Table of Contents

I. Introduction
II. What Is SEC Rule 10b-5?
III. The Elements of a Rule 10b-5 Claim
a. Is the Government a “Person” Falling Under the Scope of 10b-5?
b. Material Misrepresentations
c. Scienter or Intent
d. Reliance
IV. How Does 10b-5 Apply to Reporting and Accounting Exemptions?
a. Government Securities Exemptions
b. Private Entity National Security Exemptions
c. Federal Entity National Security Exemptions
V. Conclusion
VI. About Us

January 24, 2019

“Well, we are against fraud, aren’t we?”- Then-Commissioner of the SEC, Sumner Pike, in the only comment made before approving Rule 10b-5

I. Introduction

The creation of the Securities and Exchange Commission (SEC), and its various powers to protect against financial fraud, are among the least debated bits of law created of all time. The creation of SEC’s most sweeping regulatory power of all, Rule 10b-5, was approved with no debate or comment whatsoever except one: the then-Commissioner of the SEC, Sumner Pike, said “Well, we are against fraud, aren’t we?” (See “The Interest of the Securities and Exchange Commission in Private Civil Actions Under the Securities Acts,”

The exact contours of 10b-5 are something we’ll discuss a fair bit over the course of this article. However, it can simply be summarized as a rule against omissions or misrepresentations connected to the sale or purchase of a security. It, and the SEC as a whole, arguably exist with the primary purpose of ensuring investors are both not deceived and are as informed as possible about their investments. So how does this come into play when, as we wrote previously, the government is sometimes required to alter or omit financial statements behind government issued securities, and requires the same of their publicly traded contractors, for the purpose of national security and maintaining confidentiality? (See

The government, both federal, state and local, can all be subject to the rules of the SEC. How does the law make national security exemptions and 10b-5 disclosure requirements play nice when it comes to the disclosure documents for government issued securities? In order to explore and understand this question, let’s take a look at exactly how the SEC and 10b-5 work, some of the various national security reporting exemptions at play, and how these national security exemptions would be taken into account when it comes to 10b-5. Then, at the end, we will wrap up by taking a look at some hypothetical situations, and how the laws we’ve discussed–both 10b-5 and national security exemptions–might apply to those situations.

II. What Is SEC Rule 10b-5?

All federal agencies get their power to create enforceable regulations from a delegation of power from Congress, offering them the ability to essentially act as Congress would within a particularized scope. For the SEC, this grant of power came in Section 10 of the Securities Exchange Act of 1934 (the ‘34 Act) with the goal of enforcing the Securities Act of 1933 (the ’33 Act). Agencies such as the SEC can then create regulations within the scope of their power grant and, generally, enforce them with the power of law (see The Laws That Govern the Securities Industry, available at The SEC’s regulations can be found in Code of Federal Regulations Title 17 (see 17 CFR, available at

The 1934 Act included 10b to provide the SEC a general power to enact rules combatting manipulative and deceptive practices in securities trading. The regulations the SEC came up with to combat this are all listed as subsections to the initial 10b grant of power. These regulations evolved, and continue to evolve, over time as new rules are added or existing rules amended (see 17 CFR 240, Subpart A, Subject Group 66, available at

As a few examples, Rule 10b-1 provides that the SEC’s fraud regulations be applied even to normally exempt securities such as federal securities or the municipal securities issued by state and local governments (see 17 CFR 240.10b-1). Rule 10b-3 forbids securities brokers and dealers from directly or indirectly engaging in securities fraud (see 17 CFR 240.10b-3). Rule 10b-10 requires certain disclosures in writing by brokers and dealers before completing a securities transaction (see 17 CFR 240.10b-10). However, the broadest of these rules, generally considered a bit of a catch-all for the SEC to prevent financial fraud otherwise not considered and the source of the majority of lawsuits brought both by the SEC and the public, is 10b-5.

10b-5, codified in the Code of Federal Regulations at 17 C.F.R. 240.10b-5, can be very quickly summarized as a rule prohibiting acts or omissions which result in fraud or deceit in connection with purchase or sale of any security. It’s perhaps best known as the rule forbidding insider trading, but is extremely broad in scope and can cover any number of financial evils. As with most law, although it can be simply put, the actual application of 10b-5 is far from simple.

10b-5 makes it unlawful for any “person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,” to:

“(a) …employ any device, scheme, or artifice to defraud, (b)…make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c)…engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”

This means that a 10b-5 violation requires showing that: (1) the accused party counts as a person under the scope of 10b-5; (2) manipulation or deception has occurred through misrepresentation or omission; (3) the deception or omission was important enough to be considered “material”; (4) the deception or omission was made in connection with the sale or purchase of securities; (5) the deception or omission was done recklessly or intentionally; and, although this can sometimes be presumed as we’ll discuss later, (6) the accusing party relied on the misrepresentation. From there, the analysis shifts depending on whether action is being brought by the SEC itself or a private party. Let’s take a deeper look at these elements.

III. The Elements of a Rule 10b-5 Claim

Rule 10b-5 can be enforced against makers of a deceptive statement by both the SEC, and by private citizens through a private lawsuit. However, private lawsuits have several additional elements plaintiffs need to prove, and it requires a plaintiff to have both bought the relevant securities, and to have suffered a loss as a result. SEC and private actions do share a few basic elements, though (see id.).

A private party suing for a 10b-5 violation needs to establish that they relied and acted on the deception or omission, have standing1 to sue in the first place, and finally that they suffered losses caused by the deception or omission.

What’s more, whether brought by a private party or the SEC itself, these legal actions are somewhat limited in who they are brought against. The proper defendant of a 10b-5 lawsuit or enforcement action is the direct maker of the relevant misleading statement (see Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011)). Aiders and abettors, like lawyers, accountants, and other employees of an entity, are not liable. Instead, it is the direct source of a statement, and often the legal entity itself, that are held liable if these elements are proven (see id.).

These issues of standing and finding a proper defendant are important. However, the focus here is on where a person would have committed a 10b-5 violation as opposed to suing under the rule, so we will mostly be focusing more on the shared elements of who is a person under 10b-5, material misrepresentation, scienter (intent), and reliance.

a. Is the Government a “Person” Falling Under the Scope of 10b-5?

To a reasonable person, the question of who constitutes a person would likely be a very simple one. However, lucky you, you’ve wandered into the realm of ridiculous complexity that is law. For purposes of 10b-5, a “person” is far from limited to natural persons. It certainly includes businesses, corporations, and more. However, perhaps surprisingly, one of the most complicated and disputed issues for 10b-5 purposes is whether the federal government–as well as state and local governments–count as a person. This is further complicated by greater issues as to when and where state and local governments can properly have a 10b-5 claim brought against them.

The initial ‘34 Act has drawn a great deal of debate as to whether the government was meant to be a person. The version of the ‘33 Act passed through the House included the government as a person. However, the version ultimately passed by the Senate removed this. Then, in a 1934 House-Senate conference, it was determined that the government did in fact count as a person. That being said, at the same conference which made all the provisions under the ‘33 and ‘34 Acts applicable to fraud involving state and local government securities–no matter whether the defendant was a private person, a corporation, or the government–the ability for a private person to seek a remedy for fraud involving state and local governments was removed. This conflict in the government’s intent to let itself, or state and local governments, be subject to 10b-5 was deepened by the fact that 1975 amendments to the ‘34 Act explicitly include a “government, or political subdivision, agency, or instrument of a government” as a person subject to SEC rules like 10b-5. However, those amendments still didn’t change the fact that state and local government securities have their own registration process, as discussed later in the article. Instead, the current law specifically exempts most government securities from the majority of regulations regarding most domestic securities (see Local Government Liability Under Rule 10b-5, Margaret v. Sachs, pp. 35-42, available at

However, as you’ve seen above in our discussion of Rule 10b-1, SEC regulations apply to even these usually exempted securities. Once traded, the government entity which issued the security is generally subject to SEC scrutiny. For instance, SEC rules require offerings of state and local government securities exceeding $1M (a relatively paltry sum in the scheme of government securities) to include disclosure documents for investors and have found these state and local governments to be proper 10b-5 fraud defendants based on the contents or lack of contents of these disclosure documents (see Rule 15c2-12, 17 C.F.R. § 240.15c2-12 (1991) [hereinafter rule 15c2-12]). Rule 15c2-12 became effective on January 1, 1990 (see Municipal Securities Disclosure, Securities Exchange Act Release No. 26985, 3 Fed. Sec. L. Rep. (CCH) 25,098, at 18,190 (June 28, 1989)). However, even this rule has a number of exemptions. Most notably, literally any security can be exempted by written request if the SEC determines that this exemption is consistent with a public interest (such as confidentiality and national security) and the investors are sufficiently protected (see Rule 15c2-12(e)). If exempted, the security, and the reporting of that security, would be unlikely to create a 10b-5 issue. This concept of exempted municipal securities and the liability associated with them is something we’ll get into much more depth with later in this article.

It’s also worth noting that the government–both federal, state and local–can be liable under 10b-5 for participating in fraud involving corporate securities as opposed to simply the municipal securities they themselves issue (see, e.g., In re Citisource, Inc. Sec. Litig., 694 F. Supp. 1069, 1072 (S.D.N.Y. 1988) (claim made against New York City)). For instance, New York City was found to count as a person for purposes of 10b-5 liability where they had issued and sold corporate stock of CitiSource (see In re Citisource, Inc. Securities Litig., 694 F. Supp. 1069 (S.D.N.Y. 1988)). The SEC has also successfully brought a financial fraud suit–although not a 10b-5 suit–against a city Mayor, the city, and other city administrators over selling bonds as part of a public-private venture to fund a movie project but failing to disclose that the partnership backing the project had disintegrated before any bonds were issued (see SEC Secures Federal Judge Order Against Mayor Based on Control Person Liability, Paul Maco, Katharine D’Ambrosio, Britt Cass Steckman, Bracewell & Giuliani LLP, Feb 5, 2015, available at

These rulings, and several other rulings, have highlighted a trend in case law towards finding municipal governments to be 10b-5 persons while being more reticent when it comes to state governments. The crux of the courts’ distinction here, especially when it comes to suing for damages as opposed to an injunction to make a state or local government do or stop doing something, is a larger constitutional issue–the Eleventh Amendment. The Eleventh Amendment generally prevents a citizen from suing their own state in federal court (see Hans v. Louisiana, 134 U.S. 1 (1890), Bair v. Krug, 853 F.2d 672 (9th Cir. 1988)). This has seen state governments and their representatives frequently dismissed as defendants from 10b-5 suits, even though they count as a person for 10b-5 purposes (see Bair v. Krug, 853 F.2d 672 (9th Cir. 1988); Charter Oak Fed. Say. Bank v. Ohio, 666 F. Supp. 1040 (S.D. Ohio 1987); Finkielstain v. Seidel, 857 F.2d 893 (2d Cir. 1988)). It should be noted that this doesn’t prevent suits brought by the SEC itself based on reports from private citizens.

Courts are much less reluctant to move forward when the target of a 10b-5 suit is a local government or its representative as opposed to a state government or representatives. They’ve moved forward with suits against New York City, South Bend, and quite a few more cities/city representatives. (See In re Citisource, Inc. Sec. Litig., 694 F. Supp. 1069, 1072-78 (S.D.N.Y. 1988); and Gorsey v. I.M. Simon & Co., [1987 Transfer Binder] Fed. Sec. L. Rep. (CCH) 1 93,173 (D. Mass. Feb. 23, 1987). See also Gorsey v. I.M. Simon & Co., [1989-90 Transfer Binder] Fed. Sec. L. Rep. (CCH) % 94,996 (D. Mass. March 6, 1990); Ross v. Bank South, N.A., 837 F.2d 980, 1003 (11th Cir. 1988), aff’d on other grounds, 885 F.2d 723, 728 n.6 (11 th Cir. 1989) (en bane) (appeal dismissed as to Vestavia Hills), cert. denied, 110 S. Ct. 1924 (1990); see In re Washington Pub. Power Supply Sys. Sec. Litig., 623 F. Supp. 1466, 1476 n.4, 1478-80 (W.D. Wash. 1985), aff’d on other grounds, 823 F.2d 1349 (9th Cir. 1987).)

So does the government count as a person for purposes of 10b-5? Almost certainly yes. However, the unhelpful caveat here is that while government counts as a person under 10b-5, the actual answer to whether they fall under the scope of 10b-5 requires a lot deeper analysis that unfortunately doesn’t always have a strict yes or no answer under existing case law. Part of the problem is that 10b-5 deals with publicly traded securities; any government security that is publicly traded has a slew of regulations and exemptions that impact the 10b-5 scope analysis. We’ll discuss some of these later to hopefully better understand this relationship. While it is uncertain (legally speaking) how liable the different parts of government are under 10b-5, the private entities trading government securities downwind of the government are liable.

b. Material Misrepresentations

Next, for both SEC and private lawsuits, there must be some form of manipulation or deception made in connection with the purchase or sale of securities, and that manipulation or deception must be material. Materiality is a bit of a legal buzzword that changes based on context, but for a 10b-5 violation, it occurs where “there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available” (Caiola v. Citibank, N.A., New York, 295 F.3d 312, 329 (2d Cir. 2002) (quoting Inc. v. Levinson, 485 U.S. 224, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988)). In other words, there must be “a substantial likelihood that a reasonable shareholder would consider it important” in making his investment decision (Section 10(b) Litigation: The Current Landscape, American Bar Association, This investment decision can be as clear-cut as a decision to buy a certain security or not, or can boil down to the exact price an investor would be willing to pay for a given security. For instance, if they overpaid for a certain security, or would have sold a security off if they had known the truth, both are examples of investor decisions that might change given a piece of material information.

There obviously isn’t a particular reasonable shareholder that the courts can call up and ask for their opinion whenever there’s a 10b-5 case, so this analysis of materiality is a highly fact-specific one and changes depending on the industry norms and standards. This is intentional; the courts–and even the Supreme Court–have specifically eschewed any bright-line rules for materiality, arguing:

A bright-line rule indeed is easier to follow than a standard that requires the exercise of judgment in the light of all the circumstances. But ease of application alone is not an excuse for ignoring the purposes of the Securities Acts and Congress’ policy decisions. Any approach that designates a single fact or occurrence as always determinative of an inherently fact-specific finding such as materiality, must necessarily be overinclusive or underinclusive. In TSC Industries this Court explained: “The determination [of materiality] requires delicate assessments of the inferences a `reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him . . . .” (426 U.S., at 450). After much study, the Advisory Committee on Corporate Disclosure cautioned the SEC against administratively confining materiality to a rigid formula. Courts also would do well to heed this advice. (Basic Inc. v. Levinson, 485 U.S. 224, 235 (1988))

The thought process here is that materiality of information related to securities is too diverse and fact-specific a topic to apply a bright-line rule for when something is properly material (see Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 30-31 (2011)).

Materiality itself is intentionally a fairly high evidentiary bar. The Supreme Court has stated that this is intentional to avoid an “overabundance of information… ’simply to bury [investors] in an avalanche of trivial information–a result that is hardly conducive to informed decision making’” (see Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988)).

That being said, there are some notable factors that can come into play when determining materiality, even if it is impossible to pin down any one factor as independently dispositive on the issue. For example, an omission or deception can be material if it misstates the risk involved in an investment. In Caiola v. Citibank, Citibank misstated the risk of Caiola’s portfolio when it agreed to perform synthetic trades for the investor, with delta hedging on Citibank’s side, but stopped performing delta hedging on Caiola’s behalf, without informing Caiola. Caiola’s complaint alleged “Citibank thereby exposed Mr. Caiola to precisely the risks that Citibank advised he could and should avoid through the use of synthetic trading” (id. at 329). The court determined “These misrepresentations are clearly sufficient under Rule 10b-5 because they are the sort that ‘a reasonable person would consider important in deciding whether to buy or sell shares'” (id., citing Azrielli v. Cohen Law Offices, 21 F.3d 512, 518 (2d Cir. 1994)).

It’s notable that just because information adversely affects the value of a security, that does not by itself guarantee materiality. The adverse information has to be substantial enough to alter the total mix of information available to the person buying or selling the security such that it would change the decision of a reasonable investor. This can require a statistically likely negative impact of the adverse information, but courts have found on a number of occasions that just because something obviously bad was misrepresented there isn’t necessarily materiality. (See Matrixx, 131 S.Ct. at 1321., In re Merck Co., Inc. Securities, MDL No. 1658 (SRC), Civil Action No. 05-1151 (SRC), Civil Action No. 05-2367 (SRC), at *1 (D.N.J. Aug. 8, 2011).)

Another common way courts help determine whether something is material is to look to changes in the actual value of the security in question after the allegedly material statement is made. Essentially, materiality can be partially determined by looking at the movement in value–for good or for bad–after the statement is made (see Oran v. Stafford, 226 F.3d 275, 281 (3d Cir. 2000)). However, in practice, it is usually used by courts to prove that the statement was not material (looking to a lack of movement in the value of the security beyond the norm) as opposed to determining that a statement actually was material (see id.). What’s more, the factor is much more difficult to use with omissions, and generally only is used in situations where an allegedly materially misleading statement has been actively made.

Disclaimers can also impact materiality; courts occasionally say that a disclaimer to a representation–saying that an investment is highly risky or that research on a topic was limited and partially inconclusive and more research is needed–is sufficient to negate the materiality of some misrepresentations (see id.). This does not mean that a disclaimer removes the possibility of 10b-5 liability, far from it. Instead, it means that such a disclaimer can mitigate the impact on a reasonable investor’s choice to buy or sell a security while still looking at the totality of the circumstances.

Omissions also work slightly differently from misrepresentations when it comes to materiality. They are only material and actionable when the omission necessarily renders another affirmative statement made by the defendant false or misleading, or there is some sort of existing statutory duty to disclose the omitted information. (See Basic, Inc. v. Levinson, 485 U.S. 224, 239 n. 17 (1988); Oran v. Stafford, 226 F.3d 275, 285 (3d Cir. 2000); Glazer v. Formica Corp., 964 F.2d 149, 157 (2d Cir. 1992); Backman v. Polaroid Corp., 910 F.2d 10, 12 (1st Cir. 1990) (en banc); In re General Motors Class E Stock Buyout Sec. Litig., 694 F. Supp. 1119, 1129 (D.Del. 1988).) Speculative situations are difficult to establish materiality for, specifically because the fluid nature of a speculative situation makes it difficult to reasonably rely on as an investor (see Basic Inc. v. Levinson, 485 U.S. 224, 232 (1988)).

However, the courts have found this especially true in the case of 10b-5 actions involving omissions (see id.).

All this being said, the goal of 10b-5 is:

"To substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry" (SEC v. Capital Gains Research Bureau, Inc., 375 U.S., at 186; Accord, Affiliated Ute Citizens v. United States, 406 U.S. 128, 151 (1972); Santa Fe Industries, Inc. v. Green, 430 U.S., at 477). The role of the materiality requirement is not to “attribute to investors a child-like simplicity, and inability to grasp the probabilistic significance of negotiations” (Flamm v. Eberstadt, 814 F.2d, at 1175), but to filter out essentially useless information that a reasonable investor would not consider significant, even as part of a larger “mix” of factors to consider in making his investment decision. (See Basic Inc. v. Levinson, 485 U.S. 224, 234 (1988).)

The intent of the law here is to make sure investors get everything that is important to their decision. Materiality is a high bar, but it’s there to filter out less impactful information as opposed to provide a shield for dishonest brokers. That being said, in practice, materiality can be a hard hurdle for a 10b-5 case to clear and often requires substantial expert testimony from both sides.

c. Scienter or Intent

Plaintiffs must additionally show scienter (intent), standing, reliance, causation, and damages. To establish scienter, a plaintiff must show more than mere negligence, but instead some form of recklessness or actual knowledge of a manipulation or deception, on the part of a specific agent or agents of an entity (see Matrix Cap. Mgmt. Fund, L.P. v. BearingPoint, Inc., 576 F.3d 172, 182 (4th Cir. 2009) (quoting Teachers’ Ret. Sys. of La. v. Hunter, 477 F.3d 162, 184 (4th Cir. 2007)). In other words, being unreasonable or careless with regards to the information in question isn’t enough. The rule requires a conscious disregard for the truth and the risks being inaccurate would impose on others. Of course, being willfully misleading, or having actual knowledge of deception or manipulation works as well, but can often be much harder to prove (see Gerstle v. Gamble-Skogmo, Inc., 478 F.2d 1281, 1301 n.20 (2d Cir. 1973)). This can be done with “facts showing either that the defendant had both motive and opportunity to commit fraud, or strong circumstantial evidence of conscious misbehavior or recklessness” (see Section 10(b) Litigation: The Current Landscape, American Bar Association,, citing Novak v. Kasaks, 216 F.3d 300, 307 (2d Cir. 2000)).

d. Reliance

A private plaintiff must also show they relied on the deception. In the case of omissions of fact, reliance is often presumed, and in the case of affirmative statements, “the most direct way to demonstrate reliance is to show that the plaintiff was aware of a company’s statement and engaged in the relevant transaction based on that specific misrepresentation” (Section 10(b) Litigation: The Current Landscape, American Bar Association, If the plaintiff suffered a loss caused by relying on that misrepresentation (such as if the price of stocks the plaintiff bought in reliance drops), they can usually recover damages equal to the benefit they would have received had the misrepresentation been the correct information.

For example, if a CEO lies about a large government contract their company was granted, and you invest based on this statement, you have relied on their misrepresentation. If that same CEO concealed a project which suffered substantial losses and you would not have invested–or even if you would have sold off your stock in the company–had you known then you have reliance on his omission.

In addition, there are some cases where reliance can presumed if the plaintiff was buying from a public market. The Supreme Court has held that the typical investor presumes the price set by the market for a public security is a representation of all public information about that company, and there is a rebuttable presumption that there is a reliance on all publicly available misrepresentations issued by that company (see Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398, 2414 (2014)).

IV. How Does 10b-5 Apply to Reporting and Accounting Exemptions?

Now that you know how 10b-5 works in general, we can take a look at how government securities are specifically regulated within the confines of both 10b-5 and a broader level. In general, rule 10b-5 fully applies to any private entities, as we discussed above. However, there are some exemptions to SEC reporting requirements which can result in omissions in both internal accounting and SEC filings. These come in two forms: national security exemptions, and government securities exemptions.

a. Government Securities Exemptions

The Government Securities Act of 1986 authorizes the Secretary of the Treasury to regulate brokers and dealers of government securities in conjunction with the SEC. Specifically, the SEC shares authority with the Comptroller of the Currency, the Board of Governors of the Federal Reserve System (see The History and Organization of the Federal Reserve: The What and Why of the United States’ Most Powerful Banking Organization, available at, and the Federal Deposit Insurance Corporation, depending on the type of entity (see 15 USC 78c(a)(34) “appropriate regulatory agency”).

These securities follow rules promulgated by both the SEC and the Treasury, and have a separate registration and reporting process (see SEC Guide to Broker/Dealer Registration, available at However, the underlying statute also grants the Secretary of Treasury the ability to “conditionally or unconditionally exempt any government securities broker or government securities dealer, or class of government securities brokers or government securities dealers” from most of the requirements (see 15 USC 78o-5(a)(5)). This means that while this division of authority still involves the SEC and rule 10b-5, the regulations are fluid and subject to change.

For instance, the Office of the Comptroller of the Currency handbook advises that “[b]anks’ transactions in government securities are subject to the anti-fraud provisions of section 10(b) of the Exchange Act and SEC Exchange Act Rule 10b-5, as well as section 17(a) of the Securities Act of 1933” (see Comptroller’s Handbook, Government Securities Act, p. 16, available at However, it also holds banks to other standards determined by the Comptroller, such as “[i]n recommending to a customer . . . a government security, a bank that is a government securities broker or dealer shall have reasonable grounds for believing that the recommendation is suitable for the customer” (id. at 15). The Board of Governors of the Federal Reserve System has similar provisions for state member banks (see Federal Reserve System Government Securities Sales Practices, available at

b. Private Entity National Security Exemptions

There are also two processes by which a private entity can (and in most cases must) refrain from disclosing classified information regarding any securities; government or private. First, as we discussed in The Black Budget: The Crossroads of (Un)Constitutional Appropriations and Reporting (available at, certain internal accounting and external reporting requirements can be waived for private entities by the Director of National Intelligence. Normally, issuers of securities need to “make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer”; and maintain internal accounting according to generally accepted accounting principles (GAAP) (see 15 USC 78m(b)(2)). Failing to do so can result in criminal liability (see 15 USC 78m(b)(5)). A waiver from the Director of National Intelligence can remove some of those requirements, allowing private entities to deviate from GAAP and even alter their books if the waiver allows.

Second, any documents filed with the SEC are subject to a general national security exemption under 17 CFR 240.0-6, which requires no “. . . document filed with the Commission or any securities exchange shall contain any document or information which . . . has been classified.” However, the SEC still requires the filing of “a statement from an appropriate department or agency of the United States to the effect that such document or information has been classified or that the status thereof is awaiting determination” (see 17 CFR 240.0-6(b)). This statement must be in writing and must be obtained prior to reporting (or in lieu of reporting) any classified information to the SEC. This second requirement, in theory, creates a paper trail both on the classifying agency’s side, and on the SEC report, which should contain statements that certain information has been omitted. Such a paper trail probably qualifies as compliance with Rule 10b-5.

c. Federal Entity National Security Exemptions

The Federal Government and its associated reporting entities have quite a few situations where they can, and often are required to, omit or alter their financial statements. A notable example of this is the Federal Accounting Standards Advisory Board’s (FASAB’s) recent Statement of Federal Financial Accounting Standards 56 (SFFAS 56). SFFAS 56 allows federal agencies, and an enormous number of entities associated with the government, to alter and outright omit spending information where it is necessary to protect classified information. For a more complete understanding of SFFAS 56, see our previous article on the topic (FASAB Statement 56: Understanding New Government Financial Accounting Loopholes, available at

V. Conclusion

The SEC’s Rule 10b-5 is one of many laws and regulations protecting against omissions or misrepresentations regarding securities, and is one of the most commonly used and widely applicable of those regulations. However, Rule 10b-5 itself is highly fact-specific, and courts have explicitly stated that is intended. There is no bright-line rule on what sort of exact behavior is required. Often, Rule 10b-5 violations are proven in hindsight, after the losses of tremendous amounts of money (or equivalent opportunity costs). The various national security exemptions, like the FASAB’s new SFFAS 56, or the longstanding SEC national security exemption, make things even more complex regarding applying Rule 10b-5 to situations where lack of disclosure is expressly allowed (or even required, and we’ve put together a few hypotheticals to illustrate this complexity in Appendix A, if you want some additional examples).

The takeaway here is, when it comes to the legal duties regarding disclosure, don’t take it for granted. Do your own due diligence, and consult with experts you trust before engaging in a large investment, even if the investment is something as ostensibly safe as Treasury bonds. You’re free to simply trust in disclosure laws, but their fact-specific nature often results in violations that need to be fully argued and proven in court, which can cost you substantial legal fees for a coin-flip chance of prevailing.

Appendix A. Hypotheticals

These national security exemptions, such as SFFAS 56, raise the question of how much about the government’s accounting practices a broker of government securities–and especially a primary dealer–would have to disclose to avoid a 10b-5 issue. To help you understand this question, let’s take a look at a few hypothetical situations and how the law would be analyzed here.

Hypothetical A:

Prime-Time Bills, Inc. (PTB) is a newly incorporated and approved primary dealer (, who intends to run a business of buying U.S. Treasury securities from the Federal Reserve System to sell those securities to investors. What disclosures does PTB need to make about the government securities it’s trading in order to be safe from an SEC 10b-5 enforcement action? What sort of information is “material” when it comes to government securities?

Hypothetical B:

Shadow Aeronautics, LLC (“SA”) is a private government contractor that designs and builds stealth aircraft for the military. While they do subcontract some non-classified work for major airlines, the majority of their profits come from government contracts that are classified. What can SA do in order to comply with SEC Rule 10b-5 and avoid an enforcement action, without revealing classified information?

Elements of Rule 10b-5

Person: PTB is a corporation, a private entity, which qualifies as a person under securities laws. They only buy and sell government securities, so they need to register with the SEC as a broker/dealer of government securities. Because they aren’t a bank or savings association, they are regulated by the SEC directly.

SA is an LLC, a private entity, which also qualifies as a person under securities laws. They don’t trade in government securities at all, so they register with and are regulated by the SEC like any other private entity.

Deception or Omission: Neither PTB nor SA are allowed to make any affirmative statement or omit information, subject to the materiality requirements below.

However, SA deals with classified projects, which cannot be disclosed to the public. Therefore, SA has to get a waiver from the agency that classified whatever project they’re working on, and file that waiver with the SEC instead of information on that project. If SA does this, they are allowed to omit information that may be material to a potential shareholder, although they still can’t lie (like say they won contracts they instead lost).

Material: For a misrepresentation or omission to be material, it has to be substantial enough to affect the “total mix” of the information available to a investor, such that it would change the mind of a reasonable investor. This can be done by misstating the risk involved in an investment. For instance, if PTB sells a low risk government security, but knows the security has details that result in a higher risk than PTB states, that may be a material misrepresentation. Then, the information being disclosed, and the information being omitted, is considered in the context of the “total mix” of available information. For instance, in the case of PTB’s government securities, a recession, a bankruptcy (in the case of municipal securities), or a new piece of legislation/regulation that concerns Treasury securities, could all change the risk level of the securities PTB trades in. That underlying change then needs to be examined in the context of other available information, and the more speculative the change, the less likely it is to be material.

For example, if government accounting can be classified under the new accounting standards set by FASAB (see, whether those accounting changes also alter the risk level of government securities needs to take into account the fiscal stability of the government as a whole, the amount of money allocated to paying such securities back, as well as other factors a reasonable investor would consider in determining the risk levels and creditworthiness of a government security. If any information like that is omitted, would that omission be so significant as to change how a reasonable investor would approach that security?

If the misrepresentation results in a negative impact value on the value of the securities (for instance, by artificially inflating the value, then dropping the value once the deception becomes known), the misrepresentation is considered material. For instance, if SA represents that they won several government contracts, but they didn’t (or the contracts were worth far less than SA said), their stock prices will probably fall when the information comes out. That would result in a negative impact on stock value, and the information would be considered material.

Scienter: The misrepresentations or omissions need to be done either knowingly, or with a conscious reckless disregard for the truth and consequences of the statement. If the agent making the statement for either entity knows the information to be false, misleading, or its omission would misrepresent the investment, that qualifies for scienter. If they make a conscious effort to disregard and stay uniformed of information they need to know, that might qualify as scienter, depending on the specific facts involved.

Reliance, Causation, and Loss: If a private plaintiff is suing PTB or SA, the plaintiff will need to prove they suffered a loss in connection with the purchase or sale of a security (which may include opportunity loss, depending on the damages portion of the lawsuit) that was actually caused when they relied on a material misrepresentation. Since SA and PTB are more concerned with SEC enforcement action here, we won’t go down this rabbit hole too much.

VI. About Us

This article was written and edited by Michele Ferri and Jonathan Lurie of The Law Offices of Lurie and Ferri for use by The Solari Report. Michele Ferri and Jonathan Lurie are both practicing attorneys out of California. The Law Offices of Lurie and Ferri focus on working with start-up businesses as well as on intellectual property and business law issues. They can be found at or contacted at

1. Standing can be a complex issue unto itself, but generally, plaintiffs need to show they have the right to sue over the issue. For Rule 10b-5, the plaintiff must have bought or sold the security at issue; potential buyers who avoided buying stock because of deception do not qualify for standing.