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C H A P T E R 2 2
SECURITIES FRAUD AND INSIDER TRADING
This chapter focuses on Section 10(b) and Rule 10b–5 of the 1934 Act. It sets forth the seven
elements necessary in a Rule 10b–5 case and the fraud-on-the-market theory of liability. The
safe harbor for certain forward-looking statements is discussed. Section 17(a) of the 1933 Act,
I. OVERVIEW OF ANTIFRAUD PROVISIONS.
A. Section 10(b) gives SEC power to prohibit individuals and companies from
engaging in securities fraud by authorizing the SEC to prescribe specific rules for
the protection of investors.
II. RULE 10B-5. To recover damages a plaintiff must show each of the following elements:
(a) defendant used an instrumentality of interstate commerce or the mails or a facility of a
III. INTERSTATE COMMERCE. Defendant must have used interstate commerce, the mails, or
a national securities exchange.
IV. MISSTATEMENT OR OMISSION is relevant only if the statement or omission becomes
misleading.
A. Misstatements. A prediction is only a misstatement if the person making the
prediction does not believe. Silence will not lead to liability if the company has
not previously spoken and insiders are not trading or tipping.
CASE 22.1 SEC v. Texas Gulf Sulphur Co., 446 F.2d 1301 (2d Cir. 1971).
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B. Omissions include statements that are true at the time, but later become
misleading only if investors rely on the previous statements, while the company
fails to disclose the latter information.
CASE 22.2 Weiner v. Quaker Oats Co., 129 F.3d 310 (3d Cir. 1997). Quaker
C. Statements by Third Parties and Entanglement. If entangled, a company has a
duty to correct misleading statements about the business by third parties.
V. MATERIAL FACT is that which a reasonable investor would consider important. A
manager can be liable even she did not know an omitted or misrepresented fact was
material.
CASE 22.3 Matrixx Initiatives v. Siracusano, 131 S.Ct.1309 (2011). Plaintiffs sued,
VI. SCIENTER. Misstatements or omissions must be made with the intent to deceive. A
majority of the courts regard recklessness as sufficient for scienter.
CASE 22.4 Tellabs, Inc. v. Makor Issues & Rights, 127 S. Ct. 1511 (2007).
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A. Recklessness. On remand, Tellabs equated recklessness with scienter and
intent to deceive. The Second Circuit defined reckless conduct as “conduct
VII. IN CONNECTION WITH THE PURCHASE OR SALE OF ANY SECURITY. Only persons
who actually purchase or sell securities can sue under Rule 10b–5.
VIII. RELIANCE. To hold the defendant liable, an investor must show that he relied, directly
or indirectly, on the misrepresentation or omission.
A. Direct Reliance can be shown through demonstration of a public document, or
plaintiff will be presumed to have relied on the omission, if material.
CASE 22.5 Emergent Capital Investment Management, LLC v. Stonepath
Group, Inc, 343 F.3d 189 (2d Cir. 2003). ECI invested $2 million
B. Fraud on the Market. Suits may be brought against defendants who made
misrepresentations that would have caused the market to rely on the misstatement
or omission.
1. Truth on the Market is a defense against this allegation.
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XI. STATUTE OF LIMITATIONS. Suits under section 10(b) must be brought within two
years after the date the plaintiff discovered the facts constituting the violation.
XII. LITIGATION REFORM ACT SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS.
XIII. LIABILITY OF SECONDARY ACTORS.
A. Primary Liability.
D. Scheme Liability.
CASE 22.6 Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc.,
128 S. Ct. 761 (2008). Charter, a cable operator, faced a cash flow
shortfall and agreed to purchase cable boxes from Scientific
Atlanta and Motorola for inflated prices, in return for premium
E. Controlling Persons. Section 20(a) imposes joint and several liability on every
person who is in control, unless the controlling person acted in good faith and did
not induce the acts
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XIV. SECTION 17(a). Prohibits fraud with the sale of securities; it does not require scienter,
there is no private right of action.
XV. SEC ACTIONS. The SEC has broad powers to investigate apparent violations of section
and to recommend criminal prosecution for willful violations.
CASE 22.7 SEC v. Citigroup Global Markets, Inc., 2011 WL 5903733 (S.D.N.Y.
Nov. 28, 2011). The SEC and Citigroup entered into a ‘no–fault’ Consent
XVI. RESPONSIBILITY OF AUDITORS TO DETECT AND REPORT ILLEGALITIES. The
XVII. DEFINITION OF INSIDER TRADING. Generally, refers to trading by persons (often
insiders such as officers and directors) based on material nonpublic information.
A. Classical Theory of Insider-Trading.
1. Traditional Insiders are only persons closely allied with the corporation
itself were considered insiders, such as officers, directors, employees,
controlling shareholders, and the corporation itself.
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B. Misappropriation Theory of Insider Trading. If a person misappropriates non-
public information, she has breached a fiduciary duty and is liable under Rule
10b-5.
CASE 22.8 SEC v. Talbot, 530 F.3d 1085 (9th Cir. 208). Fidelity Financial
owned 10% of Lending Tree stock. Talbot, an attorney and board
C. Rules 10b5-1 and 10b5-2.
1. Trading Based on Nonpublic Information. Rule 10b5-1 creates a
2. Duty of Trust or Confidence. The misappropriation theory widens the class
of persons who can be found liable for insider trading, but the requirement
that there must be a duty of trust or confidence remains a limiting factor.
XVIII. MAIL AND WIRE FRAUD. Columnist was convicted based on information he
XIX. RICO (RACKETEER INFLUENCED AND CORRUPT ORGANIZATIONS ACT). Securities
fraud cannot be the basis for a RICO (see Chapter 17) case unless the defendant has been
criminally convicted for fraud.
XX. ENFORCEMENT OF ANTIFRAUD PROHIBITIONS. Those who violate insider trading
laws are subject to criminal and civil penalties.
A. Private Actions. Plaintiff must be an actual purchaser or seller of securities and
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C. Criminal Prosecutions. SEC has no criminal enforcement powers. Criminal
actions are brought by the Department of Justice/U.S. Attorney’s Office, if
XXI. SELECTIVE DISCLOSURE AND REGULATION FD. Securities traders are not allowed to
make limited disclosures to analysts or institutional investors. Regulation FD (Fair
XII. OTHER REQUIREMENTS APPLICABLE TO OFFICERS, DIRECTORS, AND GREATER–
THAN-10 PERCENT SHAREHOLDERS.
A. Short-Swing Trading. Insiders and those with more than 10% of the shares
cannot engage in the purchase-sale, or the sale-purchase within a six-month
period. Liability is imposed regardless of intent.
1. Definition of an Equity Security.
B. Filing of Beneficial-Ownership Reports. Covered persons must file frequent and
regular ownership reports.
C. Prohibition on Selling Short. Officers or directors cannot sell a security they do
not own.
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D. SOX Ban on Trading During Blackout Period and Disgorgement After
Restatements. Section 306 of Sarbanes-Oxley Act prohibits officers and
THE RESPONSIBLE MANAGER: TEACHING SUGGESTIONS
1. Discuss the following checklist with your class and what the legally astute manager
should do with each of the following:. Companies and managers have obligations:
• Do not mislead investors through public announcements, periodic reports, or
speeches.
• Avoid disclosure if you know that insiders are trading in the company’s securities.
2. Why is interstate commerce needed for Rule 10b-5 violations?
3. Why should insider trading be legalized?