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Posted on Monday, April 08, 2019

Securities fraud; false statements; SEC Rule 10b-5

Lorenzo v. Securities and Exchange Commission, ___ U.S. ___, No. 17-1077 (27 March 2019)

SEC Rule 10b-5(b) makes it unlawful to “make any untrue statement of a material fact . . . in connection with the purchase or sale of any security.”  In Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), the Supreme Court held that a person is the “maker of a statement” only if the person controls the content of the statement and whether and how to communicate the statement.  On the facts of Janus Capital, that meant that any investment advisor who merely participated in the drafting of a false statement made by another could not be held liable in a private action under subsection (b) of Rule 10b-5.

In the instant case, the petitioner, Lorenzo, worked for the investment banker Charles Vista, LLC (Vista).  Waste2Energy Holdings, Inc. (Waste2Energy) hired Vista to sell to investors $15 million worth of debentures, a form of debt secured only by the debtor’s earning power, not by a lien on any specific asset.  Lorenzo knew that Waste2Energy’s intellectual property was worthless and its total assets amounted to only $370,552.  Nonetheless, Lorenzo sent two emails to prospective investors describing the investment in Waste2Energy as having three layers of protection, including $10 million in confirmed assets.  Lorenzo sent the emails at the direction of his boss, who supplied the content and approved the messages.  Under the holding in Janus Capital, Lorenzo was not the “maker” of the emails and not liable under subsection (b) of SEC Rule 10b-5.

Was Lorenzo in the clear?  No!  There are two other subsections of Rule 10b-5.  Subsection (a) makes it unlawful to employ any “device, scheme, or artifice to defraud,” and subsection (c) prohibits engaging “in any act, practice, or course of business which operates . . . as a fraud . . . .”  In addition, the Securities Act of 1933 has the same prohibitions as Rule 10b-5, 15 U.S.C. §77q, and the Securities Exchange Act of 1934 prohibits the use of deceptive schemes and prohibits aiding and abetting violations of the securities laws, including the SEC’s rules. 15 U.S.C. §§ 78j, 78t.  The SEC found that Lorenzo violated these regulatory and statutory provisions by sending false and misleading statements to investors with intent to defraud.  The Court of Appeals affirmed.

The question before the Supreme Court was whether someone who is not a “maker” of a misstatement under Janus Capital, and therefore not in violation of Rule 10b-5(b), can nonetheless be found to have violated the subsections (a) and (c) of  Rule 10b-5, and to have violated related provisions of the Securities Act and the Securities Exchange Act, when the only conduct involved concerns a misstatement

The Supreme Court held that dissemination of false or misleading statements with intent to defraud can fall within the scope of subsections (a) and (c) of Rule 10b-5, as well as the relevant statutes, even if the disseminator did not “make” the statements and consequently falls outside subsection (b) of the Rule.

The Court said that the words in SEC Rule 10b-5 and the related statutes are sufficiently broad to include within their scope the acts done by Lorenzo.  He employed a “device, scheme” and “artifice to defraud” within the meaning of subsection (a) of the SEC’s Rule and §10(b) of the Securities Exchange Act and §17(a)(1) of the Securities Act.  The Court said that a “device” is simply that “which is devised or formed by design; a “scheme” is a project, plan or program of something to be done; and an “artifice” is an artful stratagem or trick.  Dissemination of false or misleading material is easily an “artful stratagem” or a “plan devised” to defraud an investor under subsection (a) of Rule 10b-5.  The words “act” and “practice” in subsection (c) are similarly expansive.  These provisions capture a wide range of conduct, and, in the Court’s words, there is “nothing borderline about this case.”  Moreover, Lorenzo did not challenge the appeals court’s finding that he sent the emails with intent to deceive, manipulate, or defraud the recipients.

Making false statements and disseminating false statements are different violations, and, therefore, a person can violate subsections (a) and (c) of Rule 10b-5 without violating subsection (b).  Furthermore, a non-maker-disseminator can be liable for aiding and abetting a violation of subsection (b).  Those who disseminate false statements with intent to defraud are primarily liable under Rules 10b-5(a) and (c) and can be secondarily liable under Rule 10b-5(b). 

This was a six-to-two decision.  Justices Thomas and Gorsuch dissented because in their opinion the majority had sown confusion and eviscerated the distinction between primary and secondary liability for false statements by holding that a person who has not “made” a fraudulent statement can nevertheless be liable for it.  Justice Kavanaugh took no part in the decision.   

John Polk is a Special Counsel at Berenzweig Leonard, LLP. John can be reached at JPolk@BerenzweigLaw.com.