What Is Securities Fraud Under Federal Law??

In many contexts, “securities fraud” is treated as a single, unified violation. But, as we explain in “A Guide to Defending Against Federal Civil and Criminal Securities Fraud Enforcement,” that general term refers to a family of related statutes and theories that govern different types of deceptive conduct. As a result, when a party is charged with “securities fraud,” it is important to determine:

• What specific statute or rule is at issue;
• What (if any) elements have been proven under that specific statute or rule; and
• What civil or criminal penalties, if any, are warranted in light of the evidence presented at trial.

What Theories or Legal Bases Support Securities Fraud Charges?

As a broad, conceptual matter, there are three ways that deceptive conduct involving securities transactions can qualify as federal securities fraud. These three general theories are:

• Material misrepresentation;
• Material omissions; and
• Material deceptions and schemes.

That said, the specific statute or rule involved also matters. For example, “insider trading” and “accounting fraud” are both forms of securities fraud, but they may involve different elements, different remedies, different theories of liability, and different (though often overlapping) sets of evidence.

Are There Other Statues That Apply?

Under certain circumstances, there are other statutes and regulations that can have substantive or procedural relevance to federal securities fraud allegations. While most cases fall under the framework of the federal securities laws (such as the Securities Act of 1933, the Securities Exchange Act of 1934, the SEC’s rules and regulations thereunder, and 18 U.S.C. § 1348), there may be other issues at play as well.

• Section 1348. This statute applies to schemes, fraudulent misrepresentations, and other deceptive acts designed to obtain money through securities transactions.
• Unauthorized Trading. If a broker or financial advisor trades or executes transactions without a client’s authorization, there may be grounds for regulatory discipline, even if that trading does not establish grounds for civil or criminal securities fraud.

Which federal laws govern securities fraud cases?

What Does “Scienter” Mean?

In federal securities fraud cases, “scienter” generally means a party’s intent to deceive. However, in a federal enforcement context, scienter does not necessarily mean actual or specific intent. A party can commit securities fraud by acting so recklessly that his or her conduct is substantially equivalent to intentional fraud, and, again, a jury can infer scienter based on a party’s decisions, omissions, or other subjective factors.

What Specifically Is Section 10(b)?

Section 10(b) is a provision within the federal Exchange Act. It focuses on “deception” and “manipulation,” and it applies in order to target parties who engage in “fraud, deceit, and misrepresentation” in connection with the purchase or sale of any security in the interstate commerce of the United States. Under Section 10(b), scienter is an essential (though often easy to prove) element, and the U.S. Securities and Exchange Commission (SEC) must be able to establish scienter in order to support its claims for injunctive or other penalties under this provision of the Act.

What Is SEC Rule 10b-5?

SEC Rule 10b-5 implements Exchange Act Section 10(b). The Exchange Act is the statutory foundation for federal enforcement cases involving the buy or sell of any security in the U.S., and the Rule provides the SEC and other authorities with more detailed guidance to enforce the statute. Again, proving scienter is essential under Rule 10b-5 as well.

What Is Securities Act Section 17(a)?

Securities Act Section 17(a) prohibits fraud in offer or sale of securities. In this case, the rule applies specifically to fraud in “offer” or “sale” rather than fraud in “purchase” or “sale.” Scienter is essential under Section 17(a)(1), but not under Sections 17(a)(2) and 17(a)(3). To establish a violation under Section 17(a)(1), the SEC must show that a party acted with knowledge of (i) a fraud; (ii) intent to deceive; or (iii) a reckless disregard for whether an alleged fraud is actually material.

With that said, it is worth noting that scienter is not necessarily essential to establish civil liability under Sections 17(a)(2) and 17(a)(3). If the SEC or another regulatory body is able to establish a defendant’s negligence, it may be enough to establish a civil penalty under the Securities Act in those contexts.

What Is Section 1348?

18 U.S.C. § 1348 is a criminal statute that makes it a federal crime for anyone to “knowingly execute” or “knowingly attempt to execute” schemes to defraud in order to obtain money or other property through “fraudulent representations or by omission.” Congress enacted Section 1348 through the Sarbanes-Oxley Act of 2002. In order to win cases involving Section 1348 violations, prosecutors must prove beyond a reasonable doubt that a party acted with the required scienter.

What must be proven in a securities fraud case?

What Qualifies as Material Information?

In the context of securities fraud cases, “material” information is information that, if known, would be important to a reasonable investor in the United States. The term is not formally defined within the Securities Act and the Exchange Act, but federal courts have consistently looked toward this definition in order to determine what constitutes “materially” misleading or deceptive conduct.

When Can Silence and Omissions Be Actionable?

Silence and omissions generally are not fraudulent unless a party has a specific duty to disclose. In some cases, that duty is required by law; in others, the duty may depend on circumstances. Determining when a party has an affirmative duty to disclose is a complex process, and, in cases involving private plaintiffs who are pursuing civil claims under Rule 10b-5, determining materiality, reliance, and loss causation are also complex issues in their own right.

What Standards of Proof Apply in Federal Securities Fraud Cases?

In criminal securities fraud cases, the standard of proof is the same as in all other criminal cases: “beyond a reasonable doubt.” In civil securities fraud cases, the standard of proof is lower. But the specific standard (and the standard applied to each element at issue) depends on the parties involved. As we discuss below, private plaintiffs must establish reliance and loss causation under Rule 10b-5, whereas the SEC does not need to establish either.

What Are the Material Elements for Private Plaintiffs Pursuing Claims under Rule 10b-5?

For private plaintiffs bringing claims under Rule 10b-5, the general requirements are: (i) fraudulent conduct or omission; (ii) materiality; (iii) scienter; (iv) reliance (though not in all contexts); (v) economic loss; and, (vi) loss causation. While scienter is a key element under Rule 10b-5, private plaintiffs generally also have to prove that they relied on a party’s misstatement or fraudulent scheme (though no such requirement applies in certain contexts), and that their reliance led to an actual economic loss. While these elements can also appear in the SEC’s enforcement actions, they are not universal criminal elements, and, in some cases, they have different meanings in the context of criminal securities fraud prosecutions.

How Does Reliance and Loss Causation Differs in SEC and Department of Justice (DOJ) Enforcement Actions?

In order to establish civil liability in SEC enforcement actions, the SEC generally only has to prove: (i) fraudulent conduct or omission; (ii) materiality; and (iii) scienter. There is no requirement for the SEC to establish loss causation and reliance, though loss causation may be relevant for determining other appropriate civil penalties and remedies. Criminal enforcement actions involving Rule 10b-5 violations only require proof of a fraudulent misrepresentation or deceptive scheme involving scienter, and the DOJ generally does not have to prove that the alleged fraud caused the economic loss of a particular investor or investor group.

Examples of Federal Securities Fraud

Insider Trading

Insider trading is typically defined as “trading in securities on the basis of material nonpublic information.” But, as we describe in greater detail in “A Guide to Defending Against Insider Trading Allegations,” there are several requirements that must be met before an investor can be held liable for insider trading. And while possessing material nonpublic information is one element that can potentially lead to insider-trading liability, doing so does not automatically establish criminal, civil, or regulatory culpability.

Pump-and-Dump and Ponzi Schemes

A “pump-and-dump” scheme involves an operator who promotes false or misleading claims about a particular security in order to falsely inflate its value. Once investors buy in and the price goes up, the operator dumps their holdings on unsuspecting investors. A “Ponzi scheme” also targets unsuspecting investors, but instead of selling a fraudulent security, a Ponzi operator manages to get a group of investors to trust him or her with their life savings, using the money from new investors to pay off old investors.

Market Manipulation

Market manipulation is also another form of securities fraud. In this case, fraudulent conduct has the potential to lead to an artificial price or deceptive trading volume. The SEC takes market manipulation seriously, and even if manipulation results in few retail investors losing money, the SEC considers such conduct to be inherently fraudulent and deceptive.

False Corporate Filings

Under federal law, corporate officials can face fraud charges if their company makes false corporate filings with the SEC, including forms 10-Q, 10-K, and the Annual Report of a publicly traded company. In order to sustain such claims, however, any alleged omissions or misrepresentations in corporate filings must be “material,” and prosecutors or regulators must be able to establish that the conduct in question was fraudulent.

Unsuitable Recommendations

Just as unsuitable recommendations can trigger civil liability, they can trigger criminal securities fraud charges as well. However, recommending an unsuitable security generally does not automatically establish criminal liability under the federal securities laws, and it can present unique challenges in establishing scienter in criminal cases.

Churning

Churning is the act of excessively trading in order to generate commissions or other brokerage fees. While churning itself may not always establish criminal securities fraud charges, it can be the centerpiece of cases involving insider trading, market manipulation, unsuitable investment advice, and other deceptive conduct as well.

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

When does an investment legally qualify as a security?

Are Unregistered Securities Sales Always Fraudulent?

Not necessarily. While selling unregistered securities can lead to liability under Section 5 of the Securities Act, this is true regardless of whether there is evidence of fraudulent representations or schemes.

When Does Digital Asset Misconduct Qualify as Securities Fraud?

The same principle applies when misconduct involves digital assets. Digital assets only legally qualify as securities, and thus only fall within the scope of federal securities fraud, if they meet the criteria for a security as defined under the federal securities laws.

The term “security” broadly encompasses various financial instruments. This includes, among others:

• Stocks, bonds, and other equity and debt securities;
• Options, warrants, and other derivative securities;
• Limited-partnership interests; and
• Various forms of privately offered and nonexchange-traded investments.

As a result, these broadly defined securities can trigger liability in both the SEC’s civil enforcement actions and the DOJ’s criminal prosecutions, and this includes assets that are offered or traded privately and those that are traded on the public markets.

What Registration Requirements Apply to Securities?

Section 5 of the Securities Act generally requires the registration of securities offers and sales. However, a number of exemptions apply under Section 5, and qualifying for an exemption can provide a viable defense for individuals and entities accused of selling unregistered securities.

It is also important to distinguish between offering registration and broker-dealer registration. Under the Exchange Act, certain parties must register as broker-dealers, a separate requirement from which registration is required under the Securities Act for securities offerings.

What Is the Howey Test?

The Howey test is a test that federal courts use to determine whether an asset qualifies as an “investment contract,” which is one form of security covered by the federal securities laws. An asset qualifies as an “investment contract” if it involves an investment of money in a common enterprise with an expectation of profits to be derived from the efforts of others.

When applying the Howey test, federal courts look at the nature of the overall transaction or scheme rather than the nature of the asset itself. For example, while there is little in the nature of a digital token or other digital asset that would suggest it is a security under Howey, the entire transaction, marketing effort, and business arrangement may result in digital assets qualifying as securities in many cases.

How Does an SEC Securities Fraud Investigation Start?

If you have received a letter from the SEC (or the SEC’s Division of Enforcement is contacting you), it typically means that a federal authority is investigating whether you may have violated one or more of the federal securities laws. While it is not uncommon for individuals and entities to receive letters from the SEC, it is nonetheless important to take these letters seriously. As we discuss below, although the SEC cannot file criminal charges against you, it can certainly refer the case to the Justice Department.

Does the SEC Serve as a Prosecutor?

The SEC has the authority to investigate possible violations of the federal securities laws, and it has the power to impose regulatory discipline through civil enforcement actions. However, the SEC itself does not serve as a prosecutor in the federal criminal justice system. Instead, criminal prosecutions are handled by the Justice Department.

When Does the SEC Refer Cases to the DOJ?

The SEC routinely refers cases to the DOJ when evidence of federal criminal liability is uncovered. While any communication with the SEC during an inquiry could result in the SEC referring the matter for further investigation to the DOJ, providing statements during SEC inquiries can also trigger referrals. As a result, it is not necessary (and can be extremely dangerous) to cooperate with the SEC during its investigation.

When Does the SEC Call in the Justice Department to Prosecute Criminal Securities Fraud?

As a general rule, the SEC refers cases to the DOJ in criminal matters. If you think you may face potential criminal charges, you should not try to fight the SEC’s investigation; rather, you should work with an experienced federal securities-fraud defense team to prepare to defend against DOJ enforcement as well.

How Does the SEC Use Subpoenas to Collect Evidence?

If an SEC investigation is formal, the SEC can use subpoenas to compel a party to turn over documents or provide testimony. If you are under investigation and you do not want to provide the SEC with a statement or testimony, or if you need a defense attorney to review your documents before turning them over to the SEC, you need to promptly engage an experienced federal securities-fraud defense team to intervene.

What Is a Wells Notice?

A “Wells notice” is a formal letter from the SEC staff. It informs the party that the staff has made a preliminary recommendation for enforcement action. If you have received a Wells notice, this will be an extremely urgent situation; it will be critical for you to engage an experienced securities-fraud defense team to explain why the SEC’s enforcement efforts are not warranted.

When Does the SEC File an Enforcement Action?

SEC staff must seek Commission authorization before filing an enforcement action. However, the SEC also has the authority to seek a temporary restraining order or an asset freeze in order to preserve evidence or prevent financial losses. In this case, individuals and companies accused of securities fraud will not have the opportunity to address a Wells notice before the enforcement action itself commences.

How much prison time can securities fraud bring?

How Long of a Prison Sentence Could a Section 1348 Conviction Lead to?

For an individual, a Section 1348 conviction permits imprisonment for up to 25 years. For an entity, the penalty for a Section 1348 conviction can be significant, but a company cannot be imprisoned.

Does a Section 1348 Conviction Lead to a Mandatory Minimum Prison Sentence?

No, the criminal statute under Section 1348 does not impose a mandatory minimum sentence, and the prison sentence imposed by a judge would depend substantially on factors such as the intended (or actual) losses involved, the amount of money a defendant acquired, the defendant’s record, and various other factors under the United States Sentencing Guidelines.

Does the Statutory Maximum Prison Sentence Lead to an Accurate Prediction of a Defendant’s Prison Sentence?

A statutory maximum, such as the 25-year sentence under Section 1348, does not serve as an accurate prediction of a defendant’s sentence in most cases. As a result, it is not helpful to use it as a proxy for what a defendant would actually face if convicted.

What Are the Potential Civil Remedies for Fraud?

The SEC and private plaintiffs can seek civil remedies, including injunctions, monetary penalties, and bars to association within the brokerage industry. In civil fraud cases, the civil penalty amounts depend on whether the complaint alleged fraud or if it alleged other specific violations, and on the amount of money lost in the alleged fraud as well.

Can Incarcerated Defendants Who Are Found Guilty of Financial Crimes Also Be Ordered to Pay Forfeiture?

Criminal cases also seek the forfeiture of any proceeds traceable to the fraud in question. If convicted in a criminal case, a defendant will typically have to pay both financial penalties and the government’s cost for any property recovered or otherwise seized.

How Does a Judge Decide Which Prison Sentence to Impose?

The judge calculates the advisory sentencing range (under the U.S. Sentencing Guidelines) before turning to other factors under 18 U.S.C. § 3553(a), and then he or she will make an appropriate decision within that range. The Guidelines include factors for aggravating circumstances as well as mitigating circumstances that a defendant’s counsel can use to argue against an excessive sentence.

Does a Criminal Conviction Have Further Consequences?

If the criminal conviction relates to fraud and deceit, it will also likely trigger the statutory disqualification requirements of FINRA, which generally bar a party from working as or with a registered broker-dealer or investment adviser for a specified period (and, in some cases, for life). As a result, a criminal conviction in the context of financial crimes has the potential to end a defendant’s career in the financial markets as well.

Get Advice on Your Situation

If you want someone to look at the specifics of your case, Spodek Law Group handles federal criminal defense nationwide from New York and Los Angeles. The firm has been practicing since 1976 and its motto is simple: we owe loyalty to only you. Call 212-300-5196.