Epstein, Tanya, Holleran, Linda M., Mooney, Joshua A., Shaffer, Mark A., Song, Grace J., American Criminal Law Review
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") as a result of the stock market crash in 1929. Both Acts seek to ensure vigorous market competition by mandating fun and fair disclosure of all material information in the marketplace.
Section II of this Article first discusses the elements of securities fraud by describing the various activities considered to be substantive fraud under [sections] 10(b) of the 1934 Act(2) and Rule 10b-5 promulgated by the Securities and Exchange Commission ("SEC") under the 1934 Act.(3) Section II then presents definitions of offer, purchase, or sale of securities and the use of interstate commerce or the mails requirement. In addition, this section examines [sections] 32(a) of the 1934 Act(4) 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"(5) laws that regulate the offering and sale of securities in each state.(6)
II. ELEMENTS OF THE OFFENSE
Although both the 1933 Act and the 1934 Act provide for various types of criminal conduct,(7) the sections employed in criminal prosecutions for fraud in the purchase or sale of securities are [sections] 10(b) of the 1934 Act,(8) Rule 10b-5 promulgated thereunder,(9) and [sections] 32(a) of the 1934 Act.(10)
To maintain a securities fraud cause of action under Rule 10b-5, the government must prove the following four elements: (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.(11)
Securities fraud causes of action may be criminal, civil, or administrative in nature.(12) 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.(13) Most criminal proceedings result from an SEC investigation and a subsequent SEC referral to the D0J.(14)
A. 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.(15)
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.(16) The elements of a Rule 10b-5 cause of action are: (a) a false statement or omission; (b) of a material fact; (c) made with scienter; (d) justifiably relied on by plaintiff, which was causally related to plaintiffs injury.(17) 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.(18)
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.(19) In SEC v. Texas Gulf Sulphur Co., the Second Circuit defined a misrepresentation or omission as one 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."(20) Misrepresentations and omissions occur in a variety of contexts. For example, the Eighth Circuit convicted an investor for impersonating a broker and making false pretenses in a sale of securities.(21)
Criminal omissions cases include the Southern District of New York's conviction of a company and its officers for omitting the company's financial problems and falsifying its financial record to make it seem more profitable.(22) 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.(23)
Omitted or misstated information must be material to constitute securities fraud. In TSC Industries, Inc. v. Northway, Inc.,(24) 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 [or her]."(25) Courts deem information material if it would be significant to the person relying on it in his or her investment decision. The Court stated that this materiality standard requires a showing of a substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder.(26) 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 made available.(27)
The TSC Industries Court made it clear that not all omissions or misrepresentations will be viewed as fraudulent; for instance, courts have decided that some prospective information, such as a prediction of anticipated profits, is not material.(28)
In Basic, Inc. v. Levinson,(29) 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,(30) 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."(31)
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.(32) When the merger discussions ultimately succeeded, the former shareholders brought a class action suit.(33) In applying its standard for contingent or speculative information, the Court held that the materiality of the particular merger discussions is a question of fact to be assessed in light of "indicia of interest in the transaction at the highest corporate levels."(34) Some lower courts have held that "projections and general expressions of optimism may be actionable under the federal securities laws,"(35) 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."(36)
In contrast, the Fifth Circuit held that prospectus projections of future performance stated as guarantees were unactionable.(37) The Private Securities Litigation Reform Act of 1995 gives defendants in private actions protection from "forward-looking" statements; hence, the Fifth Circuit's view on prospective statements is likely to prevail over the Ninth's Circuit's holdings.(38)
After establishing the existence of a material omission or misrepresentation, in order to prove a violation of [sections] 10(b) and Rule 10-5, it is necessary to demonstrate that the defendant made the omission or misrepresentation with scienter.(39) In Ernst & Ernst v. Hochfelder,(40) 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. In a standard adopted by most other circuits, the Seventh Circuit has permitted reckless action by the defendant to meet the scienter requirement.(41)
While reliance is an essential element of a cause of action under Rule 10b-5,(42) specific reliance by the investor need not be shown in a securities fraud prosecution.(43) Instead, the government must show some "impact of the scheme on the investor and that the mails were used in those instances where the impact occurred."(44)
The United States Supreme Court dealt with the issue of reliance when it first adopted the fraud on the market theory in Basic, Inc. v. Levinson.(45) In that case, the court applied the theory to a material public misrepresentation.(46) The Court held that, "because most publicly available information is reflected in market price, an investor's reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action."(47) Hence, the government must prove five elements before invoking a presumption of reliance: (1) the defendant made public misrepresentations; (2) the misrepresentations were material; (3) the shares traded on an efficient market; (4) the misrepresentations would induce a reasonable, relying investor to misjudge the value of the shares; and (5) the plaintiff traded the shares between the time of the misrepresentations and the time the truth was revealed.(48)
Whereas the SEC uses [sections] 10(b) and Rule 10b-5 in civil and administrative cases, DOJ utilizes Section 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.(49) 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).(50)
A defendant acts willfully when he acts intentionally and deliberately and not as the result of innocent mistake, negligence, or inadvertence.(51) Although a plaintiff need not prove specific intent to disregard or disobey the law, the defendant must be shown to have some evil purpose.(52) To prevail in a criminal case the government must prove that the defendant intended to commit the act prohibited.(53)
While civil actions require scienter and criminal actions require willfulness, it is unclear whether this semantic distinction has any practical significance. At least one commentator has argued that, "courts have interpreted the term `willfully' as used in [sections] 32(a), to mean that only ordinary scienter is necessary to support a criminal conviction."(54) This result may be attributed to the fact that "[sections] 32 was drafted before [sections] 10(b) was interpreted to require a showing of scienter."(55) As a result, it remains to be seen whether willfulness in criminal cases requires something above ordinary scienter as required in civil cases. A clear answer to this question will be elusive until a court interpreting [sections] 32(a) addresses the meaning of "willfully" in that provision.
Section 32(a) also states that an individual may be convicted of willfully violating the 1934 Act even though that individual lacks awareness of the existence of an applicable section or rule.(56) However, penalties for such a conviction may not include imprisonment.(57)
2. Insider Trading
Insider trading regulations protect the integrity of the securities market(58) by prohibiting material, non-public information from being used in connection with the purchase or sale of securities when this use breaches a fiduciary duty.(59) In 1997, the Supreme Court in United States v. O'Hagan(60) adopted the view that this fiduciary duty refers to both the relationships between corporate `insiders' and the corporation's shareholders (the classical theory),(61) and between corporate `outsiders' and the source of the material, non-public information (the misappropriation theory).(62) Both theories, classical and misappropriation, provide the theoretical underpinnings for criminal liability for most cases of insider trading.(63)
This section discusses the two complimentary(64) theories under which prosecutors enforce insider trading regulations, the classical theory and the misappropriation theory. It then concludes with a discussion of the Rule 14(e) prohibitions on insider trading related to tender offers.
a. Classical Theory
Under the classical theory of insider trading, a Rule 10b-5 violation exists when an insider of the corporation whose securities are traded purchases or sells securities on the basis of material, non-public information.(65) Criminal liability under this theory falls only upon corporate insiders who have a fiduciary duty to the corporation's shareholders not to trade on inside information.(66) This duty requires that the insider either disclose the non-public information or refrain from trading on such information.(67) Courts consider non-disclosure a "deceptive device" when the insider takes advantage of the uninformed stockholders by buying or selling securities on the basis of confidential information.(68) Thus, if the insider disclosed to the corporation's shareholders his or her intention to participate in the securities market on the basis of the non-public information, there would be no "deceptive device" and, therefore, no Rule 10b-5 violation.(69)
The classical theory also applies to "temporary" insiders and "tippees." "Temporary" insiders, such as attorneys, accountants, consultants, or others who temporarily gain access to similar "inside" information, become temporary fiduciaries of the corporation and likewise develop the same duty to disclose or refrain from trading on inside information.(70) "Tippees" are individuals who trade on the basis of non-public information gained from insiders.(71) Tippees become criminally liable only if: (1) the insider breached a fiduciary duty to the corporation for his or her own personal gain; and (2) the tippee knew or had reason to know that the insider breached his or her fiduciary duty to the shareholders of the corporation by disseminating the confidential information.(72)
Because special facts can sometimes persuade a court that a fiduciary relationship exists,(73) the Ninth Circuit delineated five factors to consider in determining whether a duty to disclose exists: "1) the relationship of the parties; 2) the relative access to the information; 3) the benefit that the defendant derives from the relationship; 4) the defendant's awareness that the plaintiff relied upon the relationship in making his investment decision; and 5) the defendant's activity in initiating the transaction."(74)
Despite courts' broad interpretation of "insiders" under the classical theory, prosecutors still were unable to prosecute many cases involving insider trading.(75) In response, they proffered the misappropriation theory.(76)
b. Misappropriation Theory
United States v. O'Hagan,(77) a landmark Supreme Court decision in 1997, resolved the conflict in the circuit courts by adopting and validating the misappropriation theory.(78) Although Chief Justice Burger first set forth a version of the misappropriation theory in his Chiarella dissent,(79) the O'Hagan Court adopted an approach to the theory more closely aligned with the Second Circuit's reasoning in United States v. Newman.(80) In O'Hagan, the Supreme Court explained that the misappropriation theory falls within the provisions of Rule 10b-5, which requires a deceptive device; the breach of a fiduciary duty; the use of material, nonpublic information in connection with the purchase or sale of a security; and the defendant's willfulness.
The misappropriator's secret use of the confidential information for personal gain while feigning loyalty to the source of the information fulfills the "deceptive device or contrivance" requirement.(81) "Deception through non-disclosure is central to [this] theory of liability."(82) The Misappropriation theory preserves the rule that no general duty between security market participants prohibits trading based upon material, nonpublic information. Rather, the misappropriation theory only bars trading on confidential information that a defendant employs for his or her own gain in breach of a fiduciary, contractual, or similar obligation to the owner or rightful possessor of the information.(83) This fiduciary relationship most frequently exists between an employer and employee,(84) although it has also been found between an attorney and client(85) and a psychiatrist and patient.(86) So far, the courts have declined to impose liability between family members.(87)
Although O'Hagan clearly enunciated the fiduciary duty element, the court did not offer any guidance as to the type of relationship that would create such a duty. Insiders at the SEC expect that the particular relationship of the parties required to meet the fiduciary duty element of the misappropriation theory will continue to be a challenged issue.(88)
Fraudulent use of material, nonpublic information, as described above, only subjects a person to criminal liability under the Securities Exchange Act if it is used in connection with the purchase or sale of a security.(89) The misappropriation theory satisfies this requirement because courts consider the fraud to be "consummated, not when the fiduciary gains the confidential information, but when without disclosure to his principal, he uses the information to purchase or sell securities."(90) Although a misappropriator would ordinarily use Such material, nonpublic information in trading securities, if he used the information for any other purpose. Rule 10b-5 would not be implicated.(91) Although the defendant in a misappropriation case would have perpetrated the fraud against the source of the confidential information, it is the defendant's trading partner who most likely would suffer the harm.(92)
The scienter requirement of this statute, that the violation be willful, prevents the statute from being too vague to impose criminal liability.(93) Both the government's burden of proving the fiduciary's willfulness and the Act's provision that defendants cannot be imprisoned if they had no knowledge of the rule provide "sturdy safeguard[s]" that the application of the statute will be just.(94) However, the O'Hagan court failed to define a standard of proof for a willful violation(95) and to determine whether or not the same "willful" standard will apply to civil cases.(96)
In sum, the Supreme Court found the misappropriation theory consistent with an appropriate application of Rule 10b-5.(97) In addition to meeting the stated requirements of the law, the Supreme Court found that the misappropriation theory furthers the policy reasons behind the statute: it helps to insure honest securities markets and thereby promotes investor confidence by "inhibiting the impact on market participation of trading on misappropriated information."(98) However, not all questions were answered and it is expected that the open issues of the type of relationship needed to create a fiduciary duty and the scienter standard necessary for litigation under this theory will be contested subjects in future court decisions.
c. Strict Regulation Under Rule 14e of Non-public Information Regarding Tender Offers
In direct response to the Supreme Court's holding in Chiarella,(99) the SEC promulgated Rule 14e-3(100) to prevent insider trading in the area of tender offers. This Rule prohibits anyone with material, nonpublic information concerning a tender offer from trading on or `tipping' that information, provided that the trader knows or should know that the source of the information is the offeror or the subject of the tender offer.(101) This activity becomes criminal if the trading party knows the forbidden nature of the conduct.(102) This rule imposes an absolute duty to disclose the confidential information or to abstain from trading regardless of whether or not a trader obtained the information through a breach of a fiduciary duty.(103) The Court in O'Hagan, with a 7-2 decision on this issue, ruled that Rule 14e-3 constituted a valid exercise of the SEC's rulemaking authority.(104) Note that there may be simultaneous violations of Rules 14e-3 and 10b-5; the government has prosecuted major cases brought for such violations.(105)
"Parking" facilitates many fraudulent security schemes and can most aptly be defined as the situation where the original party transfers the legal title of securities to another but secretly maintains the control and beneficial ownership of those securities.(106) The term "parking" also includes the practice of "warehousing," which occurs when a broker buys stock in the company that is the target of a takeover under the instructions of the bidder and agrees to transfer the stock to the bidder once the takeover bid becomes public.(107)
A court will typically consider five factors in determining whether or not the parties have entered into a parking arrangement: (1) whether the trading of securities was conducted in the ordinary course of business; (2) whether there existed restrictions on resale of the securities; (3) which party bore the risk of loss; (4) whether the sales occurred at market price; and (5) whether there was an "arms-length" transaction.(108) Because the specific definition of parking may change depending upon the particular context,(109) parking can best be understood by looking at the three most common uses of parking:(110) (1) to manipulate stock prices;(111) (2) to avoid margin rules and net capital deficiencies;(112) and (3) to enable corporate raiders to avoid disclosure requirements as they purchase significant amounts of a target's securities.(113)
Defendants most commonly "park" to manipulate stock prices and the SEC prosecutes such an action as a violation of the general anti-fraud provisions and rules of the Securities Exchange Act.(114) In United States v. Corr,(115) prosecutors obtained a conviction for a conspiracy to manipulate the price of Jerome Mackey's Judo, Inc. ("Judo") stock. The defendants directed and arranged for the "parking" of Judo stock with various brokers in order to keep the stock from being sold on the market. Specifically, the brokers bought and sold the Judo stock without the authority of those who technically owned the stock, but rather according to defendant Corr's instructions.(116) When brokers exceeded the dollar limit of Judo stock that their firm permitted them to own, they arranged to "park" thousands of shares of Judo stock with other brokers, thereby keeping those shares out of the market supply.(117) Thus, the court characterized parking in this context as a means to avoid depressing the market price by selling securities to another broker with the understanding that the seller will buy the securities back.(118)
Two other ways to manipulate stock prices involve parking "hot issues" and creating a false appearance of trading.(119) "Hot issues" are typically offered at one price and quickly "bid up" to much higher prices when trading begins. In order to stimulate the demand for the "hot issue" and restrict its supply. underwriters will "park" the stock by placing it in bogus accounts and then selling it back into the market once the initial price has increased because of the speculative demand.(120) Creating a false appearance of trading will also inflate stock prices. A company conducting securities transactions with discounted issue accomplishes this appearance through the use of bogus accounts controlled by company employees.(121)
Avoiding margin rules through parking schemes occurs when a broker purchases stock in her own name, but a third party realizes all the profits or losses and really controls the stock.(122) In effect, the broker extends 100% margin financing to the third party whereas the legal amount of margin financing rarely exceeds 50% of the market value of the purchased stock.(123) Because one may not lawfully receive this illegal extension of credit,(124) both participants, the broker and the third party, can be prosecuted for violating margin rules.(125) The facts underlying SEC v. Bilzerian(126) best exemplify this type of parking scheme. Defendant Bilzerian entered into an arrangement with an employee of Jefferies & Co. in which Jefferies would acquire and hold securities of Cluett Peabody & Co. for Bilzerian's benefit. By entering into this parking scheme, Bilzerian also aided and abetted Jefferies' violation of the margin rules governing the amount of credit a broker-dealer may extend to each customer.(127)
Brokers and traders avoid minimum net capital requirements through parking schemes when the brokers transfer securities into another's account in exchange for a liquid asset in order to meet their firm's Rule 15c-1(128) "net capital" requirement. Once the appropriate paperwork has been submitted to the SEC, the parties reverse the transaction.(129) This type of parking scheme enables brokers to remain in and expand their business illegally, while placing their customers and others in the financial community in fiscal jeopardy.(130) SEC v. Kidder, Peabody & Co. ("Kidder") provides a prime example of a parking scheme in this context.(131) Defendant Kidder entered into a consent of final judgment in an action alleging that it effected "non-bona fide purchases of," or "parked" securities from Seemala Corporation, the broker-dealer entity controlled by Ivan Boesky.(132) As a result, Seemala allegedly avoided the minimum net capital requirements. The court characterized the transaction as non-bona fide because Seemala agreed to "buy back the same securities [`sold' at a particular time and] receive all profits or sustain all losses."(133) Furthermore, Kidder was to receive unusually high commissions for the accommodation.(134) Prosecutors also charged Kidder with violating the margin rules by engaging in the parking arrangement and allegedly extending credit to Seemala in an amount greater than fifty percent of the fair market value of those shares.(135)
Others have been convicted for the use of parking schemes to circumvent disclosure requirements under [sections] 13(d) of the 1934 Securities Exchange Act(136) and Rule 13d-1.(137) Such parking schemes have been used by a corporation to preserve its control over management or by a company planning a hostile takeover in order to prevent the target corporation from effecting countermeasures.(138) SEC v. Drexel Burnham Lambert, Inc. ("Drexel") best illustrated the latter scheme.(139) In Drexel, the court imposed liability when Victor Posner attempted to take control of Fischback Corp. using a securities parking scheme. In order to avoid a standstill agreement which allowed Posner to accumulate only 24.9% of Fischback's stock, Posner employed the efforts of Michael Milken and Drexel Burnham Lambert to accumulate Fischback stock for him until the standstill agreement had ended.(140) In essence, Posner owned the stock, but tried to avoid the Rule 13d requirements by not taking physical possession of the stock until a later time.
In sum, the SEC prosecutes parking schemes such as: …
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Publication information: Article title: Securities Fraud. Contributors: Epstein, Tanya - Author, Holleran, Linda M. - Author, Mooney, Joshua A. - Author, Shaffer, Mark A. - Author, Song, Grace J. - Author. Journal title: American Criminal Law Review. Volume: 35. Issue: 3 Publication date: Spring 1998. Page number: 1167+. © 1994 Georgetown University Law Center. COPYRIGHT 1998 Gale Group.
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