Securities fraud.

• Author: Gross, Rebecca
• Position: III. Defenses through VI. Recent Developments, with footnotes, p. 1255-1286 - Twenty-Seventh Annual Survey of White Collar Crime

3. DEFENSES

   There are two broad categories of securities fraud defenses: intent-based defenses and reliance-based defenses. Intent-based defenses attempt to show that the defendant acted without scienter, (249) while reliance-based defenses attempt to show that no market participant relied upon the defendant's omissions or misrepresentations in deciding to purchase or sell a security. (250)

   1. Intent-Based Defenses

      To successfully prosecute a securities fraud action under section 32(a) of the 1934 Act, a section that prescribes penalties for violations involving false and misleading statements, the government must prove that a defendant willfully committed a particular act. (251) Thus, a typical defense to a securities fraud charge begins with a denial that the defendant carried out any violations with a criminal or fraudulent purpose. (252)

      1. Lack of Fraudulent Intent

         A defendant may vitiate a government securities fraud allegation by arguing that she did not "willfully" violate the securities laws and, therefore, lacked the requisite fraudulent intent. (253) Acting willfully has been defined as acting '"deliberately and intentionally ... [where] acts, statements or omissions were not the result of innocent mistake, negligence or inadvertence or other innocent conduct.'" (254) Deliberate ignorance of the true nature of the activity, however, is not a defense to a securities law violation. (255)

         To satisfy the willfulness requirement, the prosecution must show "'that the act [was] wrongful under the securities laws and that the knowingly wrongful act involve[d] a significant risk of effecting the violation that has occurred.'" (256) However, a violation may be willful if the defendant intends to knowingly make misrepresentations and omissions in order to induce action that would otherwise not have been taken regardless of whether the defendant knew of the particular rule or regulation that she violated. (257) Finally, some cases suggest that the government's burden of proving intent may be met using only circumstantial evidence. (258)

         Alternatively, defendants may demonstrate a lack of intent by presenting evidence of a pre-existing plan to trade in the securities prior to possession of insider information. (259) The pre-existing plan defense requires an initial finding by the court that it is the use, and not merely "knowing possession," of material, non-public information "that gives rise to an informational advantage and the requisite intent to defraud" and establishes a sufficient basis for an insider trading conviction. (260) The Ninth and Eleventh Circuits have adopted the "use test." (261) Courts that prefer the "knowing possession" standard over the "actual use" standard have either not addressed the validity of the pre-existing plan defense or have disallowed it. (262) In 2000, the SEC promulgated Rule 10b5-1, which bars trading "on the basis" of material, non-public information and allows three affirmative defenses similar to the pre-existing plan defense. (263)

      2. "No Knowledge" of the Substantive Rule

         A defendant may assert a "no knowledge" defense. Section 32(a) of the 1934 Act provides that "no person shall be subject to imprisonment under this section for the violation of any rule or regulation if he proves that he had no knowledge of such rule or regulation." (264) A successful "no knowledge" defense, however, does not eliminate the possibility of a conviction or a fine; proving lack of knowledge simply means that, if convicted, the defendant will not be imprisoned. (265) Because there is a penalty limitation, the defendant bears the burden of demonstrating lack of knowledge. (266) This defense has met with limited success because only the defendant who did not know her conduct was "contrary to law" may use it. (267) The defendant cannot avoid conviction simply by claiming that she was unaware her conduct violated a specific securities regulation. (268)

      3. Good Faith

         A defendant may offer the defense of "good faith" to rebut a showing of willfulness. (269) Good faith is more aptly described as a "quasi-defense" because the defendant has no burden to produce evidence of good faith; (270) the government has the burden to prove willful intent to defraud. (271) Good faith does not refer to a defendant's belief in the ultimate success of the venture, (272) but to the defendant's honest belief in the truth of the allegedly fraudulent statements. (273)

         After the jury determines that fraud exists, it may weigh any evidence presented by the defendant and the prosecution to determine whether the defendant acted in good faith. (274) However, a defendant's failure to exercise due diligence in ascertaining the truth of any representations will militate against a finding of good faith. (275)

      4. Reliance on Advice of Counsel

         A defendant may also invoke the "advice of counsel" defense. (276) Like the good faith defense, advice of counsel is not a complete defense, but instead a factor for the jury to consider while determining willfulness. (277) To succeed, the defendant must show: (i) a request for advice of counsel regarding the legality of the proposed action, (ii) full disclosure of all relevant facts to counsel, (iii) assurance by counsel of the action's legality, and (iv) good faith reliance on counsel's advice. (278)

         To warrant a jury charge on advice of counsel, the defendant must show that her reliance on counsel was reasonable and predicated on a full accounting of the facts to counsel by the defendant. (279) A defendant cannot claim that counsel failed to discover or "ferret out" proof of wrongdoing from defendant's disclosure of the facts. (280) The advice of counsel defense requires actual reliance on the advice given; the defendant "cannot hide now behind legal advice which it chose to ignore." (281) Furthermore, a defendant may not assert reliance upon non-legal advice, such as an assurance that documents are being produced for review by a regulatory body, given by her counsel. (282) Finally, if counsel possesses a conflict of interest with regard to the allegedly violative conduct of the client, then the defense becomes unavailable to the defendant-client. (283)

   2. Reliance-Based Defenses

      1. Truth on the Market

         Generally, the government must prove direct reliance on an omission or misstatement in order to convict a criminal defendant for securities fraud. One exception to this rule is the "fraud on the market" theory analyzed in Basic Inc. v. Levinson. (284)

         In Basic, pursuant to the fraud on the market theory, the Supreme Court held that the price of a security in an open and developed securities market will accurately reflect all information available, including any misstatements or misrepresentations. (285) Thus, if a victim relied on the price as an accurate reflection of the security's worth, a presumption of reliance on the original misstatement is established. (286)

         The Basic Court acknowledged that this presumption could be refuted by "[a]ny showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the [victim], or his decision to trade at a fair market price." (287) This severance occurs when information correcting the original misrepresentation "has been made credibly available to the market by other sources." (288) This defense to the fraud on the market theory of reliance has been entitled "truth on the market." (289)

         The Second, Fourth, Fifth, Seventh, and Ninth Circuits have expressly recognized the truth on the market defense. (290) This defense recognizes that if the market has become aware of concealed information, the facts omitted by defendant would already be reflected in the stock's price and the market will not be misled. (291) Some courts have held that a defendant may rebut fraud on the market by proof that information challenging the misrepresentation was readily available. (292) However, to ensure that the challenging information was entered "credibly" into the market, the defendant may have to show that the withheld or misrepresented information was "transmitted to the public with a degree of intensity and credibility sufficient to effectively counterbalance any misleading impression created by [the defendant's] one-sided representations." (293)

         Similarly, if the purchasers obtained stock for reasons unrelated to its price, the theory of fraud on the market will fail (294) because the misrepresentation did not affect the purchaser's actions. (295)

      2. Bespeaks Caution Doctrine

         An alternative reliance-based defense is the "bespeaks caution doctrine," which recognizes that securities issuers cannot guarantee predictions made in forward- looking statements. (296) This doctrine, applicable to civil actions only, operates to protect issuers from liability that might otherwise stem from forward-looking statements when those statements are framed in cautionary terms. (297)

         Courts utilize this doctrine to dismiss securities fraud claims based on two fact-dependent approaches. (298) The first approach, followed by the Ninth Circuit, protects defendants when the cautionary language is so strongly worded that the statement could not mislead a reasonable investor. (299) In In re Syntex Corp. Securities Litigation, (300) the defendant pharmaceutical company entered into a consent decree with the Food and Drug Administration. (301) In its Annual Report, the defendant stated that it did not anticipate the consent decree having an adverse effect on operations. The court held that the defendant's Annual Report "bespoke caution" because the "[d]efendants expressly acknowledged that the precise effect of the consent decree could not be known and that the company was merely stating its opinion that the consent decree would not have any material adverse effect." (302)

         The second approach treats cautionary language as removing the plaintiff's right to rely upon the allegedly fraudulent statements as a matter of law. If...