Section 10(b) and Rule 10b-5: What Company Leaders Need to Know

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Most company leaders know that making false or misleading statements about their company’s performance or prospects is against the rules. Most company leaders also know that making these types of false or misleading statements can lead to both private civil litigation and trouble with the U.S. Securities and Exchange Commission (SEC). However, far fewer executives and board members have a clear understanding of what exactly is prohibited, and fewer still have a clear understanding of the full ramifications of misleading prospective investors.

The Securities and Exchange Act of 1934: One of the SEC’s Primary Enforcement Tools (and a Key Tool for Plaintiffs’ Lawyers) in 2021

To understand the prohibitions on false and misleading statements in the securities market, we have to go back almost 100 years. After the stock market crash of 1929 triggered the Great Depression, Congress undertook a series of statutory efforts to stabilize the market and provide protections for both institutional and retail investors. One of the most significant of these statutory efforts was the enactment of the Securities and Exchange Act of 1934.

The Securities and Exchange Act of 1934 created the SEC, and it endowed the SEC with substantial authority to enforce the statute’s substantive provisions. One statutory provision of particular import was Section 10(b). In pertinent part, Section 10(b) states:

“It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe as necessary or appropriate in the public interest or for the protection of investors.”

Through Section 10(b), Congress gave the SEC the authority to adopt regulations as necessary to fulfill its obligations under Section 10(b) (elsewhere, it also gave the SEC the authority to adopt regulations to fulfill its obligations under the Securities and Exchange Act of 1934 more broadly). Pursuant to this authority, the SEC established 17 C.F.R. Section 240.10b-5, which is commonly referred to as Rule 10b-5. Through Rule 10b-5, the SEC further defined what constitutes a “manipulative or deceptive device” under Section 10(b):

“It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”

Despite its age and the extraordinary changes in the U.S. securities markets over the past several decades, Section 10(b) still remains one of the SEC’s primary tools for enforcing companies’ public disclosure obligations and protecting investors. It is also a key tool for plaintiffs’ lawyers seeking to pursue fraud claims against private and public companies. While the Securities and Exchange Act of 1934 does not include an express private right of action provision, the U.S. Supreme Court has recognized a private right of action under Section 10(b) since 1975.

Litigation Under Section 10(b) and Rule 10b-5

Violations of Section 10(b) and Rule 10b-5 can potentially lead to four types of litigation. These are: (i) administrative enforcement litigation initiated by the SEC; (ii) civil enforcement litigation initiated by the SEC; (iii) criminal litigation initiated by the U.S. Department of Justice (DOJ), and (iv) private civil litigation through lawsuits filed by investors.

While most of the main substantive issues involved in all four types of litigation are similar (with willfulness being the main distinguishing factor for private civil liability and criminal prosecution), defending against each type of litigation requires a very different approach. On the enforcement side, the ideal scenario (to the extent that any scenario can be categorized as ideal when dealing with the SEC or DOJ) is to assert a successful defense during the investigative process. If a company can avoid charges all together, this can significantly reduce the company’s defense costs, and it can avoid the inherent uncertainty of facing allegations in SEC enforcement proceedings or in federal district court.

On the private litigation side, this isn’t an option. However, it is still possible to achieve favorable pre-trial results in many cases. Strategic use of the pleadings, discovery, and motions practice can often facilitate productive settlement negotiations—if not set the stage for summary judgment or pre-trial dismissal.

Of course, in many cases, securities litigation will be necessary. When it becomes necessary to defend against allegations of Section 10(b) and/or Rule 10b-5 violations in an SEC administrative hearing or in court, companies must assert all viable defenses they have available. While procedural and constitutional defenses will be options in some cases, oftentimes, successfully defending against Section 10(b) and/or Rule 10b-5 allegations requires the ability to attack the elements of the government’s or the plaintiffs’ charges or claims directly.

Defending Against Claims Under Section 10(b) and Rule 10b-5

To illustrate, we will take a look at the elements of a private right of action claim under Section 10(b). As prescribed by the U.S. Supreme Court, there are six elements that plaintiffs need to prove:

  • The defendant made a material misstatement or omission;
  • The defendant made the material misstatement or omission with the intend to deceive, manipulate, or defraud;
  • There is a connection between the defendant’s misstatement or omission and the plaintiff’s purchase or sale of a security;
  • The plaintiff relied on the defendant’s misstatement or omission;
  • The plaintiff suffered economic loss; and,
  • The plaintiff’s reliance on the defendant’s misstatement or omission was the cause of the plaintiff’s economic loss.

1. No Material Misstatement or Omission

A misstatement or omission is only considered material if, “‘there is a substantial likelihood that a reasonable shareholder would consider it important’ in making his investment decision.” This is judged on a case-by-case basis, and is examined in light of both the contents of the misstatement or omission itself and its relation to any other relevant information that is publicly available.

2. No Intent to Deceive, Manipulate, or Defraud

Arguing lack of intent will prove to be an effective defense strategy in many cases. If a plaintiff (or in the case of criminal litigation, the federal government) cannot prove that a company’s leaders intended to mislead investors, then no liability or culpability can attach under Section 10(b).

3. No Connection to the Plaintiff’s Purchase or Sale

Companies can potentially attack this element of a cause of action under Section 10(b) on two different grounds. First, in some cases, companies will be able to argue that the timing is such that the plaintiff is unable to prove that its purchase or sale was made “in connection with” the defendant’s material misstatement or omission. Second, if a plaintiff did not actually make a purchase or sale (i.e. the plaintiff simply held onto a security in reliance on the misstatement or omission), then the plaintiff does not have a claim to pursue under Section 10(b).

4. No Reliance

Even if a plaintiff made a purchase or sale “in connection with” a company’s material misstatement or omission, this alone is not enough if the plaintiff cannot also prove reliance. This prevents plaintiffs from seeking to recover their losses when they make their investment decisions before learning of (or despite learning of) a company’s misstatement or omission.

5. No Economic Loss

As a practical matter, investors will not pursue claims if they do not have losses to recover. As a result, this element tends to be less of an issue in Section 10(b) cases. However, it should not be overlooked as a potential defense, and plaintiffs may inappropriately attribute their losses to companies’ misstatements and omissions in some cases.

6. No Causation

Companies can also defend against Section 10(b) claims by demonstrating that an alleged misstatement or omission did not actually cause the company’s stock price to move. If ordinary market forces played a role (or even arguably could have played a role), this could be enough to prevent a plaintiff from meeting its burden of proof.

As referenced above, these are not the only potential defenses in litigation under Section 10(b) and/or Rule 10b-5. The elements of charges and claims vary in administrative, civil, and criminal proceedings; and, depending on the circumstances involved, procedural and constitutional defenses may be available as well. Success in Section 10(b) litigation requires a comprehensive and custom-tailored defense strategy, and company leaders must work with experienced securities litigation defense counsel to protect their companies (and potentially themselves) by all means available.

Schedule a Confidential Consultation with a Securities Litigation Defense Lawyer

The federal securities litigation defense lawyers at The Criminal Defense Firm bring centuries of combined experience to representing companies and their executives in civil litigation and SEC matters. If you have questions or concerns and would like to speak with a lawyer, we invite you to call 866-603-4540 or contact us online for a complimentary consultation.

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