Securities fraud.

• Author: Epstein, Tanya
• Position: Thirteenth Survey of White Collar Crime

1. INTRODUCTION

   Seven statutes regulate securities transactions.(1) Congress passed the most important of these statutes, the Securities Act of 1933 ("1933 Act") and the Securities Exchange Act of 1934 ("1934 Act") as a result of the stock market crash in 1929. Both Acts seek to ensure vigorous market competition by mandating fun and fair disclosure of all material information in the marketplace.

   Section II of this Article first discusses the elements of securities fraud by describing the various activities considered to be substantive fraud under [sections] 10(b) of the 1934 Act(2) and Rule 10b-5 promulgated by the Securities and Exchange Commission ("SEC") under the 1934 Act.(3) Section II then presents definitions of offer, purchase, or sale of securities and the use of interstate commerce or the mails requirement. In addition, this section examines [sections] 32(a) of the 1934 Act(4) to illustrate how civil causes of action can rise to the level of criminal prosecutions where there have been willful violations of [sections] 10(b) or Rule 10b-5. Section III explains common defenses to charges of substantive fraud. Sections IV and V discuss the enforcement mechanisms available to the government and the penalties for committing securities fraud, respectively. Finally, Section VI highlights several recent developments in this area of the law. Practitioners should note that although this article is limited to federal securities law, any securities law issue must be analyzed in conjunction with the applicable state "blue sky"(5) laws that regulate the offering and sale of securities in each state.(6)

2. ELEMENTS OF THE OFFENSE

   Although both the 1933 Act and the 1934 Act provide for various types of criminal conduct,(7) the sections employed in criminal prosecutions for fraud in the purchase or sale of securities are [sections] 10(b) of the 1934 Act,(8) Rule 10b-5 promulgated thereunder,(9) and [sections] 32(a) of the 1934 Act.(10)

   To maintain a securities fraud cause of action under Rule 10b-5, the government must prove the following four elements: (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) the defendant perpetrated the fraud in connection with the purchase or sale of a security or in the offer or sale of a security; (3) the use of interstate commerce or the mails. (4) reliance by the investor, or other effect of the scheme on investors; and (5) willfulness to commit the prohibited act.(11)

   Securities fraud causes of action may be criminal, civil, or administrative in nature.(12) The SEC can initiate only civil and administrative proceedings to investigate potential violations and to rectify past and prevent future violations, while the Department of Justice ("DOJ") has sole jurisdiction over criminal proceedings.(13) Most criminal proceedings result from an SEC investigation and a subsequent SEC referral to the D0J.(14)

   1. Substantive Fraud

      The following three subparts address the three types of fraud that can be a basis for a securities violation: (1) Rule 10b-5 material omissions and misrepresentations; (2) insider trading; and (3) parking.(15)

      1. Material Omissions and Misrepresentations

         Material misrepresentations and omissions give rise to the most common securities fraud actions. Rule 10b-5 proscribes any and all such false statements if made in connection with the purchase or sale of securities.(16) The elements of a Rule 10b-5 cause of action are: (a) a false statement or omission; (b) of a material fact; (c) made with scienter; (d) justifiably relied on by plaintiff, which was causally related to plaintiffs injury.(17) Once the elements of the Rule 10b-5 cause of action are met, a criminal penalty can be imposed under [sections] 32(a) if the government satisfactorily proves a willful violation of the 1934 Act.(18)

         a. Misstatements and Omissions

         In recent years the SEC and DOJ have vigorously prosecuted individuals who misrepresent or omit material information in a securities filing.(19) In SEC v. Texas Gulf Sulphur Co., the Second Circuit defined a misrepresentation or omission as one that conveys a false impression of the facts or is misleading, explaining that this determination is made by inquiring "into the meaning of the statement to the reasonable investor and its relationship to the truth."(20) Misrepresentations and omissions occur in a variety of contexts. For example, the Eighth Circuit convicted an investor for impersonating a broker and making false pretenses in a sale of securities.(21)

         Criminal omissions cases include the Southern District of New York's conviction of a company and its officers for omitting the company's financial problems and falsifying its financial record to make it seem more profitable.(22) The Ninth Circuit upheld the conviction of a defendant who tried to sell non-existent foreign bonds and failed to disclose his previous conviction and fugitive status.(23)

         b. Materiality

         Omitted or misstated information must be material to constitute securities fraud. In TSC Industries, Inc. v. Northway, Inc.,(24) 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 [or her]."(25) Courts deem information 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.(26) 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.(27)

         The TSC Industries Court made it clear that not all omissions or misrepresentations will be viewed as fraudulent; for instance, courts have decided that some prospective information, such as a prediction of anticipated profits, is not material.(28)

         In Basic, Inc. v. Levinson,(29) 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 Rule 10b-5,(30) 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."(31)

         In Basic, Inc., former shareholders who had sold their stock based upon Basic's public statements that it was not engaged in merger negotiations alleged that the corporation had issued materially false or misleading statements.(32) When the merger discussions ultimately succeeded, the former shareholders brought a class action suit.(33) 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."(34) Some lower courts have held that "projections and general expressions of optimism may be actionable under the federal securities laws,"(35) 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."(36)

         In contrast, the Fifth Circuit held that prospectus projections of future performance stated as guarantees were unactionable.(37) The Private Securities Litigation Reform Act of 1995 gives defendants in private actions protection from "forward-looking" statements; hence, the Fifth Circuit's view on prospective statements is likely to prevail over the Ninth's Circuit's holdings.(38)

         c. Scienter

         After establishing the existence of a material omission or misrepresentation, in order to prove a violation of [sections] 10(b) and Rule 10-5, it is necessary to demonstrate that the defendant made the omission or misrepresentation with scienter.(39) In Ernst & Ernst v. Hochfelder,(40) the Supreme Court held that a private cause for damages will not lie under [sections] 10(b) and Rule 10b-5 in the absence of any allegation of scienter, i.e., intent to deceive, manipulate, or defraud on the defendant's part. In a standard adopted by most other circuits, the Seventh Circuit has permitted reckless action by the defendant to meet the scienter requirement.(41)

         d. Reliance

         While reliance is an essential element of a cause of action under Rule 10b-5,(42) specific reliance by the investor need not be shown in a securities fraud prosecution.(43) Instead, the government must show some "impact of the scheme on the investor and that the mails were used in those instances where the impact occurred."(44)

         The United States Supreme Court dealt with the issue of reliance when it first adopted the fraud on the market theory in Basic, Inc. v. Levinson.(45) In that case, the court applied the theory to a material public misrepresentation.(46) The Court held that, "because most publicly available information is reflected in market price, an investor's reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action."(47) Hence, the government must prove five elements before invoking a presumption of reliance: (1) the defendant made public misrepresentations; (2) the misrepresentations were material...