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Stretching the Limits of “Scheme Liability”

On Behalf of | Jun 29, 2018 | Business Litigation, Corporate & Technology Law

On Monday, June 18, 2018, the United States Supreme Court granted a request to review SEC v. Francis Lorenzo, a case that asks the Justices to clarify the limits of so-called “scheme liability” under the federal securities laws given the limits on so-called “statement liability” established by prior Supreme Court cases. The case has the potential to affect significantly the scope of both SEC civil enforcement and private securities actions.

Under the federal securities laws, “statement liability” arises from claims based solely on a fraudulent statement. “Scheme liability” under the federal securities laws is different: Rather than being based on a single statement, such a claim must be based on fraudulent conduct (such as market manipulation or other “schemes” or “artifices”). In Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), the Supreme Court held that the only individual who may face “statement liability” is the “maker” of the statement—that is, “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” 564 U.S. at 142. Lorenzo poses the question of whether a person may be exposed to “scheme liability” based on conduct consisting of only a fraudulent statement if that person was not the “maker” of the statement.

The case arose from two emails that Lorenzo, an investment banker, sent to prospective investors regarding debentures being sold to raise money for a company that had claimed to have technology to generate electricity from solid waste. Lorenzo’s supervisor, who owned the broker-dealer, had written the emails and directed Lorenzo to send them to the clients. But the statements about the company’s financial prospects were false: Several days earlier, the company had announced that its technology did not work. The record is unclear whether Lorenzo—as opposed to his supervisor—knew about the company’s announcement at the time he sent the emails.

The supervisor and the broker-dealer settled with the SEC. After a hearing, an administrative law judge found Lorenzo had acted with an intent to deceive, manipulate or defraud, and therefore had willfully violated (1) Section 17(a)(1) of the Securities Act of 1933, 15 U.S.C. § 77q(a)(1); Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j; and Securities Exchange Act Rule 10b-5. As a sanction the ALJ imposed a civil monetary penalty of $15,000, ordered Lorenzo to cease and desist from violating each of the securities fraud provisions giving rise to the charges, and imposed against Lorenzo a lifetime bar from the securities industry. On appeal, the full Commission upheld the imposition of the sanction ordered by the ALJ.

On appeal, the U.S. Court of Appeals for the DC Circuit overturned the Commission’s finding that Lorenzo violated Rule 10b-5(b) because it concluded that the evidence showed that Lorenzo did not make the statements in question. But the Court upheld the findings that Lorenzo violated Section 17(a)(1) of the Securities Act, Section 10(b) of the Securities Exchange Act, and Rule 10b-5(a) and (c).

In his petition, Lorenzo noted that permitting scheme liability based only on a statement for which the defendant was not the “maker” would eviscerate the limits that Janus put on statement claims by permitting the SEC or private litigants to pursue otherwise barred claims against non-makers by framing the accusation as a scheme claim. He also noted that such a rule would erase the distinction between primary and secondary violators of the securities laws. Private litigants—who lack statutory authority to pursue aiders and abettors of securities violations—could then sue non-makers under a theory of scheme liability, reaching defendants they could not otherwise sue. And, similarly, the SEC would be permitted to pursue as primary violators defendants whose liability would otherwise be limited to aiding and abetting under Section 20(e) of the Securities Exchange Act.

The DC Circuit’s decision is consistent with one in the Eleventh Circuit, but the Second, Eighth and Ninth Circuits have reached contrary decisions. Thus, in Lorenzo, the Supreme Court has the opportunity to resolve this Circuit split and, depending on one’s perspective, the Court may either provide the SEC and private litigants with greater power to hold fraudsters accountable for their misconduct, or it may rein in overreaching by the SEC that seeks to exert authority beyond what Congress has granted to it.

David Deitch is leads the White Collar Defense and Corporate Compliance practice at Berenzweig Leonard, LLP. David can be reached at [email protected].