Prosecuting Securities Fraud Under Section 17(a)(2)

Traditionally, securities fraud has been civilly enforced under Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and criminally prosecuted under Section 32 of the Exchange Act. Recently, however, the SEC has increasingly asserted claims under Section 17(a)(2) of the Securities Act for conduct that sounds in securities fraud. Moreover, because violations of Section 17 are criminalized under Section 24 of the Securities Act, an increasing number of securities fraud prosecutions may be pursued under Section 17(a)(2). Yet, unlike the elements of securities fraud under Rule 10b-5, many of the elements of Section 17(a)(2) violations remain unsettled, and that uncertainty is only exacerbated when it is criminally prosecuted. Against this backdrop, I have sought to define the elements of the crime of violating Section 17(a)(2) and to compare those elements with the crime of violating Rule 10b-5.

At first glance, the elements of Section 17(a)(2) and Rule 10b-5(b) appear coextensive. Each requires an untrue statement or omission of a material fact. Yet, in Aaron v. S.E.C., 446 U.S. 680 (1980), the Supreme Court clarified that, at least in one respect, Section 17(a)(2) and Rule 10b-5(b) differ substantially. A civil violation of Section 17(a)(2) does not require scienter and thus can be established if the defendant acted negligently. By contrast, a civil violation of Rule 10b-5 requires scienter, and thus the defendant must have acted at least recklessly. In addition, upon closer examination, Section 17(a)(2) and Rule 10b-5(b) differ in several potentially meaningful ways.

First, Section 17(a)(2) applies “in the offer or sale of any securities,” while Rule 10b-5(b) applies “in connection with the purchase or sale of any security.” The “in connection with” element of Rule 10b-5 is satisfied if the alleged misrepresentation or omission “is material to a decision by one or more individuals (other than the fraudster) to buy or to sell” a security, and thus Rule 10b-5 applies broadly to statements made to the secondary market. Chadbourne & Parke LLP v. Troice, 571 U.S. 377 (2014). Although most lower courts have held that Section 17(a)(2) likewise applies to statements made to the secondary market, I contend that Section 17(a)(2) is limited to the offering/selling context. First, although dicta in Naftalin suggests that Rule 10b-5 and Section 17(a)(2) apply coextensively, the ultimate breadth of the Rule 10b-5’s “in connection with” element was itself unclear at that time. In addition, the legislative history of the Securities Act supports Section 17(a)’s role therein as a means of enforcing the accuracy of Section 5-mandated disclosures in the offer or sale of securities, not as a roving provision that applies outside the context of offers or sales. Further, Congress explicitly tied the scope of Section 17(a) to the defined terms of “offer” and “sale,” thus supporting a more limited application of Section 17(a) to the offering/selling context. Thus, I argue that statements used outside the offering/selling context, such as statements in SEC filings that are not incorporated into registration statements, are within the scope of Rule 10b-5 but not Section 17(a)(2).

Second, Section 17(a)(2) includes an element not included in Rule 10b-5: The defendant must have acted “to obtain money or property.” Lower courts have interpreted this element in two ways. Under one line of authority, the defendant must have personally received funds as the result of participating in the wrongful conduct, such as a transfer of funds from the victim or additional compensation tied to the conduct. A second line of authority rejects the requirement of a so-called “fraud bonus” and holds that this element is satisfied if the defendant received ordinary compensation or if the defendant’s employer received money or property by virtue of the defendant’s participation in the wrongful conduct. I agree with this second line of authority. First, the “to obtain money or property” element of Section 17(a)(2), which was drawn from similar language in the mail fraud statute, should—like the mail fraud statute—be focused on the potential deprivation of a victim’s money or property, not on a defendant’s actual gain of money or property. Second, to require the defendant to receive an actual fraud bonus would, in effect, write the unconsummated “offer” context out of Section 17(a)(2).

Third, Section 17(a)(2) requires the defendant to have acted “by means of” any misrepresentation or omission, while Rule 10b-5(b) requires the defendant to “make” the misrepresentation. In Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), the Supreme Court restrictively interpreted “maker” liability under Rule 10b-5(b) as extending only to “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” I agree with the weight of authority that Janus’ restrictive interpretation of “maker” liability is inapplicable to Section 17(a)(2). The Janus court’s reasoning was based on the definition of the word “make,” which does not appear in Section 17(a)(2); and the Janus court’s policy concern about undercutting the distinction between primary and secondary violators for purposes of private civil liability is not implicated by Section 17(a)(2), because there is not a private right of action for violating Section 17(a)(2).

Finally, the crimes of violating Section 17(a)(2) and Rule 10b-5 require a multi-layered analysis of the defendant’s requisite mental state with respect to the falsity of an alleged misrepresentation. First, as noted above, each substantive provision contains an embedded mental state element. Section 17(a)(2) requires that the defendant have been at least negligent about truth or falsity, while Rule 10b-5 requires the defendant to have been at least reckless about truth or falsity. Second, Section 24, which criminalizes the violation of Section 17(a)(2), requires the defendant to have acted “willfully;” Section 32(a), which criminalizes the violation of Rule 10b-5, requires the defendant to have acted “willfully and knowingly” with respect to statements in mandatory SEC filings and registration statements, and it requires the defendant to have acted only “willfully” with respect to other violations of the Exchange Act. Thus, layering these statutory provisions together, there are three applicable mental states: (1) negligence plus willfulness (for violations of Section 17(a)(2), as criminalized by Section 24); (2) recklessness plus willfulness (for violations of Rule 10b-5 premised on statements not contained in SEC filings, as criminalized by Section 32(a)); and (3) knowledge plus willfulness (for violations of Rule 10b-5 premised on statements contained in SEC filings, as criminalized by Section 32(a)).

I have sought to interpret these intersecting statutory provisions coherently, while acknowledging that those interpretations lead to some anomalous results. In short, drawing from the structure of Sections 24 and 32(a) and case law interpreting the element of “willfulness,” I contend that violations of Section 17(a)(2) (as criminalized by Section 24) and violations of Rule 10b-5 premised on statements not contained in SEC filings (as criminalized by Section 32(a)) require defendants to have acted in a knowingly wrongful manner that involved a significant risk of a reckless misrepresentation. I contend that violations of Rule 10b-5 premised on statements contained in SEC filings (as criminalized by Section 32(a)) require defendants to have acted in a knowingly wrongful manner that involved a significant risk of a misrepresentation and with actual knowledge of falsity.

This interpretation leads to several anomalies. First, a false statement in a registration statement could be prosecuted under Section 24 with a lower mens rea than it could be prosecuted under Section 32(a). As a consequence, prosecutions for false statements in registration statements could be channeled to Section 24 rather than Section 32(a). One way of rationalizing that disparate mens rea, at least under current law, is that Section 24 violations have a lower statutory maximum penalty than Section 32(a) violations. Second, assuming that Section 17(a) violations are limited to the offering/selling context, there is a differential treatment of false statements in registration statements (which can be prosecuted with a lower mens rea under Section 24) and false statements in mandatory SEC filings (which can only be prosecuted under Section 32(a)’s “willfully and knowingly” standard). Arguably, policing the accuracy of statements in registration statements is of heightened importance because, at the time of offer or sale, the information asymmetry is greater, the incentive to make misrepresentations is more pronounced, and the impact on allocation of capital is more direct. Yet, these anomalous results lend additional support to other scholars’ calls for revision and clarification of the mens rea standards for criminal prosecution of securities violations. These calls for reform are especially pressing because there is a risk that, as the SEC has increasingly turned to Section 17(a)(2) in the realm of civil enforcement, the Department of Justice may follow suit in the realm of criminal prosecution.

This post comes to us from Professor Wendy Gerwick Couture at the University of Idaho College of Law. It is based on her recent paper, “Prosecuting Securities Fraud Under Section 17(a)(2),” available here.