The Supreme Court’s decision in Lorenzo v. Securities and Exchange Commission reads Rule 10b-5 broadly and strengthens the ability of the SEC and plaintiffs in private securities fraud suits to pursue those who engage in fraudulent schemes or practices in situations where the only conduct involved concerns a material misstatement and they are not the “makers” of the misstatement. This ruling has broad implications for anyone responsible for communicating to investors, even if not individually responsible for the content of those communications.
Breaking new ground in the securities fraud realm, the U.S. Supreme Court recently determined that even though a person who disseminates the material misstatement of another to potential investors with intent to defraud cannot be found primarily liable under Securities Exchange Act Rule 10b-5(b) on account of not being the author or “maker” of the statement, he or she can still be found primarily liable under Exchange Act Rule 10b-5(a) or (c) (and related antifraud provisions of the federal securities laws) on the basis of having engaged in a fraudulent “scheme.” This decision has favorable implications for the SEC and for plaintiffs in private actions because it arguably blurs the distinction between scheme liability and liability for making false statements and between primary and secondary (i.e., aiding and abetting) liability, thereby paving the way for the SEC and private litigants to target third-party actors who were thought to be outside of the scope of Rule 10b-5 following earlier decisions in Central Bank and Janus.
Fraudulent statements and fraudulent schemes
The antifraud provisions of the federal securities laws—Exchange Act Section 10(b), Rule 10b-5 thereunder, and Section 17(a) of the Securities Act of 1933 (available on Thomson Reuters Checkpoint)—prohibit fraudulent statements and fraudulent schemes in connection with the offer and sale of securities:
- Fraudulent statements. Rule 10b-5(b) prohibits making any “untrue statement of a material fact.” Securities Act Section 17(a)(2), which largely mirrors Rule 10b-5(b), establishes liability for untrue statements or omissions of a material fact.
- Fraudulent schemes. Rule 10b-5(a) prohibits the use of “any device, scheme, or artifice to defraud.” Rule 10b-5(c) prohibits anyone from engaging in “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.” Finally, Section 17(a)(1), like Rule 10b-5(a), prohibits the use of any “device, scheme, or artifice to defraud.”
Central Bank and Janus set the stage
In Central Bank, the Supreme Court ruled that no private right of action exists against one who aids and abets a Rule 10b-5 violation by another, and since then, such cases against secondary actors have been limited to SEC enforcement actions, pursuant to Exchange Act Section 20(e). Thereafter, in Janus, the Supreme Court ruled that only the “maker” of a statement—defined as having “ultimate authority over the statement, including its content and whether and how to communicate it”—can be found primarily liable for violations of Rule 10b-5(b) and that a person without such “ultimate authority” may only be held secondarily liable for securities fraud under an aiding-and-abetting theory. However, given the absence under Central Bank of a private right of action for aiding and abetting securities fraud, the Janus ruling placed a considerable restriction on private litigation under Rule 10b-5(b). While these decisions have served to limit the scope of Rule 10b-5 cases over the past several years, the Lorenzo opinion does the opposite: it potentially expands the universe of actors subject to primary securities fraud liability for false statements beyond those who actually make material misstatements to also include non-makers involved in disseminating false statements to the investing public.
Background on Lorenzo and lower-court decisions
Francis Lorenzo was the Director of Investment Banking at New York broker-dealer Charles Vista, LLC. His client, Waste2Energy Holdings, Inc., was developing technology to convert solid waste into clean renewable energy. In June 2009, the company reported in an 8-K (available on Thomson Reuters Checkpoint) that its total assets were worth $14 million. Then in October 2009, the company reported in an amended 8-K and in a 10-Q that its total assets amounted to less than $400,000 after having written off the value of certain assets. Shortly after that revelation, Lorenzo sent emails to two prospective investors—at the request of his boss (i.e., the owner of Charles Vista)—soliciting them to invest in the company without any mention of the devaluation. He copied and pasted into the emails content written by his boss that he knew to be false, and he indicated in each email that it was being sent at the request of his boss. However, he signed the emails with his name in his capacity as Vice President of Investment Banking, and indicated that the prospective investors could call him with questions.
The SEC subsequently brought an administrative action against Lorenzo (as well as his boss and Charles Vista, both of whom ultimately settled), charging him with violations of Exchange Act Section 10(b), Rule 10b-5 and Securities Act Section 17(a)(1). The Administrative Law Judge found that Lorenzo knew of the assets’ diminished value when he sent the emails, and held that Lorenzo had deliberately violated the antifraud provisions with his material misrepresentations and omissions. Afterwards, the SEC affirmed the decision, fined him $15,000 and banned him from working in the securities industry for life, which prompted Lorenzo to appeal the SEC’s decision to the U.S. Court of Appeals for the D.C. Circuit.
On appeal to the D.C. Circuit, Lorenzo argued that (1) he lacked the fraudulent intent necessary to establish the violations found by the SEC, and (2) he could not be held liable under Rule 10b-5(b) in light of Janus, because it was his boss who made the false statement and had the ultimate authority to control the content that went into the misleading email. The D.C. Circuit rejected Lorenzo’s lack-of-intent argument, and, interestingly enough, Lorenzo did not challenge that finding. Moreover, the D.C. Circuit agreed that Lorenzo was not liable under subsection (b) of Rule 10b-5—in line with Janus—but nevertheless upheld the SEC’s determination that he was liable under the scheme liability provisions of Rule 10b-5 (i.e., subsections (a) and (c)), as well as Section 10(b) and Section 17(a)(1).
At Lorenzo’s request, the Supreme Court agreed to review his case to resolve the question of whether someone who is not a maker of a false statement under Rule 10b-5(b) can still be found to have violated the other subsections of Rule 10b-5 (and related provisions of the securities laws), when the only conduct involved concerns a misstatement.
Supreme Court analysis
The Supreme Court answered the foregoing question in the affirmative, ruling that a person who disseminates materially false or misleading statements to potential investors with the intent to defraud may be held liable under Rule 10b-5(a) and (c) and Section 17(a)(1)—even if he or she did not make the statements, and is, thus, outside of the scope of Rule 10b-5(b).
On appeal to the Supreme Court, Lorenzo put forth two main arguments, both of which were rejected. First, Lorenzo claimed that Rule 10b-5 limited primary liability for false statements to makers of those statements under subsection (b), and that subsections (a) and (c) could only come into play when conduct other than false statements was at issue. Any other reading, Lorenzo argued, would render subsection (b) “superfluous” and Janus “dead letter” law. The Supreme Court explained that Janus was limited to whether Rule 10b-5(b) maker liability could extend to an investment advisor who helped draft false statements issued by someone else with ultimate authority and said nothing about the Rule’s application to the dissemination of false statements. Naturally then, the Supreme Court assumed that Janus would continue to prevent liability where an individual neither made nor disseminated false statements. The Supreme Court also disregarded Lorenzo’s premise that Rule 10b-5’s subsections should be regarded as mutually exclusive because it has long recognized considerable overlap among the Rule’s subsections and related securities laws.
Second, Lorenzo maintained that under Janus, he would only qualify as an aider and abettor of a violation of Rule 10b-5(b) and, thus, argued that the ruling would blur the line between primary and aider and abettor liability. The Supreme Court explained that, unlike in Janus, Lorenzo could be subject to liability under Rule 10b-5(a) and (c) as a primary actor because he was a principal violator in the scheme to defraud based on his direct contact with the prospective investors and his role in sending the emails. Moreover, noting that it is not unusual for the same conduct to be a primary violation with respect to one offense and aiding and abetting with respect to another, the Supreme Court found that Lorenzo could be considered both primarily liable under Rule 10b-5(a) and (c) for having engaged in a “scheme,” “practice,” or “course of business” to defraud, and secondarily liable for having aided and abetted the making of a false statement under Rule 10b-5(b).
The Supreme Court acknowledged, however, that its interpretation of the antifraud provisions could capture a wide range of conduct involving the dissemination of material misstatements, which could potentially lead to problems of scope in borderline cases. Though the Supreme Court believed that Lorenzo is not a borderline case—highlighting that Lorenzo knowingly sent false statements directly to investors, invited them to follow up with questions, and did so in his capacity as Vice President of Investment Banking—it maintained that liability would generally be inappropriate for those only marginally involved in dissemination, such as mailroom clerks.
Practical implications moving forward
The Lorenzo decision is a victory for the SEC. Though its authority to pursue enforcement actions against secondary actors has not changed, the SEC may now, with certainty, bring primary liability cases under Rule 10b-5(a) and (c) against those who did not make statements, but who knowingly disseminated materially false and misleading statements.
And though Lorenzo arose from an SEC enforcement action, the Supreme Court’s decision is also a victory for private litigants—perhaps even more so—because private plaintiffs, who, as discussed above, cannot sue individuals for aiding and abetting under Rule 10b-5, may now target individuals that they could not previously reach. This is so because individuals who prior to the decision would have been considered as aiding and abetting a Rule 10b-5(b) fraudulent misstatement violation—and subject to a litigation reprieve—may now be found primarily liable under Rule 10b-5(a) and (c) for knowingly disseminating fraudulent statements that they did not make.
Another interesting implication worthy of note is that while the Supreme Court explained that imposing primary liability on actors who are only marginally involved in disseminating a false statement would generally be inappropriate, it stopped short of (1) defining the amount of control over a fraudulent statement or its dissemination that is required for liability to attach, (2) defining what constitutes dissemination, and (3) clarifying why that amounts to a “device, scheme, and artifice to defraud” under Rule 10b-5(a) and an “act, practice, or course of business which operates or would operate as fraud or deceit” under Rule10b-5(c). We can expect future litigation to focus on factual differences from Lorenzo that are material enough to warrant narrowing the scope of liability under Rule 10b-5(a) and (c), and it remains to be seen how the expansion of liability will evolve in the lower courts and whether the decision will prompt amendments in the scope of the securities laws.
In any event, Lorenzo reinforces the idea that anyone responsible for communicating to investors, even if not individually responsible for the content of those communications, may incur primary liability for disseminating information that they know to be false or misleading. With that said, attorneys, broker-dealers, underwriters, placement agents, investment bankers, investment advisors, private equity funds and other licensed professionals, you should tread carefully when considering whether, and to what extent, to participate in the dissemination of information in connection with the sale of securities.
Lorenzo v. SEC, 587 U.S. ___, No. 17-1077 (Mar. 27, 2019)
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