Securities Fraud - Claims Under the Securities Exchange Act and The Securities Act

The Securities Exchange Act

Section 10(b)

Section 10(b) of the Securities Exchange Act establishes civil liability for a wide range of securities fraud.  Enacted in the wake of the stock market crash of 1929, the statute was intended to "protect investors engaged in the purchase and sale of securities by implementing a policy of full disclosure."  United States v. Bilzerian, 926 F.2d 1285, 1297 (2nd Cir. 1991).  The United States Supreme Court has emphasized repeatedly that Section 10(b) "should be construed not technically and restrictively, but flexibly to effectuate its remedial purposes."  In re Parmalat Securities Litigation, 376 F.Supp.2d 472, 501 (S.D.N.Y. 2005) (quoting Securities Exchange Commission v. Zandford, 535 U.S. 813, 819 (2002)).       

 In order to state a claim under § 10(b), a plaintiff must allege that a defendant (1) made a misstatement or omission of material fact, (2) with scienter, (3) in connection with the purchase or sale of securities, (4) upon which [such] plaintiff relied, and (5) that the plaintiff's reliance was the proximate cause of its injury."  Atsi Communications v. Shaar Fund, Ltd., 493 F.3d 87, 98 (2nd Cir. 2007); Lawrence v. Cohn, 325 F.3d 141, 147 (2nd Cir. 2003); Ganino v. Citizens utilities Co., 228 F.3d 154, 161 (2nd Cir. 2000); Luce v. Edelstein, 802 F.2d 49, 55 (2nd Cir. 1986); In re Refco, Inc. Securities Litigation, 503 F.Supp.2d 611 (S.D.N.Y. 2007). 

A (mis)statement or omission is material if it "would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."  TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).  The relevant inquiry is whether there is a "substantial likelihood that a reasonable person would consider it important in deciding whether to buy or sell shares."  Azrielli v. Cohen Law Offices, 21 F.3d 512, 518 (2nd Cir. 1994); see also, Basic, Inc. v. Levinson, 485 U.S. 224, 241 (1988).        

Rule 10b-5

Rule 10b-5 enumerates three (3) categories of practices prohibited under § 10(b), making it unlawful

            "(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 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."

17 C.F.R. § 240.10b-5.

The anti-fraud provisions set forth in Section 10(b) and Rule 10b-5 are not specific to institutional sellers of securities; rather, these provisions apply, more broadly, to "any person" who sells or offers for sale securities through "the mails" or by any other "means or instrumentality of interstate commerce."  15 U.S.C. § 78j.               


Of the elements necessary to state a claim for securities fraud, scienter is, arguably, the most difficult to plead and prove.  In relation to securities fraud, scienter "refers to a mental state embracing the intent to deceive, manipulate, or defraud."  Ernst & Ernst v. Hochfelder,  425 U.S. 185, 193 (1976).  Scienter may be established by "alleging facts (1) showing that the defendants had both motive and opportunity to commit the fraud or (2) constituting strong circumstantial evidence of conscious misbehavior or recklessness."  Atsi Communications, 493 F.3d at 99 (citing Ganino v. Citizens Utilities Co.,  228 F.3d 154, 168-69 (2d Cir. 2000)).  (Emphasis supplied.)  "Sufficient motive allegations entail concrete benefits that could be realized by one or more of the false statements and wrongful nondisclosures alleged."  Kalnit v. Eichler, 264 F.3d 131, 139 (2nd Cir. 2001).     

Where motive is not apparent, it is still possible to plead and prove scienter "by identifying circumstances indicating conscious behavior" on the part of the defendant.  Kalnit, 264 F.3d at 142.  Under this theory of scienter, a plaintiff must show that a defendant's conduct is "at the least, conduct which is highly unreasonable and which represents an extreme departure from the  standards of ordinary care to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it."  Id. (quoting In re Carter-Wallace, Inc. Securities Litigation, 220 F.3d 36, 39 (2nd Cir. 2000)); In re Refco, Inc. Securities Litigation, 503 F.Supp. 2d at 635.  

Stated differently, "heedlessness and reckless disregard of consequence may take the place of deliberate intention" in the context of securities fraud.  Rolf v. Blyth, Eastman Dillon & Co., Inc., 570 F.2d 38, 45 (2nd Cir. 1978).  Accordingly, scienter may be established where, as appears to have occurred, a defendant has (1) represented information as true while knowing it is not, (2) recklessly misstated information, (3) asserted an opinion on grounds so flimsy as to belie any genuine belief in its truth, or (4) failed to check information he or she had a duty to monitor. Id.; see also, Novak v. Kasaks, 216 F.3d 300, 311 (2nd Cir. 2000); In re eSpeed, Inc. Securities Litigation, 457 F.Supp.2d 266, 282 (S.D.N.Y. 2006) (holding, inter alia, that recklessness is established when a plaintiff demonstrates a defendant's knowledge of facts or access to information which contradict his public statements).    

            "Participation" In Securities Fraud

In certain circumstances, "participation" in a "fraudulent scheme" or, more broadly, in the commission of securities fraud may give rise to liability under Section 10(b) and Rule 10b-5.    The participation necessary for liability to attach has been both the subject of significant debate and the source of considerable confusion.  The inquiry is necessarily fact-specific and the outcome varies from Circuit to Circuit. 

The rule in the Second Circuit is that participation in a fraudulent scheme or in the commission of securities fraud will be sufficient to give rise to liability under Section 10(b) and Rule 10b-5 if, and only if, that participation took the form of statements or actions that were independently deceptive or fraudulent.  Where a person is alleged to have participated in a scheme to violate the securities laws, it is necessary to examine closely the extent of the alleged participation to determine whether the person is accused of an actual misrepresentation or the employment of a fraudulent device.  In the absence of such an accusation, a claim based on mere "participation" is legally insufficient.  See, e.g., Shapiro v. Cantor, 123 F.3d 717, 720 (2nd Cir. 1997); Securities Exchange Commission v. First Jersey Securities, Inc., 101 F.3d 1450, 1467 (2nd Cir. 1996) (holding, inter alia, that upon an allegation of participation in a fraudulent scheme, primary liability "may be imposed not only upon persons who made fraudulent misrepresentations but also on those who had knowledge of the fraud and assisted in its perpetration"); Securities and Exchange Commission v. Collins & Aikman Corp., 07 Civ. 2419 
(SAS) (S.D.N.Y. December 21, 2007), Slip Op. at pp. 16-19; In re Parmalat Securities Litigation, 376 F.Supp.2d at 501.   

The rules governing "participation" are much more lenient elsewhere. The Sixth Circuit, for example, has held that a person who undertakes to furnish information which contains a material misstatement or omission is a primary participant, so long as he or she is not so far removed from the transmission of the misleading information that liability would necessarily become vicarious.  See Securities and Exchange Commission v. Washington Co. Utility District, 676 F.2d 218, 223-24 (6th Cir. 1982); see also, Rubin v. Schottenstein, Zox & Dunn, 143 F.3d 263, 27 (6th Cir. 1998) ("direct contacts," in the form of conversations, give rise to a duty to disclose).   

            Statute Of Limitations

Prior to the enactment of the Sarbanes-Oxley Act ("Sarbanes-Oxley"), 28 U.S.C. § 1658(b), in January 2002, there was no congressionally created limitations period for Federal securities fraud claims arising under Section 10(b) of the Securities Exchange Act and Rule 10b-5.  As a result, in Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350, 111 S.Ct. 2773 (1991), the United States Supreme Court held that litigation instituted pursuant to Section 10(b) and Rule10b-5 must be commenced within one year after the discovery of the facts constituting the violation and not more than three (3) years from the date such violation occurred.  Id. at 362.  The Lampf Court viewed the three (3) year limit as a "period of repose," intended to impose an "outside limit" not subject to tolling principles.  Id. at 363.     

Sarbanes-Oxley extended these periods to two (2) years and five (5) years, respectively, for actions commenced on or after the date of enactment of the statute.  See 28 U.S.C. § 1658(b); Lieberman v. Cambridge Partners, 432 F.3d 482 (3rd Cir. 2006); In re Enterprise Mortgage Acceptance Co. LLC Securities Litigation, 391 F.3d 401 (2nd Cir. 2004).  The two (2) year limitations period applicable to discovery of the violation begins to run after a plaintiff "obtains actual knowledge of the facts giving rise to the action or notice of the facts, which in the exercise of reasonable diligence, would have led to actual knowledge."  LC Capital Partners v. Frontier Insurance Group, 318 F.3d 148, 154 (2nd Cir. 2003) (quoting Kahn v. Kohlberg, Kravis, Roberts & Co., 970 F.2d 1030, 1042 (2nd Cir. 1992)).

The limitations period codified in Sarbanes-Oxley would govern any action commenced here arising under Section 10(b) and Rule 10b-5.  Any such action would, therefore, need to be commenced within two (2) years after the discovery of facts giving rise to the underlying violation(s) and not more than five (5) years from the date any such violation(s) occurred. 

            Pleading Requirements

As is any fraud claim, securities fraud claims are subject to heightened pleading requirements.  These requirements are imposed by Rule 9(b) of the Federal Rules of Civil Procedure and the Private Securities Litigation Reform Act of 1995, 15 U.S. C. § 78u-4(b) (the "PSLRA").       

            Rule 9(b)  

Rule 9(b) of the Federal Rules of Civil Procedure requires that any fraud claim, including any claim for securities fraud, be pleaded with particularity.  See Fed.R.Civ.P. Rule 9(b).  This "pleading constraint" is predicated upon the need to provide a defendant "with fair notice of a plaintiff's claim, safeguard his reputation from improvident charges of wrongdoing, and protect him against strike suits."  Atsi Communications, 493 F.3d at 98; see also, In re Scottish Re Group Securities Litigation, 524 F.Supp.2d 370 (S.D.N.Y. 2007).              

To comply with the requirements of Rule 9(b), a plaintiff must

                       "(1) specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker,

                        (3) state where and when the statements were made, and (4) explain why the statements were fraudulent."   

Rombach v. Chang, 355 F.3d 164, 170 (2nd Cir. 2004); accord Atsi Communications, 493 F.3d at 99 (citing Novak v. Kasaks, 216 F.3d 300, 306 (2nd Cir. 2000)). 

Pursuant to Rule 9(b), "allegations that are conclusory or unsupported by factual assertions" will not suffice.  However, the Second Circuit has recognized an exception where, as here, a plaintiff has relied upon fraudulent statements found in offering materials.  In such situations, a plaintiff may satisfy his or her burden by showing that defendants are "insiders or affiliates participating in the offer of the securities in question."  DiVittorio v. Equidyne Extractive Industries, 822 F.2d 1242 1247-49 (2nd Cir. 1987); Luce v. Edelstein, 802 F.2d at 55.

           The PSLRA     

Any claim for securities fraud must also meet the requirements of the PSLRA.  15 U.S.C. § 78u-4(b)(3)(A); ATSI Communications, 493 F.2d at 99.  As the United States Supreme Court opined in the recent case of Telltabs v.  Makor Issues & Rights, ___ U.S. ___, 127 S.Ct. 2499 (2007), the PSLRA requires a plaintiff to state with particularity "both the facts constituting the alleged violation, and the facts evidencing scienter, i.e., the defendant's intention to deceive, manipulate, or defraud."  127 S.Ct. at 2504 (quoting 15 U.S.C. § 78u-4(b)(1), (2)).

As does Rule 9(b), the PSLRA also requires that any complaint alleging securities fraud based upon a "false statement or omission" by or on the part of any defendant "specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state all facts on which that belief is formed."  ATSI
Communications, 493 F.3d at 99 (quoting 15 U.S.C. § 78u-4(b)(1)).         

 Accordingly, to comply with the PSLRA, a plaintiff must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind."  Telltabs, supra (quoting 15 U.S.C. § 78u-4(b)(2)).  "[A]n inference of scienter must be more than merely plausible or reasonable -- it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent."  Telltabs, 127 S.Ct. at 2504-05. 

However, the inference need not be "irrefutable, i.e., of the 'smoking gun' genre, or even the most plausible of competing inferences."  Id. at p. 2510.  (Citations omitted.)  The relevant inquiry is whether, accepting as true the allegations of the complaint, "a reasonable person [would] deem the inference of scienter at least as strong as any opposing inference."  Telltabs, 127 S.Ct. at 2510. In the Second Circuit, it has been held that the magnitude of the alleged fraud provides some additional circumstantial evidence of scienter.  See, e.g., In re Scottish Re Group Securities Litigation, 524 F.supp.2d at 394 & n. 174.  Similarly, resignations of former company officials, especially those of senior managers, "add to the overall pleading of circumstantial evidence of fraud."  Id. at 394-95 & n. 176.         

The Securities Act

The anti-fraud provisions codified in Section 12 of the Securities Act are much more "investor-friendly" than those set forth in the Securities Exchange Act.  See 15 U.S.C. § 77l(a)(2).  Claims arising under the Section 12 are subject to less stringent pleading requirements; the requisite burden of proof is also appreciably lower.  If the jurisdictional requirements are satisfied (i.e., use of the mails or interstate commerce), and the statute of limitations has not run, liability is basically absolute. 

Section 12(a)(2) of the Securities Act imposes liability on one who "offers or sells a security … by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in light of the circumstances under which they were made, not misleading ..." 15 U.S.C. § 77l(a)(2).  (Emphasis supplied.) 

Before the United States Supreme Court rendered its decision in Gustafson v. Alloyd Co., 513 U.S. 561 (1995), the remedial provisions of Section 12(a)(2) were held to apply to the sale of all securities, whether such securities were sold in the context of a public or a private, offering.  Prior to Gustafson, "prospectus" was not a defined term; it was, therefore, applied liberally to encompass offering materials issued in connection with both public and private offerings of securities.        

In Gustafson, however, the Supreme Court defined a "prospectus" as "a document that describes a public offering of securities."  513 U.S. at 584.  (Emphasis supplied.)  A private offering of securities, the Court opined, is not effected "by means of a prospectus."  Id.  As such, the Court concluded, one who purchases securities in the context of such an offering cannot assert a claim for relief under Section 12(a)(2).  Id.; see also, Yung v. Lee, 432 F.3d 142, 149 (2nd Cir. 2005) (holding that a plaintiff who acquires securities through a private transaction, whether primary or secondary, cannot assert a claim under Section 12(a)(2).