Securities Fraud

Securities fraud is deceptive or manipulative conduct connected to the purchase, sale or offer of a security. It is best understood as a legal conclusion about conduct rather than as the name of a scheme: a Ponzi scheme, a pump and dump scheme, an affinity fraud and insider trading are four recognizable patterns of behavior, and what makes each of them unlawful is the same small body of antifraud law. That is why each named scheme has its own page and why this one is about the test rather than about any of them.

Two federal provisions and one rule carry almost all of the weight. Rule 10b-5 (17 C.F.R. 240.10b-5) makes it unlawful, "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." That is the whole rule. The Commission adopted it in 1942, and its text has not been amended since 1951.

Securities Act section 17(a) (15 U.S.C. 77q(a)) prohibits materially the same three things "in the offer or sale" of a security. The difference between "offer or sale" and "purchase or sale" is small on the page and consequential in practice, and it is set out below.

A rule, not a statute, and the distinction is load-bearing. Section 10(b) of the Securities Exchange Act, 15 U.S.C. 78j(b), makes it unlawful "to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors." Read literally, section 10(b) prohibits nothing on its own. It authorizes the Securities and Exchange Commission to prohibit things, and Rule 10b-5 is what the Commission wrote, in 1942. Almost the entire American law of securities fraud therefore rests on a rule of three short clauses whose text has not been amended since 1951, with the rest supplied by courts construing it.

The three limbs are not interchangeable. Clause (b) is the familiar one, a misstatement or a misleading omission. Clause (a) reaches a scheme, which does not require any false statement at all — useful where the conduct is a course of action rather than a claim. Clause (c) reaches a practice or course of business that "operates or would operate as a fraud or deceit", which is drafted around effect rather than intent to speak. A single set of facts often violates more than one.

Materiality is about the reader, not the size of the lie. Clause (b) turns on a "material fact", and the same word governs the omission limb: an omission is actionable only where the missing fact was "necessary in order to make the statements made … not misleading". That construction is worth noticing, because it means silence is not generally unlawful. What is unlawful is silence that makes something you did say misleading — which is why a half-true disclosure is more dangerous than no disclosure at all.

The state of mind requirement, and where Congress put it. Rule 10b-5 does not use the word scienter, but the Private Securities Litigation Reform Act presupposes it and sets how it must be pleaded. 15 U.S.C. 78u-4(b), headed "Requirements for securities fraud actions", provides at (b)(2)(A) that in a private action "in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." Subsection (b)(1) separately requires the complaint to specify each misleading statement and why it was misleading. These are pleading rules, not elements, and they are the reason a great many private securities cases end before any evidence is heard.

The offer-versus-purchase asymmetry. Rule 10b-5 applies "in connection with the purchase or sale of any security". Section 17(a) applies "in the offer or sale". So a fraudulent pitch that nobody accepts is outside the words of Rule 10b-5, because no purchase or sale occurred, and inside the words of section 17(a), because an offer did. This is the cleanest checkable difference between the two provisions, and it is why an enforcement action about a failed offering may be framed under the Securities Act rather than the Exchange Act.

Who can bring a case, written from the statutes rather than from generalization. The Commission and the Department of Justice have their own routes, described under the Securities and Exchange Commission. On the private side, Congress legislated in detail for private Exchange Act actions: 15 U.S.C. 78u-4 is titled "Private securities litigation", its subsection (a)(1) applies "in each private action arising under this chapter that is brought as a plaintiff class action pursuant to the Federal Rules of Civil Procedure", and its subsection (b)(4) places on the plaintiff "the burden of proving that the act or omission of the defendant alleged to violate this chapter caused the loss for which the plaintiff seeks to recover damages." Section 17(a) of the Securities Act, by contrast, contains no remedy clause on its face; the Securities Act's express civil-liability provisions sit in separate sections, 15 U.S.C. 77k on false registration statements and 77l on prospectuses and communications. Anyone weighing an actual claim needs a securities lawyer rather than a glossary, because the differences between these routes decide what has to be pleaded and what can be recovered.

State law exists alongside all of this, in the securities statutes generally called blue sky laws, and it is not displaced by the federal provisions.

1. Identify the security and the transaction. Rule 10b-5 requires a connection to a purchase or sale; section 17(a) requires an offer or sale. With neither, the antifraud provisions are not the right tool.

2. Identify the statement, omission, scheme or practice, and which of the rule's three clauses it engages.

3. Test materiality. For an omission, the question is whether the missing fact was necessary to keep what was actually said from being misleading.

4. Test the state of mind. In a private damages action this has to be pleaded with particularity, as facts giving rise to a strong inference.

5. Trace the loss. For a private plaintiff, 78u-4(b)(4) puts the burden of proving that the violation caused the loss on the plaintiff, which is a separate question from whether the violation happened.

A hypothetical example, and what the numbers do and do not establish. A company announces a supply contract it describes as worth $40 million. Internal documents show management knew the committed amount was $4 million. The shares rise from $12 to $18 over two weeks. Ines buys 1,000 shares at $18, spending $18,000. Six weeks later the true figure emerges and the shares settle at $9, making her holding worth $9,000, a loss of $18,000 − $9,000 = $9,000.

The $9,000 is her damage; it is not the violation. The violation is the statement of a materially untrue fact, made with knowledge of its falsity, in connection with purchases and sales of the stock — and it was complete when the announcement was made, before Ines bought and whatever the price later did. Her $9,000 matters to what she can recover, and 78u-4(b)(4) makes it her burden to show that the misstatement rather than something else in the market caused it. Figures are illustrative.

Securities fraud is not something anyone chooses, so instead of pros and cons this section sets out what the antifraud provisions reach well and where they are weaker.

What the framework does well

• It is written around conduct rather than around named schemes, so a new variety of deception needs no new statute.
• Clause (a) reaches a scheme with no false statement in it, and clause (c) reaches a practice by its effect, so the rule does not depend on finding a quotable lie.
• The omission limb is drafted precisely, catching the half-true disclosure that a simple falsity test would miss.
• Section 17(a)'s reach to the offer means a fraudulent offering that never closes is still within the law's terms.

Where it is weaker, from an investor's point of view

• The pleading requirements Congress set for private actions are demanding, and a great many claims end on them rather than on the facts.
• Loss causation is the plaintiff's burden, which is genuinely difficult to carry when a share price was moving for several reasons at once.
• Establishing state of mind is the usual battleground, and the difference between a knowingly false statement and an unreasonably optimistic one is often the whole case.
• A judgment is only worth what the defendant can pay, and in the schemes where this law is most often invoked the money is generally gone.