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Article Excerpt
I. INTRODUCTION
II. ELEMENTS OF THE OFFENSE A. Material Misrepresentations and Omissions 1. Misstatements and Omissions a. Entanglement Liability 2. Materiality 3. Intent a. Scienter b. Willfulness 4. In Connection With the Purchase or Sale of a Security a. Definition of "Security". i. Stocks and Notes Lacking a Profit Motive ii. Instruments Protected by Other Federal Legislation iii. Instruments Deemed Investment Contracts a. Investment of Money b. Common Enterprise c. Expectation of Profits d. Solely Through the Efforts of Others b. Definitions of "Purchase" and "Sale" c. Use of Interstate Commerce or the Mails 5. Reliance B. Insider Trading a. The Classical Theory b. The Misappropriation Theory c. Strict Regulation Under Rule 14e-3 of Non-public Information Regarding Tender Offers d. Use Versus Knowing Possession of Inside Information e. Regulation of Selective Disclosure III. DEFENSES A. Intent-Based Defenses 1. Lack of Fraudulent Intent 2. "No Knowledge" of the Substantive Rule 3. Good Faith 4. Reliance on Advice of Counsel B. Reliance-Based Defenses 1. Truth on the Market 2. Bespeaks Caution Doctrine C. Other Defenses IV. ENFORCEMENT MECHANISMS A. SEC Enforcement 1. Development of an Enforcement Action 2. Administrative Proceedings a. Cease and Desist Authority b. Monetary Penalties in Administrative Proceedings 3. Civil Remedies a. Injunctive Actions and Ancillary Measures b. Disgorgement and Monetary Penalties 4. International Enforcement B. Criminal Violations 1. Criminal Referrals 2. Parallel or Subsequent Suits 3. Contempt Proceedings V. PENALTIES VI. RECENT DEVELOPMENTS
I. INTRODUCTION
Although there are six federal statutes that 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 different markets. The 1933 Act regulates the primary market and the 1934 Act regulates the secondary market, but the objective of both is the same: to ensure vigorous market competition by mandating full and fair disclosure of all material information in the marketplace. (2)
Although both the 1933 and the 1934 Act deem various types of conduct unlawful, (3) the key authorities utilized in criminal prosecutions of securities fraud are Rule 10b-5 (4) and section 32(a) of the 1934 Act. (5) Rule 10b-5 was promulgated under section 10(b) of the 1934 Act (6) and is the foundation of a securities fraud claim. Section 32(a) deals with willful violations of the 1934 Act.
Practitioners should note that this article is limited to federal securities law. Any securities law issue must be analyzed in conjunction with applicable state "blue sky" (7) laws that regulate the offering and sale of securities in each state. (8)
II. ELEMENTS OF THE OFFENSE
There are two main types of fraud that may form the basis for securities violations: (A) material misrepresentations and/or omissions, and (B) insider trading. (9)
A. Material Misrepresentations and Omissions
Material misrepresentations and omissions give rise to the most common securities fraud actions. Rule 10b-5 proscribes any false statements made in connection with the purchase or sale of securities. (10) Any person "who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies" may be criminally or civilly it liable under Rule 10b-5. (12)
Under section 10(b) and Rule 10b-5, the elements of a civil cause of action and a criminal prosecution are very similar. The only difference is that in order for criminal liability to attach, a showing of willfulness is required in addition to the elements of a civil claim under Rule 10b-5. (13)
To succeed on a civil claim for securities fraud under Rule 10b-5, a plaintiff must show that the defendant made (i) a misstatement or omission; (ii) of material fact; (14) (iii) with scienter; (15) (iv) in connection with the purchase or the sale of a security; (16) (v) upon which the plaintiff reasonably relied; (17) and (vi) that the plaintiff's reliance was the proximate cause of his or her injury. (18) Once these elements of the Rule 10b-5 cause of action are shown, a criminal penalty can be imposed under section 32(a) if the government satisfactorily proves a willful violation of the 1934 Act. (19)
1. Misstatements and Omissions
The SEC and DOJ have vigorously prosecuted individuals who misrepresent or omit material information in securities filings. (20) In the landmark decision SEC v. Texas Gulf Sulphur Co., (21) the Second Circuit defined a misrepresentation or omission as an act that conveys a false impression of the facts or is misleading. (22) The court explained that this determination is made by inquiring "into the meaning of the statement to the reasonable investor and its relationship to the truth." (23)
Prosecutions by the SEC and DOJ for misstatements or omissions are not limited to filings made under the 1934 Act. Any form of publicized misstatement or omission can create liability. (24) Courts have read Rule 10b-5 as prohibiting any deceit that materially affects the purchase or sale of securities--the deception need not necessarily concern the value of the stocky
a. Entanglement Liability
Under certain circumstances, a Corporation can be found liable under Rule 10b-5 for misstatements or omissions made by others. Specifically, a Corporation may be liable for misstatements or omissions in the written reports of investment analysts if the company was "sufficiently entangled" in the production of the reports. (26) The Second Circuit altered traditional Rule 10b-5 liability and developed the "entanglement liability" doctrine in Elkind v. Liggett & Myers, Inc., (27) where the executives from Liggett & Myers, Inc. were not held liable for failing to correct or comment on the overly optimistic earnings forecasts pursuant to a policy of not commenting on analyst report forecasts. (28) However, the court also held that a company might be liable for the misstatements or omissions of an analyst report if the company has "sufficiently entangled itself with the analyst's forecasts to render those predictions attributable to it." (29)
Following Elkind, courts have differed on what level of involvement constitutes "sufficiently" entangled. (30) Generally, courts have held that merely providing the misleading information upon which the allegedly false forecast in the analyst report is based does not satisfy the entanglement requirement. (31) Instead, courts have sought to determine whether the degree of interaction between the analysts and the corporate officers resulted in the corporate officers putting their "imprimatur, express or implied, on the projections." (32) Thus, many courts have required a "two way" flow of information for the corporate officers to be held liable for the false report. (33) To prove the existence of a "two way" flow of information, the Ninth Circuit has required that (i) a corporate insider provided misleading information to an analyst, (ii) the analyst relied on the information, and (iii) the insider endorsed or approved the report prior to or after its publication. (34)
2. Materiality
Securities fraud occurs only when omitted or misstated information is material. (35) In TSC Indus., Inc. v. Northway, Inc., (36) 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." (37) The Court thus required a showing of a substantial likelihood that, in light of all the circumstances, the omitted fact would have had actual significance in the deliberations of a reasonable shareholder. (38) In other words, a misstated or omitted fact is material if there is a substantial likelihood that a reasonable investor would have viewed the disclosure of the omitted fact as having significantly altered the "total mix" of information available. (39) However, not all omissions or misrepresentations in connection with the purchase or sale of a security are fraudulent. (40)
There is a growing body of case law that treats general expressions of optimism by a company as immaterial per se. (41) Courts have distinguished between (i) generally optimistic statements and (ii) numerically specific predictions. (42) The former is considered no more than "puffery," and thus immaterial as a matter of law, (43) while the latter is considered an actionable claim. (44) Thus, the specificity with which a company predicts its financial performance can determine the issue of materiality. (45) 3. Intent
After establishing the existence of a material omission or misrepresentation, a plaintiff must prove requisite degree of intent in order to establish a violation of section 10(b) and Rule 10b-5. (46) Civil plaintiffs must meet a scienter requirement, discussed in subsection (i), while criminal cases, discussed in subsection (ii), require a showing that the defendant acted with willfulness.
a. Scienter
In civil causes of action, scienter must be proven in order to establish intent. (47) Scienter is defined as an "intent to deceive, manipulate, or defraud" on the defendant's part. (48) A private cause of action for damages under section 10(b) and Rule 10b-5 cannot stand without an allegation of scienter, (49) but scienter can be inferred from the facts, (50) The Seventh Circuit has permitted a defendant's reckless action to meet the scienter requirement, and most circuits have followed suit; however, courts have narrowly limited the definition of recklessness to not encompass ordinary negligence. (51)
b. Willfulness
Whereas the SEC uses section 10(b) and Rule 10b-5 in civil and administrative cases, the DOJ utilizes section 32(a) of the 1934 Act in criminal proceedings. Section 32(a) provides criminal penalties for willful violations of the Act or its rules. (52) Therefore, willful violations of "section 10(b) of the Act and the Commission's Rule 10b-5 thereunder ... admittedly qualify" under section 32(a) as criminal. (53)
A defendant acts willfully when his actions are intentional, deliberate, and are not the result of an innocent mistake, negligence, or inadvertence. (54) While proof of specific intent is not needed, the government must establish that the defendant had some evil purpose (55) and intended to commit the prohibited act. (56)
Section 32(a) does not require that an individual be aware of the existence of an applicable section or rule to be convicted of willfully violating the 1934 Act. (57) Penalties for such a conviction, however, do not necessarily entail imprisonment. (58)
Although civil actions require scienter and criminal actions require willfulness, it is unclear whether there is a meaningful distinction between the terms. It is debatable whether willfulness in criminal cases requires something above the ordinary scienter required in civil cases. At least one commentator has argued that "courts have interpreted the term 'willfully,' as used in [section] 32, to mean that only ordinary scienter is necessary to support a criminal conviction." (59) This may be because "[section] 32 was drafted before [section] 10(b) was interpreted to require a showing of scienter." (60) Until a court interpreting section 32(a) addresses the meaning of "willfully" in that provision, this question remains unresolved.
4. In Connection With the Purchase or Sale of a Security
A transaction is necessary in order for securities fraud to occur. (61) The definition of security, purchase, and sale are fundamental to determining whether a transaction has taken place and whether the government can charge someone with fraud. As the Supreme Court has noted:
[i]n defining the scope of the market that it wished to regulate, Congress painted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in the creation of "countless and variable schemes devised by those who seek the use of the money of others on the promise of profits." (62)
Employing the broad statutory definitions has enabled the government to attack investment schemes not expressly covered by the statute. It has also resulted in confusing and often conflicting interpretations by the courts.
a. Definition of "Security"
Federal securities law defines a security broadly. (63) Congress intended the definition of the term "security" in the 1933 Act to include "instruments that in our commercial world fall within the ordinary concept of a security." (64) The definitions of "security" found in section 2(1) of the 1933 Act and section 3(a)(10) of the 1934 Act are used consistently in civil suits, SEC enforcement actions, administrative proceedings, and criminal proceedings. (65) Neither the prosecution in a criminal case nor the plaintiff in a civil case need to show that the defendant knew of the existence of a security. (66) However, in a criminal action, whether a security existed is a question of fact for the jury. (67) The case law is inconsistent and confusing with respect to the definition of a security. The Supreme Court has even admitted that its "cases have not been entirely clear on the proper method of analysis for determining when an instrument is a 'security.'" (68) The relevant case law creates three categories of interpretive questions: (69) (i) whether certain stocks and notes, while securities in form, are considered securities for the purpose of the statute when they were not acquired as an investment made for profit; (70) (ii) whether certain financial instruments are securities when they are covered by other federal legislation; and (iii) whether an investment scheme, not in the form of a "security," amounts to an "investment contract." (71)
i. Stocks and Notes Lacking a Profit Motive
Any security having attributes commonly associated with traditional stock constitutes a section 2(1) "stock" in the 1933 Act. The Supreme Court has held that instruments bearing some of the significant attributes of traditional stock--stock plainly within the definition of a security under the Security Acts of 1933 and 1934 ("Acts")--would be treated as securities regardless of the underlying economic reality of the transaction. (72) The Court has asserted that instruments beating the name and traditional attributes of stock provide "the clearest case for coverage by the plain language of the definition." (73) A typical stock, therefore, is presumed to be a security under the Acts, unless the instrument lacks the usual characteristics of a stock as set forth by the Supreme Court. (74)
In contrast to stocks, promissory notes require an inquiry into the underlying transaction to determine whether a particular "note" is a security under the Acts. (75) In Reves v. Ernst & Young (76) the Court held that the determination of whether a note is a security depends on the underlying economic realities of the transaction. (77) The Reves Court applied the "family resemblance" test (78) to determine whether certain promissory notes met the statutory definition of "securities." (79) The Court first acknowledged the presumption that any note offering a term greater than nine months is a security, (80) but went on to list specific categories of notes that will not be deemed securities. (81) The family resemblance approach, therefore, creates a rebuttable presumption that all notes are securities, but allows the issuer to challenge the note's classification as a security if the note bears a strong "family resemblance" to a set of judicially-delineated non-security notes. (82)
If the note in question does not bear an obvious "family resemblance" to any judicially excluded category of notes, Reves provides a second chance at demonstrating that the note is not a security by analyzing the following four aspects of the economic reality of the transaction: (i) the motivation for entering the transaction, (ii) the plan of distribution, (iii) the reasonable expectations of the investing public, and (iv) whether any risk-reducing factors exist that would make the application of the securities laws unnecessary. (83)
The Second Circuit's subsequent application of the "family resemblance" test in Pollack v. Laidlaw holdings, Inc. (84) illustrates the predominant analytical framework embraced by courts to determine whether a particular instrument constitutes a "note." The Pollack Court examined whether notes secured by a mortgage on a home were "notes" within the meaning of federal securities law. Applying the four factors set forth in Reves, the court found that (i) the buyers' motivation was "clearly to invest"; (ii) the plan of distribution was broad-based; (iii) it was reasonable for the investors to expect that this plan was a conservative investment strategy, rather than a commercial loan transaction; and (iv) state regulations regulating mortgages did not afford adequate protection to investors in the case of "uncollateralized, speculative participations in mortgages." (85) Thus, because the notes were more similar to traditional securities than to any judicially defined category of non-securities, the court held that the federal securities laws applied to notes secured by a mortgage on a home. (86)
The Reves "family resemblance" test has been adopted in other circuits and applied in lower federal court opinions. (87) Among the types of notes that have been deemed non-securities under this test are: short-term unsecured notes issued by a bank to institutional investors, (88) notes based on viatical contracts, (89) notes packaged essentially as consumer loans with enhancements, (90) and notes issued to investors in exchange for bridge loans. (91)
ii. Instruments Protected by Other Federal Legislation
Certain instruments covered by federal legislation other than the securities laws are not considered securities. (92) Protection under another regulatory scheme reduces the risk of these instruments, thereby making application of the Securities Acts unnecessary. (93)
In International Brotherhood of Teamsters v. Daniel, (94) the Supreme Court held that a noncontributory, compulsory pension plan is not a security because the Employee Retirement Income Security Act of 1974 undercut the need for securities regulation. (95) Similarly, in Marine Bank v. Weaver, (96) the Court held that a certificate of deposit issued by a federally regulated bank is not a security because certificate of deposit holders were "abundantly protected under the federal banking laws." (97) The crucial factor in both cases was the existence of a federal regulation that served the same investor protection objective as the federal securities law. (98) The Eighth Circuit has even extended the application of this reasoning to instruments protected by foreign regulatory schemes. (99) State banking regulations akin to the federal banking laws, however, do not suffice to supplant the protection of the Securities Acts. (l00)
Finally, at least one court has held that contracts for future delivery of securities are not subject to the 1933 and 1934 Acts, but rather are regulated under the Commodity Futures Trading Commission Act. (101) As a result, the distinction between puts, calls, futures, and options (securities) and commodities (not securities) is an uncertain area of case law. In 2000, Congress amended the securities laws to exclude a security-based swap agreement from the definition of security. (102)
iii. Instruments Deemed Investment Contracts
In cases where a money-raising instrument is not expressly enumerated in section 2(1) of the 1933 Act or section 3(a)(10) of the 1934 Act, the Supreme Court has adopted an "economic reality" test to determine whether the instrument is a security for purposes of the Acts. (103) The four-prong test announced in SEC v. W.J. Howey Co. (104) is reserved for investment contracts and other instruments that are not readily identifiable as securities. (105) "[A]pplying the Howey test to traditional stock and all other types of instruments listed in the statutory definition would make the Acts' enumeration of many types of instruments superfluous." (106) Where a facial examination of the instrument can easily determine whether the instrument is a security, courts generally do not use the Howey economic reality test. (107)
Howey involved an investment scheme in which purchasers were simultaneously offered strips of land in an orange grove together and service contracts to farm the land. (108) Although sales contracts for strips of orange grove are not enumerated under either the 1933 or 1934 Act, the Supreme Court concluded that the combination of the land and service contracts produced a transaction that essentially created an "investment contract" under federal securities law. (109) The Court identified four elements of the transaction that established it as an investment contract: (i) the investment of money, (ii) in a common enterprise, (iii) with an expectation of profits, (iv) derived solely through the efforts of others. (110) In a civil action under the anti-fraud provisions of the 1933 and 1934 Acts, if the instruments in question are not readily identifiable as securities, the government must satisfy all four elements to prove that the investment contract is a security. (111)
a. Investment of Money
The first prong of the Howey test requires that the contract involved an investment of money. Courts have found that in addition to cash investments, goods and services (112) and promissory notes (113) also satisfy the money requirement. Courts apply a liberal construction of "investment of money" and generally look to whether the investor has subjected herself to financial loss by committing assets to the enterprise. (114)
b. Common Enterprise
The second prong of the Howey test focuses on the extent to which the success of an individual investor is intertwined with the success or failure of the other parties in the enterprise. The Circuit Courts have struggled to define what satisfies the common enterprise element and differ in their approaches to this prong of the test. The First, Third, (115) Sixth, Seventh, and the District of Columbia Circuits (116) have adopted the horizontal approach, under which the investors' funds must be pooled or their returns must fluctuate together for the investment to constitute a common enterprise. (117)
Other circuits have adopted the less demanding vertical commonality approach to the analysis of common enterprise. Vertical commonality "focuses on the relationship between the promoter and the body of investors" (118) and does not require the existence of multiple investors whose interests are pooled, nor does it require that investors' fortunes rise and fall together.
Vertical commonality can be either narrow or broad. The narrow vertical approach requires that the fortunes of the investor be "interwoven with and dependent on the efforts and success of those seeking the investment or of third parties." (119) In other words, a court must be able to infer that both the manager's and the investor's fortunes would increase if the venture proved successful and decrease if the venture suffered a setback. The Ninth Circuit follows the narrow vertical approach. (120)
The Fifth and Eleventh Circuits have adopted the broad vertical approach, also known as the "resilient standard." (121) Under this approach, a "common enterprise" exists whenever the investor's success is linked to the promoter's expertise or efforts' but not necessarily to the promoter's success. (122) Some courts have criticized broad vertical commonality because it essentially eliminates the Howey requirement that profits be derived from the efforts of others. (123)
Numerous circuits still do not have one clear test. In the Second Circuit, horizontal commonality remains a viable test, but narrow vertical commonality is also acceptable. (124) The Fourth Circuit permits plaintiffs to use the horizontal commonality test to prove a common enterprise, but the status of the vertical commonality test remains unclear. (125)
District courts in the Eighth (126) and Tenth Circuits (127) have used various approaches; therefore, it is uncertain which test or tests will be adopted in these circuits. The Tenth Circuit, however, has indicated that horizontal commonality is not a rigid requirement in that circuit. (128)
c. Expectation of Profits
To meet the third prong of the Howey test, the investor must lay out some form of consideration with the expectation to gain a profit or return on that investment. This "expectation of profits" element is not limited to capital appreciation, but can be satisfied by participation in earnings on invested funds. (129) While tax benefits from losses are insufficient to satisfy this prong, (130) if an expectation of profits exists apart from any prospect of tax benefits, then the element is met. (131) Investment schemes with no risk of loss usually fail this prong of the Howey test. (132) Plans to restructure pre-existing obligations, for example, do not constitute an underwriting of new risk for profit, and are therefore not investment contracts. (133)
d. Solely Through the Efforts of Others
The fourth prong of the Howey test requires that efforts put forth in the transaction come primarily from the promoter or third party. (134) In Howey, for example, the purchase of orange groves together with service contracts was ultimately deemed a security because the promoters had committed to making the orange groves productive. (135) If the investors had been required to tend the orange groves themselves, the Court would not have found the land contracts to be an "investment contract" under the securities laws. (136)
Despite early judicial emphasis on adhering to a literal application of the Howey test, (137) most courts have since adopted a functional and realistic approach to the definition of "solely," and find the term satisfied by significant managerial efforts on the part of the promoter. (138) Notably, the Supreme Court has tacitly omitted the word "solely" from its restatement of the Howey test in subsequent opinions. (139) The critical inquiry has thus become "whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise." (140)
To determine whether investors expected profits solely from the efforts of a promoter or third party, courts look at general partnership documents, incorporation documents, or contractual documents because these materials often elucidate whether the promoter's efforts will create a profit for all parties or whether the purchaser's own efforts will be generating the profit. (141) Courts may also look beyond written agreements with investors to promotional materials, oral representations by promoters at the time of investment, and/or the practical possibility of promoters exercising powers pursuant to agreements with investors. (142)
b. Definitions of "Purchase" and "Sale" (143)
Section 78c(a)(13) of the 1934 Act defines the terms "buy" and "purchase" to include "any contract to buy, purchase or otherwise acquire" a security. (144) Similarly, section 78c(a)(14) defines "sell" and "sale" to include "any contract to sell or otherwise dispose of" a security. (145) Courts construe these terms broadly to reflect the congressional intent in adopting the 1934 Act, while still adhering to the language of the section. (146) Moreover, in determining the meaning of "purchase" or "sale" in particular cases, courts have focused on the economic substance of the transaction, not its form. (147)
Unlike the definition for "sale" under the 1933 Act, (148) the definition for "sale" under the 1934 Act does not contain the words "for value," indicating that consideration is not required for a transaction to be deemed a sale under the 1934 Act. (149) To determine whether a sale has taken place in transactions falling outside of the traditional "cash-for-stock" purview, courts have inquired as to whether the particular transaction is one that gives rise to speculative abuse. (150)
Courts have reviewed numerous transactions to determine whether a purchase or sale has occurred. For example, the purchase or sale by a corporation of its own securities constitutes a purchase or sale under the Act. (151) Similarly, interests acquired through mergers, (152) acquisitions, (153) and other forms of corporate reorganization (154) are also deemed securities. However, the spin-off of a subsidiary into a separate company is not considered a sale of securities. (155) Furthermore, courts have held that conditional obligations to purchase or sell are not actionable. (156) Also, inducement to retain a security is generally not actionable, regardless of whether the inducement was fraudulent. (157)
c. Use of Interstate Commerce or the Mails
The jurisdictional requirement necessary to bring a violation within the scope of federal securities law is the "use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange." (158) Satisfaction of this requirement for section 10(b) of the 1934 Act requires only the "intrastate use of ... [an] interstate means of communication, or any other interstate instrumentality." (159) This interstate communication can be between any persons involved in the fraudulent act, including between codefendants. (160) The use of any means of interstate transportation will also suffice. (161) Finally, this use need only be incidental to bring the action within federal
468 (D. Mass. 1988) (rejecting broad vertical commonality approach because its effect is to merge the second and third prongs of Howey test). jurisdiction. (162)
5. Reliance
Although reliance is an essential element of a civil cause of action under Rule 10b-5, (163) the government need not demonstrate specific reliance by the investor in a securities fraud prosecution. (164) Instead, the government must show the "impact of the scheme on the investor." (165) However, in certain circumstances, an investor bringing a 10b-5 claim can rely on a rebuttable presumption of reliance.
The Supreme Court has adopted the "fraud on the market" theory of reliance for material public misrepresentations. (167) In Basic Inc. v. Levinson, the Court held that "[b]ecause 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." (168) Five elements must be met for a presumption of reliance to be shown:
(i) the defendant made public misrepresentations, (ii) the misrepresentations were material, (iii) the shares were traded on an efficient market, (iv) the misrepresentations would induce a reasonable relying investor to misjudge the value of the shares, and (v) the plaintiff traded the shares between the time of the misrepresentations and the time the truth was revealed. (169)
The Fifth Circuit has supplemented the "fraud on the market" doctrine with the "fraud created the market" doctrine. (170) In Shores v. Sklar, the court permitted a plaintiff to maintain an action under section 10(b) by proving that the defendant's fraud allowed securities that otherwise would have been unmarketable to come into and exist in the market. (171) The Sixth Circuit has articulated two methods of proving unmarketability: economic and legal. (172) Economic unmarketability occurs when a security is patently worthless. (173) Legal unmarketability occurs when a regulatory or municipal agency would have been required by law to forbid or prevent the issuance of a security. (174) Accordingly, the key to the "fraud created the market" doctrine is that the securities are unmarketable for either legal or economic reasons. (175)
B. Insider Trading
In addition to the making of a misstatement or omission of material fact in connection with the sale of a security, Rule 10b-5 can also be violated by participation in insider trading. (176) Regulation of insider trading via Rule 10b-5 protects the integrity of the securities market (177) by prohibiting material, nonpublic information from being used to purchase or sell any security in breach of a fiduciary duty. (178) In United States v. O'Hagan, (179) the Supreme Court stated that there are two separate fiduciary relationships that can serve as the basis for an insider trading violation of Rule 10b-5. The first is the relationship between corporate "insiders" and the corporation's shareholders, which is known as the classical theory of insider trading. (180) The second is the relationship between corporate "outsiders" and the "inside" source of the material, non-public information, known as the misappropriation theory. (181) The classical and misappropriation theories provide the theoretical underpinnings for criminal liability in most insider trading cases. (182)
This section discusses these two complementary theories (183) and reviews Rule 14e-3, which specifically prohibits insider trading during tender offers. (184) Next, this section analyzes Rule 10b5-1, (185) a recently endorsed standard of causation in insider trading liability. This section concludes with a discussion of Regulation FD, (186) which bars issuers from making selective disclosures of material nonpublic information to specified securities professionals.
a. The Classical Theory
Under the classical theory of insider trading, a Rule 10b-5 violation exists when a corporate insider purchases or sells securities on the basis of material, non-public information. (187) Under this theory, only corporate insiders who have a fiduciary duty to the corporation's shareholders can be found criminally liable. (188)
The fiduciary duty that a corporate "insider" owes to the corporation's shareholders requires an insider either to disclose the non-public information or abstain from trading on the information. (189) Courts consider non-disclosure a "deceptive device," through which an insider takes advantage of uninformed stockholders by buying or selling securities on the basis of confidential information that the stockholders do not possess. (190) Thus, if the insider discloses to the corporation's shareholders his or her intention to trade in the securities market based on the non-public information, there would be no "deceptive device" or Rule 10b-5 violation. (191)
In addition to traditional insiders, the classical theory also applies to both "temporary" insiders and "tippees." (192) "Temporary" insiders, such as underwriters, attorneys, accountants, consultants, or others who temporarily gain access to any "inside" information, have a duty to disclose or abstain from trading on that information because they are temporary fiduciaries of the corporation. (193)
"Tippees" are individuals who trade based on non-public information (i.e. tips) received from insiders. (194) A tippee is liable for insider trading under [section] 10(b) if: (i) the tipper possessed material, non-public information regarding the corporation; (ii) the tipper disclosed that information to the tippee; (iii) the tippee traded in the corporation's securities while in possession of that non-public information provided by the tipper; (iv) the tippee knew or should have known that the tipper violated a relationship of trust by relaying the information; and (v) the tipper benefited from disclosure of the information to tippee. (195)
Despite courts' broad interpretation of the term "insiders" under the classical theory, prosecutors were unable to prosecute many cases involving insider trading. (196) In response, prosecutors urged courts to adopt the "misappropriation theory." (197)
b. The Misappropriation Theory
In United States v. O'Hagan, (198) the Supreme Court resolved a conflict among the circuits by adopting the misappropriation theory, (199) under which a party trading on wrongfully obtained non-public information is liable solely for "misappropriating" that information. Although Chief Justice Burger had previously set forth a version of the misappropriation theory in his Chiarella dissent, (200) the O'Hagan Court adopted a version more akin to the Second Circuit's reasoning in United States v. Newman. (200)
In O'Hagan, the Supreme Court found that the misappropriation theory falls within the provisions of Rule 10b-5, which requires (i) a deceptive device; (ii) breach of a fiduciary duty; (iii) use of material, non-public information in connection with the purchase or sale of a security; and (iv) willfulness on the part of the defendant. (202)
Secretly misappropriating confidential information for personal gain while feigning loyalty to the source of the information fulfills the "deceptive device or contrivance" requirement. (203) As a result, "[d]eception through non-disclosure is central to [this] theory of liability." (204) Thus, the misappropriation theory does not impose a duty among security market participants that prohibits trades based upon material, non-public information. Rather, the misappropriation theory only bars trading on confidential information that a defendant uses for his or her own gain in breach of a fiduciary, contractual, or similar obligation to the owner or rightful possessor of the information. (205) This fiduciary relationship most frequently exists between employers and employees, (206) but it has also been found between attorneys and clients, (207) psychiatrists and patients, (208) friends and close personal relations (209) and partners and joint venture participants. (210)
Although the presence of a fiduciary relationship is well established in business situations, it is less clear whether personal relationships establish fiduciary duties that satisfy the misappropriation theory's requirement. (211) In United States v. Chestman, the Second Circuit held that marriage by itself does not create a fiduciary relationship. (212) In response to the uncertainty of the law in this area, the SEC adopted Rule 10b5-2 in 2000. (213) Rule 10b5-2 provides a non-exclusive list of three situations in which a duty can satisfy the misappropriation theory's requirement: (i) when a person explicitly agrees to maintain information in confidence; (ii) when the history or practice of the relationship demonstrates an implicit understanding between the parties that the information will be held in confidence; or (iii) when the information comes from spouses, parents, children, or siblings, unless it can be demonstrated that, under the circumstances of a particular relationship, no duty of trust existed. (214) Most recently, in SEC v. Yun, the Eleventh Circuit declined to apply the narrow approach from Chestman and found a fiduciary relationship between husband and wife where they had a "history or pattern of sharing business confidences" and the wife "explicitly accepted to keep in confidence the business information she received." (215)
Fraudulent use of material, non-public information creates criminal liability under the Securities Exchange Act only if it is used in connection with the purchase or sale of a security. (216) The misappropriation theory conforms with 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." (217) Rule 10b-5 is not implicated if misappropriated information is used for any other purpose. (218)
The scienter requirement of the statute prevents the misappropriation theory from being too vague to impose criminal liability. (219) 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]" against unjust application of the statute. (220) However, the O'Hagan Court failed both to define a standard of proof for a willful violation (221) and to determine whether the same "willful" standard applies to civil cases. (222)
In sum, the Supreme Court held that the misappropriation theory is consistent with appropriate application of Rule 10b-5. (223) The Court found that the misappropriation theory furthers the policy reasons behind the statute, in that it helps to ensure honest securities markets and accordingly promotes investor confidence by "inhibiting the impact on market participation of trading on misappropriated information." (224)
c. Strict Regulation Under Rule 14e-3 of Non-public Information Regarding Tender Offers
In direct response to the Supreme Court's holding in Chiarella, (225) the SEC promulgated Rule 14e-3 (226) to prohibit insider trading in connection with tender offers. This Rule prohibits anyone in possession of material, non-public information concerning a tender offer from trading on (227) or "tipping" that information. (228) For a violation to occur, Rule 14e-3 does not require the offender to have knowledge that the information relates to a tender offer, as long as the offender is aware of the forbidden nature of the conduct. (229) Rule 14e-3 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. (230)
In O'Hagan, the Court found that Rule 14e-3 was a valid exercise of the SEC's rulemaking authority in a 7-2 decision. (231) Additionally, there can be a simultaneous violation of Rules 14e-3 and 10b-5. (232)
d. Use Versus Knowing Possession of Inside Information
Considerable disagreement developed in the courts about whether possession of material, non-public information was enough for Rule 10b-5 liability or whether a defendant's use of that information had to be demonstrated. (233) The Second Circuit adopted the "knowing possession" standard in United States v. Teicher. (234) The knowing possession standard is based on the idea that it is difficult for a person to possess material, non-public information and purchase or sell a security without using that information. (235)
Both the Ninth Circuit, in United States v. Smith, (236) and the Eleventh Circuit, in SEC v. Adler, (237) endorsed the "use" test, instead of the "knowing possession" standard, for insider trading liability under Rule 10b-5. (238) Under the "use test," the SEC must prove that the insider used the inside information when he traded, and not merely that the insider traded while in possession of inside information. (239) The government bears the burden of proving that the defendant actually used the inside information in the transaction. (240) The inside information need not be the sole cause of the trade, but only a "'significant factor' in the insider's decision to buy or sell." (241)
In 2000, the SEC responded to Smith and...
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