Securities Fraud

• Author: Todd Kowalski/Matthew Gayden/Luke Meyer/Anne Mummery/Carly Sullivan/Dylan Seong Taeg Kang/Alan Wayne
• Pages: 1245-1320

SECURITIES FRAUD

I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1246

II. ELEMENTS OF THE OFFENSE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1247

A. Material Misrepresentations and Omissions . . . . . . . . . . . . . 1248

1. Use of Interstate Commerce or the Mails . . . . . . . . . . . . 1248

2. Misstatements and Omissions . . . . . . . . . . . . . . . . . . . . . 1249

3. Materiality ..

.

.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1253

4. Intent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1254

a. Scienter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1255

b. Willfulness. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1256

5. In Connection with the Purchase or Sale of a Security . . . 1257

a. Definition of a “Security”. . . . . . . . . . . . . . . . . . . . 1257

i. Stocks and Notes Lacking a Profit Motive . . . . 1258

ii. Instruments Protected by Other Legislation . . . 1261

iii. Instruments Deemed Investment Contracts . . . . 1262

(1) Investment of Money . . . . . . . . . . . . . . . 1263

(2) Common Enterprise . . . . . . . . . . . . . . . . 1263

(3) Expectation of Profits . . . . . . . . . . . . . . . 1265

(4) “Solely” Through the Efforts of Others . . 1266

b. Definitions of “Purchase” and “Sale”. . . . . . . . . . . . 1267

6. Reliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1269

B. Insider Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1272

1. The “Classical Theory”. . . . . . . . . . . . . . . . . . . . . . . . . 1273

2. The Misappropriation Theory . . . . . . . . . . . . . . . . . . . . . 1275

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

Public Information Regarding Tender Offers . . . . . . . . . . 1277

4. “Use” Versus “Knowing Possession” of Inside Information 1277

5. Regulation of Selective Disclosure . . . . . . . . . . . . . . . . . 1278

III. DEFENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1280

A. Intent-Based Defenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1280

1. Lack of Fraudulent Intent . . . . . . . . . . . . . . . . . . . . . . . . 1280

2. “No Knowledge” of the Substantive Rule . . . . . . . . . . . . 1281

3. Good Faith . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1282

4. Reliance on Advice of Counsel .. . . . . . . . . . . . . . . . . . . 1283

B. Reliance-Based Defenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 1284

1. Truth on the Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1284

2. Bespeaks Caution Doctrine . . . . . . . . . . . . . . . . . . . . . . . 1286

C. Defense Based on Legitimacy of Criminalization . . . . . . . . . . 1288

D. Statute of Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1288

IV. ENFORCEMENT MECHANISMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1290

1245

A. SEC Enforcement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1290

1. Development of an Enforcement Action . . . . . . . . . . . . . 1290

2. Administrative Proceedings . . . . . . . . . . . . . . . . . . . . . . 1292

a. Cease and Desist Authority . . . . . . . . . . . . . . . . . . . 1293

b. Monetary Penalties in Administrative Proceedings . . 1294

3. Civil Remedies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1294

a. Injunctive Actions and Ancillary Measures . . . . . . . . 1294

b. Disgorgement and Monetary Penalties . . . . . . . . . . . 1296

4. International Enforcement . . . . . . . . . . . . . . . . . . . . . . . 1297

B. Criminal Violations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1300

1. DOJ Criminal Enforcement . . . . . . . . . . . . . . . . . . . . . . 1300

2. Parallel or Subsequent Suits . . . . . . . . . . . . . . . . . . . . . . 1302

3. Contempt Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . 1304

V. PENALTIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1305

VI. RECENT DEVELOPMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1306

A. Cryptocurrency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1307

B. Rule 10b5-1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1310

C. Shadow Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1311

D. Internet Securities Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . 1312

E. Disclosure of Information to the Public . . . . . . . . . . . . . . . . . 1313

F. Legislative and Regulatory Changes . . . . . . . . . . . . . . . . . . . 1316

G. High Frequency Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1319

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

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, the 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

Both 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 transactions 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 to 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 to 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.).

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, 194 (1976) (stating that the 1933 Act “was

1246 AMERICAN CRIMINAL LAW REVIEW [Vol. 60:1245

1933 Act and the 1934 Act aim to “eliminate serious abuses in [the] largely

unregulated securities market” by focusing on “the sale of securities to raise capital

for profit-making purposes” in the “capital market of the enterprise system.”

3

To

this end, Congress sought to create “a broad definition of ‘security’” and to regu-

late all investments, regardless of form or the label applied.

4

The key securities fraud provisions used in criminal prosecutions are § 32(a) of

the 1934 Act

5

and Rule 10b-5.

6

Section 32(a) imposes criminal liability for willful

violations of multiple provisions of the 1934 Act, including § 10(b). Rule 10b-5

was promulgated by the Securities Exchange Commission (“SEC”) under § 10(b)

of the 1934 Act

7

and provides the foundation for a securities fraud claim.

8

Part II of this Article examines the elements of a securities fraud offense, and

Part III describes common defenses. Part IV then examines various enforcement

mechanisms. Part V highlights penalties for a securities fraud offense. Finally, Part

VI describes recent developments in this area of law.

While this Article is limited in scope to federal securities law, all securities law

issues should be analyzed in conjunction with the applicable state “blue sky

laws,”

9

which regulate the offering and sale of securities in each state.

10

II. ELEMENTS OF THE OFFENSE

Two main types of fraud form the basis of a securities law violation: (A) mate-

rial misrepresentations, omissions, or both; and (B) insider trading.

11

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

5. 15 U.S.C. § 78ff(a) (“Penalties”).

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

§ 17(a) of the 1933 Act, creating similar obligations. See SEC v. Monarch Funding Corp., 192 F.3d 295, 308 (2d

Cir. 1999) (noting the similarities but also emphasizing that unlike Rule 10b-5, § 17(a)(2) and (a)(3) require no

showing of scienter). 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 § 17(a) and Rule 10b-5).

7. 15 U.S.C. § 78j(b).

8. Id. § 78ff(a).

9. The term “blue sky” refers to the practice of land salesmen who operated so fraudulently that they would

“sell building lots in the blue sky in fee simple.” See Jonathan R. Macey & Geoffrey P. Miller, Origin of the Blue

Sky Laws, 70 TEX. L. REV. 347, 359 n.59 (1991) (quoting Thomas Mulvey, Blue Sky Law, 36 CAN. L. TIMES 37,

37 (1916)).

10. The Securities Litigation Uniform Standards Act of 1998, Pub. L. No. 105-353, 112 Stat. 3227 (1998),

which amended portions of the 1933 Act and the 1934 Act, precludes “covered” class actions that allege fraud

“in connection with the purchase or sale of a covered security” from being brought in federal or state court based

on state law. See 15 U.S.C. § 78bb(f)(1); see also id. § 78bb(f)(2) (providing that “covered class action[s]” are

removable to federal court). Consequently, such class actions must be based on federal securities laws.

11. See 17 C.F.R. § 240.10b-5 (2019).

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