Securities fraud.

Author:Anthony, Jason
Position:Fourteenth Survey of White Collar Crime

    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") in response to both fraud in the securities markets as well as a perceived lack of public information in the stock markets.(2) Both Acts seek to ensure vigorous market competition by mandating full and fair disclosure of all material information in the marketplace.(3)

    This Article discusses the methods by which the Acts monitor the securities markets. Section II analyzes securities fraud under [sections] 10(b) of the 1934 Act(4) and Rule 10b-5 promulgated by the Securities and Exchange Commission ("SEC") under the 1934 Act.(5) Section II analyzes the various activities that compromise the securities laws, provides definitions of offer, purchase, or sale of securities, and explains the use of interstate commerce or the malls requirement. In addition, this section examines [sections] 32(a) of the 1934 Act(6) 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"(7) laws that regulate the offering and sale of securities in each state.(8)


    Although both the 1933 Act and the 1934 Act prohibit various types of criminal conduct,(9) the sections employed in criminal prosecutions for fraud in the purchase or sale of securities are [sections] 10(b) of the 1934 Act,(10) Rule 10b-5 promulgated thereunder,(11) and [sections] 32(a) of the 1934 Act.(12)

    To maintain a securities fraud cause of action under Rule 10b-5, the government must prove: (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.(13)

    Securities fraud causes of action may be criminal, civil, or administrative in nature.(14) 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.(15) Most criminal proceedings result from an SEC investigation and a subsequent SEC referral to the DOJ.(16)

    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.(17)

      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.(18) A defendant can be both criminally and civilly liable under Rule 10b-5. The elements of a Rule 10b-5 civil cause of action and a 10b-5 criminal proceeding are similar. Both require a false statement or omission of a material fact made with scienter. "Impact of the scheme on the investor" is required for criminal liability to attach, whereas for civil liability, the plaintiff must prove reliance by the plaintiff, which was causally related to the plaintiff's injury.(19) 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.(20)

        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.(21) In SEC v. Texas Gulf Sulphur Co.,(22) the Second Circuit defined a misrepresentation or omission as an act 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."(23)

        Misrepresentations and omissions occur in a variety of contexts. For example, the Eighth Circuit convicted an investor for misrepresentation for impersonating a broker and making false statements in the sale of securities.(24) A court in the Southern District of New York's granted summary judgment against the defendant on an omission theory, holding that the company and its officers participated in the sale of unregistered common stock, deceived public investors as to the true financial status of the corporation, and falsified accounting records.(25) Meanwhile, 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.(26)

        b. Materiality

        Omitted or misstated information must be material to constitute securities fraud. In TSC Industries, Inc. v. Northway, Inc.,(27) 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."(28) The Court stated that this materiality standard requires a showing of a substantial likelihood that, under all the circumstances, the omitted fact would have had actual significance in the deliberations of the reasonable shareholder.(29) 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 available.(30)

        The TSC Industries Court made it clear that not all omissions or misrepresentations should be hewed as fraudulent; for instance, courts have decided that some prospective information, such as a prediction of anticipated profits, is not material.(31)

        In Basic, Inc. v. Levinson,(32) 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,(33) 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."(34)

        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.(35) When the merger discussions ultimately succeeded, the former shareholders brought a class action suit.(36) In applying its standard for contingent or speculative information, the Court held that the materiality of the particular merger discussions was a question of fact to be assessed in light of "indicia of interest in the transaction at the highest corporate levels."(37) Some lower courts have held that "projections and general expressions of optimism may be actionable under the federal securities laws,"(38) 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."(39)

        c. Intent

        After establishing the existence of a material omission or misrepresentation, requisite intent must then be proved in order to establish a violation of [sections] 10(b) and Rule 10b-5.(40) Subsection (i) explains the scienter requirement for civil causes of action. Subsection (ii) analyzes the criminal standard of willfulness.

        i. Scienter

        The intent requirement for a civil cause of action is scienter.(41) In Ernst & Ernst v. Hochfelder,(42) 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.(43) In a standard adopted by most other circuits, the Seventh Circuit has permitted reckless action by the defendant to meet the scienter requirement.(44)

        ii. Willfulness

        Whereas the SEC uses [sections] 10(b) and Rule 10b-5 in civil and administrative cases, DOJ utilizes [sections] 32(a) of the 1934 Act to bring criminal proceedings. Section 32(a) provides criminal penalties for willful violations of the Act, rules, or regulations thereunder.(45) A willful violation, therefore, of "section 10(b) of the Act and the Commission's Rule 10b-5 thereunder ... admittedly qualify" under [sections] 32(a).(46)

        A defendant acts willfully when he acts intentionally and deliberately and not as the result of innocent mistake, negligence, or inadvertence.(47) Although a plaintiff need not prove specific intent to disregard or disobey the law, the plaintiff must establish that the defendant had some evil purpose.(48) To prevail in a criminal case, the government must prove that the defendant intended to commit the...

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