SEC Rule 10b-5: The Basics of Securities Fraud.

SEC Rule 10b-5 implements the broader prohibitions of Section 10(b) of the Exchange Act. It contains three subsections, all of which apply in civil enforcement cases brought by the SEC, and also in private securities lawsuits. The three subsections each target a different type of misconduct:

• Subsection (a) prohibits the employment of “any device, scheme, or artifice to defraud.” This broad provision allows for civil enforcement action when an investor is defrauded as the result of a securities violation. The SEC’s Division of Enforcement has specifically noted that this prohibition applies to conduct in “the purchase or sale” of securities transactions as well as “offers to buy or sell,” and even to “conduct in connection with” those transactions.
• Subsection (b) prohibits making “any untrue statement of a material fact or any omission of a material fact” necessary to make existing statements “not misleading.”
• Subsection (c) prohibits the use of “any act, practice, or course of business which operates or would operate as a fraud or deceit.”

The courts created the private Rule 10b-5 action, as Congress did not expressly authorize one. However, plaintiffs have continued to seek the courts’ approval to bring private enforcement actions under Rule 10b-5, and the courts have continued to allow them.

In SEC enforcement actions, the SEC does not have to prove that investors relied on the transactions at issue, nor does it have to prove that investors suffered losses.

The SEC adopted Rule 10b-5 in 1942.

When speaking, individuals must disclose sufficient context to ensure their existing statements are not rendered misleading.

Under SEC Rule 10b-5, issuance of a negative-assurance letter is customary rather than legally required.

Negative assurance letters are often provided by law firms to state that nothing has come to their attention that would cause them to believe the disclosure contains a material misstatement or omission for purposes of Rule 10b-5. These reports are not intended to guarantee the absolute accuracy of a client’s public financial disclosures.

What must investors prove in a private Rule 10b-5 case?

Investors who seek to establish liability in a private Rule 10b-5 lawsuit must overcome the substantial hurdles created in several Supreme Court decisions. Among these decisions is Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), in which the Supreme Court held that private standing under Rule 10b-5 is limited to actual purchasers or sellers of the securities at issue in the claim. If the investors, themselves, did not buy or sell the securities in question, they cannot assert a private Rule 10b-5 claim in court.

If the investors have standing to pursue a claim, investors must prove six elements that will all be essential for establishing liability. They must prove:

• Deception;
• Materiality;
• Scienter;
• Investor reliance on the deception;
• Economic loss; and
• Loss causation.

1. Deception

To satisfy the first element of Rule 10b-5 liability, the investors must establish a claim involving some form of “deception.” Most commonly, this will involve a direct misrepresentation or a misleading statement. It can also involve omissions, but as courts have noted in the context of cases such as Macquarie Infrastructure Corp. v. Moab Partners, L.P., 601 U.S. 257 (2024), the omission(s) will need to involve some form of a positive misstatement to make the claim fall within Rule 10b-5(b). This means that while investors who sue under Rule 10b-5 can establish deception by showing that certain truths became misleading, they cannot do so by showing a pure omission of information.

2. Materiality

Materiality is also an element of Rule 10b-5 liability. Information is considered material if a reasonable investor would find it would have “significantly altered the total mix of information” available for making a “reasonable investment decision.”

3. Scienter

Scienter is a third element of a Rule 10b-5 private claim. In Ernst & Ernst v. Hochfelder, the Supreme Court made clear that scienter is a requirement of liability under Rule 10b-5. An investor can satisfy the scienter requirement by proving that the defendant acted with “intent to deceive, manipulate, or defraud.” In addition to intentional deception, reckless deception is enough for Rule 10b-5 liability as well. Negligence alone does not establish liability under Rule 10b-5, however.

4. Investor Reliance

The investors must also establish that they relied on the deception at issue in their purchase or sale of securities, which means that the securities transaction must have been based on the deception in question.

5. Economic Loss

Economic loss is also an element of liability under Rule 10b-5. The investors must demonstrate that they actually suffered an economic loss as a result of their purchase or sale of the securities.

6. Loss Causation

Finally, investors must establish loss causation. As the Supreme Court held in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), this means that simply buying a security at an inflated price (or selling it at an improperly low price) is not sufficient to establish loss causation. The investors must prove that they suffered a loss as a result of the Rule 10b-5 violation.

How do investors prove reliance in securities class actions?

In cases that involve “efficient markets,” investors can avoid the need to prove reliance by establishing what is known as the “fraud-on-the-market” presumption. This presumption was established by the Supreme Court in Basic Inc. v. Levinson, and it applies when investors rely on the notion that public disclosure of the alleged deception will be reflected in the price of the security at issue in the transaction. Basic’s presumption is rebuttable, and, as Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258 (2014) has made clear, it is possible to rebut Basic’s presumption at the class certification stage if an investor cannot demonstrate price impact (i.e., that the alleged misstatement or omission actually affected the stock’s price). When investors invoke Basic’s presumption, however, investors are not required to rely on having read the challenged public statement or omission themselves.

In order to invoke Basic’s fraud-on-the-market reliance presumption, investors must establish that the security in question traded in an efficient market, and investors must present evidence that they relied on the integrity of the prices in the market for the security at issue.

The case of Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972) is another case in which investors can rely on the presumption of reliance. With Affiliated Ute, a presumption of reliance may apply in cases centered on actionable omissions (i.e., those that constitute affirmative representations). This presumption, if established, is also rebuttable, and it is up to the defendants to rebut the presumption if they have valid defenses to liability under Rule 10b-5.

What pleading rules and deadlines govern private securities claims?

Private securities claims must satisfy pleading and discovery requirements set forth under both Rule 9(b) of the Federal Rules of Civil Procedure and the Private Securities Litigation Reform Act of 1995 (or “PSLRA”). The PSLRA requires plaintiffs to plead “with particularity” the facts supporting the investors’ “strong inference” that defendants acted with scienter.

In Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), the Supreme Court explained that, when evaluating scienter at the pleading stage, courts should compare “culpable” and “benign” inferences. In these cases, plaintiffs satisfy the PSLRA if the inference of scienter is cogent and at least as compelling as any opposing inference of nonfraudulent intent.

The PSLRA also sets forth substantive restrictions on plaintiffs’ ability to conduct discovery. Discovery is typically stayed while a motion to dismiss remains unresolved, and plaintiffs who satisfy the PSLRA must establish that any proposed discovery will focus on specific facts supporting the inference of scienter rather than on “suspicious circumstances.The PSLRA also includes a “safe harbor” provision that protects qualifying forward-looking statements under certain conditions.

When Do Rule 10b-5 Statutes of Limitation, Repose, and Other Deadlines Apply?

The statutes of limitation and repose that apply under Rule 10b-5 for private securities claims are governed by 28 U.S.C. Section 1658(b). Under Section 1658(b)(1), “An action based upon a claim in which the fraud, mistake, or deceit was not known or could not have been discovered with due diligence” may be filed within “two years after discovery.” However, Section 1658(b)(2) provides a substantial limitation: “No civil action shall be maintained… more than five years after the alleged fraud, mistake, or deceit.”

Section 1658(b)(2) establishes what is known as a “statute of repose.” A statute of repose places a deadline on filing regardless of when the harm is discovered, or when the fraud was, if ever, uncovered.

When do securities laws shield statements and omissions from liability?

The securities laws also include “safe harbor” provisions that shield certain statements and omissions from liability under Rule 10b-5. The PSLRA’s “safe harbor” provision applies only in the specific contexts described below. But it applies broadly; and, if applicable, the burden for investors to rebut the “safe harbor” for prospective projections will be particularly high.

This is the point at which most people call a lawyer. Spodek Law Group takes federal criminal defense cases nationwide from its New York and Los Angeles offices.

Who is liable for statements, schemes, or another person’s fraud?

In Janus Capital Group, Inc. v. First Derivative Traders, the Supreme Court noted that, in cases involving statements, the person (or person(s)) who “made” the statement is liable under Rule 10b-5. The Court defines the person who “made” the statement to be the individual (or entity) who “has ultimate authority over the contents” of the statement.

While the case of Janus protects individuals and entities from liability in cases involving statements, the case of Lorenzo v. SEC, 587 U.S. 71 (2019) imposes “scheme liability” where individuals knowingly distribute another person’s false statements.

Under Rule 10b-5, only primary liability, and not the liability of aiders and abettors, are at issue in cases brought by private securities plaintiffs. Aiders and abettors can face liability under Section 20(e) of the Exchange Act. Section 20(e) extends to individuals and entities who knowingly or recklessly help facilitate a primary Rule 10b-5 violation.

This is separate from controlling person liability under Section 20(a) of the Exchange Act. As investors’’ lawyers, we have had to consider the differences between these provisions in numerous cases involving claims of Rule 10b-5 liability.

The liability that can be established under Section 20(a) of the Exchange Act is a distinct form of secondary liability. Section 20(a) applies to controlling persons that have “either actually or ostensibly” controlled a person who has established primary liability for an Exchange Act violation. This means that in order to successfully assert liability under Section 20(a), an investor must be able to establish that a primary Exchange Act violation (whether intentional, negligent, or otherwise culpable) occurred.

Finally, Section 20A of the Exchange Act authorizes “contemporaneous purchasers or sellers” to seek damages from individuals who have committed insider trading violations in securities law enforcement proceedings. It does not, however, provide for additional damages beyond those that the securities law enforcement action sought to recoup.

Does Rule 10b-5 cover foreign securities transactions?

Rule 10b-5 prohibits securities fraud. Specifically, it covers “any device, scheme, or artifice to defraud,” “any untrue statement of a material fact,” “any omission of a material fact,” and “any act, practice, or course of business which operates or would operate as a fraud or deceit” in the “purchase or sale of any security.”

For the provision of federal jurisdiction, Rule 10b-5 requires that the conduct involve the use of “the interstate mail,” “instrumentalities of interstate commerce,” or a “facility of a national securities exchange.”

Rule 10b-5 applies to individuals and companies as well as foreign governments, government officials, and other legal persons.

The application of the rule to transactions involving foreign exchanges is generally limited. In Morrison v. National Australia Bank Limited, the Supreme Court explained that a private Rule 10b-5 claim is only authorized if it involves a “domestic transaction.” The Court defined domestic transactions as:

• Transactions that involve “the purchase or sale of securities listed on a U.S. exchange”; and,
• Transactions in which “irrevocable liability attaches within the United States.”

While Morrison is one of several cases that limit Rule 10b-5’s domestic application, the decision is only applicable to lawsuits brought by private plaintiffs, not enforcement actions brought by the SEC or the Department of Justice. Despite the decision, however, many companies and financial professionals still face substantial challenges due to jurisdictional issues when dealing with transactions involving foreign counterparties.

Can Rule 10b-5 lead to civil or criminal penalties?

In Rule 10b-5 enforcement cases, the SEC is authorized to seek a variety of remedies including injunctions and industry bars, as well as both civil penalties and disgorgement.

While the SEC pursues civil enforcement actions under the Exchange Act, the United States Department of Justice is responsible for pursuing criminal prosecutions under the Exchange Act and other federal securities laws.

Under Section 78ff of the Exchange Act, willful violations of the act, its rules, and regulations can carry up to 20 years in prison. Another separate provision, 18 U.S.C. Section 1348, contains an even longer sentence of up to 25 years in prison for securities fraud.

While the Exchange Act implements Rule 10b-5, several other federal securities laws may be implicated in a Rule 10b-5 enforcement case. Section 17(a) of the Securities Act, for example, prohibits “any device, scheme, or artifice to defraud,” “any untrue statement of a material fact,” or “any omission of a material fact” in connection with “the offer or sale of any security.”

While Rule 10b-5 prohibits fraud in both offers and sales, the SEC does not need to prove scienter under Section 17(a)(2) and (3) of the Securities Act in civil enforcement proceedings.

While civil enforcement of Section 17(a) falls within the SEC’s jurisdiction, the courts have consistently held that there is no private cause of action for damages under Section 17(a).

How has the Seventh Circuit’s decision in SEC v. Jarkesy v. SEC affected Rule 10b-5 enforcement?

The Seventh Circuit’s decision in SEC v. Jarkesy, 603 U.S. 109 (2024) and other defendants in SEC enforcement cases. It holds that “the Seventh Amendment grants the right to a jury trial to seek civil penalties for fraud cases under Section 21(d)(3) of the Securities Exchange Act of 1934.” This is an important, and relatively new, decision which requires trial by jury in most SEC civil enforcement proceedings.

How does Rule 10b-5 apply to insider trading plans?

Individuals who act as the “insiders” of companies, as well as those who serve as investment advisors and broker dealers, are frequently subject to “insider trading” concerns. While the term “insider trading” describes a wide range of potential violations of securities law, most securities-related insider trading claims involve Rule 10b-5 and the general prohibitions against using one’s superior knowledge or information to gain an unfair advantage over other investors.

Along with classical insider trading liability, misappropriation liability and “tippee” liability can also apply under Rule 10b-5.

Classical insider trading liability applies when insiders, i.e., corporate officers, directors, and beneficial owners, misuse material nonpublic information in order to take advantage of investors to whom they owe a fiduciary duty.

Misappropriation liability exists, as well, when individuals or entities trade securities in a manner that involves a deception of the source of a confidential investment tip. The key difference between classical insider trading and misappropriation liability is that misappropriation liability does not require the individual or entity involved in the violation to have owed a fiduciary duty to investors in the first place.

Tippees, or individuals and entities who know (or should know) that information was obtained from a confidential information source, can face insider trading liability, as well. However, tippees can only face liability under Rule 10b-5 if the “tipper” involved also breached a fiduciary duty.

What is Rule 10b5-1?

Rule 10b5-1 has long been used as an affirmative defense for directors, officers, and other individuals and entities who trade securities in a manner that could otherwise involve insider trading liability. But as recent Supreme Court decisions have shown, Rule 10b5-1 provides an affirmative defense, rather than blanket trading authorization. As the court explained, “While Rule 10b5-1 provides for an affirmative defense in appropriate cases, it cannot be used to shield securities trading violations from the reaches of a criminal prosecution under Rule 10b-5.”

For example, in order to utilize the Rule 10b5-1 affirmative defense in securities litigation, directors, officers, and others must satisfy specific requirements. At a minimum, they must be able to prove that they adopted the trading plan in question “while not in possession of any material nonpublic information.”

Additionally, Rule 10b5-1 imposes substantial cooling-off periods for insiders when establishing insider trading plans. Depending on the specific type of insider involved, cooling-off periods can go up to 120 days before they can make a sale or purchase of the company’s stock.

The SEC adopted amended and revised Rule 10b5-1 in December 2022. As a result, there are now certification requirements for insiders that adopt Rule 10b5-1 trading plans as well. To establish the Rule 10b5-1 affirmative defense, insiders must now be able to certify that they do not have material nonpublic information on the date of the plan’s adoption.

Speak With a Federal Defense Lawyer

If you are dealing with any part of what this article describes, the next step is a conversation with a lawyer who handles these cases. Spodek Law Group is a second generation criminal defense firm practicing since 1976, representing clients nationwide from offices in New York, Brooklyn, Queens and Los Angeles. Call 212-300-5196 to speak with our team.