i Forms of action
Nearly all private US securities enforcement is through class-action litigation in the federal courts. Where a corporation is itself the entity that suffered injury under the securities laws, derivative actions can be pursued. This litigation is usually ‘lawyer-driven’, relying on plaintiffs’ lawyers to enforce the rights of absent class members. Class-action lawyers typically derive their fees from settlements, or through recovery obtained at the end of the action. Most private securities class actions are brought under Sections 11 and 12 of the Securities Act and Sections 10 and 14 of the Exchange Act.
One notable impediment to private claimants seeking remedies under the US securities laws is the frequent absence of a private right to sue. While the right for individual buyers and sellers to bring suit to recover actual losses is well established for claims of fraud under Section 10 of the Exchange Act and some other statutory provisions, it should not be assumed that private plaintiffs can sue to redress conduct that violated the securities laws. In recent years, federal courts have generally been unwilling to imply new private rights of action where Congress has not explicitly provided one. As such, certain areas of enforcement are exclusively in the hands of government authorities.
An additional barrier that plaintiffs must surmount is the need to show standing to sue. The contours of the standing requirement vary from one statutory provision to the next, but in general a plaintiff must show that he or she is the type of party who is authorised to sue under the statute. For example, the Supreme Court has held that to bring an action under Rule 10b-5, a plaintiff must show that he or she purchased or sold securities in the transaction complained of.8 These standing requirements are reviewed where relevant in the discussion below. Note, however, that these obstacles to suit – standing and a private right of action – do not apply to the Securities and Exchange Commission, which can bring an action on behalf of the government under all provisions of the securities laws.
Because the federal securities laws are broadly disclosure-based (rather than contract-based), a complaining plaintiff will usually bear the burden of establishing that an issuer, seller or buyer traded securities on the basis of a material misstatement or omission. The leading case on materiality is TSC Industries, Inc. v. Northway, Inc.,9 in which the Supreme Court defined a material fact as one to which there is a substantial likelihood that a reasonable investor would attach importance in making a decision because the fact would significantly alter the ‘total mix’ of available information.10 In applying this standard, some courts have held that false statements or omissions are not materially misleading as long as the market possessed the correct information.11 Additionally, actionable statements must be sufficiently ‘concrete’ and ‘specific’, as opposed to ‘single, vague statement[s] that are essentially mere puffery’.12
Under SLUSA, plaintiffs are barred from bringing class actions asserting certain securities fraud claims under state law.13 This restriction was enacted to prevent plaintiffs from using state law to evade the PSLRA’s restrictions on federal securities class actions. To effect that purpose, the Supreme Court has interpreted SLUSA broadly to block fraud class actions premised on any alleged misrepresentation that ‘coincides with a securities transaction – whether by the plaintiff or by someone else’.14
Notably, while SLUSA restricts plaintiffs’ ability to circumvent federal law, the Supreme Court recently held in Cyan, Inc. v. Beaver County Employees’ Retirement Fund15 that the statute does not restrict plaintiffs from pursuing Securities Act class actions in the state courts. In addition, the Cyan Court held that defendants may not remove Securities Act class actions to federal court. Cyan thus preserves plaintiffs’ ability to pursue Securities Act class actions outside the federal forum. The decision has spawned a boom in litigation pressing federal securities claims in the state courts, particularly in New York and California. This in turn has given rise to significant questions around whether and how to import federal procedural restrictions on security litigation into the state forums. For example, the New York state courts are presently divided over whether the PSLRA’s discovery stay applies in state court.16
Defendants have adopted a range of approaches to contain the post-Cyan explosion in state litigation. Most prominently, following a March 2020 decision of the Delaware Supreme Court holding that Delaware corporations can include forum-selection provisions in their charters and by-laws requiring plaintiffs to file any Securities Act claims against them in federal court,17 a number of corporations have adopted such provisions to redirect litigation from state courts. Courts have generally enforced these forum-selection provisions.18 In addition, even absent such structural protections against duplicative litigation, defendants have met with occasional success in staying state proceedings in favour of first-filed federal actions.19 Failing that, several recent decisions from the New York appellate courts have made clear that the courts of that state will carefully apply federal precedent.20
Securities Act: Section 11
To bring a securities claim under Section 11(a) of the Securities Act, a plaintiff must show that a registration statement ‘contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading’.21 Once a plaintiff satisfies this burden, Section 11(a) makes liable the issuer, the directors of the issuer, anyone named in the registration statement as about to become a director of the issuer, every person who signed the registration statement, every expert (e.g., accountant or appraiser) who was named as having certified or prepared the misleading part of the registration statement and every underwriter of the security. The plaintiff need not show that he or she relied upon the misstatements or that any defendant acted in bad faith.
An issuer has virtually no defence under Section 11; it is effectively strictly liable for material misstatements and omissions in registration statements. Assuming a material misstatement, an issuer’s only hope of avoiding liability is to prove that the plaintiff knew of the misstatements or omissions when the trade occurred. However, other defendants have a variety of defences under Section 11(b). Thus, a party named in a registration statement can avoid liability if he or she resigns and informs the SEC of the false or misleading statement before the registration statement becomes effective. In addition, under Section 11(b)(3), a non-issuer defendant can avoid liability if he or she can show reasonable grounds for believing that the alleged misstatements were true.
In Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund,22 the Supreme Court rejected a lower court holding that an issuer’s sincerely held opinion could constitute an ‘untrue statement of a material fact’ under Section 11. The Court reasoned that accurately disclosing a belief cannot amount to an untrue statement. But the Court also held that some genuinely held opinions could still be actionable, because Section 11 also proscribes statements that have ‘omitted to state a material fact . . . necessary to make statements not misleading’. Omitted facts could render a genuinely held opinion misleading where investors expect that the opinion ‘fairly aligns with the information in the issuer’s possession at the time’. Accordingly, ‘if a registration statement omits material facts about the issuer’s inquiry into or knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable investor would take from [the issuer’s statement of opinion], then Section 11’s omissions clause creates liability’. The Court counselled that ‘to avoid exposure for omissions under Section 11, an issuer need only divulge an opinion’s basis, or else make clear the real tentativeness of its belief’. In applying Omnicare, the Second Circuit has held that a securities claim may fail even where defendants were aware of significant information that undermined their public statements.23 Significantly, the principles of Omnicare have gained purchase on other areas of federal securities law, including claims brought under Section 10(b) of the Exchange Act.24
Securities Act: Section 12
Under Section 12(a)(1), any person who offers or sells a security required to be registered under the Securities Act but not registered is liable to the person purchasing the security. Under Section 12(a)(2), any person who by the use of any means of interstate commerce offers or sells a security on the basis of a materially false or misleading prospectus or materially false or misleading oral statements is liable to the person purchasing from him or her, unless he or she can show that he or she did not know, and could not in the exercise of reasonable care have known, of the falsehood or omission.
To succeed in a Section 12 claim, a plaintiff need not show that he or she relied on the misstatements or that the defendant acted in bad faith. However, no liability will attach in a private action – under Section 12 or other provisions of the Securities Act or the Exchange Act – based on certain statutorily defined ‘forward-looking statements’ unless the plaintiff proves actual knowledge of the false or misleading nature of the statement on the part of a natural person making the statement or on the part of an executive officer approving the statement made on behalf of a business entity.25
Exchange Act: Section 10
Section 10 authorises the SEC to prescribe rules addressing prohibited securities trading practices. Under Section 10(a), the SEC is empowered to prohibit short sales and the use of stop-loss orders for securities registered under the Exchange Act or traded on national security exchanges. The statute also empowers the SEC to prohibit ‘the use of a manipulative or deceptive device or contrivance’ in connection with the purchase or sale of any securities or in connection with security-based swap agreements. While there are currently 11 SEC-promulgated rules in force under Section 10(b), the most important by far is the general anti-fraud rule, Rule 10b-5. Rule 10b-5 prohibits use of any means of interstate commerce to (a) employ any device, scheme or artifice to defraud; (b) make material misstatements or omissions; or (c) engage in any course of business that operates as a fraud against any person, in connection with the purchase or sale of any security or securities-based swap agreement. This rule is the great engine of private securities enforcement in the United States.
In general, to prevail on a Rule 10b-5 claim, a plaintiff must prove that the defendant: (1) made a false statement or an omission of material fact26 (2) with scienter (3) in connection with the purchase or sale of a security (4) upon which the plaintiff justifiably relied27 and (5) that proximately caused (6) the plaintiff’s economic loss.28 The most important violations of Rule 10b-5 fall into three categories:
- common fraud in transactions by sellers, purchasers, brokers and others;
- false or misleading statements of material fact by corporate insiders or others that affect the prices in which securities trade; and
- trading on material non-public information by corporate insiders and their tippees (insider trading).
There has been substantial debate and disagreement in the courts over how to construe the reliance element of Rule 10b-5 in the context of class actions. The difficulty is that to proceed as a class under the Federal Rules of Civil Procedure, plaintiffs must show that common questions of law or fact ‘predominate over any questions affecting only individual members’.29 But whether a particular buyer or seller relied on an alleged misstatement is typically an individualised question. Thus, if Rule 10b-5 were interpreted to require proof of individual reliance on defendants’ misstatements, it would be more challenging for plaintiffs’ lawyers to bring claims on a class basis.
The Supreme Court rode to the rescue of plaintiffs in Basic Inc. v. Levinson,30 endorsing a ‘fraud-on-the-market’ theory under which courts may presume that ‘[a]n investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price’.31 This theory obviates the need for proof of individual reliance and facilitates class certification. However, the fraud-on-the-market presumption is only available if a plaintiff can allege and prove that the market was ‘efficient’ – which is to say that market prices were responsive to new, material news. To establish (or refute) the claim of market efficiency, parties present economists armed with event studies analysing how the relevant market reacted to new information.
In Halliburton Co. v. Erica P. John Fund, Inc,32 the Supreme Court clarified that Rule 10b-5 defendants can defeat class certification by demonstrating that alleged misstatements had no effect on price. Based on this holding, defendants can rebut the Basic presumption by citing news and analyst reports and other public information that shows how the supposedly undisclosed truth was already known to the market. Courts continue to grapple with the application of this standard. The Second and Sixth Circuits have held that defendants must ‘demonstrate a lack of price impact by a preponderance of the evidence’ under Halliburton,33 diverging from the Eighth Circuit, which has suggested that defendants can defeat Basic by simply ‘com[ing] forward with evidence showing a lack of price impact’.34 Meanwhile, courts across the country have endorsed the ‘price maintenance’ theory of liability, under which an alleged misstatement’s lack of price impact can be overlooked so long as the misstatement ‘maintained’ an inflated share price by reinforcing or failing to correct a pre-existing market misapprehension.35
The Supreme Court has also clarified that courts should not presume that a misstatement caused an inflated purchase price in Rule 10b-5 cases. In Dura Pharmaceuticals Inc. v. Broudo,36 the Court unanimously held that ‘an inflated purchase price will not itself constitute or proximately cause the relevant economic loss’.37 Following Dura, plaintiffs in fraud-on-the-market and other Rule 10b-5 cases must prove that their economic losses were actually attributable to a defendant’s misrepresentations.38
More recently, the Supreme Court made clear in Goldman Sachs Group, Inc. v. Arkansas Teacher Retirement System39 that courts are to consider all probative evidence when assessing price impact, including the nature of the alleged misrepresentations, even if that evidence is also relevant to merits questions, such as materiality, that are not addressed at the class certification stage.40 Where the alleged misrepresentation is ‘generic’, but the alleged corrective statement is ‘specific’, there may be ‘less reason to infer’ a link between a drop in stock price following the corrective statement and alleged price inflation in the wake of a ‘generic’ misrepresentation.41 The defendant-friendly bent of Goldman Sachs is tempered by the Supreme Court’s holding that defendants seeking to rebut the Basic presumption bear the burden of persuasion to prove, by a preponderance of the evidence, a lack of price impact.42
Insider trading in violation of Section 10
Since the decision of the SEC in Cady, Roberts & Co.,43 insider trading – trading on material non-public information – by both corporate insiders and their tippees has been viewed by the SEC and the courts as a violation of Rule 10b-5. As such, a range of defendants can be held liable: insiders who trade on insider information; insiders who disclose material non-public information to others who may then trade (tippers); and the third-party traders who are tipped off by insiders (tippees).
This does not mean that corporate insiders have a duty to disclose all material information to the public.44 Rather, their duty is to disclose or to abstain from trading until disclosure takes place. The duty to disclose material non-public information or abstain from trading has been held to apply not only to registered securities, but to unregistered and delisted securities as well. Since this liability is rooted in Rule 10b-5, it is subject to the purchaser–seller standing requirements discussed above.
To succeed on an insider-trading claim under Rule 10b-5, a plaintiff generally must establish five basic elements: (1) the buying or selling of a security or the tipping thereof (2) on the basis of information about the security that is (3) non-public, (4) material, and (5) where trading without disclosure constitutes a breach of a fiduciary duty or other relationship of trust and confidence owed to the source of the information.
Other than materiality (discussed under ‘Forms of action’), the most complex of these elements is the last – the rule that insider-trading liability can attach only if the trading constitutes a breach of a duty. This element is generally satisfied under one of two established theories. Under the ‘classical’ theory, a corporate insider or ‘temporary insider’ working for the benefit of a corporation breaches his duty to the corporation and its shareholders by using confidential corporate information to trade in the corporation’s stock for his or her personal benefit.45 Under the ‘misappropriation’ theory, a tipper or trader who has no duty to the issuer or to shareholders may nevertheless be liable where he or she obtains confidential information in breach of a duty owed to the source of the information.46
Insider-trading tippees can also be sued or prosecuted under Section 10 and Rule 10b-5. Under the standard established by the Supreme Court in Dirks v. SEC,47 a tippee is liable where: (1) an insider receives a ‘direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings’; and (2) the tippee knew or had reason to know of the tipper’s breach of duty to an issuer.48 As the Supreme Court reaffirmed in United States v. Salman,49 insider-trading liability extends to circumstances where an insider gifts non-public information to a ‘trading relative or friend’.50
Rule 14a-9 prohibits any proxy solicitation made pursuant to Section 14 of the Exchange Act that ‘contain[s] any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication . . . which has become false or misleading’.51 To succeed on a Rule 14a-9 claim, a plaintiff must establish that a proxy statement contained a material misrepresentation or omission that caused the plaintiff injury and that the proxy solicitation itself was an essential link in accomplishing the transaction.52 In recent years, this provision has frequently been invoked by plaintiffs seeking to challenge merger disclosures. In 2018, for example, some 76 per cent of large mergers were challenged in federal court.53 The large majority of such lawsuits are mooted through minor updates to merger disclosures, a practice that has been criticised as yielding little value beyond a mootness fee for plaintiffs’ counsel.54
Unlike Section 10(b), Section 14(a) does not require a showing of manipulative or deceptive conduct. As a result, most courts require proof of negligence, not scienter.55 However, some courts have adopted a more nuanced approach to the scienter requirement. For example, the Eighth Circuit has held that while proof of negligence suffices for corporate officer defendants, scienter must be shown where the defendant is an accountant or an outside director.56
Section 14(e) and Rule 14e-3
Section 14(e) broadly prohibits the making of untrue statements and the commission of fraudulent acts in connection with tender offers. Unlike Section 14(a), Section 14(e) has been widely understood to require allegations of scienter.57 Recently, however, the Ninth Circuit diverged from this position, holding that Section 14(e) only requires proof of negligence.58 Given the disagreement among the federal circuits, it is likely that the dispute will find itself before the Supreme Court in the coming years.59
The SEC has also issued several regulations under the authority granted by Section 14(e), the most significant being Rule 14e-3(a), which effectively broadens the scope of insider-trading liability in the tender-offer context by dispensing with the requirement that a breach of fiduciary duty be shown.60
In general, plaintiffs bringing a complaint in federal court must allege facts sufficient to render their claim plausible on its face, but must allege fraud with particularity. The PSLRA codifies a heightened pleading standard imposed for securities fraud claims brought under the Exchange Act. Under the PSLRA, a securities fraud claim must specify each statement alleged to have been misleading, identify the speaker, state when and where the statement was made, plead with particularity the elements of the false representation, plead with particularity what the person making the representation obtained and explain the reason or reasons why the statement is misleading. In addition, where scienter is an element of the securities claim, plaintiffs must ‘state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind’.61 Often, a defendant will test the adequacy of a private securities complaint by bringing a motion to dismiss soon after filing.
Federal discovery procedures are liberal, coupling broad mandatory disclosures with invasive depositions, subpoenas and interrogatories. Under the PSLRA, however, in any private action brought under the Acts, all discovery is stayed while a motion to dismiss is pending unless the court finds that particularised discovery is necessary to preserve evidence or prevent prejudice. As such, the federal courts often weigh defendants’ motions to dismiss on a thin factual record, drawing solely from the facts alleged in the complaint, documents that the complaint incorporates by reference and public information that is available for judicial notice.
Far more often than not, securities suits that survive a motion to dismiss are settled rather than litigated to trial. Since securities lawsuits are typically brought as class actions, their settlement can bind absent class members and judicial review of such settlements must comply with Federal Rule of Civil Procedure 23 (Rule 23). Rule 23 requires the court to conduct a hearing and to approve a settlement only after a finding that it is ‘fair, reasonable, and adequate’. In applying this standard, the courts look to a range of factors, including the complexity, expense and likely duration of the litigation, and the risk-reward calculus of proceeding to judgment.62 Under Federal Rule of Civil Procedure 23(e)(5), ‘[a]ny class member may object to [a proposed settlement subject to judicial review]’. Attorneys’ fees are also subject to judicial review for reasonableness in the securities class action context.63
iv Damages and remedies
Different remedies are available for the common securities claims described above. For claims brought under Section 11 of the Securities Act, the measure of a plaintiff’s damages is the decline in the value of his or her securities, quantified as the difference between purchase price and sale price. For Section 12 of the Securities Act, the remedy is rescission – the plaintiff tenders his or her securities to the defendant and receives his or her purchase price with interest. Where appropriate, a court can also order injunctive relief for a Securities Act plaintiff.64
Remedies available under Section 10, Rule 10b-5, Rule 14a-9 and Rule 14e-3 include both injunctive relief and damages. However, the measure of damages in all Exchange Act claims is limited to ‘actual damages’. In the context of a Rule 10b-5 claim, the Supreme Court has held that this imposes an ‘out-of-pocket’ measure, which is the difference between the price paid or received for the security and its true value at the time of purchase.65 In insider-trading cases brought under Rule 10b-5, a disgorgement remedy is often available, under which defendants are liable for the profits that they and their tippees obtained. Finally, at least where the plaintiff dealt face-to-face with the defendant and the securities purchased or sold have not been re-transferred, the plaintiff may elect to sue for rescission rather than damages. In a Rule 14a-9 claim, courts have allowed both out-of-pocket and disgorgement damages, and have fashioned damages designed to give the plaintiff the benefit of the bargain they would have received had the misrepresentations been true.