Securities Fraud

• Author: Adam Governale/Meredith Keenan/Peter Singhal/Kenton Debouter/Margaret Leatherwood/Nathan Hogan
• Pages: 1339-1432

SECURITIES FRAUD

I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1340

II. ELEMENTS OF THE OFFENSE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1342

A. Material Misrepresentations and Omissions . . . . . . . . . . . . . . 1342

1. Use of Interstate Commerce or the Mails . . . . . . . . . . . . . 1343

2. Misstatements and Omissions . . . . . . . . . . . . . . . . . . . . . 1344

3. Materiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1348

4. Intent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1350

a. Scienter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1351

b. Willfulness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1352

5. In Connection with the Purchase or Sale of a Security . . . 1353

a. Definition of a “Security”. . . . . . . . . . . . . . . . . . . . 1353

i. Stocks and Notes Lacking a Profit Motive . . . 1355

ii. Instruments Protected by Other Legislation . . 1359

iii. Instruments Deemed Investment Contracts . . 1360

(1) Investment of Money . . . . . . . . . . . . . . 1361

(2) Common Enterprise . . . . . . . . . . . . . . . 1361

(3) Expectation of Profits. . . . . . . . . . . . . . 1364

(4) “Solely” Through the Efforts of Others . 1365

b. Definitions of “Purchase” and “Sale”. . . . . . . . . . . . 1366

6. Reliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1369

7. Causation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1371

a. Transaction Causation . . . . . . . . . . . . . . . . . . . . . . . 1372

b. Loss Causation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1372

B. Insider Trading. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1373

1. The Classical Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . 1374

2. The Misappropriation Theory . . . . . . . . . . . . . . . . . . . . . 1377

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

Information Regarding Tender Offers . . . . . . . . . . . . . . . 1380

4. “Use” Versus “Knowing Possession” of Inside Information 1381

5. Regulation of Selective Disclosure . . . . . . . . . . . . . . . . . 1382

III. DEFENSES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1384

A. Intent-Based Defenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1384

1. Lack of Fraudulent Intent . . . . . . . . . . . . . . . . . . . . . . . . 1385

2. “No Knowledge” of the Substantive Rule . . . . . . . . . . . . 1386

3. Good Faith. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1387

4. Reliance on Advice of Counsel . . . . . . . . . . . . . . . . . . . . 1388

B. Reliance-Based Defenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 1390

1. Truth on the Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1390

2. Bespeaks Caution Doctrine . . . . . . . . . . . . . . . . . . . . . . . 1392

1339

C. Defense Based on Legitimacy of Criminalization . . . . . . . . . . 1395

D. Statute of Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1395

IV. ENFORCEMENT MECHANISMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1397

A. SEC Enforcement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1398

1. Development of an Enforcement Action . . . . . . . . . . . . . 1398

2. Administrative Proceedings . . . . . . . . . . . . . . . . . . . . . . 1400

a. Cease and Desist Authority . . . . . . . . . . . . . . . . . . . 1401

b. Monetary Penalties in Administrative Proceedings . . 1402

3. Civil Remedies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1402

a. Injunctive Actions and Ancillary Measures . . . . . . . . 1403

b. Disgorgement and Monetary Penalties . . . . . . . . . . . 1404

4. International Enforcement. . . . . . . . . . . . . . . . . . . . . . . . 1407

B. Criminal Violations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1410

1. DOJ Criminal Enforcement. . . . . . . . . . . . . . . . . . . . . . . 1410

2. Parallel or Subsequent Suits . . . . . . . . . . . . . . . . . . . . . . 1413

3. Contempt Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . 1415

V. PENALTIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1416

VI. RECENT DEVELOPMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1418

A. Cryptocurrency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1419

B. Rule 10b5-1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1422

C. Shadow Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1423

D. Internet Securities Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . 1424

E. Disclosure of Information to the Public . . . . . . . . . . . . . . . . . 1425

F. Legislative and Regulatory Changes . . . . . . . . . . . . . . . . . . . 1428

G. High Frequency Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1431

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

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-1–80a-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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mandating full and fair disclosure of all material information in the marketplace.

2

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

largely unregulated securities market by regulating the capital market of the enter-

prise system.”

3

To this end, Congress sought to create “a broad definition of ‘secu-

rity’” and to regulate all investments, regardless of form or the label applied.

4

The key securities fraud provisions used in criminal prosecutions are Rule 10b-

5

5

and Section 32(a) of the 1934 Act.

6

Rule 10b-5 was promulgated under Section

10(b) of the 1934 Act

7

and provides the foundation for a securities fraud claim.

Section 32(a) imposes criminal liability for willful violations of multiple provi-

sions of the 1934 Act, including Section 10(b) and the Securities Exchange

Commission (“SEC”) rule created thereunder (i.e., Rule 10b-5).

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

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

6. 15 U.S.C. § 78ff(a) (“Penalties”).

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

protection of investors.”).

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.

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