Securities Fraud - Module 4 of 5
Securities
Module 4 -- Securities Fraud
Overview of Securities Fraud
Several stock market crashes or corrections in
the United States have been caused, at least in part, by the revelation of
misleading corporate disclosures. In the 1920s, stock values rapidly rose
thanks in part to overzealous promoters. The bottom dropped out in the fall of
1929, when the Dow Jones Industrial plummeted nearly 50% in a matter of weeks.[1] This crash
led to the disclosure and fraud-prevention regime embodied in the Securities
Act of 1933 and the Exchange Act of 1934.
In the 1990s, excitement in the technology
sector and loose accounting practices led to another stock market bubble. In
2000 and 2001, as various frauds were revealed, stock market prices fell
precipitously. The bursting of the tech bubble led to the Sarbanes-Oxley Act of
2002, which revamped the rules for accounting and internal control disclosures.[2]
In the 2000s, financial firms were investment
darlings due in part to inadequate disclosures concerning their susceptibility
to credit stress events and the housing market crisis. In September, 2008, the
bottom dropped out, with the S&P 500 plummeting nine percent, the Dow Jones
dropping nearly seven percent, and $1.2 trillion in stock market investment vanishing,
all in a single day.[3] These and
other events associated with the financial crisis led to passage of the
Dodd-Frank Act, which amended securities law provisions concerning disclosures
and internal controls, particularly for financial institutions.
What happens when promoters of an investment
misrepresent its quality or characteristics? If the founders of a startup cloud
computing company embellish the number of big contracts the company has in the
lead up to an initial public offering, subsequent sales revenues will be lower
than investors expected. If an established car company grossly understates its
labor and equipment expenses, it will find itself short on cash and credit,
leading to financial distress. If the CEO of an energy company exaggerates the
likelihood that the company’s oil fields will be productive, promised revenues
will never materialize. Investors in these companies will have made their
investments at artificially high prices that were premised on
misrepresentations. Once the truth emerges, their investments will depreciate.
Securities laws provide investors with
recourse. False statements in connection with securities amount to “securities
fraud.” Securities fraud provisions provide a fundamental tool for ensuring
fair and orderly markets and the overall growth of the capital markets in the
United States.
In this module, we will examine the securities
fraud laws and available recourse to investors. First, we will examine key
concepts that are used in analyzing securities fraud issues, including: the
types of fraud, states of mind, materiality, reliance, causation and damages.
Second, we will examine Sections 11 and 12 of the Securities Act, which
prohibit fraud in registration statements and prospectuses used to lure investors.
Third, we will examine Section 10(b) of the Exchange Act, which prohibits all
securities fraud of various types.
States of Mind in Securities Fraud
Securities fraud may consist of
“misrepresentations,” “omissions” or “half-truths,” or a combination. A
“misrepresentation” is an affirmative statement that is false. An example of a
misrepresentation would be a company that states that its revenues were $100
million when, in fact, they were only $50 million. An “omission” is silence on
an important issue. An example of an omission would be a company that fails to
timely disclose that it is subject to a government investigation. A
“half-truth” is a statement that is misleadingly incomplete. An example of a
half-truth would be a company that states it sold two million laptops in a
quarter, without also informing investors that one million of those laptops
were returned due to defective screens. Offering the good, but not the bad, is
misleading.
The various provisions prohibiting false
statements in connection with securities involve different states of mind.
Scienter
“Scienter” is a term of art meaning an intent
to mislead, manipulate or defraud. It applies when the person specifically
intended to defraud another.[4] Scienter
also includes reckless disregard for the truth or a known risk that its
statement would mislead investors. An example of “scienter” would be a Ponzi-scheme
artist who sets up a phony company that she does not plan to operate, dupes
investors into thinking that they are investing in an active company and then
uses the money instead for her personal lifestyle expenses.
Negligence
Negligence means that the person made a false
statement under circumstances in which, in the exercise of reasonable care, he
should have known that the statement was false. Negligence can come into play
even when the speaker did not intend to deceive investors. An example of a
“negligent” misrepresentation would be a company that claims, based on
research, that it will be able to obtain a patent on some proprietary
technology, when, in fact, there are prior claims by other companies to the
same technology. Full research would have revealed this, and the company did
not exercise reasonable care before making the statement to investors.
Strict Liability
Strict liability means responsibility even
without any culpable intent or negligence. Strict liability is sometimes
imposed on the idea that the company--and not the investors--should be
responsible for a false statement.
Strict liability only applies in limited
circumstances in the securities laws and when applied, they result in civil
liability, not criminal liability. Companies engaged in IPOs are strictly
liable for representations in their initial offering documents. The securities
laws do not want to leave investors on the hook for important statements that
turn out to be untrue.
Materiality and Reliance
A stated or omitted fact is “material” if
there is a substantial likelihood that a reasonable investor would consider the
fact important in making an investment decision in light of the information
available to the investor.[5] A
statement or omission is immaterial if it is meaningless, trivial, or
inconsequential.
Examples of material misstatements or
omissions include overstating company-wide revenues significantly, failing to
disclose that the company’s main factory suffered an explosion and falsely
claiming that the CFO is a certified public accountant.
Examples of statements that are not material
may include overstating revenues by a fraction of a percent, failing to
disclose that one of the company’s stores had to close for a day due to
renovations and claiming that the CFO graduated college in 1983 when in fact
she graduated in 1984.
Some statements, commonly used in sales, are
deemed too vague to be material. Often, these statements are called “puffery.”
Examples of “puffery” include statements such as: “next year will be a great
year for the company,” “we are excited about our new product development,” and
“our management team is excellent.”
There can be a fine line between puffery and
materiality. Consider the statement, “we are anticipating significant revenue
growth based on new orders in the pipeline.” Although this is a somewhat vague
statement, it implies some specifics, such as a comparison of next year’s
projections with last year’s revenues and that new orders are in the works.
To determine materiality, one must look at the
statement in the context of other facts. If the company has also stated that it
had revenues of $100 million last year and anticipates revenues of $105 million
this year, the phrase “significant growth” might merely mean a 5% increase and
nothing more. If revenue growth turns out to be 5%, investors would be hard
pressed to claim “significant growth” meant something more, like 10% or 20%.
Reliance
“Reliance” requires that the investor used the
statement in making an investment decision. It is interwoven with the concept
of materiality but focuses on what the investor did with the information. An
investor who reviews a company’s press release before deciding to buy its stock
has “relied” on the release. Conversely, an investor who never saw the release
cannot claim to have relied on it.
In cases involving material omissions,
reliance may be presumed. This rule flows from the difficulty in proving
reliance on something that was not stated. Thus, an investor may prove reliance
in omission cases by proving the omitted fact would have been material to a
reasonable investor if it was disclosed.[6]
Causation and Damages
“Causation” means that the misstatement or
omission caused the investor’s losses. Typically, investors pursuing securities
fraud claims must establish two forms of causation: “transaction causation” and
“loss causation.”
Transaction causation is similar to reliance.
It means that the misstatement was one of the pieces of information that caused
the investor to enter into the transaction.[7]
Loss causation focuses on the impact that the
misstatement or omission had on the security’s price. It requires proof of a
nexus between the fraud and the investor’s losses.[8]
The goal is to separate the portion of the security’s price attributable to the
fraud from price factors that are attributable to other market forces, such as
economic downturns, overall stock market trends and changes to the law.[9]
Consider a company that exaggerates its
revenues, leading the stock price to rise from $60 per share to $100 per share
on a day when there is no other news about the company. The misstatement likely
“caused” the stock price to move up by $40.
Loss causation gets tricky when there are
multiple economic factors or news factors that may have contributed to a price
decline. Expert economists may offer reports to indicate what aspect of a price
decline is attributable to the fraud and which aspect is attributable to other
factors.
Consider a situation in which, on the same
day, a company’s fraud is revealed but the general stock market declined by 1%.
If the company’s price dropped from $100 to $90, economists may opine that $1
was attributed to the general stock market decline, and $9 is attributable to
the fraud.
Damages
“Damages” refer to the economic loss suffered
by the investor. If a company lied about its financial prospects, the truth is
revealed, and the price drops from $100 per share to $70 per share as a result,
the investor’s “damages” are $30.
Rules 11 and 12: Registration Statements
and Prospectuses
The Securities Act requires companies that go
public to disclose to investors important information regarding the company,
its business, management and financial status. Section 11 is designed to
protect investors from false registration statements that are filed and
published by the company before its initial public offering.
Section 11 applies to registration statements
that contain untrue statements of material fact or omit material facts that
make it misleading.[10] Because registration statements are filed
only for public offerings, a Section 11 claim is not available for
non-registered securities.
An investor may recover under Section 11 if
she can prove that (1) she purchased securities pursuant to a false
registration statement and did not know the truth at the time of purchase; (2)
the registration statement contained a material misstatement or omission; (3)
the defendant is a type of person or entity enumerated in Section 11; and (4)
the complaint was brought in a timely fashion.
Six types of entities can be liable under
Section 11:
(1) the issuer (i.e., the company whose
securities are being sold);
(2) every person who signed the registration
statement (such as corporate officers and directors);
(3) directors of the issuer at the time the
registration statement was filed;
(4) directors, or people who are about to become
directors;
(5) experts who have prepared or certified
portions of the registration statement or any report or valuation used in
connection with the registration statement, including accountants, engineers
and appraisers; and
(6) underwriters with respect to the IPO.[11]
These defendants may be held “jointly and
severally liable,” which means an injured plaintiff may seek full recovery from
any one of them, a group of them or all of them. It is then up to the
defendants to apportion their respective liability amongst each other, as part
of the same lawsuit or in separate suits if necessary.[12]
While issuers are strictly liable for the IPO
misrepresentations,[13] signers,
directors, underwriters and experts are not liable if they can show that “after
reasonable investigation” they had “reasonable ground to believe and did
believe” that the statements were true and that there were no omissions.[14]
What constitutes a “reasonable investigation”
and “reasonable ground for belief” is based on that “required of a prudent man
in the management of his own property.”[15]
These defendants bear the burden of proving that they acted reasonably, and investors
may likely present evidence of lack of reasonableness to refute the affirmative
defense.
An investor may recover the difference between
the price it paid for the security and its value at the time the suit was
brought. However, if defendants are able to prove that a portion of the price
decline was caused by a factor other than the misrepresentation or omission, that
can reduce their liability.[16] The
defendants bear the burden of proof on this issue as well.
An investor cannot recover under Section 11 if
the defendant proves that the investor knew that there was a misrepresentation
or omission—in other words, that the investor knew the truth and invested
anyway.[17]
Finally, an investor must bring suit under
Section 11 within one year of discovering the fraud (or within a year of when the
fraud could have reasonably been discovered through reasonable diligence) and
not later than three years after the security was first offered to the public.[18]
Section 12 applies to misstatements and
omissions in a “prospectus.” The term “prospectus” is broad and covers any
notice, advertisement, letter, communication or other document that offers a
security for sale.[19]
Prospectuses are used in a broad range of securities offerings--both public and
private.
Liability attaches to any person who offers or
sells a security pursuant to a prospectus that contains a material misstatement
or omission.[20] Liability extends to others involved in the
sales process as well, such as brokers.[21]
The investor may recover the difference in price paid and the value of the
security at the time of suit or it can require the seller to take the security
back and return the full purchase price.[22]
As with Section 11, investors do not need to
prove that the seller acted with the intent to defraud the investor or that it
recklessly disregarded the truth. Defendants under Section 12 can avoid
liability, however, if they prove that they did not know, and, in the exercise
of reasonable care, could not have known of the untruth or omission.[23] This
defense is similar to the defenses available under Section 11 for non-issuers.
Likewise, sellers can limit their liability by proving that a portion of the
investor’s loss is attributable to factors other than the misstatement or
omission.[24]
Finally, as with Section 11, an investor must
bring suit under Section 12 within one year of discovering the fraud (or when
the fraud could have reasonably been discovered through reasonable diligence)
and not later than three years after the security was first offered to the
public.[25]
Rule 10b-5: Fraud
Section 10(b) prohibits all fraud in
connection with the purchase or sale of a security.[26]
Section 10(b) and Rule 10b-5, which the SEC adopted as a regulation, have been
interpreted to allow a private right of action for investors.[27] These
provisions are critical to the anti-fraud objectives of securities laws because
they cover all securities fraud, regardless of whether the issuer is public or
private, and regardless of whether the fraud occurred in registration statements,
prospectuses, quarterly reports, annual reports or other documents or
communications.
An investor bringing a Section 10(b) claim must prove:
(1) the defendant made a material misrepresentation
or omission;
(2) it was in connection with the investor’s
purchase or sale of a security;
(3) the investor relied on the
misrepresentation or omission;
(4) the defendant’s fraud was intentional or with
severe recklessness; and
(5) the fraud proximately caused the
investor’s damages.[28]
Investors may recover their actual damages and
consequential damages such as brokerage fees. Investors must bring suit within two years
after discovering the fraud and not more than five years after the fraud
occurred.[29] There are limitations to actions under Rule
10(b). Most importantly, investors must prove “scienter,” or intentional
falsity or recklessness and so negligence is insufficient.[30]
Rather, the investor must prove that the defendant wanted to defraud her or
consciously disregarded a known risk that the statement was misleading. Also, investors have to prove that the fraud
was “in connection with” a purchase or sale. This means that investors who hold
stock based on a misrepresentation or omission cannot sue under Section 10(b).[31]
With that said, the courts have embraced some
concepts to make it easier for investors to recover for securities fraud. For example, many investors in large publicly
traded companies do not read prospectuses, annual reports or other statements
by companies, but rely on the integrity of the market price. These investors can
show reliance on the falsities through the “fraud on the market” theory. This
theory applies to securities traded in a large market (such as a stock
exchange). In such markets, information and misinformation regarding the
company is assumed to be quickly incorporated into the stock’s price. False
statements may lead to increased market prices. Investors are entitled to rely
on those market prices. Thus, for highly liquid securities traded on national
exchanges, the courts assume that investors rely--via the market price--on all
information available to the market. Once the truth is revealed, and the price
drops, investors are harmed because the market price at which they acquired the
security was premised on the fraudulent conduct.[32]
If a fraudulent statement is made in a
registration statement, the investor may pursue claims under both Section 11
and Section 10(b). Likewise, if a fraudulent statement is made in a prospectus,
the investor may pursue claims under both Section 12 and Section 10(b). In
other words, these causes of action are “cumulative.” That said, the investor
can only recover once even though multiple provisions were violated.
In
our last module, we’ll look at a common specific type of securities fraud:
insider trading and the rules that prohibit and prevent it.
[1] Gary Richardson, Alejandro Komai & Michael
Gou, “Stock Market Crash of 1929,” Federal Reserve History, https://www.federalreservehistory.org/essays/stock_market_crash_of_1929 (last visited Oct. 26, 2018).
[2] William H. Donaldson, “Testimony Concerning Implementation of the Sarbanes-Oxley Act of 2002,”
U.S. Securities and Exchange
Commission, (Sept. 9, 2003), https://www.sec.gov/news/testimony/090903tswhd.htm.
[3] Vikas Bajaj & Michael M. Grynbaum, “For Stocks, Worst Single-Day Drop in Two
Decades,” N.Y. Times (Sept.
29, 2008), https://www.nytimes.com/2008/09/30/business/30markets.html.
[7] Id.
[8] Huddlestonv. Herman & MacLean, 640 F.2d 534, 549 (5th Cir. 1981), aff’d in part, rev’d in part on other
grounds, 459 U.S. 375 (1983).
[9] Id.
[11] Id.
[12] 15 U.S.C. 77k(f).
[13] 15 U.S.C. 77k(b).
[14] Id.
[15] 15 U.S.C. 77k(c).
[16] 15 U.S.C. 77k(e).
[17] 15 U.S.C. 77k(a).
[22] 15 U.S.C. 77l(a)(2).
[23] 15 U.S.C. 77l(a)(2).
[24] 15 U.S.C. 77l(b).
[25] 15 U.S.C. 77m.
[32] BasicInc. v. Levinson, 485 U.S. 224, 247-49 (1988).