CHAPTER 25
Securities Fraud and
Insider Trading
INTRODUCTION
This chapter focuses on Section 10(b) and Rule 10b–5. It
sets forth the seven elements necessary in a Rule 10b–5
securities fraud case and the fraud-on-the-market theory of
liability. The safe-harbor for certain forward-looking
statements is discussed. Section 17(a) of the 1933 Act,
under which the U.S. government can bring fraud claims, is
briefly discussed. The chapter defines insider trading and
discusses in detail the legal elements of an insider-trading
case. Short-swing trading is then defined, and the rules for
calculating the recoverable profits are discussed, as well as
the requirements for reporting by insiders.
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SECTION 10(B)
OF THE 1934 ACT
 Section 10(b) gives the SEC power to prohibit individuals or companies from
engaging in securities fraud by authorizing the SEC to prescribe specific
rules for the protection of investors.
 Rule 10b–5. More suits brought under 10b-5 than any other security law
provision:
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,
(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 the 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, in connection with the purchase or sale
of any security.
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RULE 10B–5
 Individual investors have a private cause of action.
 Controlling Persons. Every person who, directly or
indirectly, controls any person is jointly and severally
liable, unless the controlling person acted in good
faith and did not directly or indirectly induce the acts.
 Aiding and Abetting. Private plaintiff may not
maintain an aiding and abetting suit; however SEC
may bring suit.
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RULE 10B–5
 Conspiracy. No private implied cause of action for
conspiracy under Section 10(b).
 Primary Liability for Secondary Actors. Secondary
actors (such as an accountant, lawyer, or bank) can be
liable in private suits if their conduct satisfies the
requirements for primary liability.
 Statute of Limitations--suits must be brought within one
year of the date the plaintiff discovered or should have
discovered the fraud or within three years of the date of
the violation, whichever is shorter.
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PRIMARY LIABILITY FOR
SECONDARY ACTORS
Case 25.1 Synopsis. McGann v. Ernst & Young.
Ernst & Young was the auditor for Community Psychiatric Centers
(CPC). Plaintiffs alleged that Ernst & Young failed to disclose that CPC
had major accounts receivable problems, thereby issuing a false and
misleading auditing opinion. Plaintiffs also alleged Ernst & Young knew
that CPC would include this audit report in its Form 10-K. The district
dismissed the case and Plaintiffs appealed. ISSUE: Is an accounting
firm subject to primary liability under Section 10(b) of the 1934 Act when
it prepares a fraudulent audit report that it knows its client will include in
a Form 10–K? HELD: YES--REVERSED. an accounting firm can have
primary liability under Section 10(b) when it prepares a fraudulent audit
report it knows will be used in a Form 10-K. The case was remanded for
further proceedings on this issue.
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PRIMA FACIE ELEMENTS FOR
RULE 10B-5 CAUSE OF ACTION
 Summary. Plaintiff must show each of the following
elements, described in more detail below:
– The defendant used either an instrumentality of interstate
commerce or the mails or a facility of a national
securities exchange.
– The defendant made a statement that either
misrepresented or omitted a fact.
– The fact was of material importance.
– The misrepresentation or omission was made with
scienter (culpable state of mind).
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PRIMA FACIE ELEMENTS FOR
RULE 10B-5 CAUSE OF ACTION
 Summary. Plaintiff must show each of the following
elements, described in more detail below:
– The statement or mission was made in connection with
the purchase or sale of securities.
– The plaintiff acted in reliance either on the defendant’s
misrepresentation or on the assumption that the market
price of the stock accurately reflected its value.
– The defendant’s misrepresentation or omission caused
the plaintiff to suffer losses.
 Interstate Commerce - defendant must have used interstate
commerce, the mails, or a national securities exchange.
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PRIMA FACIE ELEMENTS FOR
RULE 10B-5 CAUSE OF ACTION
• Misstatement or Omission - misrepresentation of a fact, or a
fact that is left out of a statement, such that the statement
becomes misleading.
– Misstatements. A prediction about the future can be a
misstatement, but only if the person making the
prediction does not believe it at the time. Generally,
silence or a “no comment” statement in response to
rumors will not lead to liability if the company has not
previously spoken on the subject and insiders are not
trading or tipping.
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PRIMA FACIE ELEMENTS FOR
RULE 10B-5 CAUSE OF ACTION
• Omissions - can occur when a company makes a
statement that is true at the time but that becomes
misleading in light of later events. However, if
investors are reasonably relying on the previous
statements, the company can be held liable for
failing to disclose the new information.
• Statements by Third Parties and Entanglement - a
company may have a duty to disclose all facts
regarding a particular issue, even if the company
itself did not publish the misleading projection or
make the statement.
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OMISSIONS
Case 25.3--Weiner v. Quaker Oats Co.
Quaker was acquiring Snapple for $1.7 billion in cash. The market did not
approve of the acquisition and showed it by dropping Quaker’s stock price by
ten percent. Quaker borrowed the money to acquire Snapple, thus increasing
its total debt-to-total capitalization ratio to approximately 80 percent. In the
current Quaker Annual Report, Quaker states that its guideline for this ratio is
in the “upper 60-percent range.” Quaker also said it was committed by sevenpercent, real earning growth over time. The plaintiff alleged that Quaker had a
duty to update these statements because they were misleading. The court
dismissed the growth statements because it is “over time”. ISSUE: Under
what circumstances do a corporation and its officers have a duty to update,
or at least not to repeat, particular projections regarding the corporation’s
financial condition (for example, total debt-to-total capitalization ratio or
earnings growth projections)? HELD: The appeals court remanded the case
for further findings to decide if a reasonable investor would find Quaker’s
statements misleading based on the Annual Reports.
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PRIMA FACIE ELEMENTS FOR
RULE 10B-5 CAUSE OF ACTION
•
Material Fact - to recover, a plaintiff must prove a material fact, i.e., what a
reasonable investor would consider important in deciding how to act. Material
facts affect the market value of the company’s stock. A manager can be liable
even if she did not know the omitted or misrepresented fact came within the
legal definition of a material fact. Examples of material facts:
– Any statements about the earnings, distributions, or assets of a company.
– Significant facts about a parent or a subsidiary. These include the
discovery of embezzlement or falsification of financial statements, an
impending tender offer, or the loss of a manufacturer’s major customer.
– Perhaps the inability to obtain supplies, increased costs of supplies, a
decision to close a plant, or potential liability in a lawsuit.
– Vague statements of corporate optimism and mere puffing are NOT
material.
•
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PRIMA FACIE ELEMENTS FOR
RULE 10B-5 CAUSE OF ACTION
• Bespeaks Caution Doctrine - precise
cautionary language that adequately
discloses the risks involved about
projections, estimates, and other
forward-looking statements that renders
immaterial any misrepresentation or
omission.
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PRIMA FACIE ELEMENTS FOR
RULE 10B-5 CAUSE OF ACTION
• Scienter - no liability for innocent
misstatements or omissions, only
misstatements or omissions made with
the intent to deceive. The U.S. Supreme
Court has made clear that scienter is
more than mere negligence or lack of
care
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SCIENTER
Case 25.4 Synopsis. Kasaks v. Novak.
Plaintiffs sued AnnTaylor Stores Corporation — which, through its wholly-owned
subsidiary, defendant AnnTaylor, Inc., is a specialty retailer of women’s clothing,
shoes, and accessories — and several of its top officers (including Novak) for
violation of Section 10(b) and Rule 10b-5. They alleged that the defendants
knowingly and intentionally issued financial statements that overstated
AnnTaylor’s financial condition by accounting for inventory that they knew to be
obsolete and nearly worthless at inflated values and by deliberately failing to
adhere to the Company’s publicly stated markdown policy. The district court
dismissed the complaint for failure to plead scienter and fraud with sufficient
particularity. Plaintiffs appealed. issue: Are allegations of motive and
opportunity sufficient to meet the PSLRA’s heightened pleading standards for
scienter? Can fraud be pleaded with sufficient particularity if the plaintiff relies
on unnamed confidential sources? HELD: REVERSED and REMANDED to the
trial court with instructions that the plaintiffs be permitted to re-plead their
claims in light of the Second Circuit’s opinion.
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PRIMA FACIE ELEMENTS FOR
RULE 10B-5 CAUSE OF ACTION
 Recklessness - majority of courts regard recklessness as
sufficient for scienter. To avoid liability, managers should make
no statement unless, after thorough investigation, they in good
faith believe it to be true.
 In Connection with the Purchase or Sale of Any Security - only
persons who actually purchase or sell securities can sue under
Rule 10b–5. Parties that make or are responsible for
misstatements and omissions in a manner reasonably calculated
to influence the investing public or if they were of the sort upon
which the investing public might reasonably rely may be liable. A
company must be careful to monitor its public statements, such
as those made in periodic reports, press releases, proxy
solicitations, and annual reports.
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PRIMA FACIE ELEMENTS FOR
RULE 10B-5 CAUSE OF ACTION
•
Reliance - to hold defendant liable, an investor must show that she relied
either directly or indirectly on the misrepresentation or omission.
– Direct Reliance - plaintiff actually read the document. In the case of an
omission, plaintiff will be presumed to have relied on the omission, if it
was material.
– Fraud on the Market - rare because transactions are usually not
conducted on a face-to-face basis. The market is interposed between
the parties, providing important information to the parties in the form of
the market price.
– Truth on the Market - In the following case, an appellate court found that
the market was aware of one set of facts undisclosed by the
defendants, but was not aware of another set of undisclosed facts.
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PRIMA FACIE ELEMENTS FOR
RULE 10B-5 CAUSE OF ACTION
• Causation - plaintiff must prove that the defendant’s
misstatement or omission caused him or her to
suffer losses. Increasingly, this is an economic
question, e.g., what factors influence the price of a
stock in the securities market?
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DIRECT RELIANCE
Case 25.5 Synopsis. Rissman v. Rissman.
Randall Rissman owned 2/3 of the stock of Tiger Electronics, a
toy and game company founded by his father. His brother
Arnold owned the balance. Randall managed the business
while Arnold worked as a salesperson. Arnold did not elect
himself to the board of directors of Tiger, although he could
have done so because Tiger permitted cumulative voting. After
the brothers had a falling out, Arnold sold his shares to Randall
for $17 million. Thirteen months later, Tiger sold its assets to
Hasbro for $335 million. Arnold sued Randall, claiming that
Randall had deceived him into thinking that he would never
take Tiger public or sell it to a third party. CONTINUED
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DIRECT RELIANCE
Case 25.5 Synopsis. (Cont’d)
Based on representations made to Arnold who believed his stock
would remain illiquid and not pay dividends, he sold his shares for
whatever Randall was willing to pay. Arnold then sought the extra
$95 million he would have received had he retained his stock until
the sale to Hasbro. Arnold sued. The trial court granted Randall’s
motion to dismiss the federal securities law claims, and Arnold
appealed. For purposes of the appeal, the appeals court assumed
the accuracy of Arnold’s allegations that Randall had told Arnold that
he was determined to keep Tiger a family firm and that Randall
secretly had planned to sell Tiger after acquiring Arnold’s shares.
ISSUE: Does a non-reliance clause in a written stock-sale agreement
preclude a seller of stock from recovering damages under the federal
securities laws for prior oral statements? HELD: AFFIRMED.
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FRAUD ON THE MARKET
Case 25.6 Synopsis. In Re Apple Computer Securities
Litigation.
Apple was highly touting its new computer, the Lisa. The
market was discounting the news. When the failure of Lisa
occurred, Apple stock dropped by 75 percent. The plaintiffs
sued under Section 10(b) claiming fraud on the market.
ISSUE: Is there fraud on the market when a manufacturer
made optimistic predictions about a new product, even
though analysts and others following the company
discounted the predictions and publicized the true state of
affairs? HELD: NO. Since the market was aware of the
situation, the suit was dismissed as a matter of law.
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REFORM ACT SAFE HARBOR FOR
FORWARD-LOOKING STATEMENTS
Forward-looking statements were designed
to promote market efficiency by encouraging
companies to disclose projections and other
information about the company’s future
prospects.
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REFORM ACT SAFE HARBOR FOR
FORWARD-LOOKING STATEMENTS

Safe Harbor - forward-looking statements provide a safe harbor for certain
statements made by a company regarding its securities. These include:
– Statements concerning projection of revenues, income, earnings per
share, capital expenditures, dividends, capital structure, or other
financial items;
– Statements concerning the plans and objectives of management for
future operations, including plans relating to the issuer’s products and
services;
– Statements of future economic performance, including any such
statement in the management’s discussion and analysis of financial
condition; and
– Any statement of the assumptions underlying or relating to any such
statement.
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REFORM ACT SAFE HARBOR FOR
FORWARD-LOOKING STATEMENTS
 Scope of Safe Harbor - the forward-looking statement
safe harbor does not apply to:
– An initial public offering (IPO);
– An offering of securities by a blank check company;
– A rollup or going-private transaction;
– A tender offer; or
– An offering by a partnership, limited liability
company, or direct participation investment
program.
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REFORM ACT SAFE HARBOR FOR
FORWARD-LOOKING STATEMENTS
 Two Prongs. Safe harbors limit liability as long as the
forward-looking statement is identified as forward-looking,
and the statement is accompanied by meaningful cautionary
statements.
 Other factors. The safe harbor applies when the company:
– Identifies the statement as a forward-looking statement,
– States that results may differ materially from those
projected in the statement, and
– Identifies a readily available written document that
contains factors that could cause results to differ
materially.
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AUDITOR DISCLOSURE OF
CORPORATE FRAUD
The Reform Act promotes disclosures by
independent public accountants of illegal
acts committed by their publicly traded audit
clients. The accounting firm must notify the
company’s management of the illegal act(s)
and notify the SEC in the event the company
does not correct the errors in a timely
manner.
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REMEDIES FOR VIOLATION
OF RULE 10B-5
 Damages. Generally, an investor’s damages are outof-pocket losses, i.e., that is, the difference between
what the investor paid (or received) and the fair
value of the stock on the date of the transaction.
 Rescission. An investor can also elect to rescind
the transaction and receive the investment plus, in
some cases, interest. Punitive damages are not
available.
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INSIDER TRADING
Definition. Generally, insider trading is stock-trading by
“insiders” (such as officers and directors) based on material
nonpublic information. Insider trading focuses on the duty
to disclose by insiders. In other words, an insider must
either disclose the information or not trade. The U.S.
Supreme Court has held that a trade based on material
nonpublic information is illegal only if there is a breach of
duty by the person trading; or if the person trading is the
recipient of a tip - a piece of inside information - there must
be a breach of duty by the person who gave the tip. The
person giving the tip is known as the tipper; the person
receiving it is known as the tippee.
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INSIDER TRADING
• 10b-5 Presumption - persons who trade while
in possession of material, nonpublic
information trade on the basis of that
information are presume insider traders
unless the trade is pursuant to a pre-existing
plan.
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CLASSICAL THEORY OF
INSIDER-TRADING
 Insiders include not only traditional insiders - such as officers
and directors - but also temporary insiders, such as outside
counsel and financial consultants.
 Traditional Insiders - Traditionally, only persons closely allied
with the corporation itself were considered insiders.
– Officers and Directors - owe fiduciary duties to the shareholders.
– Controlling Shareholders - can control corporate activities and owe fidicuary duty to
minority shareholders.
– Employees - may not personally profit from confidential information.
– The Corporation - must not trade while in possession of material nonpublic
information, e.g., buy-back shares.
 Temporary Insiders - contractors who are attorneys,
accountants, consultants, and investment bankers.
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TIPPEES OF INSIDERS
• Scope. Tippees, persons who receive information from a traditional
or temporary insider, may also be subject to liability under Rule 10b–
5. However, in most cases a tippee has no independent legal duty to
the shareholders of the corporation.
• Liability of Tippers and Tippees - to be liable, the tipper must desire
to benefit herself and breach a fiduciary duty to the corporation by
disclosing non-public, confidential information to the tippee. The
tippee is liable only if she knew or should have known that the
tipper’s disclosure of the confidential information constituted a
fiduciary breach.
• Remote Tippees (tippees of tippees) - are not liable unless they knew
or should have known that the first-tier tipper was breaching a
fiduciary duty in passing on the nonpublic information.
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TIPPEES OF INSIDERS
Case 25.7--Dirks v. SEC.
Dirks was an investment analyst of insurance company
securities to institutional investors. Secrist, a former employee
of Equity Funding of America and someone wanting to expose
fraudulent activities there, contacted Dirks and told Dirks of
overvaluation of assets of Equity Funding. After checking out
Secrist’s story, Dirks advised clients to sell their Equity
Funding shares. When the fraud was later revealed at Equity
Funding, the stock priced dropped. ISSUE: Is the tippee liable
absent a violation of fiduciary duty by the tipper? HELD: No.
The U.S. Supreme Court held that since Secrist, the tipper, had
no fiduciary duty, Dirks was not liable as a tippee.
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MISAPPROPRIATION THEORY
OF INSIDER TRADING
 Scope. If a person misappropriates non-public information, he has
breached a fiduciary duty to the source of nonpublic information and
is therefore liable under Rule 10b-5 because he converted the
confidential information to his own use.
 Duties of Trust or Confidence - are assumed in the following
situations:
– Agreement - when a person agrees to keep the information
confidential.
– Prior Dealings - when two people have a history, pattern, or
practice of sharing confidences.
– Family Connection - when a person receives or obtains material
nonpublic information from a spouse, parent, child, or sibling.
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MISAPPROPRIATION THEORY
OF INSIDER TRADING
Case 25.8-- United States v. O’Hagan.
O’Hagan was a partner in a law firm that represented
Grand Met in its acquisition of Pillsbury. O’Hagan traded on this
non-public information and made over $4 million in profits. He
was convicted on 57 counts of securities violations. ISSUE: Is
a person who trades in securities for personal profit, using
confidential information misappropriated in breach of fiduciary
duty to the source of the information, guilty of violating Section
10(b) and Rule 10b–5? HELD: YES. The Supreme Court upheld
the convictions under Section 10(b) and Rule 10b-5 because
O’Hagan misappropriated information in violation of his duty to
his partners and client.
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RICO
Securities fraud cannot be the basis for a
RICO (see Chapter 17) case unless the
defendant has been criminally convicted in
connection with the fraud. Similarly, a
criminal conviction under the Wire and Mail
Fraud Acts for misappropriation of an
employer’s confidential information could,
assuming other requirements are met, be the
basis for a civil RICO case.
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ENFORCEMENT OF INSIDERTRADING PROHIBITIONS
 Elements. In both government and private actions,
the complaining party must demonstrate:
– A misstatement or omission of a material fact,
– Scienter,
– Reliance by the injured party,
– Causation, and
– Loss.
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ENFORCEMENT OF INSIDERTRADING PROHIBITIONS
 Private Actions - plaintiff must have standing, i.e., plaintiff is
the actual purchaser or seller of securities, and the plaintiff’s
loss must have been proximately caused by the acts of the
defendant. Plaintiffs costs are limited to her actual out-ofpocket damages.
 SEC Civil Enforcement - defendant may be liable for treble
damages and enjoined from future trading.
 Criminal Prosecutions - brought by the Department of
Justice/U.S. Attorney’s Office. If convicted, defendant faces
up to $1 million fine and/or imprisonment for up to ten years.
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THE SECURITIES FRAUD
ENFORCEMENT ACT OF 1988
 Increased Penalties - now up to 10 years in prison and up to
$1 million in fines. Violators and their firms may be liable for
civil penalties of triple the profit gained or loss avoided as a
result of the wrongful trading.
 Bounty Payments - of up to 10% of the revenues recovered
may be paid to individuals whose tips result in insidertrading prosecutions.
 Private Right of Action - for contemporaneous traders
(persons who purchased or sold securities of the same
class at the same time the insider was trading)
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SHORT-SWING TRADING
 Scope. Short-swing trading is the
purchase and sale, or the sale and
purchase, by officers, directors, and
greater-than-10% shareholders of equity
securities of a public company within a
six-month period. Liability is imposed
regardless of the defendant’s state of
mind.
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SHORT-SWING TRADING
 Equity Security—any stock, any security or bond that is
convertible or carries a warrant and any other security the
SEC deems an equity security.
 Matching—the shares that are sold need not be the same
shares that were purchased, as long as the sales occurred
within six months.
 Profit Calculation—recoverable profits are calculated by
comparing the sale price with the purchase price of the
transaction(s).
 Six Months—the clock starts ticking on the day the first
purchase or sale occurred and ends at midnight two days
before the corresponding date in the sixth succeeding
month.
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DEFINITIONS
 Officer or Director—at the time of either the purchase or
sale.
 Greater-than-10% Shareholder—a shareholder, even though
not an officer or director, who owns more than 10% of the
stock at the time or the sale or purchase may be liable.
 Beneficial Ownership of Shares—officers, directors, and
greater-than-10% shareholders can be liable for short-swing
trades of shares owned by a spouse, minor children, or any
other relative living in her household, as long as she can
vest title in herself or derive an economic benefit from the
ownership of the shares.
41
SHORT-SWING TRADING
 Unorthodox Transactions - a director, officer or 10%
shareholder will not be liable if he did not receive cash
and the sale/purchase of shares was involuntary,
generally in the context of mergers and corporate
reorganizations. However, if the trader received cash, then
liability would attach.
 Prohibition on Selling Short - officers or directors cannot
sell a security they do not own. If the trader does not
deliver the security within twenty days of the sale, she will
be liable unless she acted in good faith and was unable to
make the delivery or deposit within the specified time, or
satisfying the time requirements would have caused
undue inconvenience or expense
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THE RESPONSIBLE MANAGER
Preventing Securities Fraud and Insider Trading
•
Companies and managers have an obligation:
– Not to mislead investors in company public announcements, periodic reports,
or speeches.
– To make disclosure if it knows its insiders, such as officers or directors, are
trading in the company’s securities.
– Comply with forward-looking factors and cautionary language.
– To not trade while in possession of material nonpublic information.
– To carefully guard confidential information and establish rigid procedures to
enforce confidentiality.
– Establish comprehensive policies on insider trading policies and punishment.
– To disclose any short swing purchases or sales within a six month period and
pay all profits to the corporation.
– Report their security holdings and their trades in a timely manner.
43
REVIEW
1. What is an S-1 review, and why should
an accountant do one?
2. Why is materiality judged at the time
of the misstatement or omission?
3. When do courts consider a market
efficient?
44