SEC Rule 10b-5

SEC Rule 10b-5 is one of the most important rules promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under the Securities Exchange Act of 1934. The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security, including insider trading.

History

In 1942, SEC lawyers in the Boston Regional Office learned that a company president was issuing pessimistic statements about company earnings while simultaneously purchasing the company's stock. Although the Securities Act of 1933 prohibited fraudulent sales of securities, no regulation precluded fraudulent purchases. Rule 10b-5, issued by the SEC under section 10b of the Exchange Act, was implemented to fill this regulatory void. The commissioners approved the rule without debate or comment, with the exception of Commissioner Sumner Pike who indicated approval of the rule by asking, "Well, we are against fraud aren't we?"

Language of the rule

The rule itself is relatively short, and to the point. The formal title is "Rule 10b-5: Employment of Manipulative and Deceptive Practices", and the complete text reads:

: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.

In the case of "TSC Industries, Inc. v. Northway, Inc.", the word "material" was defined by the U.S. Supreme Court - "an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote." 426 U.S. 438, 449.

Elements of the Offense

In order to establish a claim under Rule 10b-5 plaintiff must show (i) fraudulent conduct (materiality and scienter) (ii) in connection with the purchase or sale of a security by plaintiff, (iii) in interstate commerce, (iv) reliance, and (v) damages.

In a case for insider trading, anyone who uses insider information can be held liable. The tippee can be liable if tipper breached the duty and the tippee knew that tipper was breaching the duty.

Insider trading

To what extent Rule 10b-5 prohibits insider trading is a matter of some dispute. The SEC has long advocated an "equal access theory" with regard to 10b-5, arguing that anyone who has material, non-public information must either disclose that information or abstain from trading. However, the Supreme Court rejected the strongest version of that theory in "Chiarella v. United States" [http://www.oyez.org/cases/1970-1979/1979/1979_78_1202/] , holding a person with no fiduciary duty to the shareholders had no duty to disclose information before trading on it. Recently, the Supreme Court has embraced a "misappropriation" theory of omissions, holding in "United States v. O'Hagan" [http://www.oyez.org/cases/1990-1999/1996/1996_96_842/] that misappropriating confidential information for securities trading purposes, in breach of a duty owed to the source of that information, gives rise to a duty to disclose or abstain.

Fraud or deceit

In order for Rule 10b-5 to be invoked, there must be "intentional" fraud or deceit by the party charged with the violation. Furthermore, for a private party to recover damages, they must be able to show that they were injured because they relied on the fraudulent claim. If the defendant had publicly made a fraudulent statement, "every" investor could sue if it could be shown that the statement affected the market as a whole - this is the "fraud on the market" theory enunciated by the Supreme Court in "Basic Inc. v. Levinson", 485 U.S. 224 (1988). This "fraud on the market" presumption of the plaintiff's reliance upon the deceit is only available in situations (like in "Basic") where the security is traded on a well organized market.

Various cases have held that a statement that "bespeaks caution" is sufficient to absolve the defendant of liability. If the defendant had prefaced remarks about the health of the company with a disclaimer that he might be wrong, then his subsequent statements can not be held against him.

Purchase or sale

In "Blue Chip Stamps v. Manor Drug Stores", 421 U.S. 723 (1975), the Supreme Court held that Rule 10b-5 provides no cause of action for a securities owner who decides not to sell based on false information. The rule specifically requires that the act or omission occur in the context of a "purchase or sale", which simply does not encompass a failure to sell. However, in "SEC v. Zandford", 535 U.S. 813 (2002), the Court held that a banker who stole money from client by convincing client to buy stocks, then cashing the stocks in for himself was liable under Rule 10b-5 even though the banker's fraud had nothing to do with the value of the stock. It was enough that the fraud was connected to the purchase of the stock by the defrauded party.

More recently, the SEC staff has [http://www.sec.gov/interps/telephone/phonesupplement4.htm publicly taken the position] that the Court's holding in Blue Chip Stamps prevents the SEC from taking action against someone who creates a supposedly "irrevocable" trading plan under the safe harbor provision of SEC Rule 10b5-1, but then later cancels the plan based on inside information, because no actual trade ever takes place.

In "Merrill Lynch v. Dabit", No. 04-1371, 547 U.S. 71 (Mar. 21, 2006), a broker commenced a state law class action against Merrill Lynch for disseminating false information that caused him and other brokers to continue to hold certain securities. The Supreme Court ruled that 10b-5's private right of action for claims "in connection" with a purchase or sale of a security, included claims that induced the broker to hold the securities. Further, the Court held that Congress preempted state securities class actions "in connection" with a purchase or sale under the Securities Litigation Uniform Standards Act of 1998.

Enforcement

Both the SEC and private citizens can enforce the requirements of the rule through lawsuits. The defendant need not be the seller of the stock - any person who fraudulently induces a person to purchase any stock may be held liable.

Link

* [http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=58f51ef9e4b6ba7c33601e15ad076ce2&rgn=div8&view=text&node=17:3.0.1.1.1.1.58.75&idno=17 Full text of the regulation from the National Archives and Records Administration]
* [http://www.seclaw.com/seclaw.htm Introduction to the Federal Securities Laws]