SEC Rule 10b-5
SEC Rule 10b-5, codified at 17 C.F.R. 240.10b-5, is one of the most important rules targeting securities fraud promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of 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. The issue of insider trading is given further definition in SEC Rule 10b5-1.
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
"Rule 10b-5: Employment of Manipulative and Deceptive Practices":
- 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."
Elements of the offense
In order to establish a claim under Rule 10b-5, plaintiffs (including the SEC) must show (i) Manipulation or Deception (through misrepresentation and/or omission); (ii) Materiality; (iii) "In Connection With" the purchase or sale of securities; and (iv) Scienter. Private plaintiffs have the additional burden of establishing (v) Standing - Purchaser/Seller Requirement; (vi) Reliance (presumed if there was an omission); (vii) Loss Causation; and (viii) Damages.
In a case for insider trading, anyone who uses insider information can be held liable. A tippee can be liable if the tipper breached a fiduciary duty and the tippee knew or had reason to know that the tipper was breaching the duty.
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, holding a person with no fiduciary duty to the shareholders had no duty to disclose information before trading on it. In 1997, the Supreme Court has embraced a "misappropriation" theory of omissions, holding in United States v. O'Hagan 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. Fraud can also happen through reckless conduct. 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. Alternately, fraud can also occur through omission of a material fact where reliance does not have to be proved by the party injured but is instead assumed to have occurred. 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. 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, and presumably efficient, market. The same can be said for an omission of material information.
Both the "bespeaks caution" doctrine and the safe harbor provisions of the Private Securities Litigation Reform Act offer protection for forward-looking statements if they are accompanied by cautionary language identifying specific factors that could cause actual results to differ materially from those in the forward-looking statement and may be sufficient to absolve a defendant of liability. However, in Iowa Public Employees' Retirement System v. MF Global Ltd., the US Second Circuit Court of Appeals overturned a decision by the District Court for the Southern District of New York, ruling that the "bespeaks caution" defense to securities disclosure claims applies exclusively to forward-looking statements and not to characterizations that communicate present or historical fact.
Both the SEC and private citizens can enforce the requirements of the rule through lawsuits. In Blue Chip Stamps v. Manor Drug Stores, the Supreme Court held that only purchasers or sellers of securities may bring a private action for damages under Rule 10b-5, however any member of the public may provide information to the SEC regarding possible violations of the federal securities laws.
- 15 U.S.C. § 78j(b)
- Lin, Tom C. W., A Behavioral Framework for Securities Risk. 34 Seattle University Law Review 325 (2011) . Available at SSRN: http://ssrn.com/abstract=2040946
- TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), 449.
- Chiarella v. United States, 445 U.S. 222 (1980) 
- United States v. O'Hagan, 521 U.S. 642 (1997) 
- Basic Inc. v. Levinson, 485 U.S. 224 (1988)
- Definition of bespeaks caution doctrine USLegal.com
- SECOND CIRCUIT CLARIFIES BESPEAKS-CAUTION DOCTRINE
- SEC tips and complaints
- SEC "Tips, Complaints and Referrals" website/portal
- Cioppa, Paolo (2009) "Unexpected Insider Trading Abuses and the Need for Revision of Rule 10b5-1(c)," Global Jurist: Vol. 9 : Iss. 1 (Topics), Article 5.