The SEC promulgated Rule 10b-5 under Section 10(b) of the Exchange Act, which authorizes the SEC to regulate securities fraud. The text of the regulation, formally 17 CFR § 240.10b-5, states that “it shall be unlawful for any person . . . (a) [t]o employ any device, scheme, or artifice to defraud, (b) [t]o make any untrue statement of a material fact or to omit to state a material fact . . . 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.”
While not explicit in the language, courts have interpreted Rule 10b-5 to create a private civil cause of action and additionally allow the SEC to bring criminal enforcement actions. In order to bring a private right of action under Rule 10b-5, the plaintiff must have standing. In Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), the U.S. Supreme Court ruled that a plaintiff must have actually purchased or sold a security to have standing under Rule 10b-5. That is, claiming that a fraudulent misrepresentation caused the plaintiff to forego purchasing or selling a security does not allow them to bring a cause of action under Rule 10b-5. Unlike Section 11, however, Rule 10b-5 applies to both public offerings and private placements.
For a private plaintiff or the SEC to prove a violation of Rule 10b-5, they must prove the following elements:
- The individual misrepresented a material fact. In Virginia Bankshares v. Sandberg, 501 U.S. 1083 (1991), the Supreme Court found knowingly false statements of reason or opinion to be actionable even though they were conclusory in form. There, the company’s directors informed shareholders that the price they would get for their shares from a merger was “high” and a premium, where in fact the directors believed that the value was fair.
- The individual did so knowingly, i.e. scienter. This is a lower mental state than strict liability, as required by Section 11, but the U.S. Supreme Court in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) clarified that it was higher than negligence. In Tellabs v. Makor Issues & Rights, 551 U.S. 308 (2007), the U.S. Supreme Court described the mental state requirement as being more or equally plausible that the individual knew of the misrepresentation than not.
- The plaintiff relied on the individual’s material misrepresentation. That is, the misrepresentation must have caused the individual to transact in the security.
- The plaintiff suffered loss.
In addition to a private suit, if the SEC establishes those elements, then the individual may be criminally liable.
[Last updated in January of 2022 by the Wex Definitions Team]