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Securities Fraud: When Do Inaccurate Financial Reports Become Criminal?

When Do Inaccurate Financial Reports Become Criminal?

Securities fraud is a complex issue that sits at the intersection of business, finance, and criminal law. While not all inaccurate financial reports are illegal, there is a point when misstatements, omissions, and accounting errors cross the line into criminality. Understanding where this line is drawn is important for companies, executives, accountants, investors, and regulators.

What Constitutes Securities Fraud?

The most common forms of securities fraud involve:

• Misleading or false statements – This includes material misstatements or omissions in financial reports, statements to investors/analysts, marketing materials, etc. Even if misstatements are unintentional, they can still constitute fraud if they would impact an investor’s decision.
• Accounting fraud – This involves manipulation of financial records and statements through improper revenue recognition, concealment of liabilities/expenses, fictitious transactions, etc.
• Insider trading – This occurs when corporate insiders trade stock based on material, non-public information before it is disclosed to the public.
• Market manipulation – This aims to artificially inflate or depress share prices through practices like spreading false information, wash trading, rigging prices, etc.
• Pump-and-dump schemes – This is when stock is artificially hyped through false statements, then sold once the price rises.

Securities fraud can occur within publicly traded companies, private investment funds, penny stock scams, and other contexts. The unifying theme is deception aimed at financial gain.

When Does it Become Criminal?

Securities fraud crosses into illegality when there is intentional deception. This does not require malicious intent, but there must be a knowing misstatement, omission, or act of deception.According to legal experts, the key factors distinguishing civil liability from criminal securities fraud include:

• Level of intent – Criminal charges require showing the defendant purposely or knowingly committed fraud. Civil charges have a lower threshold of recklessness.
• Burden of proof – Criminal prosecution requires meeting the high standard of “beyond a reasonable doubt.” Civil charges use the lower standard of “preponderance of evidence.”
• Type of penalties – Criminal convictions result in fines and imprisonment. Civil judgments award monetary damages.
• Who brings charges – Criminal charges are prosecuted by the government. Civil charges can be brought by private plaintiffs or the SEC.
• State of mind – Prosecutors must prove the defendant had awareness and intent. This is not necessary for civil liability.

In general, inaccuracies, misstatements, and accounting errors that are unintentional or negligent may lead to civil penalties but not criminal prosecution. However, patterns of deception, cover-ups, improperly benefiting, and other intentional acts are likely to trigger criminal charges.

Key Laws and Regulations

Several laws establish the illegality of securities fraud and allow both civil and criminal prosecution:

• Securities Act of 1933 – This law regulates the initial issuance of securities and authorizes civil and criminal penalties for fraud in securities offerings.
• Securities Exchange Act of 1934 – This law governs securities trading and exchange markets. It defines unlawful trading practices and allows SEC civil enforcement and criminal prosecution.
• Sarbanes-Oxley Act – This law increased criminal penalties for fraud and mandated corporate responsibility, financial disclosures, and internal controls.
• Dodd-Frank Act – This law enhanced securities fraud penalties and whistleblower incentives and protections.
• State “blue sky” laws – These are state laws regulating the offering/sale of securities. Most establish civil and criminal penalties for fraud.

In addition to these laws, the SEC has established detailed regulations around accounting methods, financial reporting, and other standards public companies must follow. Deviation from these rules can trigger civil and criminal liability depending on the circumstances.

Potential Charges and Penalties

Depending on the nature and scope of alleged fraud, both individuals and corporations can face a range of civil and criminal charges:

• SEC Civil Charges – These may include injunctive relief, disgorgement, fines, and bars from serving as corporate officers or directors.
• Criminal Charges – Possible charges include wire fraud, mail fraud, making false statements/filings, conspiracy, racketeering, and obstruction of justice.
• Imprisonment – Securities fraud convictions can result in years in prison. Sentences depend on the losses caused, sophistication of the scheme, and other factors.
• Fines – Criminal fines can reach millions of dollars. Corporations may face higher fines than individuals.
• Asset Seizure – Authorities can seize property and assets connected with criminal violations.
• Whistleblower Awards – The SEC rewards whistleblowers who provide information leading to successful enforcement. Awards range from 10-30% of penalties.

The consequences for securities fraud vary case-by-case based on the scope, intent, losses caused, and other specifics. But penalties can be severe for both companies and individuals.

Notable Recent Cases

Several high-profile securities fraud cases in recent years demonstrate prosecutors’ willingness to pursue criminal charges:

• In 2018, Theranos CEO Elizabeth Holmes was criminally charged with massive fraud after her blood testing company collapsed. She currently faces 20 years in prison.
• In 2020, Nikola Motors founder Trevor Milton was criminally charged with lying to investors about his hydrogen truck company’s technology. His trial is pending.
• In 2021, Lordstown Motors CEO Steve Burns resigned after being criminally charged with misleading investors about pre-orders for the company’s electric trucks.
• In 2022, The Boeing Company agreed to pay $2.5 billion to settle criminal charges of misleading regulators and customers about the safety of 737 MAX airplanes after two deadly crashes.

These cases illustrate that even well-known founders and executives can face criminal prosecution for securities violations in the right circumstances.

Defenses Against Criminal Charges

For executives or companies facing criminal securities fraud charges, some possible defenses include:

• Lack of intent – Argue the defendant did not knowingly commit fraud or intend to deceive investors.
• Good faith – Contend the defendant honestly believed statements were true when made due to a misunderstanding or error.
• Reliance on professionals – Claim the defendant reasonably relied on accountants, lawyers, or other experts who approved disclosures.
• No investor harm – Point out that misstatements did not actually impact investor decisions or cause losses.
• Cooperation – Cooperate with prosecutors to identify all involved parties and provide evidence. This can help secure a favorable plea deal.

An experienced white collar criminal defense attorney can assess available defenses and negotiate the best possible outcome for those facing charges.

The Bottom Line

Distinguishing civil securities violations from criminal fraud requires examining intent, deceit, investor harm, and other factors on a case-by-case basis. Prosecutors have significant discretion in deciding when to press criminal charges. Companies and executives should be aware of the line between regulatory noncompliance and criminality. Navigating this complex landscape requires experienced legal guidance.