Section 10(b) Defense: Fighting Allegations of Securities Fraud from the SEC and DOJ

Section 10(b) of the Securities Exchange Act of 1934 is one of the primary tools that the Securities and Exchange Commission (SEC) and Department of Justice (DOJ) use to pursue securities fraud allegations. Companies and individuals can face civil and criminal liability under Section 10(b); and, in both types of cases, substantial penalties can be on the table. While there are several potential defenses to securities fraud allegations under Section 10(b), avoiding unnecessary consequences requires an informed, comprehensive, and cohesive defense strategy.  

Facing federal securities fraud allegations can pose substantial risks. While the Securities and Exchange Commission (SEC) pursues administrative enforcement in many cases, the SEC also works with the Department of Justice (DOJ) to pursue civil and criminal enforcement actions when warranted.

In many cases, this involves pursuing civil or criminal allegations under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”). Section 10(b) of the Exchange Act (15 USC Section 78j) contains a broad prohibition against fraudulent acts and omissions related to the sale of securities, and Section 32 of the Exchange Act (15 USC Section 78ff) imposes criminal penalties for willful violations. Civil and criminal enforcement actions both carry risks for substantial fines, while criminal enforcement actions also carry the possibility of federal imprisonment for corporate insiders and other individuals.

What Does Section 10(b) of the Exchange Act Prohibit?

While Section 10 of the Exchange Act prohibits a handful of discrete actions, the statute’s primary operative provision is Section 10(b). Under Section 10(b), companies and individuals are prohibited from engaging in any “manipulative or deceptive device or contrivance” that violates SEC rules in connection with the purchase or sale of securities. It states, in full:

“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—[t]o 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.”

Here, some historical context is important. Congress enacted the Exchange Act in 1934, and one of the driving forces behind the enactment of the Exchange Act was to create a regulatory agency to oversee the emerging US securities markets. As a result, rather than focusing on establishing prohibitions directly, Congress left this task primarily to the newly formed SEC.

Less than a decade after its creation, the SEC adopted Rule 10b-5. Rule 10b-5 was a direct response to the reference to “such rules and regulations as the [SEC] may prescribe” under the Exchange Act. Under Rule 10b-5 (and therefore under Section 10(b) of the Exchange Act):

“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) [t]o employ any device, scheme, or artifice to defraud, (b) [t]o 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) [t]o 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.”

Section 10(b) of the Exchange Act and the SEC’s Rule 10b-5 work together to prohibit fraud in connection with the purchase and sale of securities in the United States. As noted above, Section 32 of the Exchange Act goes one step further, imposing criminal penalties for willful violations.

What Are Some Defenses to Civil Liability Under Section 10(b)?

In civil enforcement actions under Section 10(b), avoiding unnecessary liability generally involves focusing on the specific elements that the government needs to prove in order to establish a violation of Rule 10b-5. With this in mind, some examples of potential defenses include:

• No “Device, Scheme, or Artifice to Defraud” – To pursue civil enforcement under Section 10(b), the government must be able to prove that a company or individual engaged in a “device, scheme, or artifice to defraud.” If the government cannot prove the existence of a device, scheme, or artifice, then enforcement is unwarranted.
• No Untrue Statement or Omission – Rule 10b-5 also requires evidence of an untrue statement or omission. While the government can prove that a statement is objectively false to meet this requirement, proof that a statement or omission effectively resulted in a misrepresentation (i.e., a half-truth) can be sufficient as well.
• Lack of Materiality – Under Rule 10b-5, civil enforcement also requires evidence of materiality. If a misrepresentation or omission is not material—that is, if it would not impact a reasonable investor’s decision regarding whether to buy or sell a security—then it does not warrant civil liability.

But, these are not the only possibilities. Federal court decisions interpreting Section 10(b) and Rule 10b-5 have shed light on additional defenses that can be used to avoid civil liability. These additional defenses include (but are not limited to):

• Lack of “Scienter” – To establish civil liability under Section 10(b), the federal government must be able to establish a sufficient level of mental culpability, which is referred to as “scienter.” While the level of scienter required for civil liability is lower than the level required for criminal culpability, the element of scienter is often what determines whether the SEC will pursue administrative enforcement or the DOJ will pursue civil or criminal enforcement.
• Lack of Causation – The materiality standard established in Rule 10b-5 has been interpreted to also establish a requirement for causation in relevant cases. As a result, if the federal government cannot prove that a misrepresentation or omission caused investor losses, this could also be a viable defense to civil liability.
• The “Truth on the Market” Defense – Related to the requirement for causation is the “truth on the market” defense. If a target or defendant made a false or misleading statement or omission but accurate information was readily available from other sources, this can also be enough to avoid civil liability in some cases.

Keep in mind, in all securities fraud enforcement cases, the government has the burden of proof. In other words, targets and defendants do not necessarily need to prove compliance—it is enough to show that the government cannot prove noncompliance by a preponderance of the evidence. As a result, exposing flaws in the government’s case will also be a key defense strategy in many cases, whether this involves highlighting shortcomings in the government’s evidence or demonstrating that the government’s evidence is inadmissible in court.

What Are Some Defenses to Criminal Liability Under Section 10(b)?

The defenses discussed above generally apply in criminal securities fraud enforcement cases under Section 10(b) as well. However, there are two critical differences.

First, to establish criminal liability, the DOJ must be able to prove that the defendant acted willfully—or with intent. If the DOJ cannot prove intent, then criminal prosecution is unwarranted (though civil liability could still be on the table).

Second, while the standard of proof in civil cases is “by a preponderance of the evidence,” the standard of proof in criminal cases is “beyond a reasonable doubt.” The criminal standard is significantly higher, and this can play a key role in determining what defenses are available.

Importantly, however, while the DOJ needs more to prove criminal liability than it does to prove civil liability, the DOJ can also pursue criminal charges under other federal statutes. These include the federal securities fraud statute (18 USC Section 1348) and the federal attempt and conspiracy statute (18 USC Section 1349), among others. Under Section 1349, any corporate entity or individual who “attempts or conspires” to commit securities fraud can face prosecution regardless of whether the attempt or conspiracy resulted in actual fraud.

What Should Companies and Individuals Do When Facing Scrutiny Under Section 10(b)?

With all of this in mind, when facing scrutiny under Section 10(b), companies and individuals need to engage experienced defense counsel promptly. In this scenario, it is critical to have a clear and comprehensive understanding of the risks at hand. Once you know your (or your company’s) risk exposure, then you can focus on building a comprehensive and cohesive defense strategy focused on challenging the specific elements the federal government needs to prove in order to establish liability.

Contact the Federal Securities Fraud Defense Lawyers at Oberheiden PC

If you need defense counsel for an SEC investigation or DOJ enforcement proceeding under Section 10(b) of the Exchange Act, we encourage you to contact us promptly. To speak with one of our experienced federal securities fraud defense lawyers in confidence as soon as possible, call Oberheiden PC at 888-680-1745 or contact us online now.