When Your Government Thinks You've Been Unreasonable: The SEC's New War On Negligence

May 16, 2012

Originally published in the Boston Bar Association's Securities Fraud 2012.

The SEC's Enforcement Division has recently made clear that it intends to bring more enforcement actions based on allegations that a defendant has been negligent, even if there is no evidence of any intent to defraud anyone. (See, e.g., "At SEC, Strategy Changes Course," WSJ, 9/30/11.)

Charging negligent conduct is nothing new for the SEC. Section 17(a)(2) of the Securities Act of 1933 has long been understood to prohibit negligent misstatements in the offer or sale of securities. See, e.g., SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 867 (2d Cir. 1968). For many years, however, the SEC's practice has been to charge negligence in two types of cases: where the SEC also charges fraud and negligence is, in essence, a lesser included offense, and where the SEC believes the evidence would support a fraud charge but accepts negligence in a negotiated settlement. The SEC's newfound interest in negligence dramatically expands the scope of conduct that may be subject to government enforcement and raises significant questions about the SEC's interpretation of Section 17(a)(2) and the standards it will use to assess whether conduct has been negligent.

Understanding the SEC's interest in negligence starts with changes in the interpretation of a different rule, Rule 10b-5, the SEC's primary vehicle for charging defendants with fraud. Rule 10b-5 makes it illegal "to make any untrue statement of a material fact" in connection with the purchase or sale of securities. 17 C.F.R. § 240.10b-5(b). Last year, after many years of uncertainty in the lower courts over what it means "to make" a statement, the Supreme Court finally clarified the standard for primary liability under Rule 10b-5. Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011). Prior to Janus, federal courts had developed two tests for determining what it means to "make" a statement under Rule 10b-5. Under the "bright-line" test, a defendant must have actually made a statement that was publicly attributed to him. Wright v. Ernst & Young, 152 F.3d 169, 174-75 (2d Cir. 1998). Under the broader "substantial participation" test, the "substantial participation or intricate involvement in the preparation" of a statement is all that is required to establish that a defendant made a statement. Howard v. Everex Systems, Inc., 228 F.3d 1057, 1061-62, n.5 (9th Cir. 2000).

In Janus, the Court...