Section 10b Of The Exchange Act And Rule 10b 5 - Securities Regulation

§ 10(b) of the Exchange Act and Rule 10b-5

1. In general, § 10(b) of the Exchange Act proscribes, by the use of any instrumentality of interstate commerce, "any manipulative or deceptive device or contrivance" in connection with the purchase or sale of a security.

2. Rule 10b-5 bars by use of any means or instrumentality of interstate commerce or the mails or any facility of any national exchange:

   1. (1) To employ any device, scheme or artifice to defraud, (2) 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 light of the circumstances under which they were made, not misleading, or (3) to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person,

   2. In connection with the purchase or sale of a security.

3. There is an implied right of action under § 10(b) and Rule 10b-5. See Herman & McLean v. Huddleston ("[A] private right of action under Section 10(b) . . . and Rule 10b-5 has been consistently recognized for more than 35 years. The existence of this implies remedy is simply beyond peradventure.") (pg. 662)

4. Standing: To have standing to sue in a private action under Rule 10b-5, the plaintiff must be an actual purchaser or seller of the securities. See Blue Chip Stamps v. Manor Drug Stores (pg. 667)

5. ELEMENTS

   1. (1) Material Misstatement or Omission

      1. Materiality

         • SEE MATERIALITY ABOVE

      2. Misstatement or Omission

         • Duty to Correct

           • "A duty to disclose arises whenever secret information renders prior public statements materially misleading, not merely when that information completely negates the public statement." In re Time Warner Securities Litigation (pg. 687)

           • A statement need only be corrected if it was incorrect when made. Gallagher v. Abbott Laboratories (pg. 690)

             • BUT "[A] projection is not rendered false when the world turns out otherwise." Gallagher v. Abbott Laboratories (pg. 690)

         • Duty to Update

           • Generally, the mere possession of material nonpublic information does not of itself give rise to a duty of disclosure. See Gallagher v. Abbott Laboratories

           • BUT Some courts recognize a duty to update:

             • SPLIT

               • Second Circuit: There is a duty to update in the Second Circuit. See In re Time Warner Securities Litigation (pg. 685)

               • "[W]hen a corporation is pursuing a specific business goal and announces that goal as well as an intended approach for reaching it, it may come under an obligation to disclose other approaches to reaching that goal when those approaches are under active and serious consideration." In re Time Warner Securities Litigation (pg. 687)

                 • ASIDE: There is a duty to update required by various stock exchanges (e.g., the NYSE states that a listed company "is expected to release quickly to the public any news or information which might reasonably be expected to materially affect the market for securities.")

             • Seventh Circuit: There is no duty to update in the Seventh Circuit. See Gallagher v. Abbott Laboratories (pg. 688)

               • "We do not have a system of continuous disclosure. Instead firms are entitled to keep silent (about good news as well as bad news) unless positive law creates a duty to disclose." Gallagher v. Abbott Laboratories (pg. 688)

               • Updates are due "not when something 'material' happens, but on the next prescribed filing date." Gallagher v. Abbott Laboratories (pg. 689)

         • Where a voluntary statement is made, there is a duty to speak completely (i.e., avoid half-truths). See, e.g., First Virginia Bankshares v. Benson

      3. A breach of a fiduciary duty is generally a matter for state law claims and not for a 10b-5 action. See Santa Fe Industries v. Green (pg. 730)

         • BUT where there is an actual misrepresentation, the claim will fall under the purview of Rule 10b-5. See Goldberg v. Meridor (finding a violation of Rule 10b-5 based upon issuing stock in exchange for assets where there were misleading disclosures regarding inadequate consideration; had the minority shareholders known that they would have been aware that they would've been entitled to a remedy under state law, that is, for a breach of fiduciary duty)

   2. (2) In Connection with the Purchase or Sale of a Security

      1. To satisfy this element, the plaintiff must show that the false corporate publicity was disseminated in "in a manner reasonably calculated to influence the investing public." SEC v. Texas Gulf Sulphur Co. (pg. 661)

         • As far as the "in connection with" requirement, it is not necessary to show that the purpose of the misleading statement was to influence investors - only that a material misstatement was disseminated in a medium on which investors rely. See Semerenko v. Cendant Corp. (pg. 661)

         • Thus, the recipient of the information need not be a person to whom it was specifically directed. See In re Carter-Wallace Sec. Lit. (pg. 661)

   3. (3) Scienter

      1. Scienter Standard

         • The Court in Ernst & Ernst v. Hochfelder described scienter as referring to "a mental state embracing intent to deceive, manipulate or defraud." (pg. 672)

           • However, elsewhere in the opinion the Court spoke of action "other than in good faith " as that which is proscribed by Rule 10b-5. (pg. 672)

         • TWO ISSUES:

           • (1) Does the scienter requirement demand a showing that the defendant's purpose was to mislead investors, or is knowledge enough?

             • Majority Rule: It is enough that the defendant simply was aware of the true state of affairs and appreciated the propensity of the misstatement or omission to mislead. See AUSA Life Ins. Co. v. Ernst & Young (pg. 672)

             • Minority Rule: The defendant's purpose was to mislead investors. See United States v. Stewart (pg. 673)

           • (2) Is recklessness enough to satisfy the scienter requirement?

             • The overwhelming weight of authority among the courts of appeals is that recklessness is sufficient insofar as the recklessness is "a lesser form of intent [rather] than merely a greater degree of ordinary negligence." Sanders v. John Nuveen & Co. (pg. 673)

               • Most courts demand some showing of "subjective recklessness" (i.e., "those highly unreasonable omissions or misrepresentations that involve not merely simple or even inexcusable negligence but an extreme departure from the standards of ordinary care, [presenting] a danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it."). Broad v. Rockwell International Corp. (pg. 674)

                 • The First Circuit described the recklessness standard as "carelessness approaching indifference." Hoffman v. Estrabrook & Co. (pg. 674)

         • To establish corporate liability for a violation of Rule 10b-5 requires looking to the state of mind of the individual corporate official or officials who make or issue the statement (or order or approve it or its making or issuance, or who furnish information or language for inclusion therein, or the like) . . . ." Makor Issues & Rights, Ltd v. Tellabs Inc. (pg. 680)

         • "Advice of counsel may bear upon scienter in some cases; where, for example, directors rely upon counsel to conduct an investigation of the truth of information to be released; or where counsel mistakenly but in good faith represents that some information is either immaterial or clear." Pittsburgh Terminal Corp. v. Baltimore & Ohio Railroad (pg. 674)

      2. Pleading Scienter

         • The Private Securities Litigation Reform Act (PSLRA) provides that the plaintiffs must "state with particularity facts giving rise to a strong inference" of scienter. PSLRA § 21D(b)(2).

           • The PSLRA requires that misleading statements be specified in the complaint and the reasons why they are misleading. (pg. 678)

         • What kind of facts to allege:

           • According to the Second Circuit in Novak v. Kasaks, a strong inference of scienter may arise when the complaint sufficiently alleges that the defendant (1) benefitted in a concrete and personal way from the purported fraud; (2) engaged in deliberately illegal behavior; (3) knew facts or had access to information suggesting that their public statements were not accurate; or (4) failed to check information that they had a duty to monitor.

      3. There is no fraud by hindsight. DiLeo v. Ernst & Young (pg. 683)

   4. (4) Reliance (i.e., Transaction Causation)

      1. Omissions

         • Affiliated Ute Citizens v. United States stands for the proposition that there is a rebuttable presumption of reliance where the Rule 10b-5 claim arises from a material omission rather than a material misstatement. See Affiliated Ute Citizens v. United States (pg. 697)

           • The Court in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. stated that "[w]e have found a rebuttable presumption of reliance in two different circumstances. First, if there is an omission of a material fact by one with a duty to disclose, the investor to whom the duty was owed need not provide specific proof of reliance." (pg. 760)

           • However, notwithstanding the fact that the Affiliated Ute presumption is described as a rebuttable presumption, as a practical matter, it is hard to imagine any circumstances in which the presumption could be rebutted.

      1. Misstatements

         • The second presumption noted in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. is the fraud-on-the-market theory and concerns material misstatements.

           • "[U]nder the fraud-on-the-market doctrine, reliance is presumed when the statement at issue is made public." Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (pg. 760)

           • "Because most publicly available information is reflected in market price, an...