Jared L. Kopel
After a series of high-profile losses in recent years, the U.S. Securities and Exchange Commission finally prevailed at the Supreme Court, as the justices held that an investment banker who knowingly disseminated false statements to his clients committed securities fraud, even when the banker was not legally deemed to be the “maker” of the misstatements. While it may appear obvious that a securities professional who intentionally deceived investors must have liability, nothing is particularly self-evident under the securities laws. Ironically, in a case concerning the government, the biggest winners may be private plaintiffs and their lawyers, who might be better positioned to bring securities lawsuits in certain situations.
The SEC’s victory in Lorenzo v. Securities and Exchange Commission, No. 17-1077 (March 27), must be a welcome relief for the agency, after the court in recent years has delivered several major setbacks, including decisions imposing a strict five-year limit on the SEC’s ability to bring disgorgement claims and holding that the SEC’s method of appointing in-house administrative law judges was unconstitutional. The justices voted 6-2 in favor of the SEC, with Justice Brett Kavanaugh recusing himself because he had written a dissent in the ruling by the U.S. Court of Appeals for the District of Columbia that was before the Supreme Court.
Francis Lorenzo was the director of investment banking at Charles Vista, LLC, a registered broker-dealer in Staten Island, New York. Lorenzo’s only banking client was Waste2Energy Holdings, Inc., which supposedly was developing a process to convert solid waste into clean energy. In 2009, Waste2Energy retained Charles Vista to sell $15 million in debentures (unsecured debt). Lorenzo sent two emails to prospective investors stating that Waste2Energy had $10 million in “confirmed assets,” without disclosing that the company publicly had disclosed, and Lorenzo knew, that the company’s intellectual property was worthless, and that after writing off all its intangible assets, its total assets were worth less than $400,000. Lorenzo signed the emails with his own name and invited recipients to call him with any questions. Following an administrative proceeding, the SEC found that Lorenzo violated Section 10(b) of the Securities Exchange Act of 1934, Rule 10b-5 thereunder, and Section 17(a)(1) of the Securities Act of 1933. The SEC fined Lorenzo $15,000, ordered him to cease-and-desist from committing further violations, and barred him from the securities industry for life.
On appeal, the D.C. Circuit concluded that Lorenzo did not violate Rule 10b-5(b), which prohibits a person from making a materially false statement, based on the Supreme Court’s decision in Janus Capital Group v. First Derivative Traders, 564 U.S. 135 (2011). Janus held that the “maker” of a statement for purposes of Rule 10b-5(b) “is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” The D.C. Circuit agreed with Lorenzo that he was not the “maker” of the false statements that he sent to his clients, and therefore not liable under Rule 10b-5(b), because his boss asked him to send the emails, supplied the central content and approved the messages for distribution. However, the D.C. Circuit held (with now Kavanaugh dissenting) that Lorenzo was liable under Rule 10b-5(a), which makes it unlawful to employ any device, scheme, or artifice to defraud, and Rule 10b5-(c), which prohibits engaging in any act, practice or course of business which operates or would operate as fraud or deceit. Rule 10b-5(a) and (c) are often characterized as covering “scheme” liability. In agreeing to hear the case, the Supreme Court assumed that Lorenzo was not a “maker” of the false statements; Lorenzo did not challenge the finding of the D.C. Circuit that he acted with scienter, i.e., an intent to defraud.
The majority opinion, authored by Justice Stephen Breyer, held that the language of Rule 10b-5(a) and (c) was sufficiently broad to encompass the knowing dissemination of false information with the intent to defraud. Relying on dictionary definitions, the court held that the provisions “capture a wide range of conduct.” The court rejected Lorenzo’s argument that the only means to be liable in any action that concerns false statements is through those provisions that apply specifically to false statements. Otherwise, argued Lorenzo and the dissent by Justice Clarence Thomas, in which Justice Neil Gorsuch joined, Rule 10b5-(b) would become superfluous. But the court held that there is considerable overlap among the subsections of Rule 10b-5 and related provisions of the securities laws. Indeed, there is overlap in the conduct prohibited by Rule 10b-5(a) and (c). Rule 10b-5’s expansive language plainly embraced Lorenzo’s conduct. Using knowingly false representations to induce the purchase of securities “would seem a paradigmatic example of securities fraud,” wrote Breyer. Put differently, if the court had adopted Lorenzo’s view, in which Rule 10b-5(b) exclusively controlled any action involving false statements, then someone like Lorenzo who deliberately disseminated misleading information to cheat investors could escape liability altogether.
It is important to emphasize that the court did not hold that merely disseminating a false statement creates liability under Rule 10b-5(a) and (c). (The Second, Eighth and Ninth Circuits have held that misstatements alone do not support “scheme” liability, while the Eleventh and D.C. Circuits have been more open to the possibility under specific circumstances). The factual basis for any decision is critical. Lorenzo did not concern an alleged misstatement buried in a lengthy, routine SEC filing; rather, Lorenzo engaged in a fraudulent course of conduct (notwithstanding the dissent’s contrary assertion): the planning for the debenture sales, the development of a fraudulent scheme, and the knowing dissemination of multiple false statements to his clients.
The court recognized that applying Rule 10b-5(a) and (c) may present difficult problems of scope in “borderline cases” and that “purpose, precedent, and circumstance could lead to narrowing their reach in other contexts.” But there was nothing borderline about Lorenzo’s conduct. Lorenzo was not just a minor player tangentially involved in a fraud—he “sent false statements directly to investors, invited them to follow up with questions, and did so in his capacity as vice president of an investment banking company.”
Scholars and litigators will debate whether this decision renders Janus a “dead letter,” as both Lorenzo and the dissent argued. That seems unlikely, though the court may have narrowed the reach of Janus. Tackling the question head on, Breyer wrote that Janus only held that Rule 10b-5(b) did not cover “an investment adviser who helped draft misstatements issued by a different entity that controlled the statements’ content ... We said nothing about the rule’s application to the dissemination of false or misleading information.” Moreover, the four justices who dissented in Janus were part of the Lorenzo majority, and seemingly seized the opportunity to scale back the scope of Janus. Much ink has been spilled in litigation over whether an individual at a company that allegedly made false statements was liable under Janus as a “maker” of those statements. But Lorenzo suggests, although certainly does not hold, that Janus may not always apply to employees of a company that is itself accused of making false statements. The court did state that Janus still remained relevant and precluded liability where an individual neither made nor disseminated false information, so long as the person was not involved in some other fraud.
The court also dismissed Lorenzo’s assertion that holding him primarily liable blurred an otherwise sharp distinction between primary and aiding and abetting liability, because someone who was charged by the SEC with primary liability under subsection (a) of Rule 10b-5 also could be charged with aiding and abetting under subsection (b). As the Court noted, it is not unusual for the same conduct to result in a primary violation with respect to one offense and aiding and abetting with respect to another.
The major beneficiaries of the Lorenzo ruling, aside from the SEC, could be private plaintiffs and their lawyers. The Supreme Court in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), held that aiding and abetting liability does not exist under Section 10(b). Congress restored aiding and abetting liability for the SEC, but not private plaintiffs. Subsequently, the Court in Stoneridge Investment Partners v. Scientific-Atlanta, 552 U.S. 148 (2008) circumscribed primary liability in private actions by ruling that those who allegedly contributed to the fraudulent disclosures of another but whose misconduct was not revealed publicly lack Section 10(b) culpability because investors could not have relied upon them in making a trading decision (reliance is required for private plaintiffs but not the SEC).
But Lorenzo offers private plaintiffs the opportunity to argue that peripheral actors who publicly disseminated false statements—and whose conduct therefore was known to investors—have primary liability under Rule 10b-5(a) and/or (c), if not (b). Breyer dismissed Lorenzo’s suggestion that classifying the dissemination of false information as a primary violation would unfairly subject “peripheral players in fraud (including him, naturally) to substantial liability.” Breyer tartly added, “We suspect the investors who received Lorenzo’s emails would not view the deception so favorably.”
Plaintiffs’ attorneys may not be inclined to name “peripheral players” as defendants unless they have the proverbial “deep pockets.” But there may be strategic reasons for roping such persons into a lawsuit, such as triggering insurance policies that might provide a source of payment.
Like many Supreme Court decisions, Lorenzo resolved one issue on one set of facts but with language that might have wider implications. Has Lorenzo stretched the net for scheme liability? Or will it come to stand only for the unremarkable proposition that a securities professional who deliberately tries to defraud his clients indeed commits fraud? Time will tell.
Jared Kopel is senior counsel at Alto Litigation, a San Francisco firm specializing in securities litigation.
Jared L. Kopel