SEC Rule 10b-5, codified at 17 C.F.R. § 240.10b-5, is one of the most important rules promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934.[1] The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.
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In 1942, SEC lawyers in the Boston Regional Office learned that a company president was issuing pessimistic statements about company earnings while simultaneously purchasing the company's stock. Although the Securities Act of 1933 prohibited fraudulent sales of securities, no regulation precluded fraudulent purchases. Rule 10b-5, issued by the SEC under section 10b of the Exchange Act, was implemented to fill this regulatory void. The commissioners approved the rule without debate or comment, with the exception of Commissioner Sumner Pike who indicated approval of the rule by asking, "Well, we are against fraud aren't we?"
"Rule 10b-5: Employment of Manipulative and Deceptive Practices":
In the case of TSC Industries, Inc. v. Northway, Inc.,[2] the word "material" was defined by the U.S. Supreme Court - "an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote."
In order to establish a claim under Rule 10b-5, plaintiffs (including the SEC) must show (i) Manipulation or Deception; (ii) Materiality; (iii) "In Connection With" the purchase or sale of securities; and (iv) Scienter. Private plaintiffs have the additional burden of establishing (v) Standing - Purchaser/Seller Requirement; (vi) Reliance; (vii) Loss Causation; and (viii) Damages.
In a case for insider trading, anyone who uses insider information can be held liable. A tippee can be liable if the tipper breached a fiduciary duty and the tippee knew or had reason to know that the tipper was breaching the duty.
To what extent Rule 10b-5 prohibits insider trading is a matter of some dispute. The SEC has long advocated an "equal access theory" with regard to 10b-5, arguing that anyone who has material, non-public information must either disclose that information or abstain from trading. However, the Supreme Court rejected the strongest version of that theory in Chiarella v. United States[3], holding a person with no fiduciary duty to the shareholders had no duty to disclose information before trading on it. Recently, the Supreme Court has embraced a "misappropriation" theory of omissions, holding in United States v. O'Hagan[4] that misappropriating confidential information for securities trading purposes, in breach of a duty owed to the source of that information, gives rise to a duty to disclose or abstain.
In order for Rule 10b-5 to be invoked, there must be intentional fraud or deceit by the party charged with the violation. Furthermore, for a private party to recover damages, they must be able to show that they were injured because they relied on the fraudulent claim. If the defendant had publicly made a fraudulent statement, every investor could sue if it could be shown that the statement affected the market as a whole - this is the "fraud on the market" theory enunciated by the Supreme Court in Basic Inc. v. Levinson.[5] This "fraud on the market" presumption of the plaintiff's reliance upon the deceit is only available in situations (like in Basic) where the security is traded on a well organized, and presumably efficient, market.
Various cases have held that a statement that "bespeaks caution" is sufficient to absolve the defendant of liability. If the defendant had prefaced remarks about the health of the company with a disclaimer that he might be wrong, then his subsequent statements can not be held against him.
Both the SEC and private citizens can enforce the requirements of the rule through lawsuits. The defendant need not be the seller of the stock - any person who fraudulently induces a person to purchase any stock may be held liable.