Alain Leibman writes:
Under 15 U.S.C. § 78ff (a), a defendant who willfully violates any SEC rule or regulation is subject to imprisonment for up to 20 years, unless "he proves that he had no knowledge of such rule or regulation." This provision has been characterized as a safeguard implemented by Congress to ensure that severe criminal punishments fall only on those who have acted with scienter. United States v. O’Hagan, 521 U.S. 642, 665 (1997).
But what exactly does it mean to have "no knowledge" of the relevant rule or regulation? Must a defendant establish to the sentencing judge’s satisfaction that he was unaware entirely of the existence of the particular rule or regulation which he has been convicted of violating? That would be a very high bar indeed for a defendant to prove. Or is it sufficient for him to show that, although aware of the existence of the provision, he did not know that it was applicable to his specific conduct? The latter interpretation would bring Section 78ff(a) very close in meaning to the "willfulness" required to be proven by the government in tax prosecutions, i.e., that only a taxpayer who knew of, and specifically intended to violate, a particular tax provision with his conduct could be punished. See Cheek v. United States, 498 U.S. 192, 200-02 (1991).
The Eighth Circuit recently addressed this fairly novel question in United States v. Behrens, 2013 WL 1760325 (8th Cir., April 25, 2013). Behrens, who held multiple securities licenses, pled guilty to violating Rule 10b-5 by issuing worthless promissory notes to investors in his company. At sentencing, he argued that the safe harbor provision of Section 78ff allowed him to avoid jail because he did not know that the Rule was applicable to promissory notes which he contended were not "securities" under its terms. The Court of Appeals, however, upheld the conviction.
Addressing for the first time the meaning of the safe harbor provision, the Court of Appeals rejected the alternative constructions placed on the language by the defendant and the government. The defendant’s preferred construction, that the safe harbor applied in any situation where a defendant did not understand his specific conduct to violate a rule of which he was admittedly aware, was too great a departure from the general principle that ignorance of the law is no defense. The court saw no reason to import from the criminal tax area the requirement that prosecution, and exposure to jail, required proof of highly specific knowledge of legal requirements; unlike the former area, where unsophisticated laypersons would otherwise be prosecuted for violating technical or obscure provisions, in the securities area defendants are often licensed persons, like Behrens, who did not need the "added protection" from jail exposure which his interpretation offered. The government’s proffered interpretation, which would have burdened a defendant with proving his complete lack of awareness even of the existence of a rule, would hardly offer a safeguard ensuring only scienter-based prosecutions, because it would provide a defense only to the most unwitting defendants.
Choosing instead to follow the Ninth Circuit case of United States v. Reyes, 577 F.3d 1069 (9th Cir. 2009), the Eighth Circuit adopted a middle ground. The safe harbor language, it held, means that a defendant succeeds in establishing a no-knowledge defense "if he can show that he had no knowledge of the substance of the SEC rule or regulation is convicted of violating," regardless of whether he understood its particular application to his conduct. In the present case, Behrens’ statements at sentencing showed that he fully understood both the existence of Rule 10b-5 and its substance, but simply maintained that his fraudulent promissory notes did not qualify as "securities" under the Rule. Thus, the appeals court held, he failed to carry his burden of showing that the safe harbor applied in his case and he was appropriately sentenced to prison.
(Alain Leibman, Esq., the author of this entry and a co-author of this blog, is a partner with Fox Rothschild LLP, based in our Princeton, NJ office. A former decorated federal prosecutor, he practices both criminal defense and commercial litigation in federal and state courts)