Shariah’s Black Box

D. The legal landscape

The regulation of disclosures by businesses, and by the financial industry in particular, has a long and storied history in U.S.jurisprudence. Most of this regulation began in a way not normally considered regulatory but its effect was and continues to be most certainly to regulate. The common law of most states incorporated the tort action of deceit, commonly referred to as fraud, to allow private rights of action for misrepresentation in the context of what is now referred to as commercial speech.[126] The essential elements of a common law fraud action are: (1) a false representation (2) of a material fact (3) which the defendant knew to be false and (4) with the intent to induce the plaintiff to rely upon it and (5) the plaintiff in fact justifiably relied upon the representation (6) thereby suffering damages as a result.[127]

Most states have relaxed or altered many of the elements of common law fraud. For example, certain relationships under the common law, such as a fiduciary, might also give rise to a claim for constructive fraud which allows recovery for an omission of material fact. The scienter elements have also been relaxed. Thus, the intent elements noted above in (3) and (4), has been “variously defined to mean everything from knowing falsity with an implication of mens rea, through various gradations of recklessness, down to such nonaction as is virtually equivalent to negligence or even liability without fault (and would be better treated as creating a distinct species of liability not based on intent).”[128]

In addition to common law actions for fraud or misrepresentation, there are federal and state statutory regimes designed to govern disclosures in a myriad of business and financial contexts, including the sale of goods and the provision of loans; investments such as the formation of partnerships; and the sale of intangibles such as the offering of securities. In the world of SCF, the disclosure statutes most obviously implicated in civil and criminal liability issues are the federal and state securities laws.

In the main, the securities law relating to fraud and misrepresentation were modeled after common law fraud. Having said this, it is just as true to say that Congress intended the securities fraud statutes to have a far broader reach than the common law. As a result, securities laws sought to include within its enforcement orbit misrepresentations, omissions, schemes, and artifices that would not otherwise be captured by traditional common law fraud. In addition, many of the specific elements of common law fraud were relaxed or in some cases eliminated. While recent federal legislation aimed at curbing abusive class action litigation and subsequent Supreme Court case law suggest a serious trimming of the broad reach previously granted federal securities laws, the securities bar knows full well that this is counterbalanced by a concomitant movement at the state level to extend the reach of the state securities laws and to interpret them more liberally than the federal counterparts.[129]

There are principally seven federal statutes that govern securities transactions: the Securities Act of 1933; the Securities Act of 1934; the Trust Indenture Act of 1939; the Investment Company Act of 1940; the Investment Advisors Act of 1940; the Securities Investor Protection Act of 1970; and the Sarbanes-Oxley Act of 2002.[130] Civil and criminal liability under the federal securities statutes for failure to disclose, what is broadly referred to as securities fraud, is regulated by the SEC and its principal weapons are the Securities Act of 1933 (“1933 Act”) and the Securities Exchange Act of 1934 (“1934 Act”).[131] The 1933 and 1934 Acts target different markets. The 1933 Act regulates initial offerings and the 1934 Act regulates all subsequent trading, but the overriding public policy is the same: “full disclosure of every essentially important element attending the issue of a new security” and a “demand that persons, whether they be directors, experts, or underwriters, who sponsor the investment of other people’s money should be held to the high standards of trusteeship.”[132]

Although both the 1933 and the 1934 Acts proscribe various types of conduct, including incomplete or inaccurate disclosure of material information, as an administrative matter the SEC, through its rule-making authority and its regulatory responsibilities, dictates the specific kinds of minimal (and in some cases maximal) disclosure required by the specific provisions. Beyond the routine administration functions granted the SEC, the main weapons against securities fraud are the civil and criminal remedies. Thus, the SEC, in addition to administrative sanctions, has access to the civil courts to seek injunctive relief, disgorgement, and even civil fines, in addition to other ancillary equity-like relief. In addition, the Department of Justice (“DOJ”), often as a result of an SEC administrative investigation and criminal referral, is authorized to file criminal charges for violations of the federal securities laws when it appears the offending party had the requisite intent.[133] Finally, private plaintiffs have expressed and implied rights of action under several provisions. The most used and abused of all such provisions is Rule 10b-5[134], promulgated under the 1934 Act[135], which provides for civil litigation[136] and criminal prosecutions.[137] When you add the class-action club to the civil claims brought under Rule 10b-5, although reduced mightily by recent legislation[138], the weapons available to prosecute claims for misstatements and omissions of material fact in SEC filings and elsewhere in the public domain are considerable.