SEC Rule 10b-5 Overview Professor Marilyn Cane NSU LAW Rule

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SEC Rule 10b-5

• Overview

Professor Marilyn Cane NSU LAW
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Rule 10b-5 Text

• 17 CFR 240.10b-5 Employment of manipulative and
  deceptive devices
• It shall be unlawful for any person, directly or
  indirectly, by use of any means or
  instrumentality of interstate commerce, or of the
  mails, or of any facility of any national
  securities exchange,

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Rule 10b-5 Text Continued

• (a) To employ any device, scheme or artifice to
  defraud,
• (b) To make any untrue statement of a material
  fact or to omit to state a material fact
  necessary in order to make the statements made,
  in light of the circumstances which they were
  made, not misleading, or

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Rule 10b-5 text continued

• c to engage in any act, practice or course of
  business which operates or would operate as a
  fraud or deceit upon any person
• in connection with the purchase or sale of any
  security

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Who May Bring 10b-5 Action?

• The SEC
• The Department of Justice (Criminal)
• Private Parties
• No express private remedy under Section 10
• Private Cause of Action Implied under Rule 10b-5

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Keys to Rule 10b-5 Liability

• Misstatement or omission
• Materiality
• Scienter
• Reliance (Transaction Causation)
• Proximately Caused Damages (Loss Causation)

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Elements

• Use of Jurisdictional means, that is,
  interstate commerce (usually easily proven)
• In private action, that plaintiff is actual
  purchaser or seller Blue Chip v. Manor Drug,
  421 U.S. 723 (1975)
• Showing a material misrepresentation or
  nondisclosure or manipulation (breach of
  fiduciary duty with out misrepresentation is
  insufficient Santa Fe Ind. V. Green, 430 U.S.
  462 (1977)

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Elements Continued

• The misrepresentation, omission or half-truth
  must be material Basic v. Levinson, 485 U.S. 224
  (1988
• Defendant acted with scienter Ernst Ernst v.
  Hochfelder, 425 U.S. 185 ( 1976)
• Reliance by plaintiff
• Proximate Cause of loss ( in connection with
  the purchase or sale requirement
• Damages

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Misstatement or Omission

• Exchange Act reports, press releases, oral
  statements, web pages, etc
• Sarbanes-Oxley Act of 2002 (Section 409) requires
  reporting companies to disclose to the public on
  a rapid and current basis material changes

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Materiality

• The omitted fact is material if there is a
  substantial likelihood that a reasonable
  shareholder would consider it important in making
  an investment decision
• Put another way, there must be a substantial
  likelihood that the omitted disclosure would have
  been viewed by the reasonable investor as having
  significantly altered the total mix of
  information made available
• Basic v. Levinson, 435 U.S. 224 (1988)

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Scienter

• Must be proven by private plaintiff and SEC
• Federal courts have held recklessness meets
  scienter requirement
• Ernst Ernst v. Hochfelder, 425 U.S. 185 (1976)

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Scienter Defined

• A mental state embracing intent to deceive,
  manipulate or defraud
• in certain areas of the law recklessness is
  considered to be a form of intentional conduct
  for purposes of imposing liability

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Private Right of Action

• 10b-5 can be enforced by SEC in civil penalty
  and injunctive actions, and by the Justice Dept.
  for criminal violations
• Private Right of Action is IMPLIED by the
  courts, therefore the parameters of the Private
  Right of action defined by the Courts.
• Section 804 of Sarbanes-Oxley Act extends the
  Statute of Limitations for private 10b-5 actions
  to the earlier of Two (2) years from discovery
  of facts or five (5) years after such violation

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Reliance and Causation

• Reliance is a necessary element of a 10b-5 claim,
  and plaintiff must prove proximate causation.
• However, reliance on omissions may be presumed
  in certain cases
• Face-to-Face transactions Affiliated Ute
  Citizens v. US, 406 U.S. 128 (1972)
• Fraud on the Market Basic v. Levinson, 485 U.S.
  224 ( 1988)
• Presumptions are rebuttable.

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Fraud on the Market

• A theory of causation in securities fraud
  premised on distortions in the market price of a
  security because of a material misrepresentation
  or omission
• Based upon Economic Theory called Efficient
  Market Hypothesis, which posits that securities
  prices reflect all relevant information.
• Allows investors to sue for damages without
  showing that they personally relied on allegedly
  fraudulent statements issued by a corporate
  defendant.

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Remedies and Damages

• Section 28 of the 1934 Act limits damages to
  actual damages
• Pendant state blue sky or common law claims may
  give rise to a claim for punitive damages,
  however
• Usual measure is out of pocket measure

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Insider Trading

• Trading on the basis of MATERIAL NONPUBLIC
  information
• Disclose or Abstain from trading
• Tipper and Tippee both potentially liable
• Mere possession of material inside information
  not actionable, you need a breach of duty.
  Chiarella v. U.S. , 455 U.S. 222 (1980)
• There is no requirement of Parity of Information
  in the markets.

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Insider Trading is not a Good Thing
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Remedies for Insider Trading

• SEC Injunctions and Disgorgement
• Civil Liability for Contemporaneous Traders
• Civil Penalties
• Criminal Sanctions

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The Misappropriation Doctrine

• Does the misappropriation of information in order
  to trade in securities in violation of a duty of
  confidentiality to an employer or corporation
  provide a basis for insider trading liability ?
• Wall Street Journal Heard on the Street
  Case, Carpenter v. U.S. 484 U.S. 19 (1987)
• Supreme Court splits 4-4 on misappropriation

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Misappropriation Doctrine Upheld

• Finally, in 1997, the Supreme Court endorsed the
  misappropriation doctrine in U.S. V. OHagan,
  117 S.Ct. 2199 (1997)
• OHagan was an unethical lawyer who used inside
  information he took from his law firm regarding
  a possible tender offer by the firms client for
  the Pillsbury Company

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Aiding and Abetting Liability

• There is no liability in a PRIVATE Cause of
  Action for aiding and abetting primary violations
  of the securities laws. Central Bank of Denver
  v. First Interstate, 511 U.S. 164 (1994)
• However, the SEC may bring actions for AA
• Controlling Persons have liability under
  Section 20 of the Exchange Act

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Defenses

• Due Diligence, Unclean Hands, Estoppel and in
  pari delicto are all possible defenses
• If some insider-tipper gave a tippee a FALSE
  tip, may the defrauded tippee successfully bring
  suit against the tipper, since both have violated
  the law, in pari delicto ?

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Defense of In Pari Delicto

• The Supreme Court has held that for the
  Defendant -tipper in the false tip scenario to
  prevail, she must prove that Plaintiff-Tippee
• by plaintiffs s actions, he bears at least
  substantially equal responsibility for the
  violations and
• barring plaintiffs recovery would not offend the
  policies underlying the securities laws, that is,
  protection of the investing public

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SEC Regulation FD

• FD Fair Disclosure
• Prohibits selective disclosure of material
  nonpublic information to analysts, institutional
  investors and others unless widespread public
  disclosure is concurrently made.
• Intentional disclosure of non-public information
  must be done publicly and simultaneously
• Unintentional disclosure of material non-public
  information triggers a requirement to promptly
  disclose that information publicly (within 24
  hours)

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Sarbanes-Oxley Act of 2002

• Violation of Sarbanes Oxley Act (SOA) treated
  as violation of Securities Exchange Act
• Senior Management Accountability
• Certification of financial reports by CEO and CFO
• Prohibition of insider trades during pension fund
  blackouts
• Criminal penaltiesfines up to 1 million and/or
  imprisonment up to 10 years if willful
  violation 5 million and up to 20 years
• SEC may bar persons from serving as officers or
  directors of public companies if they have
  violated Securities laws and their conduct
  demonstrated unfitness

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Sarbanes- Oxley Continued

• The SEC may freeze extraordinary payments to
  persons charged with securities law violations
• Liabilities for securities law violations are NOT
  discharged by personal bankruptcy
• Section 804 of SOA extends the Statute of
  Limitations for private 10b-5 actions to the
  earlier of Two (2) years from discovery of
  facts or Five (5) years after such violation

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11/2003