Chapter 9
| Jurisdiction | United States |
Section 10(b) of the 1934 Securities Exchange Act and Rule 10b-5 are the basis for most securities litigation. As interpreted, they are probably the broadest statute and rule in the securities laws. There is very little legislative history about them. (The only comment that was made during the meeting of the Commission that approved the rule was "We are against fraud, aren't we?".)
There is no express right of action for private plaintiffs. The private right of action was only implied by the courts. (But the PSLRA certainly now assumes the existence of a private right of action under Section 10(b).)
The Writing of Rule 10b-5
The rule was written in one day in 1942 by Milton Freeman, an SEC official in Philadelphia:
It was one day in the year 1943 I believe. I was sitting in my office in the SEC building in Philadelphia and I received a call from Jim Treanor who was then the Director of Trading and Exchange Division. He said "I have just been on the telephone with Paul Rowan . . . and he told me about the president of some company in Boston who is going around buying up the stock of his company from his own shareholders at $4 a share and he has been telling them that the company is doing very badly, whereas in fact the earnings are going to be quadrupled" . . . . So he comes upstairs and I called in my secretary and I looked at Section 10(b) and I looked at Section 17, and I put them together, and the only discussion we had there was where "in connection with the purchase or sale" should be, and we decided to put it at the end.
We called the Commission and we got on the calendar and I don't remember whether we got there that morning or after lunch. We passed a piece of paper around to all the commissioners. All the commissioners read the rule and they tossed it on the table indicating approval. Nobody said anything except Sumner Pike, who said "well, we are against fraud, aren't we?" That is how it happened.1
What Is Prohibited?
Rule 10b-5 expands on the sparse relevant wording of Section 10(b) (prohibiting any manipulative or deceptive device or contrivance) and lists in more detail the activities that are prohibited. They are listed below. Note that the last element, "in connection with the purchase or sale of any security," is not in itself a prohibition but applies to each of the preceding prohibitions.
• use of any means or instrumentality of interstate commerce or mails or any facility of any national securities exchange;
• to employ any device, scheme, or artifice to defraud;
• to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
• to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person;
• in connection with the purchase or sale of any security (not necessarily the plaintiff's).
"In connection with" has been interpreted broadly by the courts. In SEC v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1966) (en banc), the Second Circuit said any misstatement violates Rule 10b-5 if it is reasonably calculated to influence investors. For example, it has been applied to "churning" customer accounts by brokers. See Rizek v. SEC, 215 F.3d 157 (1st Cir. 2000). Rizek invested in zero-coupon bonds and churned them for unsophisticated investors, ostensibly for their benefit. He argued that there was no proof of scienter, but the court found that he lied about what he was doing.
Does the "in connection with" need to be with respect to the shares purchased by the plaintiff? The cases suggest that the test is met so long as the fraud "touches" the purchase or sale of any security by anyone. See, e.g., Superintendent of Insurance v. Bankers Life & Casualty Co., 404 U.S. 6 (1971) (court seems to reject by clear implication that the "in connection with" requirement had to relate to the value of the securities being purchased). But this is far from a settled issue, as we will see in a moment.
On the one hand, we know that when the SEC is a plaintiff or when the Department of Justice brings a criminal case under Section 10(b), there is no requirement that they prove reliance or causation. So the "in connection with" that they must prove clearly does not have to be with respect to purchases or sales that they made. Note that the "in connection with" requirement in the rule is the same no matter who is the plaintiff.
On the other hand, Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), suggests that the private plaintiff must have actually purchased or sold securities. So does the fraud have to be "in connection with" that specific purchase or sale? Professor C. Edward Fletcher answers that question by writing that Blue Chip Stamps imposes a non-textually based standing require-ment.2 But what if the plaintiff is claiming reliance on the efficiency of the market, not on the actual fraud itself? Can it be said that the fraud was "in connection with" his or her actual purchase? Probably not, but she still has a cause of action if the fraud is "impounded" into the market price of the stock in question, even if she was unaware of it. But many cases confuse causation with the "in connection with" requirement. As Fletcher noted, "courts simply have been unable to articulate principles for the interpretation and application of this requirement."3 Fletcher asserts—with good reason—that part of the problem is that actions under Section 10(b) and Rule 10b-5 come in too many different situations, and it is difficult if not impossible to define "in connection with" in a way that can easily be applied in those different situations.
A Brief History of "In Connection With"
Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d Cir. 1952), was the first appellate case to discuss the issue. In that case, the directors of Newport rejected an offer of a merger that would have been beneficial to the Newport shareholders and instead accepted a higher price from a rival steel user that wished to take control of Newport and use it as a "captive" supplier. The Newport shareholders sued under Rule 10b-5 claiming that a communication to them had been false and misleading. The district court held that under Rule 10b-5, the fraud could only be perpetrated on the purchaser or seller, and that the rule had no relationship to breaches of fiduciary duty by corporate insiders resulting in fraud upon those who were not purchasers or sellers. The Second Circuit agreed. "While the rule may have been somewhat loosely drawn its meaning and scope are not difficult to ascertain when reference is had to the scheme of SEC Regulation and the purpose underlying the adoption of Rule 10b-5. . . . The Commission was attempting only to make the same prohibitions contained in Section 17(a) of the 1933 Act applicable to purchasers as well as to sellers. . . . The Commission simply copied Section 17(a), adding the words 'any person' in place of 'the purchaser' and a final clause 'in connection with the purchase or sale of any security'. . . . That section was directed solely at that type of misrepresentation or fraudulent practice usually associated with the sale or purchase of securities rather than at fraudulent mismanagement of corporate affairs." In other words, corporate mismanagement is not a violation of Section 10(b) or Rule 10b-5. Rather, the fraud must be "of the type usually associated" with the purchase or sale and the plaintiff must be an actual purchaser or seller.
In Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6 (1971), there was an elaborate scheme by a manager to use Manhattan Casualty Co. assets to purchase its stock and sell it to a person named Begole (not further identified). The lower court said there was no violation because the transactions themselves were lawful. The Supreme Court held that it was "in connection with" a purchase or sale because Manhattan was injured as an investor through a deceptive device that deprived it of any compensation for its block of securities. It was irrelevant that fraud was committed by a manager because the fraud went beyond mismanagement. Because the fraud related to the recipients of the proceeds of the sale, it was irrelevant that the deception did not relate to the value of the security being sold. The deceptive practices touched the purchase or sale of a security. This was the key takeaway.
The leading "purchase or sale" case is Blue Chip Stamps v. Manor Drugs, 421 U.S. 723 (U.S. 1975), which adopted the Birnbaum test. In that case, the Supreme Court limited standing to persons who are purchasers or sellers and in that case, there were no purchasers or sellers. In Merrill Lynch v. Dabit, 547 U.S. 71 (2006), where the plaintiffs merely held their securities when, had they known the truth they would have sold them, there were no actual purchasers or sellers, but the Supreme Court said that Blue Chip was based on policy considerations, not a factual analysis, and in that case, the Court did not "define the words 'in connection with the purchase or sale.'"
Under the 1933 Act, "sale or sell" includes "every contract of sale or disposition of a security or interest in a security for value." See Section 2(3). Dabit distinguishes standing from violation and emphasizes that the Supreme Court has given a broad definition to "in connection with." Let us see just how broad the definition is.
In SEC v. Zandford, 535 U.S. 813 (2002), a broker persuaded an elderly man to open a joint investment account with his mentally retarded daughter. The broker had a general power of attorney. When the old man died, it turned out that all of the money was gone. The broker was indicted for wire fraud for selling the stocks in the elderly man's account. The SEC then sued him for violating Section 10(b) and Rule...
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