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By: Ted Peters
Section 10(b) of the Securities Exchange Act, and Rule 10b-5 promulgated under it, makes certain conduct in connection with the purchase or sale of any security unlawful. Specifically, Rule 10b-5(a) prohibits the use of any “device, scheme, or artifice to defraud.” 10b-5(b) prohibits the use of any “untrue statement of a material fact” or the omission of any “material fact necessary in order to make the statements… not misleading.” And 10b-5(c) prohibits “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.”
In Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011), the United States Supreme Court addressed whether a mutual fund investment adviser could be held liable under Rule 10b-5 for false statements included in its client mutual funds’ prospectuses. The Court concluded that the adviser could not be held liable under the rule because it did not make the statements in the prospectuses.
In Lorenzo v. Securities and Exchange Commission, 872 F.3d 578 (2017), the D.C. Circuit Court of Appeal considered whether a registered representative of a broker-dealer, who allegedly emailed false and misleading statements prepared by his boss to investors, could be found liable under Rule 10b-5. Initially, the case was tried before an Administrative Law Judge who concluded that Lorenzo’s boss had drafted the emails in question; Lorenzo did not read the text of the emails; and Lorenzo had “sent the emails without even thinking about the contents.” The judge also found that the emails were sent “at the request” of Lorenzo’s boss. Notwithstanding these findings, the judge nevertheless concluded that Lorenzo had willfully violated securities laws (i.e., that Lorenzo had acted with an intent to deceive, manipulate or defraud). As a sanction, the judge not only fined Lorenzo, but also imposed a lifetime suspension effectively barring him from the securities industry.
Lorenzo appealed the ruling before the Securities Exchange Commission. The Commission affirmed, concluding that Lorenzo himself was “responsible” for the contents of the emails his boss asked him to send even though it was undisputed that Lorenzo’s boss had prepared the contents of the emails and that Lorenzo had simply “cut and pasted” the contents into the emails at issue. Notably, the SEC found that Lorenzo’s conduct triggered liability under each of the subparts of Rule 10b-5, including 10b-5(b) which, under Janus, necessarily required an affirmative finding that Lorenzo had actually “made” the statements in question.
Lorenzo next appealed to the D.C. Circuit Court. On September 29, 2017, a divided court upheld the SEC’s determination. The court agreed that there was substantial evidence that the statements in Lorenzo’s emails were false or misleading and that Lorenzo possessed the requisite intent to mislead, deceive or defraud. However, the court disagreed with the SEC’s determination that Lorenzo was the “maker” of the statements as required by Rule 10b-5(b). “We conclude that Lorenzo did not ‘make’ the false statements at issue for purposes of Rule 10b-5(b) because Lorenzo’s boss, and not Lorenzo himself, retained ‘ultimate authority’ over the statements.” [Citing Janus.] On this basis, the court set aside the sanctions and remanded the case to enable the SEC to reassess appropriate penalties.
Judge Brett Kavanaugh, the current presidential nominee to fill the vacancy left by Justice Kennedy, penned a strongly worded dissent. Kavanaugh criticized the conclusion reached by his colleagues that the “scheme liability” provisions of Rule 10b-5(a) and (c) may be used to find liability even where the defendant is not the “maker” of the statements (and thus not liable under 10b-5(b)).
On June 18, 2018, the U.S. Supreme Court granted the petition for writ of certiorari. The question before the Supreme Court is simple: Can a defendant be held liable under the so-called scheme liability provisions of Rule 10b-5(a) and (c) in connection with using false or misleading statements, even if that defendant is not the “maker” of the statements? That the Court accepted certiorari certainly suggests that the Court desires to further define the scope and limitations of Rule 10b-5.
Should Kavanaugh be confirmed as the next Supreme Court Justice, it remains to be seen whether he will recuse himself on the grounds that he heard the case below. If he does, then the Court could well end up with a 4-4 split, which would effectively affirm the lower court’s ruling. The Court’s four more liberal justices (Breyer, Ginsburg, Sotomayor and Kagan) each dissented from Janus. On the other hand, if Kavanaugh is confirmed and does not recuse himself, the majority of the Court will likely endorse a more restrictive interpretation of scheme liability under Rule 10b-5.
If you have questions or would like more information, please contact Ted Peters at [email protected].