Scienter in Securities Fraud: What the SEC Must Prove.

Under the Securities Exchange Act, the SEC generally has the authority to enforce the substantive provisions of the Act as well as its implementing rules (like Rule 10b-5) in federal court. As a result, for it to enforce liability under Rule 10b-5 in civil litigation, it must establish that the target acted with “scienter” or “intent to deceive, manipulate, or defraud.”

Federal appellate courts split on whether recklessness also qualifies as scienter under Rule 10b-5. However, while some circuits take a more restrictive view of scienter, most federal courts have recognized “reckless conduct” as satisfying the requirement for the SEC to establish liability under Rule 10b-5.

When evaluating liability under the Securities Act’s enforcement provisions, the Supreme Court decided in Aaron v. SEC that the substantive enforcement provisions at issue, § 17(a)(1), contain the same scienter requirement as the Exchange Act’s § 10(b). The Supreme Court has left the burden of proof open, but has implied that a scienter requirement exists for these provisions as well. While the Court also left the issue of scienter under § 17(a)(2) and § 17(a)(3) open in Aaron v. SEC, these provisions allow for negligence liability. The Supreme Court noted that while the SEC must prove intentional fraud under Section 17(a)(1), it can establish negligence liability under the other provisions without scienter.

In civil cases, the SEC has a lower burden of proof than at a criminal trial. Generally, the SEC can prove liability for securities fraud through “a preponderance of the evidence,” which is enough to establish that its allegations are more likely than not true.

How Does an SEC Case Differ from a Private Lawsuit?

In a private securities fraud action brought under Rule 10b-5, the plaintiff must establish:

• (i) that the defendant made a material misrepresentation or omission;
• (ii) that it did so with scienter (i.e., with the intent to deceive, manipulate, or defraud, or recklessly);
• (iii) that the plaintiff relied upon the misstatement or omission (or, in some cases, that the plaintiff relied upon the integrity of the market price which was affected by the misstatement or omission);
• (iv) that the plaintiff suffered an economic loss in reliance; and
• (v) that the defendant’s violation caused the economic loss.

The SEC can pursue enforcement under Rule 10b-5 and Section 17(a) based only on a showing of scienter (or recklessness). The SEC does not have to establish that investors relied on the target’s misstatements or omissions. Moreover, it is not required to show that investors suffered an economic loss as a result of the target’s violation or that the target’s violation caused their losses.

Another significant difference between private securities fraud cases and cases involving the SEC is that the Private Securities Litigation Reform Act (PSLRA) imposes a strong-inference requirement when private plaintiffs plead fraud in federal district court. While the PSLRA does not impose this scienter pleading requirement in SEC enforcement actions, this does not mean that the SEC can plead scienter carelessly. Rather, the SEC must generally satisfy Rule 9(b) of the Federal Rules of Civil Procedure, and it must plead the specific facts supporting its allegations with a certain degree of particularity.

Also, in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), the Supreme Court held that a culpable inference of scienter in a private securities case must be “compelling” after comparing it to “any and all” non-culpable inferences. This is a high bar that will be difficult to satisfy in many circumstances. The SEC is not subject to the Tellabs standard. Instead, in SEC cases, a judge will find that a federal complaint pleads an allowable inference of scienter if the allegation of scienter is “plausible.” As a result, the SEC can often plead the requisite state of mind without meeting the same standard as private plaintiffs.

Private litigation and government enforcement litigation are different, and these differences can have significant implications for your case. If you are the target of an enforcement action, it is essential to work with a defense attorney who can effectively protect your interests.

Why Can Negligence Violate Securities Act Section 17(a)?

Ordinary negligence can never be the basis for liability under any of Rule 10b-5’s provisions. Each of the rule’s three subsections incorporates a requirement for the SEC or other private plaintiffs to establish a showing of scienter. This is a key difference between the securities fraud provisions of the Securities Exchange Act and the Securities Act. While Rule 10b-5 applies “in connection with the purchase or sale of any security,” the Securities Act’s Section 17(a) applies in relation to offers and sales of securities+OR+(granuleid:USC-prelim-title15-section77q)&f=treesort&edition=prelim&num=0&jumpTo=true). Specifically, Section 17(a) prohibits any person “who, directly or indirectly… offers or sells, or causes any security to be offered or sold” from engaging in any of three broad categories of deceptive practices.

As a result of a provision in Section 17(a)(1) that includes language similar to that of Section 10(b) and Rule 10b-5, the Supreme Court held in Aaron v. SEC that an enforcement action brought under Section 17(a)(1) should be based on a finding of scienter rather than negligence. In contrast, Sections 17(a)(2) and 17(a)(3) of the Securities Act contain no express scienter requirement. Section 17(a)(2) prohibits “any transaction or practice” as a means of obtaining money or property by means of “any untrue statement of a material fact or any omission to state a material fact,” and Section 17(a)(3) prohibits “any other transaction or practice” that operates as a “fraud or deceit” or a “dishonest practice” to any prospective purchaser or investor.

The Supreme Court distinguished Section 17(a)(1) from Sections 17(a)(2) and (3), noting a substantive difference between the provision that requires a finding of scienter and the other two provisions. While the Court was hesitant to call them “negligence standards,” it also acknowledged that “liability under Section 17(a)(2) and Section 17(a)(3) can be based on negligence.”

While it will generally not be possible for the SEC to establish liability for securities fraud on the basis of ordinary negligence under Section 10(b) and Rule 10b-5, negligence can be enough to warrant civil liability under Sections 17(a)(2) and (3) of the Securities Act. As a result, individuals facing scrutiny for violations of Section 17(a) need to defend against both intentional and negligent fraud.

How Do Courts Distinguish Recklessness from Ordinary Negligence?

In private securities litigation, “scienter” is typically defined as “a mental state embracing intent to deceive, manipulate, or defraud.” As explained above, most federal circuits recognize “recklessness” as constituting scienter, but there are significant disagreements between various circuits regarding the appropriate formulation of recklessness.

There are four key elements for civil liability under Rule 10b-5: (i) material misrepresentation or omission, (ii) scienter, (iii) reliance, and (iv) economic loss. While materiality and scienter are separate elements of liability, they are also closely related, and an SEC complaint must generally prove that a defendant made a misstatement or omission that he or she knew was misleading. If the defendant should have known the misstatement was misleading but did not, then ordinary negligence will not be enough to establish scienter.

For purposes of Rule 10b-5, the scienter requirement applies at the time of the misstatement or misconduct. For example, a person cannot establish scienter by later adopting the statement or conduct of another who has scienter. And in instances where an individual is not responsible for creating an omission, a person who learns of the omission and has a duty to correct it may only be liable if he or she made an affirmative misstatement.

The distinctions between ordinary negligence and recklessness are substantial, and they are also difficult to pinpoint in many cases. With this in mind, appellate courts have articulated a number of tests and definitions that they use when distinguishing reckless conduct from negligent conduct. For example, a common formulation for severe recklessness is that “the defendant disregarded a substantial risk of misleading investors,” while in other cases the formulation has been slightly more specific: “the defendant must have known or had reason to know of the risk and the risk of misleading investors must have been obvious.”

In cases involving allegations of securities fraud, a jury will have to carefully determine whether a defendant disregarded a risk of misleading investors, consciously failed to consider the risk, or simply made a mistake. The latter may amount to ordinary negligence, and as a result, it will not be sufficient to establish liability under Rule 10b-5. Poor management can certainly be grounds for a securities fraud lawsuit, but ordinary negligence can only be a grounds for a lawsuit if the investor can prove that the individual consciously disregarded a substantial risk of misleading investors.

Todd Spodek and the attorneys at Spodek Law Group handle federal cases of this kind from New York, Brooklyn, Queens and Los Angeles.

What Evidence Can the SEC Use to Prove Scienter?

In an SEC fraud investigation, the Commission’s lawyers can attempt to establish scienter through either direct or circumstantial evidence. While a defendant’s internal communications can be used to directly establish his or her intent, the SEC can, in many instances, establish scienter based entirely on circumstantial evidence.

One piece of circumstantial evidence that the SEC frequently relies on in its fraud enforcement actions is “insider trading.” Unusual or timely stock transactions by corporate executives who allegedly committed securities fraud can be a hallmark sign of fraudulent intent, and this evidence will often be used to bolster the SEC’s case. However, evidence of insider trading must usually be corroborated by other evidence in order to effectively prove a fraudulent intent. For example, a company executive who is alleged to have overstated revenues could potentially sell his or her shares to personally profited from the stock price inflation. However, the executive who is alleged to have overstated revenues would not likely be able to have a good explanation for the transactions in his or her stock portfolio if he or she were to commit securities fraud.

Executive departures in the midst of internal investigations that are going on behind the scenes can also indicate a person’s fraudulent intent. As a result, executives who leave their companies during investigations are often closely scrutinized. If the SEC learns of unusual departures, it may request records that show why the individual left. While a sudden resignation could indicate guilt, circumstantial evidence is usually weak on its own.

Along with insider trading and executive departures, the SEC also looks for other evidence to establish scienter in its Rule 10b-5 fraud enforcement actions. Examples include:

• Motive and Opportunity - Motive and opportunity may both be important indicators of fraudulent intent. However, motive and opportunity alone have generally been considered insufficient to satisfy the scienter requirement in la SEC and private securities cases. A defendant’s motive to commit fraud is also not an element of an SEC action under Rule 10b-5, and the SEC is not required to prove that a defendant personally profited from a violation.
• Rule 10b5-1 - Rule 10b5-1, adopted in 2000 and substantially amended in 2022, defines when a trade is made “on the basis of” material nonpublic information and provides an affirmative defense for trades made under a qualifying pre-arranged trading plan.

How Do Corporate Knowledge and Good-Faith Advice Affect Scienter?

Individuals who rely in good faith on the advice of counsel and other licensed professionals will generally have an easier time avoiding liability in SEC enforcement cases. A defendant’s good-faith reliance on the advice of counsel does not, however, establish an automatic defense to liability for securities fraud. A defendant’s reliance on professional advice must be weighed in light of the specific circumstances involved in each case.

For corporations, the determination of corporate scienter will generally stem from the scienter of those corporate agents who committed the alleged violation on the corporation’s behalf. However, in cases involving corporate defendants, courts generally will not automatically attribute the knowledge possessed by individual employees to the corporation. While individual knowledge will play a role in determining corporate scienter, the issue will typically come down to whether individuals within the corporation collectively acted with the intent to deceive, manipulate, or defraud.

A corporation’s evidence showing good-faith use of its internal controls to prepare required financial statements or a prospectus can also be critical in defending against corporate liability for securities fraud. Even in cases where the SEC is able to establish that financial or disclosure violations occurred, a corporation’s documentation of a good-faith effort may significantly diminish any inference of corporate scienter.

While underwriters have previously requested that issuing companies provide them with Rule 10b-5 negative-assurance letters for all securities offerings, federal securities statutes do not explicitly require negative-assurance letters in each underwriting.Individuals and corporations facing allegations of fraud and other wrongdoing in an SEC case will need to focus on proving that they lacked the requisite state of mind to warrant civil liability under the Securities Act or Exchange Act. Defense counsel will need to investigate whether affirmative evidence exists that proves a defendant’s fraudulent intent or whether it can only be established through circumstantial evidence.

How Does Scienter Apply to Omissions and Fraudulent Schemes?

Under Rule 10b-5, SEC fraud charges can be brought for, among other things, any material misstatement or omission in “connection with the purchase or sale of any security.” This “in connection with” requirement is substantive, but it is typically easily satisfied. If an SEC complaint makes it appears as if an individual or corporation is targeting a securities transaction, the courts generally will find sufficient evidence for Rule 10b-5 liability.

A closely-related issue raised in Janus Capital Group, Inc. v. First Derivative Traders is whether a person or company can be held liable under Rule 10b-5(b) for statements that they did not make. In Janus, the Supreme Court limited the scope of Rule 10b-5(b) statements to the statements’ makers, and held that the federal securities laws do not impose liability on those who did not “make” the allegedly misleading statements.

However, the Supreme Court held in Lorenzo v. SEC that Rule 10b-5 also imposes liability for fraud even if a person is not the statement’s “maker.” This is referred to as scheme liability, and it applies when an individual “disseminated” another individual’s false statements while knowingly and intentionally assisting in a scheme to mislead investors.

Other requirements for establishing Rule 10b-5 liability include the following:

• Use of the Interstates, Mail or National Exchange - To impose liability under Rule 10b-5, the SEC must prove that the defendant used the interstate commerce facilities, the mail, or any means of interstate communication to effect any of the rule’s violations.
• Omitting a Material Fact - To establish liability under Rule 10b-5’s misstatement and omission provision, the SEC must prove that the defendant had a duty to disclose a material fact. This duty is generally presumed to exist if the omission is made during an SEC filing or a registration statement, and is also presumed to exist if a broker-dealer or financial advisor omits to state a material fact to a customer.
• Use of a Deceptive Device or Contrivance - This section of Rule 10b-5 imposes liability for schemes and practices other than issuing a misleading statement.
• Materiality - The federal securities statutes prohibit misstatements and omissions that are material in nature. In Basic Inc. v. Levinson, the Supreme Court held that a fact is “material” if there is “a substantial likelihood that a reasonable shareholder would attach importance to the fact.” In Matrixx Initiatives, Inc. v. Siracusano, the Supreme Court rejected the use of a bright-line statistical threshold for materiality, and reaffirmed Basic Inc.’s materiality test.

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Every case turns on its own facts, and general information is no substitute for advice about yours. Todd Spodek, managing partner of Spodek Law Group, and the firm's attorneys defend federal criminal and white collar matters nationwide. Reach the firm at 212-300-5196.