In addition to the cause of action provided by the common law, the Securities and Exchange Act of 1934 provides a cause of action for securities fraud. More specifically, the cause of action is provided, not by the legislation itself, but by the Securities and Exchange Commission's famous Rule 10b-5, which provides:
- "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."
Because of the large amounts of money involved, that provision is one of the most highly litigated provisions in history, and often in massive class actions.
The elements of the cause of action are: 1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.
With respect to the first element, typical allegations are that the defendant misrepresented, or failed to divulge: financial information, such as the issuer's profits; the issuer's future prospects; the properties of the goods the issuer of the security was selling, such as the properties of a medication; and the nature of the issuer's contractual obligations. Significantly, the misrepresentation or omission must be material-- i.e., of importance to a reasonable buyer or seller.
It should be noted that a material omission will satisfy the first element. As provided by Rule 10b-5, it is wrongful "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."
With respect to the second element, scienter, the plaintiff must allege facts suggesting that the defendant knew the statement was false or acted with reckless disregard of the truth or falsity of the statement. Since it's impossible to get inside the head of the defendant, the evidence of scienter will typically be circumstantial. Frequently, a showing of a strong motive for lying will satisfy the scienter requirement. In one case, corporate officers were alleged to have overstated the financial health of their company. Plaintiff was able show scienter by showing that the officers sold 30% of their holdings, and therefore had an incentive to engage in the overstatement.
With respect to the third element, called transactional causation, the plaintiff must show that the misrepresentation or omission caused him to buy or sell his stock. That is, the plaintiff must show that it was the violation of Rule 10b-5, and not some other reason, that caused him to engaged in the detrimental transaction.
With respect to the fourth element, called detrimental reliance, the plaintiff must show that, in engaging in the detrimental transaction, he reasonably relied on the misrepresentation or on the completeness of the defendant's statement. In assessing whether plaintiffs' reliance was reasonable, the court considers the entire context of the transaction, including factors such as its complexity and magnitude, sophistication of the parties, and content of any agreements between them. Where the plaintiff knows facts that would cause a reasonable person to investigate the truthfulness of the statement, a failure to undertake the investigation may prevent him from showing reasonable reliance.
With respect to the fifth element, economic loss, it is probably the easiest to show. If the transaction is the purchase of a stock, a subsequent sale at a lower price would show loss. If the transaction is the sale of a stock, a subsequent rise in the value of the stock would show loss.
With respect to the sixth element, loss causation, the plaintiff must show that the misrepresentation or omission, rather than other forces caused his loss. Thus, if there is an overall drop in the stock market, the purchaser of securities must show that the decline in value of his shares was due to the violation of Rule 10b-5 rather than due to the decline in the market.