Extracted from Law360
On Dec. 3, 2018, the U.S. Supreme Court heard oral argument in Lorenzo v. U.S. Securities and Exchange Commission, a closely watched case that could set further limits on so-called “scheme liability” claims brought pursuant to Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The Lorenzo case presents the court with the opportunity to revisit its prior decision in Janus Capital Group Inc. v. First Derivative Traders,[1] which held that only the party deemed to be the “maker” of a false or misleading statement can be held liable for that statement under Rule 10b-5(b). The issue presently before the court in Lorenzo is whether a party that fails to qualify as a “maker” of a statement under Janus can nevertheless be liable for transmitting the statement under subparts (a) and (c) of Rule 10b-5, which speak in terms of employing “any device ... to defraud” or engaging “in any act ... which operates ... as a fraud ... upon any person.”[2]
The Lorenzo oral argument revealed clear divisions within the court on the issue of what type of conduct, as opposed to speech, is sufficient to form the basis of liability under Rule 10b-5 (a) and (c). In other words, must the defendant’s conduct itself be inherently deceptive? Or is the fact that the defendant “acted” in any capacity so long as he or she did so with the requisite fraudulent intent sufficient for claims of primary liability to attach? The argument also focused on where the court should draw the line so as to preserve the important distinction under the securities laws between primary liability and “aiding and abetting” claims.
Even though Lorenzo involves claims brought by the SEC, the justices appeared very mindful of the fact that any ruling in the case has potential implications for private securities claims. As seen in Janus and other decisions, the court has refused to allow private claims to proceed against secondary actors who did not themselves engage in any deceptive speech or conduct, but rather would qualify only as “aiders and abettors” who provided “substantial assistance” to the parties who actually violated the securities laws. Much of the discussion at oral argument turned on whether sanctioning the claims at issue would arguably expand the scope of private liability in a manner inconsistent with the court’s prior decisions.
The Supreme Court and Secondary Actor Liability
On three separate occasions, the Supreme Court has rejected attempts to extend liability to “secondary actors” — parties that were, in the court’s view, too far removed from the deceptive conduct or speech that violated the securities laws to be held personally liable.[3] First, in 1994, the court held in Central Bank of Denver NA v. First Interstate Bank of Denver NA that private plaintiffs may not maintain an aiding and abetting suit for violations of Section 10(b).[4]Accordingly, in private litigation, a party cannot be liable under the federal securities laws for providing “substantial assistance” to someone else who in turn violates those laws.
More than a decade later, the court held in Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc. that scheme liability claims were properly dismissed because (1) the defendants at issue made no statements directly to investors and (2) their conduct (e.g., their willingness to agree to certain business transactions with a mutual customer) was not something that was known to or relied upon by investors.[5] Justice Anthony Kennedy’s majority opinion rejected the petitioner’s argument that in an efficient market, investors rely on the transactions underlying a company’s public statements, but acknowledged that “conduct itself can be deceptive” and refused to limit Section 10(b) liability to only misstatements or omissions.[6]
Finally, in 2011, Justice Clarence Thomas authored the 5-4 majority opinion in Janus, which held that under Rule 10b-5, the “maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”[7] The Janus court focused on the plain text of Rule 10b-5(b), which states that it is unlawful for “any person, directly or indirectly, ... to make any untrue statement of material fact” in connection with a securities transaction. Based on this text, the court held that someone who prepares a statement on behalf of another is not the “maker” of the statement. Thus, the court found that the behind-the-scenes drafter of a misstatement — whose undisclosed conduct occurs prior to the publication of the statement by another entity — could not be held personally liable for the statement. The court recognized that this ruling necessarily followed from its prior decisions in Central Bank and Stoneridge, and affirmed Stoneridge’s direction that the court must give “narrow dimensions” to private actions under Section 10(b).[8]
Lorenzo Tests the Scope of Secondary Liability
Fast forward to the Lorenzo case currently pending before the court. Francis Lorenzo was the director of investment banking for a broker-dealer, Charles Vista LLC, who sent two emails containing indisputably false information to potential investors in connection with the sale of convertible debentures for Waste2Energy Holdings Inc. Following an initial decision by an administrative law judge on charges brought by the SEC, the SEC issued an opinion finding that Lorenzo violated both Section 10(b) of the Exchange Act and Section 17(a) of the Securities Act.[9]
A key issue in dispute, however, was whether the alleged misstatements were “made” by Lorenzo under Janus. Lorenzo testified that the content of the emails had been prepared by his boss, he copied and pasted this information into his emails, and the emails were sent without further thought. The SEC rejected Lorenzo’s copy-paste exculpation theory and found him liable under Section 10(b) and Rule 10b-5(b). The SEC went one step further and also found that, even if Lorenzo did not “make” the misstatements at issue under Janus, he was also liable under Rule 10b-5(a) and (c) and Section 17(a)(1) because he employed a deceptive “device,” an “artifice to defraud” and/or a deceptive “act.”[10]
On appeal, the D.C. Circuit reversed the finding that Lorenzo violated Rule 10b-5(b). The D.C. Circuit majority opinion found that the evidence showed Lorenzo “did not ‘make’ the false statements at issue ... because Lorenzo’s boss, and not Lorenzo himself, retained ‘ultimate authority’ over the statements.”[11] Over a strong dissent from then-Circuit Judge Brett Kavanaugh, the D.C. Circuit further held that Lorenzo could nevertheless still be liable under subparts (a) and (c) of Rule 10b-5, as well as Section 17(a), because “Lorenzo played an active role in perpetrating the fraud and folding the statements into emails he sent directly to investors in his capacity as director of investment banking, and by doing so with an intent to deceive.”[12]
Lorenzo at the Supreme Court
Lorenzo timely petitioned the Supreme Court for review and the court granted his certiorari petition in June 2018. Notably, the four dissenters from the Janus majority — Justices Stephen Breyer, Ruth Bader Ginsburg, Sonia Sotomayor and Elena Kagan, remain on the bench, and Justice Kavanaugh recused himself from the case. Thus, to avoid a 4-4 split, the Janus dissenters would need to win over a member of the Janus majority or Justice Gorsuch (Justice Kennedy’s successor).
On appeal to the Supreme Court, Lorenzo presented the question of whether “a misstatement claim that does not meet the elements set forth in Janus can be repackaged and pursued as a fraudulent scheme claim under Section 10(b) of the Exchange Act, Rules 10b-5(a) and (c) and Section 17(a)(1) of the Securities Act.”[13] Although additional arguments were raised in the parties’ briefs, the justices focused on a few key issues at oral argument, including whether Lorenzo’s conduct fell within the plain language of Rule 10b-5(a) and (c), whether “scheme” liability requires a separate act of deceptive conduct, and whether Janus can survive a ruling in favor of the SEC.
From the outset of oral argument, Justices Kagan and Sotomayor pressed Lorenzo’s counsel regarding Lorenzo’s mental state at the time his emails were sent. His counsel conceded that Lorenzo was not challenging the conclusion that he “acted with an intent to deceive or defraud.”[14] The justices then pushed counsel to explain how that concession standing alone did not “give away your case” in light of the specific language of Rule 10b-5(a) and (c). In other words, if there can be no dispute that Lorenzo’s “act” of sending the emails was made with fraudulent intent, then had he not committed “an act that operates as a fraud” under the meaning of Rule 10b-5(c)?
Perhaps the most surprising exchange during the argument involved Justice Samuel Alito, who sided with the majority in Janus, but nevertheless lodged several questions at Lorenzo’s counsel in pursuit of an explanation for why Lorenzo’s conduct “doesn’t fall squarely within the language of (c).” Justice Alito’s questions suggested that Lorenzo’s position — i.e., that Rule 10b-5(a) and (c) must encompass something other than misstatements — was not actually helpful to him because both sides seemed to agree that “[Lorenzo] did [do] something else.” Justice Alito further questioned whether, if subpart (c) addresses conduct, why it “can’t include any verbal conduct,” quipping that “I don’t quite know how you’re going to engage in a fraud without ... saying some words.”[15] Justice Breyer asked questions along those same lines, noting at one point “we make statements all the time through conduct.”[16]
Although Justice Alito sided with the majority in Janus, Janus was largely grounded in a textual interpretation of Rule 10b-5(b), which focused on the fact that subpart (b) speaks in terms of “making” a false or misleading statement. Subparts (a) and (c) do not contain similar language. That point was emphasized by Justice Kagan in her questioning. If Justice Alito were to adopt the SEC’s argument that Lorenzo’s conduct falls within the plain language of Rule 10b-5(a) and (c), his vote could give the Janus dissenters the necessary majority to affirm the D.C. Circuit’s finding of liability. Indeed, one wonders whether Lorenzo’s concession of intentional misconduct renders the facts of this case sufficiently unique to support a narrow decision confined to the particular circumstances of the case — leaving the full court to decide more difficult questions related to scheme liability at a later date.
On the other side of the table, Justice Neil Gorsuch (whose tenure on the bench post-dates Janus) pressed the government to explain how liability could arise if the only deceptive act was the alleged misstatements that Lorenzo indisputably did not make. Justice Gorsuch elaborated: “[Y]ou could have an actus reus of fraud by an act or omission, [but] only act’s charged here. And the only act seems to be this statement issued to potential investors, and we have a finding from the D.C. Circuit that ... [the] act wasn’t made, that statement wasn’t made by this defendant.”[17] It appeared to be Justice Gorsuch’s view that, if the only fraudulent “act” Lorenzo stands accused of was the responsibility of another party, then “doesn’t that necessarily imply he substantially assisted” at best. In response to this line of questioning, the government was forced to concede that the only action undertaken personally by Lorenzo was the transmission of the deceptive statements via email to other persons.[18] The problem with this argument, as noted by Justice Gorsuch and Lorenzo’s counsel, is that the mere act of sending an email is not an inherently deceptive act. As his counsel explained, Lorenzo “would have to have engaged in something in addition to just mere misstatements,” such as “some other inherent deceptive conduct” or “more active misconduct.”
Justice Gorsuch returned to this line of questioning later in the proceedings — seeming to leave little question about his future vote — when he pressed the government to explain where the line could be drawn between primary and secondary liability. Although the SEC (and the questioning of certain justices) attempted to skirt this issue by characterizing the case as one of primary liability (i.e., beyond the reach of Central Bank), Justice Gorsuch noted that Lorenzo “didn’t engage in any independent conduct that created a false impression in the mind of ... other[s], other than disseminat[ing] the false statement.”[19] Justice Gorsuch appeared to embrace Lorenzo’s position that, if his conduct constitutes grounds for primary liability, “it would really leave no room for any sort of aiding and abetting liability.”[20] Indeed, such a result would seemingly run contrary to Central Bank and give rise to the possibility of expanding potential liability to secondary actors who did not “make” any misleading statements.
Similarly, Chief Justice John Roberts asked the government whether Janus would be a “dead letter” if the court agrees with the SEC’s interpretation of Rule 10b-5(a) and (c). Although the government contended that there might be certain circumstances — involving persons who are “far back in the chain of drafting copy” — where liability would still be foreclosed by Janus, it is unclear whether Justice Roberts was persuaded.[21] Indeed, Lorenzo’s counsel argued that the logical result of the SEC’s position would be to enable plaintiffs to “creatively relabel their inadequate misstatement claims as claims for deceptive devices and acts.”[22] Counsel for Lorenzo also noted that the bar had been set “very low” by the D.C. Circuit because if sending an email written by someone else was enough to trigger these provisions, then anyone providing “substantial assistance” could in theory become a primary violator.[23]
With arguments closed, the key question is whether the mere “act” of distributing a fraudulent statement, without any independent fraudulent conduct, can form the basis for scheme liability. It appears unlikely that any of the Janus dissenters are prepared to switch sides and impose any limits on scheme liability. Thus, to avoid a 4-4 split, which would result in a per curiam opinion, the dissenters will need the support of a justice in the Janus majority. Although Justice Alito’s textual approach to analyzing Rule 10b-5 seemed to find traction among the Janus dissenters, we would expect any opinion in which he joined to be narrowly tailored to the circumstances of the case, in keeping with the admonitions of Stoneridge and Janus that the scope of private actions under Section 10(b) should not be expanded.
[1] Janus Capital Group Inc. v. First Derivative Traders , 564 U.S. 135 (2011).
[2] 17 CFR 240.10b-5(a) & (c).
[3] The three cases discussed here addressed Section 10(b) of the Exchange Act and Rule 10b-5. Lorenzo was also found liable under Section 17(a)(1) of the Securities Act of 1933. Private parties can bring claims under Section 10(b), but do not have standing to bring claims under Section 17(a).
[4] 511 U.S. 164 (1994). Following the Central Bank decision, Congress amended the statutes to give the SEC, but not private parties, standing to bring aiding and abetting claims for securities fraud.
[5] 552 U.S. 148 (2008).
[6] Id. at 158.
[7] 564 U.S. 135, 142 (2011).
[8] Id.
[9] Francis V. Lorenzo, SEC Release No. 9762, 2015 WL 1927763 (April 29, 2015).
[10] Id.
[11] Lorenzo v. SEC , 872 F.3d 578, 580 (D.C. Cir. 2017), cert. granted sub nom. Lorenzo v. SEC, 138 S. Ct. 2650 (2018).
[12] Id. In his dissent, then-Circuit Judge Kavanaugh argued, inter alia, that scheme liability should be based on “conduct that goes beyond a defendant’s role in preparing mere misstatements ... made by others.” Id. at 600.
[13] Brief of Petitioner, Lorenzo v. SEC, No. 17-1077, p. i (Aug. 20, 2018).
[14] Oral Argument Transcript, Lorenzo v. SEC, No. 17-1077, 14:16-23 (Dec. 3, 2018).
[15] See id. at 10:23-12:5.
[16] Id. at 52:22-24.
[17] Id. at 33:11-19.
[18] Throughout the argument, the justices appeared to give varying levels of weight to the fact that the emails were sent from Lorenzo’s account with his signature and contact information.
[19] Oral Argument Transcript at 48:11-17.
[20] Id. at 12:17-24.
[21] Id. at 42:9-45:22.
[22] Id. at 4:7-10. A final point of note: Justice Sotomayor emphasized during the argument that Janus should not apply to the Section 17(a) claim against Lorenzo, noting that Janus by its terms did not interpret Section 17(a) and the statute itself “doesn’t talk about making statements.” Id. at 23:12-24:3. Her questions appear to comport with Justice Alito’s textual analysis of the statutory provisions, and could perhaps indicate the ability of certain justices to find common ground on Section 17(a), even if no agreement is possible under Section 10(b).
[23] Id. at 12:10-24.