INTRODUCTION II. ELEMENTS OF THE OFFENSE A. Substantive Fraud 1. Material Misrepresentations and Omissions a. Misstatements and Omissions b. Materiality c. Intent i. Scienter ii. Willfulness d. Reliance e. Entanglement Liability 2. 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 B. Defining Offer, Purchase, or Sale of a Security 1. Definition of "Security" a. Stocks and Notes Lacking a Profit Motive b. Instruments Protected by Other Federal Legislation c. Instruments Deemed Investment Contracts or Certificates of Interest i. Investment of Money ii. A Common Enterprise iii. Expectation of Profits iv. Solely Through the Efforts of Others 2. Definition of "Offer" and "Sale": The 1933 Act 3. Definition of "Purchase" and "Sale": The 1934 Act C. Use of Interstate Commerce or the Mails 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. Other Defenses 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
The Securities Act of 1933 ("1933 Act"), the first of seven statutes enacted to regulate the federal securities transactions, (1) was a congressional response to fraud in securities markets and the perceived lack of public information about the stock markets. (2) The Securities and Exchange Commission (SEC) came into being with the enactment of the Securities Exchange Act of 1934 ("1934 Act"), one of the stated aims of which is to ensure vigorous market competition by mandating full and fair disclosure of all material information in the marketplace. (3) The 1933 Act regulates the primary market, whereas the 1934 Act regulates the secondary market.
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" (4) laws that regulate the offering and sale of securities in each state. (5)
ELEMENTS OF THE OFFENSE
Both the 1933 Act and the 1934 Act prohibit various types of criminal conduct. (6) Section 10(b) of the 1934 Act, (7) Rule 10b-5 promulgated thereunder, (8) and section 32(a) of the 1934 Act are the sections utilized in a criminal prosecution for the purchase or sale of securities. (9)
To state a valid claim for securities fraud under section 10(b) and Rule 10b-5, the plaintiff must allege that the defendant (i) made a misstatement or an omission of a material fact; (10) (ii) with scienter; (11) (iii) in connection with the purchase or the sale of a security; (12) (iv) upon which the plaintiff reasonably relied; (13) and (v) the plaintiff's reliance was the proximate cause of his or her injury. (14)
Securities fraud causes of action may be criminal, civil, or administrative in nature. (15) The SEC can initiate civil and administrative proceedings to investigate, rectify, and prevent violations. (16) However, only the Department of Justice ("DOJ") has jurisdiction over criminal prosecutions)7 Most criminal prosecutions result from an SEC investigation and subsequent referral to the DOJ. (18)
The following subparts address two types of fraud that can be bases for securities violations: (i) Rule 10b-5 material misrepresentations and omissions and (ii) insider trading. (19)
Material Misrepresentations and Omissions
Material misrepresentations and omissions give rise to the most common securities fraud actions. Rule 10b-5 proscribes any false statements made in connection with the purchase or sale of securities. (20) Any person "who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies" may be criminally or civilly (21) liable under Rule 10b-5. (22) Once the elements of the Rule 10b-5 cause of action are met, a criminal penalty can be imposed under section 32(a) if the government satisfactorily proves a willful violation of the 1934 Act. (23)
Under Rule 10b-5, the elements of a civil cause of action and a criminal prosecution are similar. Both require a false statement or an omission of a material fact; however, willfulness is required for criminal liability to attach. (24) For civil liability, the plaintiff needs to prove scienter. (25)
a. Misstatements and Omissions
In recent years the SEC and DOJ have vigorously prosecuted individuals who misrepresent or omit material information in securities filings. (26) In the landmark decision SEC v. Texas Gulf Sulphur Co., (27) the Second Circuit defined a misrepresentation or omission as an act that conveys a false impression of the facts or is misleading. (28) The court explained that this determination is made by inquiring "into the meaning of the statement to the reasonable investor and its relationship to the truth." (29)
Prosecutions by the SEC and DOJ for misstatements or omissions are not limited to filings. Any form of publicized misstatement or omission can create liability. (30) Courts have read Rule 10b-5 as prohibiting any deceit that materially affects the purchase or sale of securities--the deception need not necessarily concern the value of the stock. (31)
Securities fraud occurs only when omitted or misstated information is material. (32) In TSC Indus., Inc. v. Northway, Inc., (33) 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." (34) The Court thus required a showing of substantial likelihood that, in light of all the circumstances, the omitted fact would have had actual significance in the deliberations of the reasonable shareholder. (35) In other words, a substantial likelihood must exist that a reasonable investor would have viewed the disclosure of the omitted fact as having significantly altered the "total mix" of information available. (36) However, not all omissions or misrepresentations in connection with the purchase or sale of a security are fraudulent. (37)
There is a growing body of case law that treats general expressions of optimism by a company as immaterial per se. (38) Courts have distinguished between (i) generally optimistic statements and (ii) numerically specific predictions. (39) The former is considered no more than "puffery," and thus immaterial as a matter of law, (40) while the latter is considered an actionable claim. (41) Thus, the specificity with which a company predicts its financial performance can determine the issue of materiality. (42)
After establishing the existence of a material omission or misrepresentation, a plaintiff must prove requisite intent in order to establish a violation of section 10(b) and Rule 10b-5. (43) Civil plaintiffs must meet a scienter requirement, discussed in subsection (i), while criminal cases, discussed in subsection (ii), are judged by a standard of willfulness.
In civil causes of action, scienter must be proved to establish intent. (44) Scienter is defined as an intent to deceive, manipulate, or defraud on the defendant's part. A private cause of action for damages under section 10(b) and Rule 10b-5 cannot stand without an allegation of scienter. (45) 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 not encompass ordinary negligence. (46)
Whereas the SEC uses section 10(b) and Rule 10b-5 in civil and administrative cases, 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 rules47 and 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. (48)
A defendant acts willfully when he acts intentionally and deliberately and his actions are not the result of an innocent mistake, negligence, or inadvertence. (49) While proof of specific intent is not needed, the government must establish that the defendant had some evil purpose (50) and intended to commit the prohibited act. (51)
Section 32(a) confirms that an individual who lacks awareness of the existence of an applicable section or rule may still be convicted of willfully violating the 1934 Act. (52) Penalties for such a conviction, however, do not necessarily entail imprisonment. (53)
While civil actions require scienter and criminal actions require willfulness, it is unclear whether there is a meaningful distinction between the terms. In other words, it is debatable whether willfulness in criminal cases requires something above the ordinary scienter required in civil cases. At least one commentator has argued that "courts have interpreted the term 'willfully,' as used in [section] 32, to mean that only ordinary scienter is necessary to support a criminal conviction." (54) This may be because "[section] 32 was drafted before [section] 10(b) was interpreted to require a showing of scienter." (55) Until a court interpreting section 32(a) addresses the meaning of "willfully" in that provision, this question remains unresolved.
Although reliance is an essential element of a...
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