Federal Securities Fraud: Rule 10b-5 Basics for Investors and Companies

What Rule 10b-5 prohibits

Rule 10b-5, adopted by the SEC under section 10(b) of the Securities Exchange Act of 1934, makes it unlawful for any person, directly or indirectly, in connection with the purchase or sale of any security, to employ any device, scheme or artifice to defraud; to make any untrue statement of a material fact or omit a material fact necessary to make the statements made not misleading; or to engage in any act, practice or course of business that operates as a fraud or deceit. It reaches any security, listed or not, so a founder's pitch for shares in a Dallas start-up is covered as fully as a public company's earnings release.

The rule itself says nothing about private lawsuits. Courts recognized an implied private right of action decades ago, and Congress later regulated it through the Private Securities Litigation Reform Act of 1995 (PSLRA) and set its deadline in 28 U.S.C. § 1658(b).

The six elements a private plaintiff must prove

1. A material misrepresentation or omission. A false statement of fact, or silence where there was a duty to speak, that a reasonable investor would consider important. Puffery and opinions are generally not actionable unless the speaker did not hold the opinion.
2. Scienter. An intent to deceive, manipulate or defraud. Courts in the Fifth Circuit, which includes Texas, accept severe recklessness. Negligence is not enough, which is the main difference from the Texas Securities Act.
3. In connection with the purchase or sale of a security. The plaintiff must have bought or sold; a holder who merely kept shares in reliance on a lie has no 10b-5 claim.
4. Reliance. The plaintiff acted on the misstatement. In public-market cases reliance can be presumed from an efficient market; in private deals it is proved directly.
5. Economic loss. Money actually lost.
6. Loss causation. The misstatement, not something else, caused the loss. Under 15 U.S.C. § 78u-4(b)(4) the plaintiff carries that burden.

What the PSLRA requires in the complaint

The PSLRA, 15 U.S.C. § 78u-4(b), raised the pleading bar in three ways. The complaint must specify each statement alleged to be misleading and the reasons it is misleading, and if an allegation is made on information and belief, state with particularity all facts on which the belief is formed. For each act or omission, it must state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. And the court must dismiss on motion if either requirement is not met. In Tellabs, Inc. v. Makor Issues & Rights, Ltd. (2007), the Supreme Court held that the inference of scienter must be cogent and at least as compelling as any opposing inference a court can draw from the facts alleged.

Federal Rule of Civil Procedure 9(b) separately requires fraud to be pleaded with particularity. In practice a 10b-5 complaint identifies who said what, when, to whom, why it was false when said, and the facts showing the speaker knew or recklessly disregarded that falsity.

The discovery stay

Under 15 U.S.C. § 78u-4(b)(3)(B), all discovery is stayed while a motion to dismiss is pending unless the court finds particularized discovery necessary to preserve evidence or prevent undue prejudice. The effect is that a plaintiff must plead the case from public information, documents already in hand, confidential witnesses and the investor's own records, without the benefit of the defendant's files. For a defendant company, the stay means that a well-founded motion to dismiss can end the case before any email is produced. This is one reason the same facts are often pleaded first under Texas law in state court, where no such stay exists.

Example

Suppose a Dallas software company raises $4 million from twenty investors on a deck stating that a national retailer has "signed a three-year contract" worth $2 million a year. The retailer had signed a non-binding letter of intent and walked away two months before the deck went out; internal emails show the founders knew. The company fails eighteen months later. The investors have a Rule 10b-5 claim: a false statement of fact, scienter shown by the emails, a purchase of stock in reliance, a loss, and loss causation if they can show the company's collapse flowed from the missing contract rather than from, say, a later market shift. Pleaded with the emails, the claim should survive a motion to dismiss; pleaded only on the fact that the contract never materialized, it probably does not.

Deadlines

Under 28 U.S.C. § 1658(b), a private securities fraud claim must be brought within the earlier of two years after the discovery of the facts constituting the violation or five years after the violation. The two-year period runs from when a reasonably diligent plaintiff would have discovered the facts, including facts showing scienter, so it is often disputed. The five-year period is a statute of repose that courts in the Fifth Circuit and elsewhere treat as absolute. These periods differ from the Texas Securities Act's three years from discovery and five from the sale; the differences are compared in the deadlines guide.

Who can be sued

The primary violator is the person who made the statement or carried out the scheme. Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a), adds every person who directly or indirectly controls a primary violator, jointly and severally, unless the controlling person acted in good faith and did not directly or indirectly induce the violation; officers, directors and parent companies are the usual targets. Private plaintiffs cannot sue aiders and abettors under federal law: 15 U.S.C. § 78t(e) reserves that claim to the SEC. Texas law is broader on that point, as explained in the control-person and aider guide.

For companies accused

The federal claim gives a defendant tools the Texas claim does not: the particularity requirements, the strong-inference standard, the discovery stay, the loss-causation burden and the five-year repose. The early work is to test the complaint against each element, notify the directors-and-officers insurer, impose a litigation hold, and decide whether the Texas claims that usually accompany the federal one change the calculus. A company sued by its own investors should read the guide to defending an investor lawsuit. Tina Wysk represents investors and companies in securities fraud litigation in the federal courts in Dallas and in Texas state courts; see securities and investment disputes.