Broker-Dealer Litigation - Greenberg Traurig LLP

3. Section 17
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SEC v. Gabelli, 653 F.3d 49 (2d Cir. 2011).
After the district court granted in part the defendants’ motion to dismiss and granted the
SEC’s motion to voluntarily dismiss the remaining claims, both parties appealed. On appeal, the
Second Circuit held that the SEC’s allegation that the mutual fund’s chief operating officer made
statements of “half-truth” was sufficient to state a claim for securities fraud. The basis for the
SEC’s securities fraud claims against the former COO was a statement regarding the elimination
of market timing that specifically provided that “for more than two years, scalpers have been
identified and restricted or banned from making further trades.” The district court dismissed the
SEC’s claims because this statement was, in fact, true. However, the Second Circuit noted that
the law is well-settled that so-called “half-truths,” that is, literally true statements that create a
materially misleading impression, can support claims of securities fraud. In this case, because a
reasonable investor could plausibly conclude after reading the statement at issue that the adviser
had attempted to eliminate all market timing, when in fact, the adviser had entered into an
agreement with a specific investor allowing that investor to engage in a very large amount of
market timing in return for an investment in another hedge fund run by the defendant, the Second
Circuit concluded that the district court erred in dismissing the Section 17(a) claims.
SEC v. Shanahan, 646 F.3d 536 (8th Cir. 2011).
The district court granted the defendant’s motion for judgment as a matter of law upon
conclusion of the SEC’s presentation of its case-in-chief in this action alleging that an outside
director committed securities fraud by participating in the grant of backdated stock options. The
district court concluded that the SEC had failed to prove the requisite elements of scienter and
negligence. The SEC appealed and the Eighth Circuit Court of Appeals affirmed the district
court’s decision.
In the district court, the defendant testified that as an outside director, he relied upon the
company’s finance and accounting departments, outside and general counsel, and the company’s
independent auditors to ensure that the stock option plans were properly administered and
reported. It was undisputed in the district court that none of these professionals ever raised a
concern regarding the option dating and pricing or the company’s disclosures regarding the
option grants. The Eighth Circuit noted that, depending on others to ensure the accuracy of
disclosures, even if inexcusably negligent, is not the severely reckless conduct that is the
functional equivalent of intentional securities fraud. On appeal, the SEC argued that the danger
of misleading investors “must have been obvious” to the outside director because the disclosures
stated that the company was issuing at-the-money options. The Eighth Circuit rejected this
argument, concluding that the SEC failed to meet the heavy burden of proving the severe
recklessness that is the functional equivalent of intentional fraud because the disclosure was
ambiguous and it was primarily the responsibility of the accounting and finance professionals to
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