The Whittling Away of the Private Right of Action Under Rule 10b-5: the Pslra, Janus, and the Financial Crisis

• Publication year: 2022

48 Creighton L. Rev. 23. THE WHITTLING AWAY OF THE PRIVATE RIGHT OF ACTION UNDER RULE 10B-5: THE PSLRA, JANUS, AND THE FINANCIAL CRISIS

THE WHITTLING AWAY OF THE PRIVATE RIGHT OF ACTION UNDER RULE 10B-5: THE PSLRA, JANUS, AND THE FINANCIAL CRISIS

Jamie Heine(fn*)

Private plaintiffs face an uphill battle in pleading and proving securities fraud claims under Rule 10b-5.(fn1) The Private Securities Litigation Reform Act of 1995(fn2) ("PSLRA") imposed heightened pleading standards on private plaintiffs bringing securities fraud cases. In the midst of a massive financial crisis that has engendered much public belief of widespread fraud, the Supreme Court in Janus Capital Group, Inc. v. First Derivative Traders(fn3) continued its campaign to narrow the scope of the private right of action under 10b-5. The recent financial crisis highlights new challenges for plaintiffs in securities fraud actions and opportunities for defendants to shift the blame for plaintiffs' losses to someone else. This article examines the recent history of the private right to action under Rule 10b-5 and whether it serves its purpose of protecting investors. This article argues that the private right to action has been whittled away by Congress, the Supreme Court, and now the financial crisis, leaving investors ill protected.

I. INTRODUCTION

In March 2009, Bernie Madoff pled guilty to a sixty-five billion dollar Ponzi scheme, the largest in United States history.(fn4) In June 2012, R. Allen Stanford was convicted of a seven billion dollar Ponzi scheme.(fn5) In the second half of 2007, securities litigation spiked due to the financial crisis.(fn6) Of the 100 securities class action filings in thelatter half of 2007, nearly a quarter related to subprime mortgages.(fn7) A similar trend continued into the first half of 2008.(fn8) While the recent financial crisis highlights fraud in mortgages, lending, and complex financial products, examples of other types of securities fraud abound. In 2006, Nortel Networks settled for 2.4 billion dollars for securities fraud claims brought by former shareholders alleging that Nortel falsified accounting entries after the Internet bubble burst.(fn9) Shareholders settled similar claims with AOL Time Warner for 2.5 billion dollars in 2005.(fn10) Also in 2005, World Com shareholders settled for 6.2 billion dollars for claims that the company improperly classified expenses and inflated its revenue.(fn11) No one can forget the Enron scandal, where Enron concealed losses by its special purpose entities and which the company settled for 7.2 billion dollars.(fn12)

Securities fraud occurs when someone misrepresents material information concerning a security to investors, who rely on that information in purchasing or selling that security and suffer a loss due to the misrepresentation. Private plaintiffs have a private right of action against securities fraud under Section 10(b)(fn13) of the Securities Exchange Act of 1934(fn14) ("Exchange Act") and Securities and Exchange Commission ("SEC") Rule 10b-5(fn15) thereunder. While not explicitly provided by statute, the judiciary has long read the private right of action into Section 10(b). This right of action allows private individuals to sue and recover for securities fraud. The private right of action has historically been read to be broad, but recent Supreme Court jurisprudence and Congressional legislation have significantly narrowed that right. This article describes the narrowing of this right and argues that the whittling away of the private right of action by Congress and the Supreme Court has resulted in an anti-fraud framework that does not adequately protect investors, one of the main purposes of such provisions in federal securities laws. In addition, the whittling away of this right has occurred in the midst of one of the greatest financial crises in history, at a time when an expansive right of action is necessary to protect investors. The financial crisis has also exposed additional weaknesses in the ability of plaintiffs to plead and prove securities fraud, a weakness on which defendants in securities fraud cases emerging from the financial crisis have preyed. Part II of this article describes the private right of action against securities fraud under Rule 10b-5 and the elements of this claim.(fn16) Part III discusses Congressional action constraining the private right of action, focusing on the Private Securities Litigation Reform Act of 1995(fn17) ("PSLRA") that raised pleading standards for private plaintiffs in securities fraud cases.(fn18) Part IV discusses the Supreme Court's narrowing of the private right of action over time, focusing on the notable recent case of Janus Capital Group, Inc. v. First Derivative Traders .(fn19) Part V argues that the financial crisis has made it even more difficult for plaintiffs to prove loss causation and scienter in securities fraud claims arising out of activities during or leading up to the financial crisis.(fn20) Part VI assesses the theories for limiting private enforcement of securities fraud and analyzes the future landscape of the private right of action, given the financial crisis, Congressional refusal to expand the private right of action, and lower courts' interpretations of Janus. (fn21) Part VI also argues that the current form of the private right of action does not sufficiently protect investors.(fn22) Part VII concludes.

II. THE PRIVATE RIGHT OF ACTION AGAINST SECURITIES FRAUD UNDER RULE 10B-5

In response to the stock market crash of 1929 and the Great Depression, Congress enacted the Securities Act of 1933(fn23) ("Securities Act") and the Securities Exchange Act of 1934(fn24) ("Exchange Act").(fn25) Together these laws comprise the primary framework of federal securities regulation in the United States.(fn26) The main remedy for investors injured by violations of these statutes is Section 10(b) of the Exchange Act(fn27) and the corresponding Securities and Exchange Commission ("SEC") Rule 10b-5,(fn28) prohibiting material misrepresentations or omissions and other fraudulent behavior in connection with a securities transaction.(fn29)

Shortly after Rule 10b-5's adoption, the United States District Court for the Eastern District of Pennsylvania found an implied private right of action in Rule 10b-5 that stemmed from tort principles and the intent of the Exchange Act "to 'regulate securities transactions of all kinds and . . . eliminate . . . all manipulative or deceptive methods in [securities] transactions.'"(fn30) The Supreme Court's confirmation of this right followed in Superintendent of Insurance v. Bankers Life & Casualty Co.,(fn31) where the Court held that Section 10(b) and Rule 10b-5 must be interpreted flexibly.(fn32) Thus, private parties have an established right of action under Rule 10b-5 and Section 10(b).(fn33) Generally, the rationale for the creation and protection of this private right of action is what the courts have interpreted as Congress's intent to maximize enforcement of federal securities laws.(fn34) Investors have used this implied private cause of action to sue both the parties who committed the fraud (the primary actors) and the parties who assisted in the fraud (the secondary actors).(fn35) The Supreme Court has held that Rule 10b-5 "'should be construed not technically and restric-tively, but flexibly to effectuate its remedial purpose'" and that the Court has "'long recognized that meritorious private actions to enforce federal antifraud securities laws are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively, by the Department of Justice and the [SEC].'"(fn36)

A. PRIMARY LIABILITY UNDER SECTION 10(B) AND RULE 10B-5

Under Section 10(b) of the Securities Exchange Act of 1934, one may not:

use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered . . . any manipulative or deceptive device . . . in contravention of such rules and regulations as the [SEC] may prescribe as necessary or appropriate in the public interest or for the protection of investors.(fn37)

This language was clarified by Rule 10b-5 and subsequent court cases.(fn38) Rule 10b-5 provides that the manipulative or deceptive act under Section 10(b) may be employing "any device, scheme or artifice to defraud," making "any untrue statement of material fact" or omitting "to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading," or engaging "in any act, practice, or course of business which operates or would operate as a fraud or deceit uponany person."(fn39)

Section 10(b) securities fraud plaintiffs must prove: (1) a material misrepresentation or omission; (2) scienter; (3) a connection to the sale or purchase of a security; (4) reliance; (5) damages; and (6) loss causa-tion.(fn40) These elements are described in detail below.

1. Material Misrepresentation or Omission

A plaintiff in a Rule 10b-5 action must prove that the defendant made a material misrepresentation.(fn41) A misrepresentation can occur either by an affirmative misleading statement or an omission. The Supreme Court noted in a footnote in Basic, Inc. v. Levinson (fn42) that if the misrepresentation occurs by omission, the omission is only fraudulent if there was a duty to disclose the omitted information.(fn43) However, where a defendant...