The Guide to Securities Fraud Elements and SEC Rule 10b-5

Securities fraud refers to misrepresenting information to investors regarding the sale or purchase of securities and/or the manipulation of financial markets. Read more.

What is securities fraud?

Securities fraud, according to the Federal Bureau of Investigation, includes a broad range of activities, including but not limited to high yield investment fraud, Ponzi and pyramid schemes, broker embezzlement, and advance fee schemes. Securities fraud is characterized by the misrepresentation of material information to investors in connection with the sale or purchase of securities and/or the manipulation of financial markets. A “security” includes, but is not limited to, a “note, stock, treasury stock, security future, security-based swap, bond, debenture… option… [or] certificate of deposit.” Additionally, insider trading, falsifying information in corporate filings, lying to corporate auditors and manipulating share prices also fall within the ambit of securities fraud. The Securities and Exchange Commission (the “SEC”) provides a comprehensive guide to identifying and avoiding securities fraud through its office of investor education and advocacy.

What are the elements of securities fraud?

The elements of securities fraud, as described by the American Bar Association, require an intentional misrepresentation or omission of material information in connection with the sale or purchase of a security. In addition, a plaintiff must also show that they relied detrimentally on this information, causing losses and ultimately resulting in harm to the plaintiff. The causal relationship between the information or lack-thereof and the resulting harm must be established.

Is securities fraud a criminal or civil matter, and how is it punishable?

Securities fraud can be prosecuted both as a criminal and/or civil matter. Securities and commodities fraud and the related punishments are covered by U.S. Code Section 1328. Specifically, securities fraud can result in a felony conviction and up to 25 years imprisonment and/or the imposition of civil fines (on top of restitution). 

Securities fraud is considered a serious white-collar crime and can lead to both criminal and civil penalties. The SEC itself often serves as plaintiff in filing securities fraud lawsuits, although private plaintiffs also have standing to do so if they were the defrauded investor. Furthermore, investors that were not directly targeted by securities fraud, and therefore do not have standing, may notify the SEC of the issue, who in turn can investigate and prosecute the alleged violation. 

What is SEC Rule 10b-5 and when does it apply?

Under the Securities and Exchange Act of 1934, the SEC is the governmental agency responsible for establishing, overseeing and enforcing laws pertaining to securities fraud. SEC Rule 10b-5, states that it is illegal for any person to defraud or deceive someone, including through the misrepresentation of material information, with respect to the sale or purchase of a security. Rule 10b-5 covers instances of insider trading, wherein an insider or executive uses nonpublic information to influence share prices to their benefit:

Employment of Manipulative and Deceptive Practices.

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(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 the light of the circumstances under which they were made, not misleading, or

(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.

In sum, SEC Rule 10b-5 is applicable to any person that commits securities fraud, i.e., the intentional misrepresentation of material information in connection with securities trading, including insider trading. “Person”, however, is not limited to an individual and includes businesses, corporations, and possibly even governmental bodies. 

Who can sue under Rule 10b-5? And what is a Rule 10b-5 private right of action?

As stated above, the SEC often serves as plaintiff in securities fraud lawsuits. In addition, private plaintiffs may sue if they have standing – i.e., they were directly harmed by the securities fraud. Private parties that were not directly targeted by the securities fraud may seek recourse by bringing the issue to the attention of the SEC. 

Nevertheless, it is possible to file a securities fraud class action known as a “fraud-on-the-market” claim. In this type of situation, the traditional private right of action under 10b-5 is widened so as to allow a class of securities purchasers to sue an issuer for having made a public misrepresentation. 

What are some examples of Rule 10b-5 violations?

In addition to the examples of securities fraud discussed in the introduction, Rule 10b-5 violations include but are not limited to:

  • False or misleading statements made by a corporate executive intended to increase market share price
  • False or “creative” accounting used to hide losses or insufficient revenue
  • False or misleading statements by a corporate executive intended to decrease market share price, so that they are able to buy up those shares at the lower price

What is the Rule 10b-5 statute of limitations?

There are two time-frames applicable to a Rule 10b-5 claim, both of which the plaintiff must satisfy. First, the plaintiff must file the claim within two years of having discovered the facts that constitute the alleged violation. Second, the plaintiff must file the claim no more than five years after the violation occurred. 

What is a 10b-5 letter?

Also known as a disclosure or negative assurance letter, a 10b-5 letter is provided by a security issuer’s legal counsel to certify that the security transaction (e.g. the purchase of shares) does not contain any false or misleading material information, or omit any material information. A 10b-5 letter is obligatory and required for the completion of a securities offering, and attests to the purchaser’s due diligence. Nevertheless, a 10b-5 letter is not a legal opinion. 

What is a 10b-5 opinion?

A 10b-5 legal opinion, or due diligence opinion, is a letter drafted by the issuer’s counsel stating that the information contained in the issuer’s official statement is accurate and complete, and that counsel has not identified any misrepresentation or omission of material fact. 

What is Rule 10b5-1 in relation to insider trading?

In 2000, the SEC created Rule 10b-5-1 in order to clarify when and how insiders are authorized to make predetermined trades without violating insider trading laws. In such cases, the sales date, prices and amount of securities to be traded must be established in advance, and neither the seller nor purchaser may have access to any material insider information. Although a company is not legally obligated to disclose a Rule 10b-5-1 plan to its shareholders, it is typically advisable to be transparent so as to avoid unnecessary accusations or bad press. 

When is securities fraud prosecuted under Securities and Exchange Act Section 17(a)(2) instead of Rule 10b-5?

Securities and Exchange Act Section 17(a)(2) is similar to Rule 10b-5 in that it allows for the prosecution of securities fraud, as described above. Nevertheless, the main difference between the two rules is that Section 17(a)(2) does not require intent (i.e., “scienter” or reckless action on the part of the defendant). Instead, the court could find that securities fraud was committed where the defendant acted negligently. Thus, where the plaintiff argues that the defendant, or person making the misstatement, failed to act with the appropriate standard of care, Section 17(a)(2) may apply. 

When should I contact a securities litigation attorney?

You should contact a securities litigation attorney the moment you think you have been the victim of securities fraud. Generally, the phone call and consultation are free.

Do I need a securities litigation attorney near me?

We recommend working with a securities litigation attorney who has experience in the jurisdiction where the case would be tried. For example, if the case will be tried in Los Angeles Superior Court, we recommend working with an attorney who is familiar with LASC judges and proceedings.

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