Securities Fraud: Understanding Material Misrepresentation and "Scienter"
Federal Securities fraud generally involves the use of deceptive practices, misrepresentations, or omissions of material facts in connection with the purchase or sale of securities. Securities fraud is a broad term that encompasses a wide range of illegal activities, including insider trading, market manipulation, and Ponzi schemes, among others.
Federal securities fraud offenses or violations are generally enforced under the following statutes:
Securities Act of 1933 (15 U.S.C. § 77a et seq.): This law regulates the initial issuance and registration of securities, requiring companies to provide accurate and complete information to investors about their financial condition, business operations, and the risks associated with the securities they are offering.
Securities Exchange Act of 1934 (15 U.S.C. § 78a et seq.): This law governs the secondary trading of securities (i.e., the trading of securities after their initial issuance) and establishes various reporting requirements for publicly traded companies. Section 10(b) of the Exchange Act (15 U.S.C. § 78j(b)) and the corresponding SEC Rule 10b-5 (17 C.F.R. § 240.10b-5) are the most commonly invoked provisions in securities fraud cases. These provisions make it unlawful to use any manipulative or deceptive device, make false or misleading statements, or omit material facts in connection with the purchase or sale of securities.
A conviction for securities fraud pursuant to 15 U.S.C. § 78j(b) requires the government to prove that, "in connection with the purchase or sale of a security the defendant, acting with scienter, made a material misrepresentation (or a material omission if the defendant had a duty to speak) or used a fraudulent device." United States v. Vilar , 729 F.3d 62, 88 (2d Cir. 2013) (internal quotation marks and citations omitted). "A misstatement in a securities transaction is material if there is "a substantial likelihood that a reasonable investor would find the ... misrepresentation important in making an investment decision." Id.
In order to prove securities fraud under section 17(a), section 10(b), and Rule 10b-5, the SEC must first establish that the defendants made a material misstatement or omission in connection with the offer or sale of a security. Basic Inc. v. Levinson, 485 U.S. 224, 231, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988). Violations of section 17(a)(1), section 10(b), and Rule 10b-5 also require a showing of scienter. Aaron v. SEC, 446 U.S. 680, 691, 697, 100 S.Ct. 1945, 64 L.Ed.2d 611 (1980)."
The basic elements of a Rule 10b-5 claim are: (1) a material misrepresentation or omission of fact, (2) scienter, (3) a connection with the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss.
In order to prove securities fraud, the government must generally establish the following elements:
Material misrepresentation or omission: The defendant made a false statement or failed to disclose information that a reasonable investor would consider important in making an investment decision.
Scienter: The defendant acted with intent to deceive, manipulate, or defraud, or with reckless disregard for the truth.
Connection with the purchase or sale of a security: The fraudulent conduct occurred in connection with the purchase or sale of a security.
Reliance: In certain circumstances, the government may also need to prove that the investor relied on the fraudulent information in making their investment decision.
Loss causation: The government may need to demonstrate that the defendant's fraudulent conduct directly or indirectly caused the investor's financial loss.
15 U.S.C. § 78j(b) prohibits material misrepresentations, material omissions, and the use of fraudulent devices in connection with the purchase or sale of securities.
Let’s discuss what constitutes a material misrepresentation or omission and “scienter.” A material misrepresentation occurs when a false statement is made about a fact that would be considered important by a reasonable investor in making an investment decision. As established in the Vilar case noted above, a misstatement in a securities transaction is material if there is "a substantial likelihood that a reasonable investor would find the ... misrepresentation important in making an investment decision." This standard is intended to ensure that investors have access to accurate and complete information when making decisions about their investments.
In addition to material misrepresentations, material omissions may also form the basis for a securities fraud conviction. An omission is considered material if the defendant had a duty to disclose the information and failed to do so, and the information withheld would have been important to a reasonable investor.
Under Sec. & Exch. Comm'n v. Aly, 16 Civ. 3853 (PGG) (S.D.N.Y. Mar. 27, 2018), the SEC must show that the defendant: "(1) made a material misrepresentation or a material omission as to which he had a duty to speak, or used a fraudulent device; (2) with scienter; (3) in connection with the purchase or sale of securities." Id. (citations omitted). "The element of scienter, as used in connection with the securities fraud statutes, requires a plaintiff to show that the defendant acted with intent to deceive, manipulate or defraud, or at least knowing misconduct."
This blog post was prepared with the assistance of ChatGPT-4 AI. Nothing in this post should be considered legal advice or the creation of an attorney-client relationship. This blog is strictly for informational purposes only.