Can a defendant who sent emails containing misstatements to potential investors be held liable under a fraudulent-scheme claim where the evidence showed that the defendant merely forwarded the emails at the direction of another?
This case asks the Supreme Court to determine the scope of Janus Capital Group, Inc. v. First Derivative Traders, as well as the extent of liability for securities professionals who play a supportive role in fraudulent-scheme claims. Francis Lorenzo contends that the Supreme Court should apply a narrow definition of primary liability to Rule 10b-5 securities actions. Lorenzo argues that he is not culpable for securities fraud under Rules 10b-5(a) and (c) because, in forwarding emails that were written by his superior, he did nothing more than provide “substantial assistance” to those who defrauded investors with misleading financial statements. The Securities and Exchange Commission (“SEC”) counters that Lorenzo played a primary role in advancing the fraud because he signed the emails as the director of investment banking, and he told the potential investors to contact him for information about the financial health of his brokerage firm’s clients. This case will determine the ease with which the SEC can bring claims against securities professionals accused of fraud.
Questions as Framed for the Court by the Parties
Whether a misstatement claim that does not meet the elements set forth in Janus Capital Group, Inc. v. First Derivative Traders can be repackaged and pursued as a fraudulent-scheme claim.
In 2009, Francis Lorenzo (“Lorenzo”) was appointed director of investment banking for Charles Vista, LLC (“Charles Vista”), a brokerage firm in New York City. Lorenzo oversaw the account of Charles Vista’s largest client, a startup company called Waste2Energy Holdings, Inc. (“W2E”). The company was not successful; to stave off insolvency, W2E began to sell convertible debentures. Charles Vista acted as the servicer for W2E’s $15 million debenture offer. On June 3, 2009, W2E issued their Form 8-K to investors. Shortly thereafter, it issued a private memorandum to investors interested in purchasing the debentures. Neither the Form 8-K nor the memorandum mentioned a devaluation of W2E’s intangible assets, or the possibility of asset impairment. In October 2009, W2E filed an amended Form 8-K, which more accurately reflected the reality that the company’s intangible assets were virtually worthless. On October 14, 2009, Lorenzo sent emails to two potential debentures investors, but he made no reference to W2E’s serious financial difficulties. Instead, the emails assured the potential investors that the debentures came with multiple levels of protection, emphasizing W2E’s confirmed assets and Charles Vista’s own guarantees. Lorenzo’s emails indicated that they had been sent “on behalf of” Gregg Lorenzo (no relation to Lorenzo), who was Charles Vista’s Chief Executive Officer at the time. Both emails were signed by Lorenzo.
On February 15, 2013, the Securities and Exchange Commission (“SEC”) initiated a cease-and-desist proceeding against Lorenzo, Gregg Lorenzo, and Charles Vista for violating three securities-fraud provisions. An administrative law judge (“ALJ”) found that Lorenzo had made material misrepresentations in the emails he had sent to potential investors. Lorenzo was ordered to cease from violating securities-fraud statutes, pay a civil penalty of $15,000, and permanently refrain from working in the securities industry. Lorenzo requested that the SEC review the ALJ’s findings and judgment. The SEC reviewed the findings and found that at the time he sent the emails, Lorenzo knew that statements contained in the emails were false or misleading, and that as a result, the ALJ’s penalties were appropriate. The SEC denied Lorenzo’s subsequent motion for reconsideration, and Lorenzo petitioned the United States Court of Appeals for the D.C. Circuit to review his case.
The D.C. Circuit found that Lorenzo’s actions did indeed violate Section 17(a)(1) of the Securities Act of 1933 (“Securities Act”), Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”), and SEC Rules 10b-5(a) and (c). At the same time, the court found that, for the purposes of Rule 10b-5(b)’s requirement that a defendant “make” a materially false statement, Lorenzo was not the “maker” of the material falsehoods contained in the emails. As a result, the D.C. Circuit reversed and remanded the sanctions imposed upon Lorenzo, which it found that the SEC had imposed “based in part on a misimpression that Lorenzo was the ‘maker’ of false statements in violation of Rule 10b-5(b).” According to the D.C. Circuit, the SEC mistakenly concluded that Lorenzo had final authority over the email’s misstatements, when in fact, the evidence indicated that Lorenzo had simply sent the emails at Gregg Lorenzo’s direction. While this distinction did not absolve Lorenzo of criminal liability under Rules 10b-5(a) and (c) and Section 17(a)(1), it did lead the D.C. Circuit to reverse and remand the sanctions for further review.
SCOPE OF FRAUDULENT-SCHEME CLAIMS
Lorenzo argues that the mere act of forwarding emails containing misstatements cannot render a defendant liable under any of the relevant fraudulent-scheme claims provisions: Section 17(a)(1) of the Securities Act, Section 10(b) of the Exchange Act, or SEC Rules 10b-5(a) and (c). Lorenzo reasons that the plain texts of the statutes and rules—and particularly the scope of Section 10(b)’s prohibitions—require a defendant’s action itself to be deceptive, and that the act of forwarding emails cannot be deceptive when the defendant did not read or write the emails before forwarding them.Lorenzo points out that the ALJ concluded both that Lorenzo had not read the text of the emails before forwarding them to investors and that Lorenzo only forwarded them at the request of his superior, Gregg Lorenzo. Lorenzo asserts that “copying and pasting” emails from his superior in this way does not “employ” a deceptive or fraudulent scheme as the statutes require. Instead, Lorenzo characterizes his conduct in forwarding the emails as merely “ministerial” or “supportive.”
Lorenzo also draws heavily on the Supreme Court’s holding in Janus Capital Group, Inc. v. First Derivative Traders to support his argument that forwarding the emails without reading the content cannot constitute a fraudulent scheme. According to Lorenzo, the Janus court held that a defendant can be held liable for a material misstatement under Rule 10b-5(b) only if the defendant actually made the misstatement. Lorenzo posits that simply providing “substantial assistance” to the maker of the statement, as Lorenzo argues he did by forwarding his superior’s emails without reading their content, cannot render the defendant liable in Lorenzo’s reading of Janus. In Lorenzo’s estimation, the Janus decision carefully distinguished misstatement claims (under Rule 10b-5(b) and Section 17(a)(2)) from fraudulent-scheme claims (under Rules 10b-5(a) and (c) and Section 17(a)(1)). To convict a defendant of making misstatements on the mere basis of providing “substantial assistance,” Lorenzo concludes, would be to undermine the Janus court’s distinction between “misstatements” and “schemes,” and to improperly pursue Rule 10b-5(b) and Section 17(a)(2) claims under the rubric of Rules 10b-5(a) and (c), and Section 17(a)(1). In his reasoning, Lorenzo also points to the structure of Section 17(a) and Rule 10b-5. Lorenzo maintains that the fact that Congress and the SEC listed prohibitions against misstatements and prohibitions against fraudulent schemes in different sections of the provisions proves that courts should maintain distinctions between Rule 10b-5(b), and Rules 10b-5(a) and (c).
The SEC counters that, in forwarding the emails, Lorenzo falsely induced investors, which is prohibited by Rules 10b-5(a) and (c) and by Section 17(a)(1). The SEC disputes Lorenzo’s characterization of his state of mind when he forwarded the emails, pointing out that Lorenzo had first claimed that he had never read the emails and then contradicted himself by claiming that he “believed” the information in the emails to be true. According to the SEC, a person cannot believe a statement to be true without first reading it. Because the D.C. Circuit based its holding on the assumption that Lorenzo had read the emails and thus possessed intent to defraud the investors, the SEC argues that the Supreme Court should similarly assume that Lorenzo was aware of the emails’ misleading content. The SEC further contends that Lorenzo’s argument in front of the D.C. Circuit—that he “believed” the statements in the emails to be true—undermines his argument that he did not “use” or “employ” any fraudulent device because he merely copied and pasted the misleading content.
The SEC also responds that the Janus decision’s “maker” rule, which the D.C. Circuit applied to find that Lorenzo did not “make” the false statements in the emails he forwarded, only implicates Rule 10b-5(b)––not Rules 10b-5(a) or (c), as Lorenzo claims. The SEC characterizes Lorenzo’s logic as an “attempted bootstrapping,” arguing that it improperly implies that Lorenzo cannot be liable for criminal conduct under Rules 10b-5(a) and (c) so long as he is not liable under Rule 10b-5(b). Moreover, the SEC asserts, a textual reading of the statutes provides no indication that the Janus court’s interpretation of the word “make” in Rule 10b-5(b) has any bearing on the scope of different statutory provisions that happen to include the word “make.” Although the SEC concedes that Lorenzo did not “make” a misstatement under Rule 10b-5(b), it nevertheless maintains that by forwarding the emails, Lorenzo engaged in a “device, scheme, or artifice to defraud” of the kind prohibited by Section 17(a)(1) and Rule 10b-5(a). In response to Lorenzo’s argument that courts should maintain distinctions between Rule 10b-5(b), on the one hand, and Rules 10b-5(a) and (c), on the other, the SEC counters that courts have long understood various subsections of Rule 10b-5 to prohibit identical criminal conduct.
PRIMARY AND SECONDARY LIABILITY IN FRAUDULENT-SCHEME CLAIMS
Lorenzo asserts that the Janus decision drew a clear line between primary liability and secondary liability in securities fraud cases. According to Lorenzo, the Janus court limited Rule 10b-5(b) liability to those defendants who actually made misstatements. In doing so, Lorenzo claims, the court ensured that defendants such as himself, who merely supported misstatements, would at most expose themselves to secondary liability—or to charges of “aiding and abetting” a defendant who was primarily liable for the misstatements. Lorenzo points to several cases in which the Supreme Court found the SEC’s interpretation of Rule 10b-5 liability to be overly broad to demonstrate that he cannot be held primarily liable under Rules 10b-5(a) or (c). Lorenzo highlights the distinction between primary and secondary liability, pointing out that each requires the SEC to prove that a defendant committed different criminal elements. According to Lorenzo, the D.C. Circuit’s holding would allow the SEC to sidestep these different requirements, and to hold a secondary actor primarily liable under Rules 10b-5(a) and (c). Lorenzo argues that if the Supreme Court were to uphold this “backdoor,” it would ultimately undercut the careful distinctions between primary and secondary liability that precedent such as Janus delineated.
The SEC responds that Lorenzo is not simply a secondary actor, but that he is primarily liable for fraud. In forwarding the emails, the SEC maintains, Lorenzo “disseminat[ed] false financial information to investors”— an act that constitutes a fraudulent scheme according to Section 17(a)(1) and Rules 10b-5(a) and (c). Holding Lorenzo liable for his own actions, the SEC continues, will not undermine the distinction between primary and secondary liability in the way that Lorenzo claims it will. The SEC contends that Lorenzo misinterpreted the holdings of Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. and Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. Those cases, the SEC argues, considered whether Rule 10b-5 should be extended to cover secondary liability, not whether the defendants in those cases were primarily liable for their actions. According to the SEC, Lorenzo’s own actions were fraudulent, not merely supportive of his superior’s fraudulent conduct, because he knowingly sent misstatements with the intent to defraud potential investors.
AGENCY OVERREACH OF CONFERRED AUTHORITY
Writing in support of Lorenzo, the Securities Industry and Financial Markets Association and the Chamber of Commerce of the United States (“SIMFA”) argue that the statutory language at issue should be construed so as to prevent the SEC from exceeding the power conferred to it by Congress. In particular, SIMFA worries that a broad interpretation of Rule 10b-5 of the kind advanced by the SEC—which could make it easier to convict defendants who act negligently, rather than intentionally—could result in agency overreach. If the Supreme Court accepts the SEC’s proposed interpretation of the rule, SIMFA claims, then the SEC would effectively be making law, rather than creating regulatory guidelines. A group of Law Professors (“the Professors”) writing on behalf of Lorenzo add that the SEC’s broad interpretation of primarily liability will “smudge the line” between primary and secondary liability, and potentially allow the SEC to reach a broader category of defendants than Congress originally intended. In order for a defendant to be found primarily liable, the Professors continue, he or she must do more than merely provide “substantial assistance” to a more culpable co-defendant.
The North American Securities Administrators Association (“NASAA”), writing in support of the SEC, calls SIFMA’s claims about agency overreach and expansive prosecution of securities laws “hyperbolic,” arguing instead that financial professionals are only liable under Rule 10b-5 for their own knowing or reckless conduct. If Rule 10b-5 is read too narrowly, the NASAA warns, investors are unlikely to be sufficiently protected from fraud. The NASAA argues that investors currently expect—and should be able to expect going forward—a straightforward cause of action against a broker-dealer who sells them a security using financial information he or she knows to be false. The NASAA maintains that a “plain text” reading of Rule 10b-5 allows the SEC to properly enforce just such a cause of action. SIMFA’s interpretation of the law, the NASAA continues, could result in a “free pass” for brokers to knowingly sell securities pursuant to misleading financials—so long as the broker was not the original “maker” of the misstatements.” The NASAA also takes issue with the Professors’ contention that primary liability for securities must require more than “substantial assistance” on the part of the defendant. Such an approach to primary liability, the NASAA claims, would undermine current judicial interpretations of insider trading liability, where co-defendants are often held equally liable, even though one defendant was more actively involved in the scheme than the other.
EFFECTUATING FAIR AND EFFICIENT MARKETS
SIMFA warns that an expansive understanding of Rule 10b-5 liability might result in a deluge of baseless or unwarranted securities enforcement actions. SIMFA points to data suggesting that fewer companies are going public because they fear costly litigation of the kind that results from “abus[e]” of Section 10(b) and Rule 10b-5 enforcement. SIMFA argues that a narrower interpretation of Rule 10b-5 liability—one consistent with the Janus decision—would provide regulators, securities professionals, and investors with the certainty that is required for functional securities laws and healthy securities markets. Indeed, SIMFA claims, the Supreme Court itself has stressed the need for clear, administrable securities regulations. Without such straightforward regulations, SIMFA continues, plaintiffs might bring baseless private enforcement actions against companies, effectively extorting large settlements from companies that fear litigation and discovery costs.
The NASAA disputes SIMFA’s claims about an increase in frivolous public and private enforcement actions. NASAA dismisses such concerns as “meritless hyperbole,” and points to legislation like the Private Securities Litigation Reform Act and the Securities Litigation Uniform Standards Act as examples of sufficient protections for companies against meritless claims. Despite SIMFA’s professed fear of such a deluge of litigation, NASAA continues, there are simply no recent instances of securities professionals being prosecuted for routine, noncriminal acts, such as unknowingly distributing financial prospectuses that contain false or misleading information. In addition, according to NASAA, private securities lawsuits are a necessary addition to SEC enforcement actions, since there are simply too many fraud cases for the SEC to reach on its own. SIMFA’s concerns about an increase in private enforcement actions as a result of an expansive reading of regulatory rules are thus unfounded, NASAA claims; and even if such fears were merited, NASAA argues, the proper venue to address them would be through Congress, not the courts.
- Greg Stohr, Supreme Court Will Consider Narrowing Securities-Fraud Laws, Bloomberg (June 18, 2018).
- Peter J. Henning, Are False Statements Enough to Prove Fraud?, The New York Times (July 3, 2018).