Elements of a SEC Rule 10b‑5 Violation

Dur­ing the depths of the depres­sion, in order to “clean up” Wall Street, who large­ly (right­ly or wrong­ly) took the brunt of ire over the econ­o­my going from bad to worse, Con­gress enact­ed var­i­ous secu­ri­ty laws designed to help lev­el the play­ing field between insid­ers and out­side investors. In that process, the new­ly formed Secu­ri­ties and Exchange Com­mis­sion was tasked with cre­at­ing rules to effect the changes Con­gress desired, includ­ing Rule 10B‑5, which is under Title 17, chap­ter II, Part 240, Sub­part A/ titled “Manip­u­la­tive and Decep­tive Devices and Con­trivances.”

The pur­pose was to stop mar­keters (and oth­ers) from mak­ing mis­lead­ing state­ments regard­ing secu­ri­ties they were try­ing to sell (or pur­chase as the case may be).

Statute 240.10b‑5 Employ­ment of manip­u­la­tive and decep­tive devices:
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 any facil­i­ty of any nation­al secu­ri­ties exchange,
A. To employ an 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 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

The rule was updat­ed in 2004 to the fol­low­ing:
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,
1. To employ any device, scheme, or arti­fice to defraud,
2. 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
3. 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.

Courts have ruled that in order for the SEC (or pri­vate par­ty) to suc­ceed on a Rule 10b‑5 fraud, the plain­tiff must estab­lish the fol­low­ing:
1. A false state­ment or omis­sion of mate­r­i­al fact
2. Made with SCIENTER,
3. Upon which the plain­tiff jus­ti­fi­ably relied, and
4. That prox­i­mate­ly caused the plain­tiff’s injury
Rob­bins v. Koger Props., Inc., 116 F.3d 1441, 1447 (11th Cir. 1997) (cit­ing Bruschi v. Brown, 876 F.2d 1526, 1528 (11th Cir. 1989)).

When think­ing about the cau­sa­tion ele­ment, it’s impor­tant to note that in this con­text, cau­sa­tion means BOTH trans­ac­tion cau­sa­tion and damages/loss cau­sa­tion. For trans­ac­tion cau­sa­tion to be found, it means the plain­tiff (rea­son­ably) relied upon the defen­dan­t’s mis­lead­ing state­ments and the loss was caused by the tor­tious state­ments. In oth­er words, for exam­ple, if the Plain­tiff bought shares in a com­pa­ny in reliance of the Defen­dan­t’s (misleading/fraudulent) state­ments, the trans­ac­tion cau­sa­tion is like­ly met, how­ev­er, if the loss occurred regard­less of the state­ments, and the state­ment did­n’t cause the shares to fall in price, the Plain­tiff may not suc­ceed on the claim. Anoth­er way to view this is to ask if the shares were inflat­ed in price BECAUSE of the fraud­u­lent state­ment by the Defen­dant? If yes, then the ele­ment is met, how­ev­er, if no, then the loss cau­sa­tion ele­ment is not met.

Also, regard­ing the loss cau­sa­tion, some courts have accept­ed the the­o­ry of “fraud on the mar­ket” as a loss cau­sa­tion, while oth­er courts have reject­ed this the­o­ry. In oth­er words, depend­ing on the juris­dic­tion, a Plain­tiff may suc­ceed or fail on the same set of facts. “the fraud on the mar­ket the­o­ry, as artic­u­lat­ed by the Supreme Court, is used to sup­port a rebut­table pre­sump­tion of reliance, not a pre­sump­tion of cau­sa­tion.” Id. at 1448 (cit­ing Basic v. Levin­son, 485 U.S. 224, 241–42, 108 S. Ct. 978, 992, 99 L. Ed. 2d 194 (1988)).

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