In SEC v. Pirate Investor, LLC, 2009 WL 2949091 (4th Cir., Sept. 15, 2009), the SEC filed suit against Pirate Investor, LLC (“Pirate”), alleging the publisher made fraudulent misrepresentations violating §10(b) of the 1934 Securities Exchange Act. The court held that the Appellants’ conduct did constitute securities fraud and that the First Amendment to the Constitution did not shield their conduct.
According to the opinion, Pirate published investment newsletters and emails to subscribers. Co-defendant Frank Stansberry was Pirate’s editor-in-chief; he wrote and published Pirate’s investment newsletters and emails. In April 2002, Stansberry discovered that USEC, Inc. (“USEC”), which provided uranium enrichment services to the United States government, was renegotiating a contract with a Russian corporation. Under a 1993 international pact between the U.S. and Russia entitled “Megatons for Megawatts,” Russia sold warhead uranium to USEC for use in power plants. USEC would negotiate the contract with a Russian corporation, subject to U.S. and Russian government approval. Stansberry heard about negotiations of a new agreement in February 2002, but that the agreement was still awaiting approval from both governments. He contacted Steven Wingfield, USEC’s Director of Investor Relations to discuss the contract.
Subsequently, Stansberry, on behalf of Pirate, published a special report (the “Report”) on USEC’s upcoming contract. The Report analyzed USEC’s financials and role in the pact, and included a statement that a senior USEC executive told Stansberry about a May 22nd approval date for the contract. Stansberry also created and distributed an email solicitation (the “Solicitation”) containing the same claim of information about the contract approval date, but not disclosing which company it was. In order to discover the company’s identity, people had to pay Pirate $1,000 for a copy of the Report.
The Solicitation went out in various waves, with later emails also including representations about USEC’s rising share prices. Ultimately, Pirate sold 1,217 copies of the Report, earning $1,005,000 in net proceeds and $626,500 in profits for Pirate alone. The court, however, found that Wingfield never told Stansberry the agreement would be approved on May 22nd; in fact, it was approved June 19.
The SEC filed a complaint charging Pirate and Stansberry with securities fraud under § 10(b) of the ’34 Exchange Act. At trial, the U.S. District Court for the District of Maryland ruled that Pirate and Stansberry violated § 10(b) by falsely claiming a company insider provided the information in the Solicitation and Report. Pirate and Stansberry appealed to the U.S. Court of Appeals for the Fourth Circuit, arguing they had not violated § 10(b) and that the First Amendment protected their conduct.
The court first considered whether Pirate’s conduct was a § 10(b) violation. Section 10(b) violations require a false statement or omission of a material fact with scienter in connection with the purchase or sale of securities. Since Wingfield never gave Stansberry a date, the court said that Pirate’s statements were misstatements of fact. In determining whether the statements were material, the court applied the Food Lion standard: that information is material if there is a substantial likelihood that a reasonable investor would consider the fact important in deciding to buy or sell, or would have viewed the total mix of information about the company to be significantly altered by the fact’s disclosure. Under a clear error standard, the court said that since the information came from an insider there was no serious question of materiality because directors tend to have better access to information. The court also noted trial testimony by investors that the Solicitation’s purported insider information induced them to buy both the Report and shares of USEC, which also indicated the information was material.
Scienter, the court said, refers to “a mental state embracing intent to deceive, manipulate or defraud” and the SEC could meet its burden by showing Pirate and Stansberry acted intentionally or recklessly. After rejecting Pirate’s contention that the “actual malice” standard from New York Times Co. v. Sullivan required the SEC to prove the violations with clear and convincing evidence, the court emphasized that the proper standard was a preponderance of the evidence. Under that standard, the court said the district court’s ruling was not clearly erroneous since Wingfield did not give Stansberry a closing date; thus, it inferred that Stansberry knew his claim of inside information pointing to May 22nd was false. This, the court said, was classic evidence of scienter.
The court next analyzed the “in connection with” the purchase or sale of securities § 10(b) element, and began by considering factors other courts had used. The first factor was whether a securities sale was necessary to the completion of the fraudulent scheme. The court said the fraud was not complete when investors paid for the Report because those investors still needed to purchase USEC stock. However, once investors purchased USEC the stock price rose, thereby lending credibility to the Solicitation so Pirate could obtain more payments. Further, emails from Stanberry explicitly mentioned how he expected the rise in USEC stock prices would improve Pirate’s reputation among investors generally, bolstering future profits. Thus, the court said this factor indicated the statements were “in connection” with a securities transaction.
The court rejected the next factor, whether the parties’ relationship was such that it would necessarily involve trading in securities, because the decision whether to purchase securities rested solely with those who received the Solicitation and purchased the Report, not with Pirate.
The third factor looked to whether the defendants intended to induce a securities transaction. This was satisfied, said the court, because Pirate sent the Report to investors after they had paid the $1,000, because the Report also contained the misrepresentations, and because the Report instructed investors to “call [their] broker now and tell him to buy shares of USEC.”
In considering the fourth factor, whether material misrepresentations were “disseminated to the public in a medium upon which a reasonable investor would rely,” the court applied the Texas Gulf standard, which has two elements: 1) the misrepresentations in question were disseminated to the public in a medium upon which a reasonable investor would rely, and 2) they were material when disseminated. Since materiality was already established, the court focused on the test’s first prong. The Texas Gulf standard was focused on notice and concerned with attaching liability under the securities laws for statements made in any medium, no matter how tangentially related to the securities markets, and that individuals would run the risk of unknowingly incurring § 10(b) liability. After admitting that most investors would not rely on stock tips distributed as SPAM, the court refused to exempt Pirate and Stansberry because they knew that they were directing their misstatements to particular investors who did rely on internet investment advice.
Pirate and Stansberry contended that to apply § 10(b) to everyone who makes statements about securities would have a chilling effect on reporting of financial matters. They asked the court to carve out an exception for publishers of non-personalized financial news who do not have a financial interest in the securities they discuss. The Defendants argued that the cannon of constitutional avoidance demanded such an exception because “in connection with” is too vague. Rejecting this argument, the court explained that the cannon applies only when a statute is found to have more than one plausible construction. Section 10(b), the court explained, was not vague because Congress intended it to provide a flexible regime for addressing new, unforeseen types of fraud. In this case the cannon did not apply because there was only one interpretation. Since Pirate and Stansberry’s statements had met three of the four factors for being “in connection with” a securities transaction, the court upheld the lower court’s ruling that they had indeed violated § 10(b) of the Exchange Act.
Finally, the court addressed Pirate and Stansberry’s contention regarding First Amendment protections. The statements were not protected speech, ruled the court, because the First Amendment does not shield fraud. Laws directly punishing fraudulent speech survive constitutional scrutiny even where applied to pure, fully protected speech; thus, the First Amendment did not protect Pirate and Stansberry’s misleading assertions in the Report and Solicitation. Similarly, the court ruled that the permanent injunction was not an unlawful prior restraint because it only enjoined engaging in unprotected (fraudulent) speech.
Primary materials for this case may be found on the DU Corporate Governance web site.