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Recklessness Under the Federal Securities Laws
Whenever the Enforcement Division of the Securities and Exchange Commission (SEC) investigates potential fraudulent conduct, one of the key issues it must address is whether there is evidence of scienter; in the words of the Supreme Court, 'a mental state embracing intent to deceive, manipulate, or defraud.' (Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193-194, n.12 (1976)). In some cases ' for example, where an individual engages in insider trading, or falsifies accounting records as part of a scheme to manage earnings ' scienter may be fairly clear-cut. In other instances, the evidence regarding an actor's mental state is murky, a problem made more acute by the fact that the law treats a finding of 'recklessness' as the equivalent of fraudulent intent. The thin line between conduct that is reckless, and conduct that is something less ' for example, grossly negligent or, as the SEC put it in one case, 'alarmingly careless' (In the Matter of KPMG Peat Marwick, 54 SEC 1135 (2001), pet. for rev. denied, KPMG, LLP v. SEC, 289 F.3d 109 (D.C. Cir. 2002)), may mean the difference between a career-ending fraud charge, and a finding of a lesser regulatory violation or even no violation at all. When defense counsel engage the SEC staff in discussions about proposed enforcement actions, often a major focus of their efforts is to make the case that the client, though his conduct may not have been perfect, did not behave recklessly within the meaning of the securities laws.
This article offers guidance for executives and others on the interpretation and application of recklessness in SEC enforcement actions, as well as in private litigation, charging securities fraud. We first provide an overview of the concept of recklessness as it has evolved in the case law, and its use in the statutes the SEC enforces. The article next suggests business practices that may help deter claims of fraud based on allegedly reckless conduct. As will be seen, although the contours of recklessness are ill-defined and tend to shift with the facts of each case, some helpful governing principles can be identified.
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