Securities fraud.

• Author: Armstrong, James J.
• Position: Eleventh Survey of White Collar Crime

1. INTRODUCTION II. ELEMENTS OF THE OFFENSE

   1. Substantive Fraud

      1. Material Omissions and Misrepresentations

         1. Misstatements and Omissions

         2. Materiality

         3. Scienter

         4. Reliance

         5. Willfulness

      2. Insider Trading

         1. The Classical Theory

         2. The Misappropriation Theory

         3. Strict Regulation under Rule 14e of Nonpublic

         Information Regarding Tender Offers

      3. Parking

      4. Broker-Dealer Fraud

   2. Offer, Purchase, or Sale

      1. To whom the 1933 and 1934 Acts Apply

      2. Definition of "Security"

      3. Definition of "Offer " and "Sale ": The 1933 Act

      4. Definition of "Purchase" and "Sale ": The 1934 Act

   3. Use of Interstate Commerce or the Mails III. DEFENSES

   1. Intent-Based Defenses

      1. Lack of Fraudulent Intent

      2. "No Knowledge " of the Substantive Rule

      3. Good Faith

      4. Reliance on Counsel

   2. Reliance-Based Defenses

   3. Other Defenses IV. ENFORCEMENT MECHANISMS

   1. SEC Enforcement

      1. Development of an Enforcement Action

      2. Administrative Proceedings

      3. Cease and Desist Authority

      4. Injunctive Actions

      5. International Enforcement

   2. Criminal Enforcement

      1. Criminal Referral

      2. Parallel or Subsequent Suits

      3. Contempt Proceedings V. PENALTIES

1. INTRODUCTION

   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"). The purpose of both Acts is to ensure vigorous market competition by mandating full and fair disclosure of all material information in the marketplace. This article focuses on [sections] 10(b) of the 1934 Act(2) and Rule 10b-5 promulgated under the 1934 Act,(3) outlining the elements of securities fraud by describing the various activities considered to be substantive frauds under these laws. In addition, [sections] 32(a) of the 1934 Act4 is examined to illustrate how civil causes of action can rise to the level of criminal prosecutions where there has been willful violations of [sections] 10(b) or Rule 10b-5. This article also explains common defences to charges of substantive fraud as well as the enforcement mechanisms available to the government.

2. ELEMENTS OF THE OFFENSE

   Although both the 1933 ACt and the 1934 ACt provide for various types of criminal conduct,(5) the sections employed most frequently in criminal prosecutions for fraud in the purchase or sale of securities are [sections] 10(b) of the 1934 Act(6), Rule 0b-5 promulgated thereunder,(7) and [sections] 32(a) of the 1 934 Act(8).

   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; (2) in connection with the purchase or sale of a security or in the offer or sale of a security; (3) employing the use of interstate commerce or the mails. Each area of substantive fraud has itS own necessary elements for establishing a cause of action. In order for the Government to pursue a criminal prosecution, in addition to the three elements set out above, the Government must satifactorily prove that the defendant willfully intended to commit the prohibited act.(9)

   Securities fraud causes of action can be criminal, civil, or administrative in nature.(10) Whereas civil and administrative proceedings may be brought by the SEC to investigate potential violations and to rectify past and prevent future violations, the Department of Justice has sole jurisdiction over criminal proceedings.(11) Most, but not all, criminal proceedings are initiated as the result of an SEC investigation and a subsequent SEC criminal referral to the Department of Justice.(12)

   1. Substantive Fraud

      This section discusses four types of fraud that can be a basis for a securities violation: (1) Rule 10b-5 material omissions and misrepresentations, (2) insider trading, (3) parking, and (4) broker-dealer fraud.

      1. Material Omissions and Misrepresentations

         Material misrepresentations and omissions give rise to the most common type of securities fraud action. Rule 10b-5 proscribes any and all such false statements if they are made in connection with the purchase or sale of series.(13) The four elements of a Rule 10b-5 cause of action are: (a) the defendant made a false statement or omission of (b) a material fact (c) with scienter (d) upon which the injured party justifiably relied and that proximately caused the injured party's damages.(14) Once the four elements of the Rule 10b-5 cause of action are met, a criminal penalty can be imposed under [sections] 32(a) if a willful violation of the 1934 Act is satisfactorily proven by the government.(15)

         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 circumstances, misleading, or engaged in an act, practice or course of business that operated, or would operate, as a fraud or deceit upon a purchaser or seller; (2) participated in the scheme to defraud knowingly, willfully and with intent to defraud; (3) knowingly used, or caused to be used, instrumentalities of interstate commerce in furtherance of the scheme to defraud or fraudulent conduct). omit material information in a securities filing.(16)

            In SEC v. Texas Gulf Sulphur Co.,(17) the Second Circuit defined a misrepresentation or omission as one that conveys a false impression of the facts or is misleading. 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."(18)

            Misrepresentations and omissions have occurred in a variety of contexts. 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.(19) The Eighth Circuit has held that evidence of material representations by former officers of a failed savings and loan association during the private sale of subordinated debentures was sufficient to support their securities fraud convictions.(20)

            The Seventh Circuit upheld the conviction of an Indiana pastor who made false and fraudulent representations and material omissions in the sale of church "Certificates of Deposit" to investors.(21) And the Fourth Circuit upheld the convictions of defendants charged with securities fraud and conspiracy to violate federal securities law in making statements that contained misstatements and omissions of material facts in offering and selling retirement center bonds.(22)

         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.,(23) 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."(24) 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 requires:

            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.(25)

            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.(26)

            In Basic, Inc. v. Levinson,(27) the Supreme Court articulated the standard for materiality with respect to contingent or speculative information. After adopting the TSC Industries standard of materiality for cases arising under 10b-5,(28) the Court held that a finding of materiality with respect to contingent or speculative information 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."(29)

            In Basic, Inc., former shareholders who had sold their stock based on Basic's public statements that it was not engaged in merger negotiations alleged that the corporation had issued materially false or misleading statements.(30) When the merger agreement ultimately was reached, the shareholders brought a class action suit.(31) In applying its standard for contingent or speculative information, the Court held that the materiality of the particular merger discussions is a question of fact to be assessed in light of "indicia of interest in the transaction at the highest corporate levels."(32) Lower courts have held that "projections and general expressions of optimism may be actionable under the federal securities laws,"(33) though they have applied varying standards. The Ninth Circuit, for example, has stated

            A projection or statement of belief contains at least three implicit factual

            assertions: (1) that the statement is genuinely believed, (2) that there is a

            reasonable basis for that belief, and (3) that the speaker is not aware of any

            undisclosed facts tending to seriously undermine the accuracy of the

            statement. A projection or statement of belief may be actionable to the extent

            that one of these implied factual assertions is inaccurate.(34)

            In contrast, the Fifth Circuit has held that prospectus projections of future performance that were stated as guarantees generally are not considered actionable.(35)

         3. Scienter

            After establishing the existence of a material omission or misrepresentation, it becomes necessary, in proving a...