BUELL IN PRINTER PROOF 11/11/2011 5:38:12 PM Duke Law Journal VOLUME 61 DECEMBER 2011 NUMBER 3 WHAT IS SECURITIES FRAUD? SAMUEL W. BUELL† ABSTRACT As Rule 10b-5 approaches the age of seventy, deep familiarity with this supremely potent and consequential provision of American administrative law has obscured its lack of clear conceptual content. The rule, as written, interpreted, and enforced, is missing a fully developed connection to—of all things—fraud. Fraud is difficult to define. Several approaches are plausible. But the law of securities fraud, and much of the commentary about that body of law, has neither attempted such a definition nor acknowledged its necessity to the coherence and effectiveness of the doctrine. Securities fraud’s lack of mooring in a fully developed concept of fraud produces at least three costs: public and private actions are not brought on behalf of clearly specified regulatory objectives; the line between civil and criminal liability has become unacceptably blurred; and the law has come to provide at best a weak means of resolving vital public questions about wrongdoing in financial markets. The agenda of this Article is threefold. First, this Article illuminates and clarifies the relationship between securities fraud and fraud and structures a discussion of legal reform that more explicitly connects Copyright © 2011 by Samuel W. Buell. † Professor of Law, Duke University School of Law. I am grateful for the helpful questions and comments of Tom Baker, Sara Sun Beale, Stuart Benjamin, Ben Depoorter, Lisa Kern Griffin, Kim Krawiec, Dan Markel, James Park, and participants in workshops at Duke University School of Law, Willamette University College of Law, Notre Dame Law School, and Florida State University College of Law. Many thanks to Calvin Winder for research assistance of true excellence. BUELL IN PRINTER PROOF 11/11/2011 5:38:12 PM 512 DUKE LAW JOURNAL [Vol. 61:511 securities fraud remedies with the purposes of a regime of securities regulation. Second, it clarifies the line between civil and criminal liability. And third, this Article seeks a better understanding of what is being asked when legal actors and the public wonder whether to label an important instance of market failure “fraud.” TABLE OF CONTENTS Introduction .............................................................................................512 I. What Is Fraud?....................................................................................520 A. The Question Is Hard and Important.................................520 B. Some Axes of Fraud .............................................................522 C. Mental State and Fraud........................................................526 1. Core Fraud Versus Misrepresentation ...........................526 2. Goal Versus Awareness ...................................................530 3. Level of Awareness...........................................................534 4. Criminal Fault....................................................................537 II. What Is Securities Fraud? ................................................................540 A. Structure of the Statutory and Regulatory Scheme ..........541 B. Elements, According to the Federal Courts ......................545 C. The Scienter Mess .................................................................548 1. Private Lawsuits ................................................................548 2. SEC Actions.......................................................................553 3. Criminal Prosecutions.......................................................555 D. Insider Trading ......................................................................561 E. Securities Fraud Remains Undefined.................................564 III. Improving the Law of Securities Fraud.........................................565 A. Costs of the Status Quo ........................................................565 B. Objectives for Reform ..........................................................568 1. Fraud and the Purposes of Securities Regulation .........568 2. The Civil-Criminal Line ...................................................572 3. Capitalizing on Expressive Capital .................................573 C. Reform Angles ......................................................................576 1. Amend the Statutes and Rules ........................................576 2. Repair the Doctrine in the Courts ..................................579 Conclusion................................................................................................581 INTRODUCTION The Securities and Exchange Commission (SEC) recently leveled a highly publicized enforcement action against the venerable investment banking and securities firm, Goldman Sachs. When the BUELL IN PRINTER PROOF 11/11/2011 5:38:12 PM 2011] WHAT IS SECURITIES FRAUD? 513 suit was filed, the headlines blared, “U.S. Charges Goldman Sachs with Fraud.”1 The theory of the case was that Goldman had sold a German bank a derivative product tied to the fate of a basket of mortgage-backed securities, while simultaneously obscuring the weaknesses of the securities in that basket. According to the SEC, Goldman obfuscated the matter by touting the role of a reputable independent firm in the selection of the underlying securities and by failing to disclose that a player who was betting against the securities was also allowed to participate in the selection process.2 A lively public discussion followed about whether Goldman, widely tagged as a symbol of bubble-era greed, was also crooked. Did the Goldman bankers deserve condemnation for purposely exploiting the naïveté of investors, so they could profit from the sale of products that were bets on a market Goldman knew was bound to crash?3 Although the transaction involved in the SEC’s lawsuit was small by Goldman’s standards, its structure implicated big questions about the culpability of global banks for inflating a market in mortgage-derived 4 securities that was practically designed to self-destruct. 1. E.g., Francesco Guerrera & Henny Sender, Goldman Sachs Splash, FIN. TIMES, Apr. 17, 2010, at 1; Louise Story & Gretchen Morgenson, S.E.C. Accuses Goldman of Fraud in Housing Deal, N.Y. TIMES, Apr. 17, 2010, at A1; Gregory Zuckerman, Susanne Craig & Serena Ng, U.S. Charges Goldman Sachs with Fraud, WALL ST. J., Apr. 17, 2010, at A1. 2. Complaint at 7–11, SEC v. Goldman Sachs & Co., No. 10-CV-3229 (S.D.N.Y. Apr. 16, 2010). 3. See, e.g., Editorial, After Goldman, N.Y. TIMES, Apr. 22, 2010, at A28 (characterizing Goldman’s conduct as gambling on the market); Paul Krugman, Op-Ed., Looters in Loafers, N.Y. TIMES, Apr. 19, 2010, at A23 (“[N]ow the S.E.C. is charging that Goldman created and marketed securities that were deliberately designed to fail, so that an important client could make money off that failure. That’s what I would call looting.”); John Carney, Goldman Sachs Girds for Battle with the SEC over Fraud Case, CNBC.COM (May 26, 2010, 4:00 PM ET), http:// www.cnbc.com/id/37362236/Goldman_Sachs_Girds_for_Battle_With_the_SEC_Over_Fraud_ Case (“A sticking point for Goldman is the SEC’s fraud allegations. The company is unwilling to agree to any settlement that would have the appearance of affirming that Goldman committed fraud, a person familiar with the matter says. However, Goldman might be willing to settle a case alleging that Goldman was only negligent in omitting a material fact in marketing the deal, the person said.”); Abigail Field, Deconstructing Goldman Sachs’s Fraud Defense, DAILY FIN. (Apr. 19, 2010, 1:45 PM), http://www.dailyfinance.com/story/investing/deconstruct ing-goldman-sachss-fraud-defense/19444284 (evaluating the merits of the SEC’s complaint and Goldman’s defense); Tom Granahan, In Defense of Goldman Sachs, FOX BUS. (Apr. 21, 2010), http://www.foxbusiness.com/markets/2010/04/21/defense-goldman-sachs (questioning whether Goldman’s sale of assets should really be labeled fraudulent solely because a third party believed the assets were weak). 4. Complaint, supra note 2, at 1. See generally MICHAEL LEWIS, THE BIG SHORT: INSIDE THE DOOMSDAY MACHINE 6–10, 14–15 (2010) (“All these subprime lending companies were growing so rapidly, and using such goofy accounting, that they could mask the fact that they had no real earnings, just illusory, accounting-driven, ones.”). BUELL IN PRINTER PROOF 11/11/2011 5:38:12 PM 514 DUKE LAW JOURNAL [Vol. 61:511 Did Goldman commit fraud? This seems like an important question to answer.5 Indeed, given that the damages at issue in the suit were unlikely to threaten Goldman seriously,6 this enforcement action seems to have served no greater public purpose than letting the public know whether Goldman committed fraud—thereby informing the public what such an institution is capable of and instructing other institutions and their managers about what is expected of them. But the public never got an answer to this question. A large part of the explanation for this lacuna lies in the procedural habits and economics of SEC enforcement actions. As did the Goldman case, these actions almost all settle without a trial, and almost always with the alleged perpetrator of fraud “neither admit[ting] nor deny[ing]” the SEC’s claims.7 Because the facts of the Goldman case were never developed with any granularity—and because Goldman admitted nothing—the great case of “U.S. Charges Goldman Sachs with Fraud” simply evaporated, leaving hardly a trace 8 beyond the $550 million fine that