Securities fraud.

Author:Brennan, Jason C.
Position:Tenth Survey of White Collar Crime

Seven statutes regulate securities transactions.(1) In the aftermath of the stock market crash of 1929, Congress passed the most important of these statutes, the Securities Act of 1933 ("1933 Act") and the Securities Exchange Act of 1934 ("1934 Act"). Their purpose is to ensure vigorous market competition by mandating full and fair disclosure of all material information in the marketplace. This article focuses primarily on Section 17(a) of the 1933 Act,(2) section 10(b) of the 1934 Act,(3) and Rule l0b-5 promulgated under the 1934 Act,(4) outlining the elements of securities fraud by describing the various activities considered to be substantive frauds under these laws. This article also explains common defenses to charges of substantive fraud as well as the enforcement mechanisms available to the government. Due to the frequent overlap of civil and criminal law in securities regulation, this article incorporates an overview of the law in the civil context in addition to exploring securities fraud as a white collar crime.


    Although both the 1933 Act and the 1934 Act provide for various types of criminal conduct,(5) the section employed most frequently in criminal prosecutions for fraud in the purchase or sale of securities is section 10(b) of the 1934 Act(6) and Rule l0b-5 promulgated thereunder.(7)

    To maintain a securities fraud cause of action, three elements must be proven: (1) the existence of a substantive fraud, including material misrepresentations or omissions, a scheme or artifice to defraud, or a fraudulent act, practice, or course of business;(8) (2) in connection with the purchase or sale of a security or in the offer or sale of a security;(9) and (3) employing the use of interstate commerce or the mails.(10) In addition, each area of substantive fraud has its own necessary elements for establishing a cause of action.

    1. Substantive Fraud

  2. Material Omissions and Misrepresentations

    Material misrepresentations and omissions give rise to the most common type of securities fraud action. Rule l0b-5 proscribes any and all such false statements if they are made in connection with the purchase or sale of securities.(11) In order to establish liability under the 1934 Act, four elements must be shown: (1) the defendant committed a misstatement or omission of a material fact; (2) which was made with scienter; (3) on which the plaintiff reasonably relied; and (4) which proximately caused the plaintiff's injury.(12)

    1. Misstatements and Omissions

      In recent years, the Securities and Exchange Commission ("SEC") and the Department of Justice have vigorously prosecuted individuals who misrepresent or omit material information in a securities filing.(13)

      The Fifth Circuit has upheld the conviction of a businessman involved in a scheme to inappropriately use corporate funds to cover loan payments used to expedite the sale of a company,(14) and has found a land developer liable for failing to disclose material facts regarding his property in connection with a bond offering.(15) The Seventh Circuit has found a stock purchaser liable for falsely denying his intention to make a tender offer,(16) and other circuits have found defendants liable for misrepresentations and omissions in projections if those projections failed to suggest reliability, were not sufficiently cautious in tone, were not made in good faith, or were not founded on sound factual or historic bases.(17)

      Liability has also been found in cases involving omissions and misrepresentations in connection with the sale of real estate limited partnerships,(18) misstatements regarding a stock purchaser's true speculative intentions,(19) and nondisclosure of a corporation's economic condition.(20)

    2. Materiality

      Merely demonstrating an omission or misstatement is insufficient to prove securities fraud unless the information is material. In TSC Industries, Inc. v. Northway, Inc.,(21) 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."(22) Information is deemed material if it would be significant to the person relying on it in his or her investment decision. The Court stated that this materiality standard contemplates:

      a showing of a substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder. Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available.(23)

      While the Court in TSC Industries made it clear that not all omissions or misrepresentations will be viewed as fraudulent, the issue of whether prospective information, such as predictions of anticipated profits, could be material was not decided.(24) In the lower courts, case law in the area of forward looking statements has held that "projections and general expressions of optimism may be actionable under the federal securities laws."(25)

      In Basic Inc. v. Levinson,(26) the Supreme Court recognized the potential materiality of prospective information regarding preliminary merger negotiations. Discussions of a possible merger began between Basic and Combustion Engineering in late 1976. Basic made three public statements in the period between 1977 and 1978 denying that it was engaged in such negotiations.(27) When a merger agreement ultimately was reached in late 1978, former Basic shareholders, who had sold their stock between the date of Basic's first denial of corporate developments and the suspension of trading in late 1978, brought a class action suit against Basic and its board of directors. They alleged that Basic had issued materially false or misleading statements in violation of section 10(b) of the 1934 Act and Rule l0b-5.(28)

      After adopting the TSC Industries standard of materiality for cases arising under Rule l0b-5,(29) the Supreme Court held that a finding of materiality based on contingent or speculative information or events depends "upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity."(30) The materiality of particular merger discussions is, therefore, a question of fact to be assessed in light of "indicia of interest in the transaction at the highest corporate levels."(31) Thus, a plaintiff must show that the statements were misleading as to a material fact in order to succeed on a Rule l0b-5 claim. "It is not enough that a statement is false or incomplete, if the misrepresented fact is otherwise insignificant."(32) In general, an omitted fact is material if there is a substantial likelihood that the investor would consider it important in making an investment decision.(33)

    3. Scienter

      After establishing the existence of a material omission or misrepresentation, it becomes necessary, in proving a violation of the 1934 Act, to demonstrate that the defendant made the omission or misrepresentation with scienter.(34) The idea of reckless scienter in securities fraud cases, as opposed to negligence, was put forth by the Supreme Court in Ernst & Ernst v. Hochfelder.(35) Most circuits agree with the definition of recklessness expounded by the Seventh Circuit, which requires an "extreme departure from the standards of ordinary care . . . presenting a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it."(36)

    4. Reliance

      In List v. Fashion Park, Inc.,(37) the Second Circuit articulated a test for reliance which requires a showing as to whether the plaintiff would have acted differently if the truth was made known.(38) Subsequent decisions have created two exceptions to the requirement that direct reliance be shown. The first is found in Affiliated Ute Citizens of Utah v. United States,(39) where positive proof of reliance is not a prerequisite to recovery if the information withheld is material. Instead, a rebuttable presumption of reliance is created when the defendant fails to disclose a material fact.(40) The second exception, first enunciated by the Ninth Circuit in Blackie v. Barrack,(41) is based on a "fraud on the market" theory and expands the scope of Affiliated Ute to cover material misrepresentations that adversely affect the market price of stock traded in efficient markets.(42)

      The United States Supreme Court first adopted the fraud on the market theory in Basic, Inc. v. Levinson(43) when it applied the theory to a material public misrepresentation. According to Levinson, the plaintiff must prove five elements before invoking a presumption of reliance. Plaintiff must allege and prove that: (1) the defendant made public misrepresentations; (2) the misrepresentations were material; (3) the shares were traded on an efficient market; (4) the misrepresentations would induce a reasonable, relying investor to misjudge the value of the shares; and (5) the plaintiff traded the shares between the time the misrepresentations were made and the time the truth was revealed.(44)

      The statute of limitations period for Section 10(b) actions is a combination of a one-year period after discovery of the violations with a three-year period in which to discover the violations to be applied retroactively to all pending litigation.(45) This prompted Congress to pass Section 476 of the Federal Deposit Insurance Corporation Improvement Act of 1991,(46) which amends Section 27A of the 1934 Act and reestablishes pre-Lampf limitations for cases pending on the date Lampf was decided. Section 27(A)(b) allowed for actions dismissed under Lampf's retroactivity rule to be reinstated within sixty days of December 19, 1991.(47)

  3. Insider Trading

    Insider trading...

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