SECURITIES FRAUD

SECURITIES FRAUD

I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1432

II. ELEMENTS OF THE OFFENSE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1434

A. Material Misrepresentations and Omissions . . . . . . . . . . . . . . 1434

1. Use of Interstate Commerce or the Mails . . . . . . . . . . . . . 1435

2. Misstatements and Omissions . . . . . . . . . . . . . . . . . . . . . 1436

3. Materiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1440

4. Intent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1443

a. Scienter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1443

b. Willfulness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1444

5. In Connection with the Purchase or Sale of a Security . . . 1446

a. Def‌inition of a “Security” . . . . . . . . . . . . . . . . . . . . 1446

i. Stocks and Notes Lacking a Prof‌it Motive . . . 1448

ii. Instruments Protected by Other Legislation . . 1452

iii. Instruments Deemed Investment Contracts . . 1453

(1) Investment of Money . . . . . . . . . . . . . . 1454

(2) Common Enterprise . . . . . . . . . . . . . . . 1455

(3) Expectation of Prof‌its. . . . . . . . . . . . . . 1457

(4) “Solely” Through the Efforts of Others . 1458

b. Def‌initions of “Purchase” and “Sale” . . . . . . . . . . . . 1459

6. Reliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1462

7. Causation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1465

a. Transaction Causation . . . . . . . . . . . . . . . . . . . . . . . 1465

b. Loss Causation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1465

B. Insider Trading. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1466

1. The Classical Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . 1467

2. The Misappropriation Theory . . . . . . . . . . . . . . . . . . . . . 1470

3. Strict Regulation Under Rule 14e-3 of Material, Non-Public

Information Regarding Tender Offers . . . . . . . . . . . . . . . 1473

4. “Use” Versus “Knowing Possession” of Inside Information 1474

5. Regulation of Selective Disclosure . . . . . . . . . . . . . . . . . 1475

III. DEFENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1477

A. Intent-Based Defenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1477

1. Lack of Fraudulent Intent . . . . . . . . . . . . . . . . . . . . . . . . 1478

2. “No Knowledge” of the Substantive Rule . . . . . . . . . . . . 1480

3. Good Faith. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1480

4. Reliance on Advice of Counsel . . . . . . . . . . . . . . . . . . . . 1482

B. Reliance-Based Defenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 1483

1. Truth on the Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1483

2. Bespeaks Caution Doctrine . . . . . . . . . . . . . . . . . . . . . . . 1485

1431

C. Defense Based on Legitimacy of Criminalization . . . . . . . . . . 1488

D. Statute of Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1489

IV. ENFORCEMENT MECHANISMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1491

A. SEC Enforcement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1492

1. Development of an Enforcement Action . . . . . . . . . . . . . 1492

2. Administrative Proceedings . . . . . . . . . . . . . . . . . . . . . . 1494

a. Cease and Desist Authority . . . . . . . . . . . . . . . . . . . 1496

b. Monetary Penalties in Administrative Proceedings . . 1496

3. Civil Remedies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1496

a. Injunctive Actions and Ancillary Measures . . . . . . . . 1497

b. Disgorgement and Monetary Penalties . . . . . . . . . . . 1499

4. International Enforcement. . . . . . . . . . . . . . . . . . . . . . . . 1501

B. Criminal Violations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1505

1. DOJ Criminal Enforcement. . . . . . . . . . . . . . . . . . . . . . . 1505

2. Parallel or Subsequent Suits . . . . . . . . . . . . . . . . . . . . . . 1507

3. Contempt Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . 1509

V. PENALTIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1511

VI. RECENT DEVELOPMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1513

A. Internet Securities Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . 1513

B. Disclosure of Information to the Public . . . . . . . . . . . . . . . . . 1515

C. Executive Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1518

D. Legislative and Regulatory Changes . . . . . . . . . . . . . . . . . . . 1519

E. Wiretaps and Expert Networks in Insider Trading Prosecutions 1523

F. High Frequency Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1524

G. Cryptocurrency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1525

H. Recent Enforcement Trends . . . . . . . . . . . . . . . . . . . . . . . . . . 1528

1. “Admit or Deny” Settlement Requirements . . . . . . . . . . . 1528

2. Expanding the Scope of Accountability . . . . . . . . . . . . . . 1529

3. Shifts in the Use of Administrative Proceedings . . . . . . . . 1530

I. INTRODUCTION

Although seven federal statutes govern securities transactions,

1

securities fraud

is primarily regulated through the Securities Act of 1933 (“1933 Act”) and the

1. Securities Act of 1933, 15 U.S.C. §§ 77a–77aa (regulating the distribution of securities); Trust Indenture Act of

1939, 15 U.S.C. §§ 77aaa–77bbbb (regulating the public offering of debt securities to protect capital markets, investors,

and the general public); Securities Exchange Act of 1934, 15 U.S.C. §§ 78a–78nn (providing for regulation and control

of transaction in securities to protect the national public interest therein); Securities Investor Protection Act of 1970, 15

U.S.C. §§ 78aaa–78lll (creating a nonprof‌it membership corporation that covers loss when a securities f‌irm cannot pay

its customer accounts); Investment Company Act of 1940, 15 U.S.C. §§ 80a-1–80a-64 (governing the activity of

publicly owned companies that invest and trade securities); Investment Advisers Act of 1940, 15 U.S.C. §§ 80b-1–80b-

21 (providing for regulation and registration of those in the business of advising others on securities investments); Dodd-

Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (codif‌ied in scattered

Sections of 7, 12, 15, 18, 31, and 42 U.S.C.).

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Securities Exchange Act of 1934 (“1934 Act”). The 1933 and 1934 Acts target dif-

ferent markets: the 1933 Act regulates the primary market, and the 1934 Act regu-

lates the secondary market. Nevertheless, both acts share the same objective:

protecting the national public interest in vigorous market competition by mandat-

ing full and fair disclosure of all material information in the marketplace.

2

Indeed, the primary purpose of both the 1933 Act and the 1934 Act “was to

eliminate serious abuses in [the] largely unregulated securities market by regulat-

ing the capital market of the enterprise system.”

3

In so doing, Congress sought to

create “a broad def‌inition of ‘security’” and to regulate all investments, regardless

of form or the label applied.

4

Both Acts regulate the sale of securities.

5

The key securities fraud provisions

used in criminal prosecutions are Rule 10b-5

6

and Section 32(a) of the 1934 Act.

7

Rule 10b-5 was promulgated under Section 10(b) of the 1934 Act

8

and provides

the foundation for a securities fraud claim. Section 32(a) imposes criminal liability

for willful violations of multiple provisions of the 1934 Act, including Section 10

(b) and the Securities Exchange Commission (“SEC”) rule created thereunder (i.e.,

Rule 10b-5).

9

2. See 15 U.S.C. § 78b (identifying one purpose of the securities law as “to insure the maintenance of fair and

honest markets”); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 195 (1976) (stating that the 1933 Act “was

designed to provide investors with full disclosure of material information concerning public offerings of

securities in commerce”).

3. United Hous. Found., Inc. v. Forman, 421 U.S. 837, 849 (1975).

4. See SEC v. Edwards, 540 U.S. 389, 393 (2004) (quoting Reves v. Ernst & Young, 494 U.S. 56, 61 (1990)).

5. For conduct prohibited under the 1933 Act, see 15 U.S.C. § 77e(a) (def‌ining unlawful sale of unregistered

securities); id. § 77q(a) (def‌ining unlawful use of interstate commerce for the purpose of fraud or deceit); id.

§ 77q(b) (def‌ining unlawful use of interstate commerce for the purpose of offering securities for sale). For

conduct prohibited under the 1934 Act, see 15 U.S.C. §§ 78g(c), 78h, 78q(a) (def‌ining unlawful conduct of

broker-dealers); id. § 78j(a)(1) (def‌ining unlawful short selling of securities); id. § 78n(a) (def‌ining unlawful

proxy solicitation); id. § 78n(e) (def‌ining false statements and fraudulent practices in connection with tender

offers); id. § 78o (def‌ining unlawful conduct of broker-dealers); id. § 78p(a) (def‌ining failure to f‌ile required

statements by an owner of ten percent or more of a class of securities).

6. 17 C.F.R. § 240.10b-5 (2019). Section 17(a), the general fraud provision of the 1933 Act, is also used

occasionally in criminal prosecutions. See 15 U.S.C. § 77q(a). The language of Rule 10b-5 traces the language of

Section 17(a) of the 1933 Act, creating similar obligations. See SEC v. Monarch Funding Corp., 192 F.3d 295,

308 (2d Cir. 1999) (“Essentially the same elements are required under Section 17(a)(1)–(3) [as under Rule 10b-5]

. . . though no showing of scienter is required . . . under subsections (a)(2) or (a)(3).” (citing SEC v. First Jersey

Sec., Inc., 101 F.3d 1450, 1467 (2d Cir. 1996))). But see Finkel v. Stratton Corp., 962 F.2d 169, 175 (2d Cir.

1992) (holding that a private right of action under Section 17(a) is not justif‌ied on the grounds that Rule 10b-5

provides the same cause of action). See generally Brook Dooley, Matan Shacham & Daniel W. Gordon, Section

17(a) of the Securities Act of 1933: Unanswered Questions, 45 SEC. REG. & L. REP. (BNA) No. 27 (July 8, 2013)

(describing the relationship between section 17(a) and Rule 10b-5).

7. 15 U.S.C. § 78ff(a) (“Penalties”).

8. Id. § 78j(b) (authorizing the SEC to prescribe rules “necessary or appropriate in the public interest or for the

protection of investors.”).

9. Id. § 78ff(a).

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