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 1. The Classical Theory 2. The Misappropriation Theory 3. Strict Regulation Under Rule 14e-3 of 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. 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
While 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 and 1934 Acts 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: ensuring vigorous market competition by mandating full and fair disclosure of all material information in the marketplace. (2)
Although both the 1933 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 is the foundation of a securities fraud claim. Section 32(a) deals with willful violations of the 1934 Act.
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" (7) laws that regulate the offering and sale of securities in each state. (8)
ELEMENTS OF THE OFFENSE
There are two main types of fraud that can be bases for securities violations: (A) material misrepresentations and/or omissions, and (B) insider trading. (9)
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. (10) 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 (11) liable under Rule 10b-5. (12)
Under Rule 10b-5, the elements of a civil cause of action and a criminal prosecution are very similar. The only difference is that in order for criminal liability to attach, a showing of willfulness is required in addition to the elements of a civil claim under Rule 10b-5. (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; (ii) of material fact; (14) (iii) with scienter; (15) (iv) in connection with the purchase or the sale of a security; (16) (v) upon which the plaintiff reasonably relied; (17) and (vi) that the plaintiff's reliance was the proximate cause of his or her injury. (18) 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 satisfactorily proves a willful violation of the 1934 Act. (19)
Misstatements and Omissions
In recent years the SEC and DOJ have vigorously prosecuted individuals who misrepresent or omit material information in securities filings. (20) 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 is made by inquiring "into the meaning of the statement to the reasonable investor and its relationship to the truth." (23)
Prosecutions by the SEC and DOJ for misstatements or omissions are not limited to filings made under the 1934 Act. Any form of publicized misstatement or omission can create liability. (24) 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. (25)
a. Entanglement Liability
Under certain circumstances, a Corporation can be found liable under Rule 10b-5 for misstatements or omissions made by others. Specifically, a Corporation may be liable for misstatements or omissions in the written reports of investment analysts if the company was "sufficiently entangled" in the production of the reports. (26) The Second Circuit altered traditional Rule 10b-5 liability and developed the "entanglement liability" doctrine in Elkind v. Liggett & Myers, Inc., (27) where the executives from Liggett & Myers, Inc. were not held liable for failing to correct or comment on the overly optimistic earnings forecasts pursuant to a policy of not commenting on analyst report forecasts. (28) However, the court also held that a company might be liable for the misstatements or omissions of an analyst report if the company has "sufficiently entangled itself with the analyst's forecasts to render those predictions attributable to it" (29)
Following Elkind, courts have differed on what level of involvement constitutes "sufficiently" entangled. (30) Generally, courts have held that merely providing the misleading information upon which the allegedly false forecast in the analyst 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 corporate officers resulted in the corporate officers putting their "imprimatur, express or implied, on the projections." (32) Thus, many courts have required a "two way" flow of information for the corporate 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 corporate 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 there is a substantial likelihood that a reasonable investor would have viewed the disclosure of the omitted fact as having significantly altered the "total mix" of information available. (39) However, not all omissions or misrepresentations in connection with the purchase or sale of a security are fraudulent. (40)
There is a growing body of case law that treats general expressions of optimism by a company as immaterial per se. (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 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 (i), while criminal cases, discussed in subsection (ii), 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 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, (48) but scienter can be inferred from the facts. (49) 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. (50)
Whereas the SEC uses section 10(b) and Rule 10b-5 in civil and administrative cases, 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. (51) Therefore, willful...
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