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Securities Fraud: Understanding Criminal vs Civil Liability

Understanding Criminal vs Civil Liability for Securities Fraud

Securities fraud involves the intentional deception of investors when buying or selling securities such as stocks and bonds. While securities fraud is always a violation of common law fraud, there are also specific criminal and civil laws that impose liability for this conduct. This article will provide an overview of the key differences between criminal and civil liability for securities fraud.

Criminal Liability for Securities Fraud

On the criminal side, the main federal statute used to prosecute securities fraud is Rule 10b-5, promulgated under Section 10(b) of the Securities Exchange Act of 1934. To establish criminal liability under Rule 10b-5, prosecutors must prove the following key elements:

  • Material Misrepresentation or Omission: The defendant made a statement about a material fact that was false or misleading, or failed to state a material fact that made their other statements misleading.
  • Scienter: The defendant acted knowingly or recklessly in making the misrepresentation or omission.
  • Reliance: The victim relied on the defendant’s misrepresentation or omission.
  • Resulting Loss: The victim suffered a financial loss as a result of their reliance.

In 2002, Congress also enacted a specific criminal securities fraud statute as part of the Sarbanes-Oxley Act, 18 U.S.C. §1348. This statute prohibits schemes to defraud persons in connection with securities or to obtain money or property by false representations related to securities.

The penalties for criminal securities fraud can be severe. Under Rule 10b-5, the maximum prison sentence is 20 years. Fines can also be imposed up to $5 million for individuals and $25 million for entities. Under §1348, the maximum prison sentence is 25 years and the maximum fines are the same.

Civil Liability for Securities Fraud

In addition to criminal prosecution, securities fraud also leads to civil liability. The main laws imposing civil liability are Section 10(b) and Rule 10b-5, as well as Section 11 of the Securities Act of 1933 for false statements in registration statements.

To establish civil liability under Section 10(b) and Rule 10b-5, plaintiffs must prove largely the same elements as prosecutors do in a criminal case. However, there are some key differences in how the elements apply:

  • The materiality standard is generally seen as lower in criminal cases. Prosecutors only need to show that a reasonable investor would have viewed the misrepresentation or omission as important, whereas civil plaintiffs must show it would have altered the total mix of information.
  • Certain forward-looking statements get safe harbor protection in civil cases if accompanied by meaningful cautionary language, but no such protection exists in criminal cases.
  • For secondary actors like lawyers and accountants, civil liability requires proof they made the misrepresentations themselves or had control over the primary violator. Criminal liability has no such limitation.

Section 11 allows civil liability when a securities registration statement contains material misstatements or omissions, without any need to show scienter, reliance or causation. Issuers can be held strictly liable for misstatements in registration statements.

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Remedies available in civil securities fraud cases include rescission of the transaction, disgorgement of profits, civil fines and penalties, and monetary damages for losses. Damages can later be tripled if the violation was willful.

Key Differences in Application

Beyond the technical legal differences in standards and elements, securities fraud laws also tend to be applied differently in criminal and civil contexts:

  • Burden of Proof: The standard is “beyond a reasonable doubt” in criminal cases, versus the lower “preponderance of evidence” standard in civil cases.
  • Pretrial Scrutiny: Judges review civil securities complaints to ensure legal sufficiency of the allegations before allowing a case to proceed. Such scrutiny does not happen at the indictment stage in criminal cases.
  • Motivation for Cases: Criminal charges are selective and emphasize egregious cases with clear intent. Civil suits are often class actions aimed more at restitution than punishment.
  • Settlements: Authorities push for guilty pleas in criminal cases, while civil defendants often settle claims without admitting wrongdoing.
  • Blue Sky Laws: State securities fraud laws allow for criminal prosecutions even when federal laws may not permit civil liability.

So in many instances, the exact same securities fraud conduct could potentially lead to imprisonment under criminal laws but no monetary damages under civil laws.

Explaining the Civil-Criminal Divide in Securities Fraud

What explains this anomaly where similar securities fraud triggers harsh criminal penalties but no civil liability? Legal scholars have put forward several theories:

  • Deterrence: The threat of prison provides stronger deterrence against securities fraud compared to just monetary damages.
  • Retribution: Securities fraud erodes trust in capital markets, so prison sentences justly punish moral culpability.
  • Federalism: Federal law narrows civil liability to avoid impinging on state authority over corporations and other entities.
  • Politics: Pro-business interests lobby for narrower civil liability while prosecutors push to expand criminal liability.

So in principle, there are arguable policy reasons for imposing criminal liability for conduct not subject to civil liability in the context of securities fraud. Nonetheless, the extremely severe prison sentences that can result under this framework should give lawmakers and enforcers pause.

Perhaps in the future we may see efforts to better align criminal and civil liability standards for securities violations. But for now, the discrepancies will continue to lead to situations where conduct triggers huge fines or lengthy jail time as a crime but no compensation or remedies under civil law.

The complex intersection of criminal and civil fraud law means both individual and corporate defendants face extensive litigation exposure. Be sure to consult an experienced securities fraud attorney if you have any questions or concerns. Reach out today to schedule a consultation and ensure your rights are protected.

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