Can the Securities and Exchange Commission (SEC) penalize an investment banker on the ground that, even though he did not “make” false statements under Janus Capital Group v. First Derivative Traders, his distribution of false statements constituted a “device, scheme, or artifice to defraud” or an “act, practice, or course of business which operates . . . as a fraud or deceit” under subsections (a) and (c) of Rule 10b-5? On December 3, 2018, the Supreme Court heard oral argument on that question in Lorenzo v. SEC. The stakes in Lorenzo are high. The SEC argues that prohibiting it from penalizing distributors of false statements will create a significant hole in its enforcement authority. Lorenzo responds that penalizing mere distributors under Rules 10b-5(a) and 10b-5(c) will render Janus a nullity, erode the Supreme Court’s limitations on liability for aiding and abetting, and lead to a deluge of private securities litigation. The Supreme Court’s anticipated decision will have a significant impact on liability for distributors of false statements.
Petitioner Lorenzo was the director of investment banking at Charles Vista LLC, a registered broker-dealer. Lorenzo’s client, Waste2Energy Holdings, Inc. (W2E), claimed to have developed technology that could generate electricity by converting trash into gas. That technology never materialized, however, and W2E issued a Form 8-K—which Lorenzo received—in which it changed its valuation of the technology from $10 million to nothing.
After learning that W2E had written off this $10 million asset, Lorenzo sent two emails to potential investors marketing a W2E debenture offering. The emails itemized several “layers of protection” that investors would enjoy and attributed a $10 million value to the asset Lorenzo knew was worthless. The other promised layers of protection also did not exist. The emails stated that they were sent at the request of Charles Vista’s president. However, Lorenzo signed the emails with his name and title, and invited the recipients to call him with questions.
Lower Court Decisions
Based on the false statements in Lorenzo’s emails, the SEC commenced cease-and-desist proceedings against him, charging him with violations of section 17(a)(1) of the Securities Act of 1933, section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5. Lorenzo proceeded to a hearing before an administrative law judge (ALJ). The ALJ found that (1) Charles Vista’s president had drafted the emails, which contained numerous false statements; (2) Lorenzo had sent the emails at the president’s request; and (3) Lorenzo had, at a minimum, acted recklessly in so doing. Based on those findings, the ALJ fined Lorenzo and banned him from participating in the securities industry. The SEC sustained the ALJ’s decision, finding that Lorenzo knew that the emails’ key statements were false.
A divided panel of the D.C. Circuit agreed in part. The court found that substantial evidence supported the SEC’s determination that Lorenzo acted with knowledge of the emails’ falsity. Nonetheless, applying the Supreme Court’s decision in Janus—which held that the “maker” of a statement for purposes of Rule 10b-5(b) is the person or entity with “ultimate authority” over that statement—the court concluded that Charles Vista’s president, not Lorenzo, had “made” the false statements in the emails. Thus, it rejected the SEC’s finding that Lorenzo had violated Rule 10b-5(b).
The court further held, however, that Lorenzo’s knowing dissemination of false statements constituted a violation of section 17(a)(1), section 10(b), and Rules 10b-5(a) and 10b-5(c) (the “scheme liability provisions”). Unlike Rule 10b-5(b), the court explained, the scheme liability provisions do not require a violator to “make” a false statement. Instead, those provisions are violated by any “device, scheme, or artifice to defraud” or by conduct that “operate[s] as a fraud or deceit.” The court concluded that Lorenzo’s conduct fit within those prohibitions.
The third member of the panel, then judge Brett Kavanaugh (who has recused himself from the proceedings before the Supreme Court), dissented. He argued that permitting the SEC to penalize someone under the scheme liability provisions for a false statement that is not actionable under Rule 10b-5(b) undermines the distinction between primary and secondary liability, i.e., liability for aiding and abetting.
Issues Presented and Oral Argument
In his briefing and argument before the Supreme Court, Lorenzo argues that penalizing him under the scheme liability provisions for false statements he did not “make” will undercut the Supreme Court’s decision in Janus. That decision limited liability under Rule 10b-5(b) to the “makers” of deceptive statements in order to preserve the distinction between primary actors and those who only aid and abet. This distinction matters, in no small part, because investors have a private right of action against primary actors, whereas only the SEC can pursue aiders and abettors. Lorenzo argues that if someone who did not make a false statement can be held primarily liable for that statement under the scheme liability provisions, then the SEC could repackage defective Rule 10b-5(b) claims by arguing that actions that merely aided and abetted a fraud—such as Lorenzo’s emails—instead constituted a primary fraudulent scheme. This, Lorenzo argues, would destroy the distinction between primary and secondary liability that the Court sought to preserve in Janus. To avoid such an outcome, Lorenzo would interpret only Rule 10b-5(b) to cover fraudulent misstatements and would read the scheme liability provisions to require some additional conduct beyond a mere statement.
The SEC responds that the different provisions of Rule 10b-5 have overlapping coverage and that penalizing Lorenzo under the scheme liability provisions will not undermine the distinction between primary violators and aiders and abettors. According to the SEC, knowingly distributing the false statements of others in an effort to induce investment “fits comfortably” within an ordinary understanding of a “device, scheme, or artifice to defraud” or an “act, practice, or course of business which . . . would operate as a fraud,” making Lorenzo a primary violator of the scheme liability provisions. The SEC contends its enforcement efforts would be undermined if it could not penalize fraudulent conduct under the scheme liability provisions simply because, under Rule 10b-5(b), the relevant person did not “make” the false statements at issue. Specifically, the SEC warns of a “loophole” that will arise if the Court accepts Lorenzo’s position. To hold someone liable for aiding and abetting pursuant to 15 U.S.C. §78t(e), the SEC must first prove a primary violation. If the person who “makes” the relevant statement does not know it is false, no primary violation will occur. Thus, those who distribute the statement with knowledge of its falsity cannot be held liable for aiding and abetting.
During oral argument, several members of the Court viewed Lorenzo’s argument skeptically. Justices Elena Kagan, Sonia Sotomayor, and Samuel Alito each suggested that sending a false email is an “act” that can properly give rise to primary liability under Rule 10b-5(c). Justices Ruth Bader Ginsburg and Stephen Breyer, too, emphasized Lorenzo’s active role in sending the emails, suggesting that his conduct was properly penalized as a primary violation of the securities laws—not an instance of mere aiding and abetting. Justices Kagan and Sotomayor also challenged Lorenzo’s reliance on Janus, emphasizing that its limitation of liability to “makers” of false statements was explicitly based on the term “make” in Rule 10b-5(b), which does not appear in the scheme liability provisions and thus does not apply to those provisions.
Justice Neil Gorsuch, by contrast, indicated some receptiveness to Lorenzo’s argument that the D.C. Circuit had blurred the distinction between primary and secondary violators. Justice Gorsuch noted that the only “acts” alleged were the statements in the emails—which, under Janus, Lorenzo did not “make”—and thus Lorenzo might be more properly characterized as an aider/abettor than a primary violator.
What Is at Stake?
The Supreme Court’s decision in Lorenzo will have important implications for the scope of securities fraud liability. If Lorenzo prevails, then liability for isolated deceptive statements will be limited to those who “make” them, a narrow class that includes only those with “ultimate authority” over the contents of a statement. Those who do nothing more than knowingly distribute false statements “made” by others will not face private civil liability under Rule 10b-5, although the SEC could still prosecute them as aiders and abettors if it can show a primary violation by another.
On the other hand, if the Supreme Court adopts the SEC’s position, then distributors of false statements will be subject to liability under the scheme liability provisions, even if they lacked ultimate authority over the statements’ contents and did not in fact draft the statements. Such a ruling may encourage the SEC and private plaintiffs to recast actions that were previously understood as aiding and abetting others’ misstatements as “schemes” or “practices” that independently violate Rules 10b-5(a) and 10b-5(c). Courts may thus have to identify the point at which promotion of others’ misstatements ceases to simply aid and abet, and instead becomes a separate deceptive scheme.
Because Justice Kavanaugh has recused himself from consideration of the case, Lorenzo will be decided by an eight-member Court. Should the Court split 4–4, the D.C. Circuit’s decision holding that Lorenzo’s statements violated the scheme liability provisions would remain undisturbed. In that case, a circuit split would remain in place, with the D.C. and Eleventh Circuits holding that false and misleading statements are actionable under the scheme liability provisions, and the Second, Eighth, and Ninth Circuits holding that something more is required to violate those provisions. Private plaintiffs thus would be able to pursue claims under the scheme liability provisions in D.C., Alabama, Florida, and Georgia that would be legally insufficient elsewhere.
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