Several stock market crashes or corrections in the United States have been caused, at least in part, by the revelation of misleading corporate disclosures. In the 1920s, stock values rapidly rose thanks in part to overzealous promoters. The bottom dropped out in the fall of 1929, when the Dow Jones Industrial plummeted nearly 50% in a matter of weeks.[1] This crash led to the disclosure and fraud-prevention regime embodied in the Securities Act of 1933 and the Exchange Act of 1934.
In the 1990s, excitement in the technology sector and loose accounting practices led to another stock market bubble. In 2000 and 2001, as various frauds were revealed, stock market prices fell precipitously. The bursting of the tech bubble led to the Sarbanes-Oxley Act of 2002, which revamped the rules for accounting and internal control disclosures.[2]
In the 2000s, financial firms were investment darlings due in part to inadequate disclosures concerning their susceptibility to credit stress events and the housing market crisis. In September, 2008, the bottom dropped out, with the S&P 500 plummeting nine percent, the Dow Jones dropping nearly seven percent, and $1.2 trillion in stock market investment vanishing, all in a single day.[3] These and other events associated with the financial crisis led to passage of the Dodd-Frank Act, which amended securities law provisions concerning disclosures and internal controls, particularly for financial institutions.
What happens when promoters of an investment misrepresent its quality or characteristics? If the founders of a startup cloud computing company embellish the number of big contracts the company has in the lead up to an initial public offering, subsequent sales revenues will be lower than investors expected. If an established car company grossly understates its labor and equipment expenses, it will find itself short on cash and credit, leading to financial distress. If the CEO of an energy company exaggerates the likelihood that the company’s oil fields will be productive, promised revenues will never materialize. Investors in these companies will have made their investments at artificially high prices that were premised on misrepresentations. Once the truth emerges, their investments will depreciate.
Securities laws provide investors with recourse. False statements in connection with securities amount to “securities fraud.” Securities fraud provisions provide a fundamental tool for ensuring fair and orderly markets and the overall growth of the capital markets in the United States.
In this module, we will examine the securities fraud laws and available recourse to investors. First, we will examine key concepts that are used in analyzing securities fraud issues, including: the types of fraud, states of mind, materiality, reliance, causation and damages. Second, we will examine Sections 11 and 12 of the Securities Act, which prohibit fraud in registration statements and prospectuses used to lure investors. Third, we will examine Section 10(b) of the Exchange Act, which prohibits all securities fraud of various types.
States of Mind in Securities Fraud
Securities fraud may consist of “misrepresentations,” “omissions” or “half-truths,” or a combination. A “misrepresentation” is an affirmative statement that is false. An example of a misrepresentation would be a company that states that its revenues were $100 million when, in fact, they were only $50 million. An “omission” is silence on an important issue. An example of an omission would be a company that fails to timely disclose that it is subject to a government investigation. A “half-truth” is a statement that is misleadingly incomplete. An example of a half-truth would be a company that states it sold two million laptops in a quarter, without also informing investors that one million of those laptops were returned due to defective screens. Offering the good, but not the bad, is misleading.
The various provisions prohibiting false statements in connection with securities involve different states of mind.
Scienter
“Scienter” is a term of art meaning an intent to mislead, manipulate or defraud. It applies when the person specifically intended to defraud another.[4] Scienter also includes reckless disregard for the truth or a known risk that its statement would mislead investors. An example of “scienter” would be a Ponzi-scheme artist who sets up a phony company that she does not plan to operate, dupes investors into thinking that they are investing in an active company and then uses the money instead for her personal lifestyle expenses.
Negligence
Negligence means that the person made a false statement under circumstances in which, in the exercise of reasonable care, he should have known that the statement was false. Negligence can come into play even when the speaker did not intend to deceive investors. An example of a “negligent” misrepresentation would be a company that claims, based on research, that it will be able to obtain a patent on some proprietary technology, when, in fact, there are prior claims by other companies to the same technology. Full research would have revealed this, and the company did not exercise reasonable care before making the statement to investors.
Strict Liability
Strict liability means responsibility even without any culpable intent or negligence. Strict liability is sometimes imposed on the idea that the company–and not the investors–should be responsible for a false statement.
Strict liability only applies in limited circumstances in the securities laws and when applied, they result in civil liability, not criminal liability. Companies engaged in IPOs are strictly liable for representations in their initial offering documents. The securities laws do not want to leave investors on the hook for important statements that turn out to be untrue.
Materiality and Reliance
A stated or omitted fact is “material” if there is a substantial likelihood that a reasonable investor would consider the fact important in making an investment decision in light of the information available to the investor.[5] A statement or omission is immaterial if it is meaningless, trivial, or inconsequential.
Examples of material misstatements or omissions include overstating company-wide revenues significantly, failing to disclose that the company’s main factory suffered an explosion and falsely claiming that the CFO is a certified public accountant.
Examples of statements that are not material may include overstating revenues by a fraction of a percent, failing to disclose that one of the company’s stores had to close for a day due to renovations and claiming that the CFO graduated college in 1983 when in fact she graduated in 1984.
Some statements, commonly used in sales, are deemed too vague to be material. Often, these statements are called “puffery.” Examples of “puffery” include statements such as: “next year will be a great year for the company,” “we are excited about our new product development,” and “our management team is excellent.”
There can be a fine line between puffery and materiality. Consider the statement, “we are anticipating significant revenue growth based on new orders in the pipeline.” Although this is a somewhat vague statement, it implies some specifics, such as a comparison of next year’s projections with last year’s revenues and that new orders are in the works.
To determine materiality, one must look at the statement in the context of other facts. If the company has also stated that it had revenues of $100 million last year and anticipates revenues of $105 million this year, the phrase “significant growth” might merely mean a 5% increase and nothing more. If revenue growth turns out to be 5%, investors would be hard pressed to claim “significant growth” meant something more, like 10% or 20%.
Reliance
“Reliance” requires that the investor used the statement in making an investment decision. It is interwoven with the concept of materiality but focuses on what the investor did with the information. An investor who reviews a company’s press release before deciding to buy its stock has “relied” on the release. Conversely, an investor who never saw the release cannot claim to have relied on it.
In cases involving material omissions, reliance may be presumed. This rule flows from the difficulty in proving reliance on something that was not stated. Thus, an investor may prove reliance in omission cases by proving the omitted fact would have been material to a reasonable investor if it was disclosed.[6]
Causation and Damages
“Causation” means that the misstatement or omission caused the investor’s losses. Typically, investors pursuing securities fraud claims must establish two forms of causation: “transaction causation” and “loss causation.”
Transaction causation is similar to reliance. It means that the misstatement was one of the pieces of information that caused the investor to enter into the transaction.[7]
Loss causation focuses on the impact that the misstatement or omission had on the security’s price. It requires proof of a nexus between the fraud and the investor’s losses.[8] The goal is to separate the portion of the security’s price attributable to the fraud from price factors that are attributable to other market forces, such as economic downturns, overall stock market trends and changes to the law.[9]
Consider a company that exaggerates its revenues, leading the stock price to rise from $60 per share to $100 per share on a day when there is no other news about the company. The misstatement likely “caused” the stock price to move up by $40.
Loss causation gets tricky when there are multiple economic factors or news factors that may have contributed to a price decline. Expert economists may offer reports to indicate what aspect of a price decline is attributable to the fraud and which aspect is attributable to other factors.
Consider a situation in which, on the same day, a company’s fraud is revealed but the general stock market declined by 1%. If the company’s price dropped from $100 to $90, economists may opine that $1 was attributed to the general stock market decline, and $9 is attributable to the fraud.
Damages
“Damages” refer to the economic loss suffered by the investor. If a company lied about its financial prospects, the truth is revealed, and the price drops from $100 per share to $70 per share as a result, the investor’s “damages” are $30.
Rules 11 and 12: Registration Statements and Prospectuses
The Securities Act requires companies that go public to disclose to investors important information regarding the company, its business, management and financial status. Section 11 is designed to protect investors from false registration statements that are filed and published by the company before its initial public offering.
Section 11 applies to registration statements that contain untrue statements of material fact or omit material facts that make it misleading.[10] Because registration statements are filed only for public offerings, a Section 11 claim is not available for non-registered securities.
An investor may recover under Section 11 if she can prove that (1) she purchased securities pursuant to a false registration statement and did not know the truth at the time of purchase; (2) the registration statement contained a material misstatement or omission; (3) the defendant is a type of person or entity enumerated in Section 11; and (4) the complaint was brought in a timely fashion.
Six types of entities can be liable under Section 11:
(1) the issuer (i.e., the company whose securities are being sold);
(2) every person who signed the registration statement (such as corporate officers and directors);
(3) directors of the issuer at the time the registration statement was filed;
(4) directors, or people who are about to become directors;
(5) experts who have prepared or certified portions of the registration statement or any report or valuation used in connection with the registration statement, including accountants, engineers and appraisers; and
(6) underwriters with respect to the IPO.[11]
These defendants may be held “jointly and severally liable,” which means an injured plaintiff may seek full recovery from any one of them, a group of them or all of them. It is then up to the defendants to apportion their respective liability amongst each other, as part of the same lawsuit or in separate suits if necessary.[12]
While issuers are strictly liable for the IPO misrepresentations,[13] signers, directors, underwriters and experts are not liable if they can show that “after reasonable investigation” they had “reasonable ground to believe and did believe” that the statements were true and that there were no omissions.[14]
What constitutes a “reasonable investigation” and “reasonable ground for belief” is based on that “required of a prudent man in the management of his own property.”[15] These defendants bear the burden of proving that they acted reasonably, and investors may likely present evidence of lack of reasonableness to refute the affirmative defense.
An investor may recover the difference between the price it paid for the security and its value at the time the suit was brought. However, if defendants are able to prove that a portion of the price decline was caused by a factor other than the misrepresentation or omission, that can reduce their liability.[16] The defendants bear the burden of proof on this issue as well.
An investor cannot recover under Section 11 if the defendant proves that the investor knew that there was a misrepresentation or omission—in other words, that the investor knew the truth and invested anyway.[17]
Finally, an investor must bring suit under Section 11 within one year of discovering the fraud (or within a year of when the fraud could have reasonably been discovered through reasonable diligence) and not later than three years after the security was first offered to the public.[18]
Section 12 applies to misstatements and omissions in a “prospectus.” The term “prospectus” is broad and covers any notice, advertisement, letter, communication or other document that offers a security for sale.[19] Prospectuses are used in a broad range of securities offerings–both public and private.
Liability attaches to any person who offers or sells a security pursuant to a prospectus that contains a material misstatement or omission.[20] Liability extends to others involved in the sales process as well, such as brokers.[21] The investor may recover the difference in price paid and the value of the security at the time of suit or it can require the seller to take the security back and return the full purchase price.[22]
As with Section 11, investors do not need to prove that the seller acted with the intent to defraud the investor or that it recklessly disregarded the truth. Defendants under Section 12 can avoid liability, however, if they prove that they did not know, and, in the exercise of reasonable care, could not have known of the untruth or omission.[23] This defense is similar to the defenses available under Section 11 for non-issuers. Likewise, sellers can limit their liability by proving that a portion of the investor’s loss is attributable to factors other than the misstatement or omission.[24]
Finally, as with Section 11, an investor must bring suit under Section 12 within one year of discovering the fraud (or when the fraud could have reasonably been discovered through reasonable diligence) and not later than three years after the security was first offered to the public.[25]
Rule 10b-5: Fraud
Section 10(b) prohibits all fraud in connection with the purchase or sale of a security.[26] Section 10(b) and Rule 10b-5, which the SEC adopted as a regulation, have been interpreted to allow a private right of action for investors.[27] These provisions are critical to the anti-fraud objectives of securities laws because they cover all securities fraud, regardless of whether the issuer is public or private, and regardless of whether the fraud occurred in registration statements, prospectuses, quarterly reports, annual reports or other documents or communications.
An investor bringing a Section 10(b) claim must prove:
(1) the defendant made a material misrepresentation or omission;
(2) it was in connection with the investor’s purchase or sale of a security;
(3) the investor relied on the misrepresentation or omission;
(4) the defendant’s fraud was intentional or with severe recklessness; and
(5) the fraud proximately caused the investor’s damages.[28]
Investors may recover their actual damages and consequential damages such as brokerage fees. Investors must bring suit within two years after discovering the fraud and not more than five years after the fraud occurred.[29] There are limitations to actions under Rule 10(b). Most importantly, investors must prove “scienter,” or intentional falsity or recklessness and so negligence is insufficient.[30] Rather, the investor must prove that the defendant wanted to defraud her or consciously disregarded a known risk that the statement was misleading. Also, investors have to prove that the fraud was “in connection with” a purchase or sale. This means that investors who hold stock based on a misrepresentation or omission cannot sue under Section 10(b).[31]
With that said, the courts have embraced some concepts to make it easier for investors to recover for securities fraud. For example, many investors in large publicly traded companies do not read prospectuses, annual reports or other statements by companies, but rely on the integrity of the market price. These investors can show reliance on the falsities through the “fraud on the market” theory. This theory applies to securities traded in a large market (such as a stock exchange). In such markets, information and misinformation regarding the company is assumed to be quickly incorporated into the stock’s price. False statements may lead to increased market prices. Investors are entitled to rely on those market prices. Thus, for highly liquid securities traded on national exchanges, the courts assume that investors rely–via the market price–on all information available to the market. Once the truth is revealed, and the price drops, investors are harmed because the market price at which they acquired the security was premised on the fraudulent conduct.[32]
If a fraudulent statement is made in a registration statement, the investor may pursue claims under both Section 11 and Section 10(b). Likewise, if a fraudulent statement is made in a prospectus, the investor may pursue claims under both Section 12 and Section 10(b). In other words, these causes of action are “cumulative.” That said, the investor can only recover once even though multiple provisions were violated.
In our last module, we’ll look at a common specific type of securities fraud: insider trading and the rules that prohibit and prevent it.
[1] Gary Richardson, Alejandro Komai & Michael Gou, “Stock Market Crash of 1929,” Federal Reserve History, https://www.federalreservehistory.org/essays/stock_market_crash_of_1929 (last visited Oct. 26, 2018).
[2] William H. Donaldson, “Testimony Concerning Implementation of the Sarbanes-Oxley Act of 2002,” U.S. Securities and Exchange Commission, (Sept. 9, 2003), https://www.sec.gov/news/testimony/090903tswhd.htm.
[3] Vikas Bajaj & Michael M. Grynbaum, “For Stocks, Worst Single-Day Drop in Two Decades,” N.Y. Times (Sept. 29, 2008), https://www.nytimes.com/2008/09/30/business/30markets.html.
[4] Ernst& Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976).
[5] TSCIndustries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
[6] Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 153-54 (1972).
[7] Id.
[8] Huddlestonv. Herman & MacLean, 640 F.2d 534, 549 (5th Cir. 1981), aff’d in part, rev’d in part on other grounds, 459 U.S. 375 (1983).
[9] Id.
[10] 15 U.S.C. 77k(a).
[11] Id.
[12] 15 U.S.C. 77k(f).
[13] 15 U.S.C. 77k(b).
[14] Id.
[15] 15 U.S.C. 77k(c).
[16] 15 U.S.C. 77k(e).
[17] 15 U.S.C. 77k(a).
[18] 15 U.S.C. 77m.
[19] 15 U.S.C. 77b(a)(10).
[20] 15 U.S.C. 77l(a)(1).
[21] Pinter v. Dahl, 486 U.S. 622, 646 (1988).
[22] 15 U.S.C. 77l(a)(2).
[23] 15 U.S.C. 77l(a)(2).
[24] 15 U.S.C. 77l(b).
[25] 15 U.S.C. 77m.
[26] 15 U.S.C. 78j.
[27] StoneridgeInv. Partners, LLC v. Sci-Atlanta, 552 U.S. 148, 157 (2008).
[28] Neiman v. Bulmahn, 854 F.3d 741, 746 (5th Cir. 2017).
[29] 28 U.S.C. 1658(b).
[30] Ernst& Ernst v. Hochfelder, 425 U.S. 185, 199 (1976).
[31] BlueChip Stamps et al. v. Manor Drug Stores, 421 U.S. 723, 754 (1975).
[32] BasicInc. v. Levinson, 485 U.S. 224, 247-49 (1988).