Supreme Court Hears Argument On “Scheme Liability” Under Section 10(b) And Rule 10b-5
On December 3, 2018, the Supreme Court heard argument on an appeal in a case where a divided panel of the D.C. Circuit held that a defendant who did not “make” a misstatement within the meaning of Janus Capital Group v. First Derivative Traders, 564 U.S. 135, 142 (2011), nonetheless could be liable for participating in a “scheme” to defraud under Section 10(b) of the Exchange Act, SEC Rule 10-b5 promulgated thereunder, and Section 17(a) of the Securities Act, by disseminating with fraudulent intent a misstatement made by someone else. See Lorenzo v. S.E.C., No. 17-1077.
In a 5-4 decision, Janus held that where a Section 10(b) claim is predicated on a misstatement, only the “maker” of that misstatement can be a primary violator of Section 10(b) and SEC Rule 10b-5. Janus, 564 U.S. at 142. Janus defined a “maker” as the person or entity with “ultimate authority” over the statement. Id. This squared, among other things, with the Supreme Court’s prior decision in Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., which held that there is no aiding and abetting liability under Section 10(b) – it is primary liability or nothing. 511 U.S. 164, 191 (1994). (Congress later amended the Exchange Act to permit aiding and abetting liability in actions brought by the Securities and Exchange Commission (“SEC”). Exchange Act § 20(e), 15 U.S.C. § 78t (2011).)
In Lorenzo, defendant Lorenzo was directed by his boss to send two emails to potential investors with statements that his boss had prepared. In the Matter of Gregg C. Lorenzo, Francis v. Lorenzo, & Charles Vista, LLC, S.E.C. Release No. 544, 2013 WL 6858820, at *5 (Dec. 31, 2013). The case proceeded before an SEC administrative law judge, and the Commission reviewed the ALJ’s decision. The SEC determined in the administrative proceeding that Lorenzo acted with scienter (i.e., fraudulent intent) when sending the emails. Id. at *7-*8. The Commission’s findings and penalties were reviewed by the D.C. Circuit.
On appeal, consistent with Janus, the D.C. Circuit panel agreed that Lorenzo could not be liable as the “maker” of the misstatements, because his boss was the one with “ultimate authority” over them. Lorenzo v. S.E.C., 872 F.3d 578, 587 (D.C. Cir. 2017). A majority of the court, however, held that the SEC was still within its rights to find Lorenzo liable for a violation, because Section 10(b) and SEC Rule 10b-5 permit liability for primary participation in a “scheme” to defraud. Id. at 588-89. In so doing, the D.C. Circuit relied on subsections (a) and (c) of SEC Rule 10b-5, which deal expressly with schemes to defraud, rather than subsection (b), which deals expressly with misstatements and was interpreted in Janus. Id. The majority also distinguished the case from Stoneridge Inv. Partners, LLC v. Sci.-Atlanta, 552 U.S. 148, 166-67 (2008). There, the Supreme Court rejected the idea that “scheme” liability could be used to impose primary liability on secondary actors whose transactions with the corporate issuer might have facilitated a disclosure fraud. Unlike the fact pattern in Stoneridge, wrote the majority, Lorenzo directly communicated with investors rather than acting behind the scenes. Lorenzo, 872 F.3d at 591.
Justice Brett Kavanaugh, then a D.C. Circuit judge, authored a fairly scathing dissent, noting – among other things – that relying on scheme liability and subsections (a) and (c) in a case ultimately premised on a misstatement was contrary to decisions of other circuits. Id. at 600-01 (citing Public Pension Fund Group v. KV Pharmaceutical Co., 679 F.3d 972, 987 (8th Cir. 2012); WPP Luxembourg Gamma Three Sarl v. Spot Runner, Inc., 655 F.3d 1039, 1057 (9th Cir. 2011); Lentell v. Merrill Lynch & Co., 396 F.3d 161, 177 (2d Cir. 2005); S.E.C. v. Kelly, 817 F. Supp. 2d 340, 343-44 (S.D.N.Y. 2011)). On appeal to the Supreme Court, Justice Kavanaugh’s involvement below required his recusal, meaning that only eight justices heard argument and that there may be a 4-4 split, which would result in the D.C. Circuit’s decision continuing to stand, but not as a national precedent.
Now for the argument: Justices Breyer, Ginsburg, Kagan and Sotomayor – all of whom, notably, were in the dissent in Janus – appeared skeptical of Lorenzo’s arguments on appeal. Justice Kagan labeled Janus a “very textual decision,” while Justice Sotomayor noted that “Janus was based explicitly on the ‘making’ language of 10b-5(b).” Questions from Justices Alito and Roberts – both in the Janus majority – were less revealing, perhaps leaving open the prospect that a majority decision in the SEC’s favor could be reached on some basis. Indeed, Justice Alito suggested that “verbal conduct” might constitute a fraudulent act under the language of subsection (c), and questioned whether the defendant’s argument regarding secondary liability was relevant, because it appeared that the defendant was “a principal under [Rule 10b-5] (c)” who “did the act that is described in (c).” Questions from Justice Gorsuch appeared more accepting of Lorenzo’s argument that if Lorenzo was not the “maker” of the statement under Janus, because he lacked ultimate authority, that should be the end of it. Two Justices who reached opposing conclusions in Janus – Chief Justice Roberts and Justice Ginsburg – did question whether reading 10b-5(a) and (c) as allowing liability here would render Janus a “dead letter” and “essentially inconsequential” by “repackage[ing] what would have been a 10b charge under 17 or 10b-5(a) and (c).” And, indeed, this would seem to be the core problem with the D.C. Circuit’s decision, especially if applied beyond its fairly idiosyncratic facts.
As a practical matter, how the Court decides the case seems more important than whether it affirms or not. Holding an employee, who acted with scienter (as the SEC found administratively) liable under Section 10(b) for sending out a material misstatement at the instruction of his employer – although arguably incompatible with Janus – probably would do no structural violence to the overall “primary violator versus secondary actor” framework resulting from the trilogy of Janus, Central Bank and Stoneridge. Similarly, a rejection of the SEC’s position probably would not change the landscape much either (and probably even less). If, however, the Court embraces the broad conclusion that anyone who “schemes” with the “maker” of a misstatement is just as liable as the maker, notwithstanding Janus, then Janus would indeed be diminished. It seems doubtful that a majority would embrace so broad a ruling.