In the following guest post, Arkady Bukh, founding partner of Bukh Law Firm, takes a look at the U.S. Supreme Court’s 2014 decision in Loughrin v. United States (here) and examines how the Court’s holding with respect to the federal bank fraud statute could reach far beyond the realm of bank fraud to reach the securities fraud arena.
I would like to thank Arkady for his willingness to publish his article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to readers of this blog. Please contact me directly if you would like to submit a guest post.
Arkady’s guest post follows below. The Bukh Law Firm is dedicated solely to criminal defense. You can contact Arkady at Bukh Law Firm, P.C., 14 Wall St, New York NY 10005, (212) 729-1632, https://www.nyccriminallawyer.com
Resolving a Four Way Split
The federal bank fraud statute provides: “Whoever knowingly executes, or attempts to execute, a scheme or artifice – (1) to defraud a financial institution; or (2) to obtain any of the moneys, funds, credits, assets, securities, or other property owned by, or under the custody or control of, a financial institution, by means of false or fraudulent pretenses, representations, or promises; shall be fined not more than $1,000,000 or imprisoned more than 30 years, or both.” 18 U.S.C. § 1344.
Prior to the Supreme Court’s decision in Loughrin v. United States,[i] the lower courts had staked out four different positions. First, some circuits had held that a risk of loss requirement was necessary under section (1) of § 1344 but not section (2). See United States v. Stavroulakis, 952 F.2d 686 (2d Cir. 1992); United States v. Jacobs, 117 F.3d 82 (2d Cir. 1997) (holding that intent to harm is, in fact, an element of the offense); United States v. Nkansah, 699 F.3d 743 (2d Cir. 2012) (holding intent to harm is necessary); United States v. Thomas, 315 F.3d 190, 201 (3rd Cir. 2002) (holding that “mere deceptive conduct” is not enough); United States v. Wilkinson, 137 F.3d 214, 232 (4th Cir. 1998) (Hamilton concurring) (explaining that to convict under 1344(1), the government must prove that the financial institution was placed at risk of an actual or potential loss); United States v. Lemons, 941 F.2d 309, 316 & 316 n.3 (5th Cir. 1991) (“must place banks at risk of loss”); United States v. Odiodio, 244 F.3d 398, 400-401 (5th Cir. 2001) (holding that the defendants could not be convicted under the federal bank fraud statute, because there was insufficient evidence that they “placed the financial institution at risk of civil liability”); United States v. Sapp, 53 F.3d 1100, 1102 (10th Cir. 1995) (finding a risk of loss showing is required for a conviction under section (1) but not section (2)).
Second, some circuits came to the exact opposite conclusion; they found a risk of loss requirement under section (2) but not section (1). See United States v. Davis, 989 F.2d 244, 246 (7th Cir. 1993) (holding that defendant could not be convicted of bank fraud where the defendant deposited into an withdrew a fraudulently obtained, but actual IRS refund check from a bank); and United States v. Ponec, 163 F.3d 486, 488 (8th Cir. 1998) (under paragraph (2) of the statute “some loss to the institution, or at least an attempt to cause a loss, appears to be required.”).
Third, a number of other circuits found that neither section (1) nor section (2) requires the government to show the bank was exposed to an actual or potential risk of financial loss or civil liability. See United States v. Kenrick, 221 F.3d 19 (1st Cir. 2000); United States v. Hoglund, 178 F.3d 410 (6th Cir. 1999); United States v. McNeil, 320 F.3d 1034, 1037-40 (9th Cir. 2003); United States v. De La Mata, 266 F.3d 1275 (11th Cir. 2001).
Fourth, one circuit required that the government establish a risk of loss showing under both section (1) and section (2). See United States v. McCauley, 253 F.3d 815, 819-820 (5th Cir. 2001) (requiring the government to show the bank was faced with a risk of loss under both sections).
Next, Courts were even divided on the issue of whether sections (1) and (2) of the bank fraud statute were to be treated independently or read together. For instance, in United States v. Dennis, 237 F.3d 1295, 1303 (11th Cir. 2001), the Eleventh Circuit held that a “[a] conviction can be sustained under either [section] when the indictment… charge[s] both clauses.” See also United States v. Ponec, 163 F.3d 486, 488 (8th Cir. 1998) (same). In United States v. Thomas, 315 F.3d 190, 196-98 (3rd Cir. 2002), the Third Circuit held that section (2) does not set forth an independent basis of liability but rather “underscores the breadth” of section (1). Finally, while most courts that have considered the issue have not held that the risk of loss requirement goes to the elements of the crime, the Second Circuit concluded that the risk of loss requirement is an element of the offense in Jacobs, 117 F.3d at 91.
In Loughrin, the Supreme Court resolved this four-way circuit split on whether a risk of loss was a required to sustain a conviction under 18 U.S.C. § 1344(2). [ii] A unanimous Supreme Court clarified that the federal bank fraud statute “requires neither intent to defraud a bank nor the creation of a risk of financial loss to a bank,” as Justice Alito summarized it in concurrence.[iii] According to the Court, to read section 1344(2) as requiring that the defendant have the specific intent to defraud a bank, would ignore Congress’ use of the disjunctive “or” that separates section § 1344(1), which does refer to a specific intent to defraud a bank, from section § 1344(2), which does not require a showing of intent to defraud a bank.
From Bank Fraud to Securities Fraud
The reasoning of Loughrin; however, may reach far beyond bank fraud to the realm of Securities Fraud. In Loughrin, the Supreme Court held that one obtains money or property from a bank ‘‘by means of’’ a false statement only if the false statement ‘‘is the mechanism naturally inducing a bank . . . to part with money in its control.”[iv] The Court further explained that this test cannot be satisfied “where no false statement will ever go to a financial institution.”[v] The reasoning of Loughrin, if applied to the nearly identical language of Section 17(a)(2) of the Securities Act of 1933, should narrow the reach of that provision. Section 17(a) of the Securities Act of 1933 provides:
It shall be unlawful for any person in the offer or sale of any securities or any security-based swap agreement by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly—
(1) to employ any device, scheme, or artifice to defraud, or
(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
While some courts have treated these three subsections as all covering the same types of misconduct,[vi] most courts have interpreted the three subsections as proscribing different types of misconduct, with subsections (a)(1) and (a)(3) covering so-called “scheme” liability and subsection (a)(2) covering misrepresentation and omission liability.[vii]
In many respects, Section 17(a) is similar to Rule 10b-5, promulgated pursuant to Section 10(b) of the 1934 Securities Exchange Act, and subject to a few exceptions, the two provisions follow the same structure. However, Section 17(a) and Rule 10b-5 can be distinguished in two respects. First, Section 17 is broader than Section 10(b) and Rule 10b-5 because claims under Section 17(a)(2) and (a)(3) may be based on negligent conduct, while all Rule 10b-5 claims require proof of scienter. See e.g., Aaron v. SEC, 446 U.S. 680, 696-97 (1980); SEC v. Monarch Funding Corp., 192 F.3d 295, 308 (2d Cir. 1999); Pagel Inc. v. SEC, 803 F.2d 942, 946 (8th Cir. 1986). Second, Section 17 is narrower than Rule 10b-5 because it does not allow for private right of action. See e.g., Touche Ross & Co. v. Redington, 442 U.S. 560, 568-71 (1979); Finkel v. Stratton Corp., 962 F.2d 169, 174-75 (2d Cir. 1992); e.g., Finkel, 962 F.2d at 174 (explaining that Section 17 also only applies to “the offer or sale of securities,” whereas Section 10(b) and Rule 10b-5 reach the “purchase” of securities as well); see also SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 859 (2d Cir. 1968) (noting that Section 10(b) was intended as a “catch-all” enforcement provision directed at both buyers and sellers of securities and was purposefully written in broad language to effect this purpose).
Section 17(a)(2), in language nearly identical to the bank fraud statute, makes it unlawful to ‘‘obtain money or property’’ in the offer or sale of securities ‘‘by means of’’ a materially false statement.[viii] Both the bank fraud statute and Section 17(a)(2) require proof that the defendant obtained money or property ‘‘by means of’’ a false statement. Under the bank fraud statute, of course, that money or property must be obtained from a bank,[ix] while under Section 17(a)(2) the money or property must be obtained in the offer or sale of securities.[x] Thus, it appears that the Loughrin Court’s interpretation of the language of the bank fraud statute, in particular, the causal connection required by the “by means of” language would apply with equal force to Section 17(a)(2).
So what is the practical significance of Loughrin’s reasoning when applied to Section 17(a)(2)? Since the Government must prove in a bank fraud prosecution that the defendant’s fraud was “the mechanism naturally inducing a bank . . . to part with money in its control,” so too then should the SEC be required, in an action under Section 17(a)(2), to prove that the defendant’s fraud was “the mechanism naturally inducing” the buyer of securities “to part with money in its control.” In the wake of Loughrin, the bar has been raised since this cannot be proven “where no false statement will ever go to” a buyer of securities. Put simply: applying Loughrin to the language of Section 17(a)(2) would require proving that a false statement reach the buyer of securities, that the false statement be “the mechanism naturally inducing” the buyer of securities “to part with money,” and that the money reach the fraudster.
Applying the Loughrin reasoning to Section 17(a)(2), frauds with regard to trading in securities, such as accounting frauds, may become more difficult to prove because, in those situations, neither the company making the false statement nor any corporate officer obtains any money (even indirectly) from the buyer of securities. In the same vein, it is hard to see a scenario where a third-party such as an accounting firm may be liable if Loughrin’s reasoning is applied to Section 17(a)(2). Finally, Loughrin’s potential application to Section 17(a)(2) may also preclude misappropriation theory liability in insider trading cases under that subsection because, in those cases, the false statement is directed to someone other than the buyer of the securities.
While Loughrin was hardly a “landmark” decision or a “blockbuster,” its reasoning reaches far beyond bank fraud and has the potential to dramatically alter the securities fraud landscape and limit potential liability under Section 17(a)(2). However, given the significant number of tools in the SEC and Department of Justice’s arsenal, and the growing number of SEC enforcement actions and criminal actions brought by the Department of Justice, the possibility of further significant litigation on this point seems probable if not certain.
[i] 134 S.Ct. 2384 (2014).
[ii] 134 S.Ct. 2384 (2014). The “no risk of loss” holding appears only in footnote 9 of the Court’s opinion.
[vi] See, e.g., SEC v. Merchant Capital, LLC, 483 F.3d 747, 766 (11th Cir. 2007).
[vii] See, e.g., SEC v. Kelly, 817 F. Supp. 2d 340, 343-45 (S.D.N.Y. 2011).
[viii] 15 U.S.C. § 77q(a)(2).
[ix] 18 U.S.C. § 1344(2).
[x] 15 U.S.C. § 77q(a)(2).