Securities fraud.

• Author: Yeager, Christopher A.
• Position: III. Defenses through VI. Recent Developments, with footnotes, p. 1706-1747 - Annual Survey of White Collar Crime

3. DEFENSES

   There are two broad categories of securities fraud defenses: (A) intent-based defenses; and (B) reliance-based defenses. Intent-based defenses attempt to show that the defendant acted without scienter, (278) 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. (279)

   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. (280) 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. (281) Defendants typically assert one of four arguments to undermine the intent element: (1) lack of fraudulent intent; (2) "no knowledge" of the substantive rule; or (3) good faith; or (4) reliance on the advice of counsel.

      1. Lack of Fraudulent Intent

         A defendant may defend against a securities fraud allegation by arguing that she did not act "willfully." (282) In the securities fraud context, a willful act is one that the defendant realizes is wrongful and that "involve[s] a significant risk of effecting the violation that has occurred." (283) Courts require general intent to commit a fraudulent act, not specific intent to violate a securities law. (284) To avoid liability, the defendant therefore must show that the act was "the result of innocent mistake, negligence or inadvertence or other innocent conduct." (285) However, even mistake, negligence, or inadvertence is not a defense where the defendant should have known that the activity was unlawful or where the defendant was deliberately ignorant of the fraudulent nature of the activity. (286) Additionally, some cases suggest that the government's burden of proving intent may be met using only circumstantial evidence. (287)

         Alternatively, defendants may demonstrate a lack of intent to commit insider trading violations by presenting evidence of a pre-existing plan to trade in the securities prior to possession of insider information. (288) "[A]n investor who has a preexisting plan to trade, and who carries through with that plan after coming into possession of material nonpublic information, does not intend to defraud or deceive; he simply intends to implement his pre-possession financial strategy." (289) The pre-existing plan defense is more likely to be successful in a jurisdiction that follows the "actual use" rule; a jurisdiction that follows the "knowing possession" rule will presume that a trade made while the defendant was knowingly in possession of material nonpublic information was made on the basis of that information. (290) The Ninth and Eleventh Circuits have adopted the "use test." (291) 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. (292) 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. (293)

      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." (294) 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. (295) Because there is a penalty limitation, the defendant bears the burden of demonstrating lack of knowledge. (296) This defense has met with limited success because only the defendant who did not know her conduct was "contrary to law" may use it. (297) The defendant cannot avoid conviction simply by claiming that she was unaware her conduct violated a specific securities regulation. (298)

      3. Good Faith

         A defendant may offer the defense of "good faith" to rebut a showing of willfulness. (299) Good faith refers to the defendant's honest belief in the truth of the allegedly fraudulent statements (300) and not a defendant's belief in the ultimate success of the venture. (301) Good faith is more aptly described as a "quasi- defense" because the defendant has no burden to produce evidence of good faith; (302) the government has the burden to prove willful intent to defraud. (303) 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. (304)

         However, similar to the deliberate ignorance limit discussed above, (305) some courts refuse to recognize a good faith defense when the defendant's belief in the truth of the statements was "based upon nothing more than a reckless disregard of the truth." (306)

      4. Reliance on Advice of Counsel

         A defendant may also invoke the "advice of counsel" defense. (307) 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. (308) 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. (309) Note that asserting an advice of counsel defense waives privilege with respect to the contents of the advice. (310)

         To warrant a jury instruction on the reliance 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. (311) A defendant cannot claim that counsel failed to discover or "ferret out" proof of wrongdoing from defendant's disclosure of the facts. (312) 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." (313) 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. (314) Finally, a defendant may not rely on the advice of counsel defense if the counsel possesses a conflict of interest with respect to the client's allegedly fraudulent conduct. (315)

   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. (316)

         In Basic, pursuant to the fraud on the market theory, the Supreme Court noted that the price of a security in an open and developed securities market will accurately reflect all information available, including any misstatements or misrepresentations. (317) The Court presumed that a victim who buys a security from the open market relied on the market price as a measure of the security's true value and therefore also relied on the misstatements or misrepresentations that influenced the market price. (318)

         The Basic court also held that defendants can rebut this presumption (319) with what became known as the truth on the market defense. (320) "Any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price will be sufficient to rebut the presumption of reliance." (321) One example of evidence of severance is evidence that information correcting the original misrepresentation "has been made credibly available to the market by other sources." (322) 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." (323) Similarly, the defendant could show that the purchasers obtained stock for reasons unrelated to the stock price to defeat fraud on the market theory. (324) Such evidence would prove that the misrepresentation did not affect the purchaser's actions. (325)

      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. (326) 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. (327) Courts applying the doctrine deem that the statements at issue were not materially misleading and that the plaintiff could not have reasonably relied on the statements, thereby defeating an element of the plaintiff's prima facie case. (328) The bespeaks caution doctrine is therefore typically asserted in a motion to dismiss for failure to state a claim or a motion for summary judgment. (329)

         The bespeaks caution doctrine requires a fact-based inquiry to judge the reasonableness of the plaintiff's reliance on the defendant's statements. (330) Courts have accordingly refused to create per se rules that certain types of predictions always bespeak caution. (331) "To put it another way, the 'bespeaks caution' doctrine merely reflects the unremarkable proposition that statements must be analyzed in context." (332) In context...