Securities fraud.

AuthorYeager, Christopher A.
PositionI. Introduction through II. Elements of the Offense, p. 1661-1706 - Annual Survey of White Collar Crime

SECURITIES FRAUD I. Introduction II. Elements of the Offense. A. Material Misrepresentations and Omissions 1. Use of Interstate Commerce or the Mails. 2. Misstatements and Omissions. 3. Materiality. 4. Intent. a. Scienter b. Willfulness 5. In Connection with the Purchase or Sale of a Security a. Definition of "Security " i. Stocks and Notes Lacking a Profit Motive ii. Instruments Protected by Other Legislation iii. Instruments Deemed Investment Contracts a. Investment of Money b. Common Enterprise c. Expectation of Profits d. Solely Through the Efforts of Others. 5. Definitions of "Purchase "and "Sale" 6. Reliance 7. Causation a. Transaction Causation b. Loss Causation B. Insider Trading 1. The Classical Theory 2. The Misappropriation Theory 3. Strict Regulation Under Rule 14e-3 of Material, Non-Public Information Regarding Tender Offers 4. "Use" Versus "Knowing Possession" of Inside Information 5. Regulation of Selective Disclosure III. Defenses A. Intent-Based Defenses 1. Lack of Fraudulent Intent 2. "No Knowledge" of the Substantive Rule 3. Good Faith 4. Reliance on Advice of Counsel B. Reliance-Based Defenses 1. Truth on the Market 2. Bespeaks Caution Doctrine C. Defense Based on Legitimacy of Criminalization D. Statute of Limitations IV. Enforcement Mechanisms A. SEC Enforcement 1. Development of an Enforcement Action 2. Administrative Proceedings a. Cease and Desist Authority b. Monetary Penalties in Administrative Proceedings 3. Civil Remedies a. Injunctive Actions and Ancillary Measures b. Disgorgement and Monetary Penalties 4. International Enforcement B. Criminal Violations 1. DOJ Criminal Enforcement 2. Parallel or Subsequent Suits 3. Contempt Proceedings V. Penalties. VI. Recent Developments A. Internet Securities Fraud B. Disclosure of Information to the Public C. Executive Stock Options D. Legislative Changes E. Wiretaps and Expert Networks in Insider Trading Prosecutions F. Recent Enforcement Trends 1. "Admit or Deny" Settlement Requirements 2. Expanding the Scope of Accountability a. Gatekeepers b. Mid-level Employees I. INTRODUCTION

Although there are seven federal statutes that govern securities transactions, (1) securities fraud is primarily regulated through the Securities Act of 1933 ("1933 Act") and the Securities Exchange Act of 1934 ("1934 Act"). The 1933 Act and 1934 Act target different markets: the 1933 Act regulates the primary market, and the 1934 Act regulates the secondary market. Despite focusing on different markets, both acts share the same objective of ensuring vigorous market competition by mandating full and fair disclosure of all material information in the marketplace. (2)

Both the 1933 Act and the 1934 Act regulate the offer and sale of securities. (3) In the context of securities fraud, the key provisions utilized in criminal prosecutions are Rule 10b-5 (4) and section 32(a) of the 1934 Act. (5) Rule 10b-5 was promulgated under section 10(b) of the 1934 Act (6) and provides the foundation for a securities fraud claim. Section 32(a) imposes criminal liability for willful violations of section 10(b) of the 1934 Act, the Securities Exchange Commission ("SEC") rules promulgated under that provision (e.g., Rule 10b-5), and other provisions of the Act. (7)

The primary purpose of the 1933 and 1934 Acts was to eliminate abuses in a largely unregulated securities market by regulating the capital system of the enterprise market. (8) In so doing, Congress sought to regulate investments, regardless of their form or the label applied to them. (9) 494 U.S. 56, 61 (1990)).

It is important to note that this Article is limited to federal securities law. Any securities law issue must be analyzed in conjunction with applicable state "blue sky laws," (10) which regulate the offering and sale of securities in each state. (11)


Two main types of fraud generally form the basis for securities violations: (A) material misrepresentations, omissions, or both; and (B) insider trading. (12)

  1. Material Misrepresentations and Omissions

    Material misrepresentations and omissions give rise to the most common securities fraud actions. Any person who employs a deceptive device or makes a false statement or an omission of material fact in connection with the purchase or sale of securities (13) may be criminally or civilly liable under Rule 10b-5. (14) Criminal prosecution under section 10(b) of the 1934 Act and Rule 10b-5 requires proof of elements similar to those required to maintain a Rule 10b-5 civil action. In order for criminal liability to attach, however, there must be an additional showing that the defendant acted "willfully" in violating the federal securities laws. (15)

    To succeed on a civil claim for securities fraud under Rule 10b-5, a plaintiff must show that a defendant (1) using interstate commerce or the mails (16) made (2) a misstatement or omission (17) (3) of material fact (18) (4) with scienter (19) (5) in connection with the purchase or the sale of a security (20) (6) upon which the plaintiff reasonably relied (21) and (7) that the plaintiff's reliance proximately caused his or her injury. (22) Once these elements of the Rule 10b-5 cause of action are shown, and if the government provides sufficient proof that the violation of the 1934 Act was willful, a criminal penalty can be imposed under section 32(a). (23)

    1. Use of Interstate Commerce or the Mails

      Jurisdiction under federal securities laws depends on the "use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange." (24) Under section 10(b) of the 1934 Act, this jurisdictional requirement requires only the "intrastate use of ... [an] interstate means of communication, or any other interstate instrumentality." (25) Interstate communication can occur between any persons involved in the fraudulent act, including between codefendants. (26) The use of any means of interstate transportation will also suffice. (27) Finally, the use of an interstate instrumentality need only be incidental to the transaction to bring the action within federal jurisdiction. (28)

    2. Misstatements and Omissions

      In the landmark decision SEC v. Texas Gulf Sulphur Co., the Second Circuit defined a misrepresentation or omission as an act that conveys a false impression of the facts or is misleading. (29) The court explained that this determination requires inquiry "into the meaning of the statement to the reasonable investor and its relationship to the truth." (30)

      Any form of publicized deception can create liability. (31) The misrepresentation or omission need not concern the value of the stock; "[i]t is enough that the scheme to defraud and the sale of securities coincide." (32)

      In Janus Capital Group v. First Derivative Traders, the Supreme Court found that only the "maker" of the untrue statement will be liable under Rule 10b-5, with a statement's maker being "the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it." (33) Many lower courts have interpreted Janus to have raised the pleading bar in private securities fraud actions seeking to hold defendants liable for others' misstatements, requiring the allegation that the defendant made or had ultimate authority over the statement at issue at the pleading stage. (34)

      Under certain circumstances, a company may be liable under Rule 10b-5 for misstatements or omissions made by persons outside the company. In Elkind v. Liggett & Myers, Inc., the Second Circuit expanded the traditional limits of Rule 10b-5 liability and created the "entanglement liability" doctrine. (35) Under this doctrine, misstatements or omissions in the reports of investment analysts may be attributed to a company if the company "sufficiently entangled" itself in the production of the analysts' reports. (36)

      Following Elkind, courts have disagreed over what level of involvement constitutes "sufficient entanglement." (37) Generally, courts have held that merely providing misleading information that serves as the basis for the allegedly false forecast in the analyst's report does not satisfy the entanglement requirement. (38) Courts have determined that in order to be liable for unreasonably disclosed third-party forecasts, company officers must put their "imprimatur, express or implied, on the projections." (39) Thus, many courts have required a "two-way" flow of information for the officers to be held liable for the false report. (40) To prove the existence of a two-way flow of information, the Ninth Circuit has required that (i) a company insider provided misleading information to an analyst, (ii) the analyst relied on the information, and (iii) the insider endorsed or approved the report prior to or after its publication. (41)

    3. Materiality

      Securities fraud occurs only when omitted or misstated information is material. (42) In TSC Industries, Inc. v. Northway, Inc., the Supreme Court explained that determining materiality "requires delicate assessments of the inferences a 'reasonable shareholder' would draw from a given set of facts and the significance of these inferences to him." (43) What is material in one situation, however, may not be in another; materiality cannot be reduced to a bright-line rule. (44) Thus, the Court required a showing of a substantial likelihood that, in light of all the circumstances, the omitted fact would have had actual significance in the deliberations of a reasonable shareholder. (45) In other words, a misstated or omitted fact is material if substantial likelihood exists that a reasonable investor would have viewed the disclosure of the omitted fact as having significantly altered the "total mix" of information available. (46)

      However, not all misrepresentations or omissions in connection with a security transaction, however, are fraudulent. (47) Courts traditionally view general expressions of optimism by a company as...

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