In Neubronner v. Milken,31 the court upheld the dismissal of an action where the plaintiff had alleged a three-year period of contemporaneous trading. According to the court, this lacked sufficient particularity as required by F.R.C.P. 9(b).

§ 16.4.2Securities Are Offered Or Sold By Fraudulent Scheme Or Material Misstatement Or Omission

A "fraudulent scheme" for the purposes of Rule 10b-5 may include an investor's pattern of purchasing a company's common stock at or near the end of the trading day to cause the stock to close on an "uptick."32 On the other hand, where the evidence shows that the damages were the result of mismanagement rather than fraud, liability under Rule 10b-5 will not be found.33

As stated in TSC Industries, Inc. v. Northway, Inc., materiality is "a mixed question of law and fact. . . . The determination requires delicate assessments of the inferences 'a reasonable shareholder' would draw from a given set of facts and the significance of those inferences to him, and these assessments are peculiarly ones for the trier of fact."34 The Supreme Court has rejected any attempt to impose a "bright line" test to define materiality.35 (For a more detailed discussion of materiality, see § 14.11, "The Concept of Materiality.")

When a party to a securities transaction communicates information to another who will use that information in connection with the transaction, the former assumes the duty to communicate any additional qualifying information, the absence of which would render the information communicated misleading.36

When a bank has commented on the quality of its management and its loan portfolio, the comments have caused otherwise potentially immaterial issues to become material. In such a case, the statements must be truthful.

[I]t is not a violation of the securities laws to fail to characterize [certain management] practices as inadequate, meaningless, . . . or ineffective . . . . However, where a defendant affirmatively characterizes management practices as "adequate" . . . and the like, the subject is "in play." By addressing the quality of a particular management practice, a defendant declares the subject of its representation to be material to the reasonable shareholder, and thus is bound to speak truthfully.37

Although most courts interpret F.R.C.P. 9(b) to require that the complaint contain specific allegations against individual defendants regarding their participation in the scheme,38 some courts permit a "group pleading" — alleging claims against a group of persons who likely put together the challenged documents. The Ninth Circuit developed the "group pleading doctrine" holding in Wool v. Tandem Computers, Inc.:39

In cases of corporate fraud where the false or misleading information is conveyed in prospectuses, registration statements, annual reports, press releases, or other "group-published information," it is reasonable to presume that these are the collective actions of the officers. . . . Under such circumstances, a plaintiff fulfills the particularity requirement of Rule 9(b) by pleading the misrepresentations with particularity and where possible the roles of the individual defendants in the misrepresentations.40

The Fifth Circuit further explained the group pleading doctrine in a 2004 case by stating: "Under this doctrine, the plaintiff need not allege any facts demonstrating an individual defendant's participation in the particular communication containing the misstatement or omission where the defendants are 'insiders or affiliates' of the company."41 The Third Circuit, however, has rejected the group pleading doctrine, stating:

Assuming Winer [could] properly plead violations of Rule 10b-5, it contends the Individual Defendants are liable for misrepresentations and omissions based upon the group pleading doctrine. . . . In rejecting this argument, the District Court held the group pleading doctrine did not

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