Settlement Fund Fraud Is Not Securities Fraud
In SEC v. Cammarata, the SEC sued a group of persons who, according to the SEC, falsified records and submitted them to administrators of distribution funds in securities class actions or SEC enforcement cases to obtain payments as compensation for losses in securities trades. The SEC claimed that the defendants collected payments in excess of $40 million from distribution fund administrators as a result of the phony claims and asserted that the defendants violated the main anti-fraud provision in the securities laws, Rule 10b-5.
If the defendants did what the SEC says, they engaged in serious violations of state and federal law, but is it securities fraud under Rule 10b-5? Probably not. Rule 10b-5 does not catch all conceivable forms of fraud. It catches fraud in securities transactions. Rule 10b-5 prohibits schemes to defraud “in connection with the purchase or sale of any security.” The bad act, the fraud or deceit, must be sufficiently close to a securities trade to be viewed as “securities fraud.” Otherwise the securities laws and SEC enforcement would become an all-purpose federal remedy for fraud.
The classic example of a deceit in connection with a securities trade is when a seller of stock lies to the buyer about the stock’s value, but Supreme Court decisions go further. “It is enough that the scheme to defraud and the sale of securities coincide.” A broker who sold a customer’s security and then took the proceeds for his own personal use did more than engage in theft; he violated Rule 10b-5 because each sale of securities was part of, and coincided with, an undisclosed plan to take the proceeds. The securities sales and the broker’s fraudulent practices were not independent events. A lawyer who had confidential client information violated Rule 10b-5 when he used the information without authority to buy securities in the open market for himself. The lawyer’s deceitful breach of duty and the securities transaction coincided.
Even with these broader constructions, the purchase or sale of a security closely linked to fraudulent conduct remains an indispensable part of a violation of Rule 10b-5, and that close link does not exist in Cammarata. The defendants did not buy or sell a security during the course of sending false claim records to the administrators of the distribution funds, and the administrators did not buy or sell securities in direct response to the false records from the defendants. Neither the administrators nor any other person needed to buy or sell a security for the defendants to complete the fraudulent plan. The goal of the defendants was not to induce the administrators to buy or sell a security, and the relationship between the administrators and the defendants or other claimants did not necessarily involve trading in securities.
Allegations in the Cammarata complaint suggest that the SEC has a different approach to satisfying the “in connection with” requirement. Administrators of distribution funds received payments from the wrongdoers or settling defendants in the underlying securities litigation and put the money in escrow. Sometimes, the administrators held the escrow amounts in a money market account or other kind of security and later sold the securities to make distributions. The SEC could plan to argue that, when administrators sold securities investments to pay false claims from the Cammarata defendants, the sales were “in connection with” the false claims.
If this is the approach the SEC plans to take on the “in connection with” requirement, it should not be accepted. The Supreme Court rejected a similar SEC argument in a 2014 decision when the Court determined that misrepresentations must relate to the immediate relationship and actions between a wrongdoer and a victim and not to activities behind the scenes. In Cammarata, the immediate actions concerned whether the fund administrators were to pay or not pay a person claiming a loss resolved in the underlying securities litigation. It was not about the way fund administrators stored the value of the escrow funds.
In addition, securities trades did not always occur, and, when they did, they were too remote and disconnected from the actions of the defendants. The misconduct of the defendants did not affect securities investments by the administrators. The administrator invested the proceeds for the fund before or without regard to the false claims from the defendants and sold any securities to reconvert the body of the fund to cash to pay successful claims or otherwise terminate the fund whether the defendants submitted false claims or not. The purchases and sales of securities, when they occurred, were administrative steps that would have happened even if the defendants had not engaged in their bad acts. Misstatements from the defendants did not coincide with or make a significant difference to an administrator’s decision to buy or sell a security.
The SEC’s apparent attempt to use the unrelated and only occasional securities transactions of the administrators as the hook for a securities fraud charge against these defendants is the kind of agency over-reaching that is receiving close scrutiny today. The charge against the Cammarata defendants exceeds limitations Congress and the courts imposed on the SEC’s enforcement powers. It is an effort to extend securities fraud liability beyond settled doctrine, which creates uncertainty and unpredictability about the scope of securities fraud and therefore unfairly deprives market participants of sufficient notice about the way to comply with the securities laws. If the SEC’s approach is accepted or leads to a settlement, the case, as a practical matter, will create a precedent that will be enlarged in the future to ensnare someone engaged in much less malign conduct.
Securities fraud does not extend to every conversion or theft. The securities laws should not be used to police all bad acts.
Andrew N. Vollmer is a Senior Affiliated Scholar, Mercatus Center at George Mason University. Former Professor of Law, General Faculty, University of Virginia School of Law; former Deputy General Counsel of the Securities and Exchange Commission; and former partner in the securities enforcement practice of Wilmer Cutler Pickering Hale and Dorr LLP.
