Shariah’s Black Box

As the Supreme Court made clear in SEC v. Capital Gains Research Bureau, 375 U.S. 180, 195 (1963), the Investment Advisors Act was meant to safeguard the fiduciary relationship between the advisor and the investor. The nature of the SEC proceeding, the heightened duty of such fiduciaries, and the purposes of the act, eliminate the need to show intent to injure as in common law fraud.[221] The exposure of investment advisors to the claim they have a duty to disclose all of the material facts about Shariah prior to any investment in a SCF fund, securitization, or company, seems quite substantial, which is further highlighted by the complete lack of attention given the duty and its breach by the SCF industry.

While scienter’s common law and statutory roles appear greatly diminished in the contexts discussed above, that is not the case for implied rights of action under Rule 10b-5. It is well documented in the literature and disparate court opinions across the federal circuits that Congress and the Supreme Court have gone a long way to gut both the 1934 Act and the blue sky laws of their private class action fear factor — in part by requiring strict pleading of all necessary elements including scienter.[222] What the attorney representing the financial institution must keep in mind, however, is that the SEC and large institutional private plaintiffs with significant investments at stake will continue to employ Rule 10b-5 and state securities anti-fraud provisions quite effectively. Large institutional investors with huge investment portfolios are less inclined to turn to class actions when they can bring far more manageable private civil claims which carry enough investment clout to make a difference to the defendant.

Moreover, even after the Supreme Court’s decision in the oft-cited Ernst & Ernst v. Hochfelder case[223], while a Rule 10b-5 allegation will require far more than negligence, it is likely that a reckless disregard for the truth suffices. Furthermore, this is as much about artful pleading as it is about trying to nail down the legal standard. This is especially the case after a financial institution opens the door to a partial but misleading truth.[224] Thus, a financial institution, which recognizes the threshold duty to disclose something about Shariah and the Shariah authorities who set the standards for their particular SCF investment or business, must be extremely careful to capture all of the material facts about what Shariah is, its purposes, and methods. Failure to recognize any extant connection between Shariah and terror and violence after providing some banal representation about Shariah as divine Islamic law based on the Qur’an, the Sunna, and legal rulings of the competent Shariah authorities, will likely suffice to satisfy the scienter requirement at least at the pleadings stage.

Recklessness, especially in a case where a representation was made but without all the requisite material facts, is a notoriously fact-based standard which allows a showing of proof through circumstantial evidence.[225] The case law suggests a “totality of the circumstances” test where a variety of factors come into play to establish recklessness.[226] The specific factors typically cited can be characterized in rubric form to include an analysis which examines: how material the omission was; how available were the omitted facts to the defendant; was there an extant standard of care in the industry giving rise to a duty to disclose the omitted facts; how egregious was the breach; and what were the likely consequences (i.e., benefits to defendant/damages to plaintiff) of not disclosing the material facts. In the case studies presented in Section III below, these questions will be addressed within two fact-specific settings to begin to flush out the liability exposure facing a financial institution which promotes SCF but ignores Shariah.[227]

Rule 10b-5 is important because it operates as a ‘catch-all’ anti-fraud statute with an implied private right of action. But beyond Rule 10b-5, there are many state securities laws which require no scienter and are broader in their reach than Rule 10b-5. Arizona’s blue sky anti-fraud provisions have been given a quite expansive reach to get at all kinds of securities fraud and without the burden of scienter.[228] Arizona blue sky laws also permit punitive damages.[229] In addition, at least three states provide for a securities fraud claim under their respective consumer anti-fraud statutes[230], of which two have a private right of action allowing for punitive damages.[231] Furthermore, even a state like California, which does not recognize securities fraud as a cause of action under its very expansive consumer fraud statute, will allow a consumer fraud claim relating to a “holder” of securities where the allegation is of fraud but not in connection with the “sale” or “purchase” of a security.[232] These state consumer fraud actions are devastatingly effective weapons in the hands of a sophisticated plaintiffs’ bar against financial institutions treading blindly down the seemingly golden path of SCF.