INTRODUCTION II. ELEMENTS OF THE OFFENSE A. Material Misrepresentations and Omissions 1. Misstatements and Omissions a. Entanglement Liability 2. Materiality 3. Intent a. Scienter b. Willfulness 4. 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 Federal Legislation iii. Instruments Deemed Investment Contracts a. Investment of Money b. Common Enterprise c. Expectation of Profits. d. Solely Through the Efforts of Others b. Definitions of "Purchase" and "Sale" c. Use of Interstate Commerce or the Mails 5. Reliance B. Insider Trading a. The Classical Theory b. The Misappropriation Theory c. Strict Regulation Under Rule 14e-3 of Non-public Information Regarding Tender Offers d. Use Versus Knowing Possession of Inside Information e. 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 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. Criminal Referrals 2. Parallel or Subsequent Suits 3. Contempt Proceedings V. PENALTIES VI. RECENT DEVELOPMENTS I. INTRODUCTION
Although there are six 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, but the objective of both is the same: to ensure vigorous market competition by mandating full and fair disclosure of all material information in the marketplace. (2)
Although both the 1933 Act and the 1934 Act deem various types of conduct unlawful, (3) the key authorities utilized in criminal prosecutions of securities fraud 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 the 1934 Act, including violations of section 10(b) and the SEC rules promulgated under that provision (e.g. Rule 10b-5). (7)
Practitioners should note that this article is limited to federal securities law. Any securities law issue must be analyzed in conjunction with applicable state "blue sky" (8) laws, which regulate the offering and sale of securities in each state. (9)
ELEMENTS OF THE OFFENSE
TWO main types of fraud may form the basis for securities violations: (A) material misrepresentations, omissions, or both; and (B) insider trading. (10)
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 omission of material fact in connection with the purchase or sale of securities (11) may be criminally or civilly liable under Rule 10b-5. (12)
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 a showing that the defendant acted "willfully" in violating the federal securities laws. (13)
To succeed on a civil claim for securities fraud under Rule 10b-5, a plaintiff must show that the defendant made (i) a misstatement or omission (14) (ii) of material fact (15) (iii) with scienter (16) (iv) in connection with the purchase or the sale of a security (17) (v) upon which the plaintiff reasonably relied (18) and (vi) that the plaintiff's reliance proximately caused his or her injury. (19) Once these elements of the Rule 10b-5 cause of action are shown, a criminal penalty can be imposed under section 32(a) if the government provides sufficient proof that the violation of the 1934 Act was willful. (20)
Misstatements and Omissions
In the landmark decision SEC v. Texas Gulf Sulphur Co., (21) the Second Circuit defined a misrepresentation or omission as an act that conveys a false impression of the facts or is misleading. (22) The court explained that this determination requires inquiry "into the meaning of the statement to the reasonable investor and its relationship to the truth." (23)
Any form of publicized deception can create liability. (24) 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." (25)
a. Entanglement Liability
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., (26) the Second Circuit expanded the traditional limits on Rule 10b-5 liability and created the "entanglement liability" doctrine. (27) 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. (28) The Elkind court did not find the requisite "entanglement" because the company neither provided the analysts with the information for the reports nor represented that the reports were accurate or reflected the views of the company. (29)
Following Elkind, courts have differed on what level of involvement constitutes "sufficient entanglement." (30) Generally, courts have held that merely providing misleading information upon which the allegedly false forecast in the analyst's report is based does not satisfy the entanglement requirement. (31) Instead, courts have sought to determine whether the degree of interaction between the analysts and the company officers resulted in the company officers putting their "imprimatur, express or implied, on the projections." (32) Thus, many courts have required a "two way" flow of information for the officers to be held liable for the false report. (33) 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. (34)
Securities fraud occurs only when omitted or misstated information is material. (35) In TSC Indus., Inc. v. Northway, Inc., (36) 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." (37) The Court thus 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. (38) 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. (39) Not all misrepresentations or omissions in connection with a security transaction, however, are fraudulent. (40)
Courts view general expressions of optimism by a company as strong evidence of immateriality. (41) Courts have distinguished between (i) generally optimistic statements and (ii) numerically specific predictions. (42) The former is considered no more than "puffery," and thus immaterial as a matter of law, (43) while the latter is considered an actionable claim. (44) Thus, the specificity with which a company predicts its financial performance can determine the issue of materiality. (45)
After establishing the existence of a material omission or misrepresentation, a plaintiff must prove the requisite degree of intent in order to establish a violation of section 10(b) and Rule 10b-5. (46) Civil plaintiffs must meet a scienter requirement, discussed in subsection (a), while criminal cases, discussed in subsection (b), require a showing that the defendant acted with willfulness.
In civil causes of action, scienter must be proven in order to establish intent. (47) Scienter is defined as an "intent to deceive, manipulate, or defraud" by the defendant. (48) A private cause of action for damages under section 10(b) and Rule 10b-5 cannot stand without an allegation of scienter. (49) but scienter can be inferred from the facts. (50) The Seventh Circuit has permitted a defendant's reckless action to meet the scienter requirement, and most circuits have followed suit; however, courts have narrowly limited the definition of recklessness to exclude ordinary negligence. (51)
Whereas the SEC uses section 10(b) and Rule 10b-5 in civil and administrative actions, the DOJ utilizes section 32(a) of the 1934 Act in criminal proceedings. Section 32(a) provides criminal penalties for willful violations of the Act or its rules. (52) Therefore, willful violations of "section 10(b) of the Act and the Commission's Rule 10b-5 thereunder ... admittedly qualify" under section 32(a) as criminal. (53)
A defendant acts willfully when his actions are intentional, deliberate, and are not the result of an innocent mistake, negligence, or inadvertence. (54) Although the government must establish that the defendant had some evil purpose (55) and intended to commit the prohibited act...
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