Saturday, June 23, 2018
The Supreme Court just granted cert in Lorenzo v. Securities & Exchange Commission to decide the scope of primary liability/scheme liability under the federal securities laws. It’s an important issue and I’m glad that the Court seeks to clarify the law, but I have to say that procedurally speaking, this strikes me as an odd grant.
Below is way too long a post; it’s so much easier to write long than take the time to edit down, so forgive the extended backstory. (Also, for the record, I pulled a lot of the citations from my - very first! - real law review article, Slouching Towards Monell: The Disappearance of Vicarious Liability Under Section 10(b), which contains a long discussion of Janus, primary liability, and secondary liability, so, you know, enjoy if you’re into that).
[More under the jump]
Section 10(b) of the Exchange Act prohibits any person:
To use or employ, in connection with the purchase or sale of any security…any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
The government can enforce Section 10(b), both civilly and criminally, and private plaintiffs can also bring claims. Private plaintiffs, though, must show they were harmed by the deception, which means, among other things, they must show both that they relied on the misconduct and that the misconduct caused economic loss.
Note the language here: the statute defines what is prohibited by reference to the SEC rule, and the SEC used that authority to promulgate Rule 10b-5, which states:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person
It is well-established that in promulgating 10b-5, the SEC intended to capture the full extent of manipulative and deceptive activity prohibited by Section 10(b). SEC v. Zandford, 535 U.S. 813 (2002).
In Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), the Supreme Court held that Section 10(b) prohibits only the commission of a manipulative or deceptive act, not merely “aiding and abetting” fraudsters. This, of course, would give rise to decades of litigation over the distinction between actually committing a deceptive act, and aiding a deceptive act. That said, one year after Central Bank, Congress restored to the SEC – but not private plaintiffs – the ability to bring enforcement actions for aiding and abetting a fraud. Still, one element of an aiding and abetting charge is that there be – somewhere – a primary violator who was aided, so even the SEC has to distinguish between the two types of misconduct.
The Supreme Court revisited the scope of Section 10(b) in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148 (2008). There, Scientific-Atlanta agreed to falsify certain documents in a transaction with Charter Communications, so as to make it easier for Charter to falsify its publicly-reported financial results. Private plaintiffs who had been harmed by Charter’s fraud brought a Section 10(b) claim against Scientific-Atlanta, claiming that its behind-the-scenes actions violated Section 10(b). The Supreme Court agreed that Scientific-Atlanta had violated Section 10(b) by falsifying paperwork, but held that the plaintiffs had not “relied” on its conduct, because those documents were never publicized or made visible to the plaintiffs.
Finally, in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), the Supreme Court addressed a case involving mutual fund prospectuses that falsely described matters relating to the funds’ policies for allowing investors to trade in and out of the fund. The mutual funds were technically the authors of the prospectuses – they’d filed them with the SEC, the prospectuses were legally issued by the mutual funds, etc – but the funds were mere shells; all substantive operations were handled by their affiliated investment adviser, including all of the prospectus drafting. The investment adviser, then, was ultimately responsible for the false statements, and for setting the fund policies that were misdescribed. And any investor would necessarily know that; it is common knowledge that mutual fund operations are handled by the affiliated investment adviser.
Nonetheless, the Supreme Court held that the investment adviser had not “made” a statement under Rule 10b-5(b), and therefore could not be liable to private plaintiffs under that subsection. The Court explained that under 10b-5(b) “the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” Further, the Court held, “in the ordinary case, attribution within a statement or implicit from surrounding circumstances is strong evidence that a statement was made by—and only by—the party to whom it is attributed.” Here, the statements were legally those of the mutual funds – the entity to whom the statements were attributed – and therefore the investment adviser was off the hook. Notably, in so holding, the Court invoked Central Bank and the importance of distinguishing primary violators from mere aiders and abetters.
Janus is troubling for a number of reasons, the main one being that it seems difficult to dispute that the investment adviser had, in fact, committed a manipulative or deceptive act within the meaning of Section 10(b); indeed, the Court did not say otherwise. This, naturally, would suggest that if it had not “made” a 10b-5(b) statement, then surely it had either employed a “device, scheme, or artifice to defraud” under 10b-5(a) or “engage[d] in any act, practice, or course of business which operates or would operate as a fraud or deceit” under 10b-5(c), given that the three subsections together comprise the whole of conduct prohibited by Section 10(b). And the plaintiffs, knowing of the investment adviser’s role, likely relied on the adviser’s conduct, thus satisfying Stoneridge. But if that’s true, then is the whole point of Janus that the claim should have been brought under a different subsection? And if so, was it even worth a Supreme Court grant? And how does that square with Janus’s suggestion that liability in this instance would violate Central Bank?
As you can see, the whole thing is a doctrinal mess, and as a result, both before Janus (as these issues were bubbling around) and after, courts went in different directions. There’s authority for the idea that liability under 10b-5(a) and (c) is available but only if a plaintiff or the SEC can show that the conduct in question involved more than a scheme to make a false statement, Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005); SEC v. KPMG, LLP, 412 F. Supp. 2d 349 (S.D.N.Y. 2006), the Fourth Circuit has said that criminal liability under Section 10(b) has a different rule, Prousalis v. Moore, 751 F.3d 272 (4th Cir. 2014) (see BLPB post on it here), some cases – in the context of public enforcement – have said that Janus is limited to 10b-5(b) and has no application to (a) and (c), see, e.g., SEC v. Monterosso, 756 F.3d 1326 (11th Cir. 2014) – it’s all over the map.
And what does it mean to “attribute” a statement or have “ultimate authority” over it anyway? In his Janus dissent, Justice Breyer suggested that only the corporation’s Board of Directors have ultimate authority over corporate statements, so that if CEOs knowingly lie to the public, the CEO cannot be held liable.
Despite his dire predictions, courts have not gone quite that far; they’ve softened Janus’s edges by holding that officers have authority over their own statements, Merck & Co., Sec., Derivative & “ERISA” Litig., 2011 WL 3444199 (D.N.J. Aug. 8, 2011); that signing a document counts as a form of attribution, In re Pfizer Inc. Securities Litigation, 2012 WL 983548 (S.D.N.Y. 2012); and that corporate statements may have multiple authors, In re Satyam Computer Servs. Secs. Litig., 915 F. Supp. 2d 450 (S.D.N.Y. 2013); Touchtone Group, LLC v. Rink, 913 F. Supp. 2d 1063 (D. Colo. 2012). But that doesn’t even get into the whole complication where most of the private actions are decided on motions to dismiss, so there’s a whole level of pleading standard issues layered on top.
And you still have odd scenarios, which brings us to Lorenzo.
Francis Lorenzo worked for a brokerage company and knowingly sent two false emails to clients regarding an upcoming debt offering. The email’s text, however, was entirely provided by his boss (Gregg Lorenzo, no relation) and another broker at the company. The email said as much, opening with: “At the request of [the boss and the other broker], the Investment Banking division … has summarized several key points of the … Debenture Offering,” before going on to falsely describe the company’s financial condition. The email was signed by Francis Lorenzo, however, with the note “Please call with any questions.”
The SEC charged Lorenzo with fraud, and Lorenzo’s argument was that because he attributed the statements to someone other than himself, he was not their “ultimate authority” and therefore had not made a statement under 10b-5(b). (He concedes that he at the very least aided and abetted the fraud committed by his boss and the other broker, but he apparently feels the penalties for such an offense are lower than those for primary violations.) The DC Circuit bought his argument, but held that Lorenzo could nonetheless be liable for participating in an illicit scheme under the other subsections.
Which is where the Supreme Court picks it up.
Now, first, this case looks most like one that came up several years ago, prior to Janus, but at a time when many courts had anticipated it. As many may recall, Refco was a brokerage company that collapsed after it turned out that it had massively falsified its financial statements, with the extensive involvement of one of its attorneys, Joseph Collins, then a partner at Mayer Brown (who was ultimately criminally prosecuted for his role in the scheme).
At some point before the truth came to light, some TH Lee Funds agreed to invest in Refco, and Collins provided them with information about Refco’s financial condition. The information was false, and Collins knew it – Collins helped create the transactions that made it false – but when he gave the information to the Funds, he explicitly attributed it to Refco. I.e., “Refco told me that xxxx is true,” etc.
The district court subsequently dismissed the inevitable Section 10(b) lawsuit against Mayer Brown (though it sustained the state law fraud claims), reasoning that – per Stoneridge –the Funds had not relied on Collins, but on Refco. See Thomas H. Lee Equity Fund V, L.P. v. Mayer Brown, Rowe & Maw LLP, 612 F. Supp. 2d 267 (S.D.N.Y. 2009).
Not that the judge was happy about it; in a related case, he said:
While the impulse to protect professionals and other marginal actors who may too easily be drawn into securities litigation may well be sound, a bright line between principals and accomplices may not be appropriate. There are accomplices and there are accomplices: after all, in the criminal context when the Godfather orders a hit, he is only an accomplice to murder—one who “counsels, commands, induces or procures” but he is nonetheless liable as a principal for the commission of the crime. 18 U.S.C. § 2(a). Likewise, some civil accomplices are deeply and indispensably implicated in wrongful conduct. Perhaps a provision authorizing the SEC not only to bring actions in its own right but also to permit private plaintiffs to proceed against accomplices after some form of agency review would provide the necessary flexibility without involving the courts in standardless and difficult-to-administer line-drawing exercises.
In re Refco Inc. Sec. Litig., 609 F. Supp. 2d 304 (S.D.N.Y. 2009).
So the takeaway here is, yes, this is a deeply inconsistent area of law and the world will benefit from some clearer rules.
That said, Lorenzo is an odd grant, because it is not “clean,” in the sense that it has a lot of different embedded questions.
First, there are the obvious questions that the Court probably wants to get at. Namely, if you are the person who speaks the statement out of your own mouth, have you nonetheless not “made” a statement for 10b-5(b) purposes if you attribute to someone else? And if so, is scheme liability available under Rules (a) and (c)?
But there are other questions as well, like:
Does the signing/invitation for emailed questions amount to Lorenzo’s adoption of the statement, the equivalent of signing a statement in other contexts? In other words, is it possible that Lorenzo did not clearly attribute the entire statement solely to other people, leaving room for the idea that he was a partial “author”? Is that a factual question? And if he was not an author, does that have implications for all the cases where signing or similar is deemed an attribution?
Is the rule for the SEC different than for private plaintiffs?
And whither Section 17(a)? Because the SEC did not just charge Lorenzo with 10(b) violations: it also charged him with violations of Section 17(a) of the Securities Act, which is not enforceable by private plaintiffs. Section 17(a) provides:
It shall be unlawful for any person in the offer or sale of any securities …
(1) to employ any device, scheme, or artifice to defraud, or
(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
The SEC used 17(a)(1) because that is the most serious subsection, in that it requires scienter, and the others only require negligence (actually, the SEC didn’t really specify a subsection in the original charge but the Commission settled on 17(a)(1) later). Lorenzo claims that Section 17(a)(1), like 10b-5(a) and (c), is only available for “schemes” which go beyond mere statements. And the Supreme Court appears to have granted cert on that issue, too! But there’s no circuit split on the question and barely any appellate examination.
So should Section 17 be interpreted the same as Rule 10b-5? The wording is similar but not identical, there are different scienter requirements for different subsections (unlike under Rule 10b-5) – and is the Supreme Court really going to decide all of this without serious percolation in the lower courts?
I have no idea, basically, but if the Court really does engage all of this – rather than DIG’ing or only partially addressing – it’ll be a wild ride.