Saturday, September 7, 2019
A few weeks ago, we had an interesting opinion out of the 10th Circuit interpreting the scope of primary liability under Section 10(b) in the wake of the Supreme Court’s Lorenzo v. SEC decision. The short version is that in Malouf v. SEC, the Tenth Circuit found that scheme liability under Section 10(b) (and parallel provisions of Section 17(a) and the Investment Advisers Act) may be incurred when a defendant knowingly fails to correct someone else’s false statement. But matters are actually a bit more complicated.
More under the jump; warning, this post assumes basic familiarity with Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011) and Lorenzo. If you want that backstory, see this post on Janus and the Lorenzo cert grant and my discussion of the actual Lorenzo decision.
It all began when Dennis Malouf became the majority shareholder and CEO of an investment adviser firm (UASNM), while owning a branch of a broker-dealer known as Raymond James. The two firms operated out of the same offices, but Raymond James deemed Malouf’s control of both to be a conflict and asked that he choose one or the other. Malouf sold the Raymond James branch, but the terms of the deal required that the buyer continue to pay an earnout to Malouf, so Malouf maintained an interest in the branch despite the sale. As a result, Malouf routed orders from his clients at UASNM through the Raymond James brokerage, even when better prices could be obtained elsewhere.
That’s the conflict. Then there was the false statement. UASNM, like all investment advisers, was required to file a Form ADV disclosing any conflicts. At UASNM, the chief compliance officer – who was also Malouf’s father-in-law, and the prior owner of UASNM who maintained a small stake after Malouf’s purchase – was tasked with drafting the Form ADV, but Malouf never told him about the conflict, and so he never disclosed it.
Now, there was a factual dispute about whether Malouf intentionally misled anyone etc etc, but the SEC found otherwise and we’ll skip it: for our purposes, Malouf knew the Form ADV was incomplete, knew that he had withheld information, and nonetheless allowed the misleading Form to be filed. Additionally, the firm’s website stated that there were no conflicts, and that was false too. In fact – and you have to dig into the ALJ opinion for this – the website stated:
Uncompromised objectivity through independence, UASNM is not owned by any product, company nor compensated by any commissions. This allows us to provide investment advice devoid of conflicts of interest. UASNM may place trades through multiple sources ensuring that the best cost/service/execution mix is met for its clients
Anyhoo, when all of this came to light, the SEC charged Malouf with committing a scheme to defraud in violation of Section 10(b), Section 17(a), and the Investment Advisers Act . The ALJ found he was guilty, affirmed by the Commission and ultimately by the Tenth Circuit. The Tenth Circuit concluded that by failing to correct the Form ADV and the website, Malouf had sufficiently participated in an illicit scheme to trigger primary liability under the statutes.
Separately, he was found to have aided and abetted the firm’s own violations of the Investment Advisers Act Section 206(4), because the firm had made false statements and Malouf failed to correct them. (Violations of Section 206(4) do not require a showing of scienter.)
So, the first question I had reading this was: Why are we worried about a duty to correct? Why can’t we just say he “made” the false statements in violation of 10b-5(b) and hold him liable for that?
As we all know by now, in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), the Supreme Court held that “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.” Here, the Tenth Circuit described Malouf as having “responsibility” for preparing UASNM’s forms and ensuring the website’s accuracy – a task which, the Tenth Circuit says, the firm “delegated” to its chief compliance officer. And in fact, the ALJ made a factual finding that:
Malouf, as CEO, president, and majority shareholder of UASNM, had final and ultimate responsibility for UASNM's Forms ADV between 2006 and the end of 2010.
This finding was based on some oral testimony by Malouf that “the buck stops with me, there's no doubt, as the president and CEO and the majority shareholder.” So that certainly sounds like Malouf may have been the ultimate authority over the Form ADV, and of course, given his position, he could have been the ultimate authority over the firm’s website, as well. So there’s certainly quite an argument that we don’t have to worry about scheme liability at all, this was just straight up a Janus-misstatement.
As it turns out, the Commission agrees with me. In a footnote in its decision, it said:
From the record, it is clear that Malouf was, as he himself described his role, the “top dog” at UASNM and he admitted he was at least “partially responsible” for its disclosures in its Forms ADV and on its website. This evidence might support a finding that Malouf had “ultimate authority” over those statements for purposes of assessing liability under Rule 10b-5(b); however, we do not reach the issue since Malouf was not charged under that provision.
Okay. So maybe he made a misstatement. But no one charged him with that, and now we’re left with scheme liability for failing to correct the misstatements once they were made.
What about this “duty to correct,” then?
Well, prior to Lorenzo, the state of the law was a bit confused. Everyone seemed to agree that if a particular party makes a statement that was untrue at the time, that same party also has a duty to correct it. See, e.g., In re Healthcare Compare Corp. Securities Litigation, 75 F.3d 276 (7th Cir. 1996); Overton v. Todman & Co., CPAs, 478 F.3d 479 (2d Cir. 2007); Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000). The issue chiefly arose when a party innocently misspoke, and later discovered the error. At that point, the duty to correct is triggered, and the failure to do so can be a Section 10(b) violation – a misleading omission committed with scienter.
What was less clear was how this duty was to run against particular individuals within a firm who were not themselves responsible for the original misstatement. In Barrie v Intervoice-Brite, 409 F.3d 653 (5th Cir. 2005), the Fifth Circuit held:
a high ranking company official cannot sit quietly at a conference with analysts, knowing that another official is making false statements and hope to escape liability for those statements. If nothing else, the former official is at fault for a material omission in failing to correct such statements in that context.
But other cases have held that one executive has no responsibility for failing to correct the misstatements of another executive, on the ground that failure to act is not a sufficiently deceptive act to trigger primary Section 10(b) liability. See, e.g., United States v. Schiff, 602 F.3d 152 (3d Cir. 2010); Makor Issues & Rights v. Tellabs, 735 F.Supp.2d 856 (N.D. Ill. 2010).
Moving out further, the Seventh Circuit held that representatives of one firm on an earnings conference call had no duty to correct the misstatements of executives of another firm (of which it was a 46% owner). See Fulton County Emp. Ret. System v. MGIC Investment Co., 675 F.3d 1047 (7th Cir. 2012). The Seventh Circuit’s logic, post-Janus, was that if such a duty to correct existed, the Janus defendants themselves would have violated it; the Supreme Court held that the Janus defendants had no liability; therefore, there is no duty. QED.
But Janus only held that the defendants escaped liability under 10b-5(b), not subsections (a) or (c) (though that was certainly implied). And after that came Lorenzo, which held (1) subsections (a) and (c) “capture a wide range of conduct” beyond “making” a misstatement; (2) subsections (a) and (c) prohibit some forms of participation in frauds that are accomplished via a statement that was technically “made” by someone else; (3) they include conduct such as “disseminating” someone else’s false statements; and (4) their full scope will be decided on a case-by-case basis.
So it was at this point that the Tenth Circuit entered the fray, and – honestly with very little discussion – easily concluded that since Lorenzo expressly held that one person can incur primary liability for a statement “made” by someone else, the SEC acted properly in finding that Malouf had engaged in a scheme to defraud:
[W]e conclude that the SEC did not err in finding a fraudulent device, scheme, or artifice to defraud.
The evidence allowed the SEC to reasonably find a conflict of interest: while working at UASNM, Mr. Malouf maintained a financial arrangement with Mr. Lamonde, the purchaser of the Raymond James branch. Mr. Malouf knew not only that a conflict existed but also that UASNM was telling its clients that he was independent. Despite this knowledge, Mr. Malouf took no steps to correct UASNM’s statements or to disclose his own conflict. Given this failure to correct misstatements or to disclose his conflict, the SEC reasonably found the existence of an artful stratagem or plan devised to defraud investors under Rule 10b-5(a) and the Securities Act of 1933 § 17(a)(1) and a fraudulent or deceptive act, practice, or course of business under Rule 10b-5(c) and the Securities Act of 1933 § 17(a)(3).
That’s really as far as the Tenth Circuit got, but now there are a lot of continuing questions about the scope of this duty to correct, and when the (knowing) failure to correct another’s false statement counts as a deceptive scheme.
First, you could argue – and the SEC actually did argue in its briefing – that Malouf, as an investment adviser, had fiduciary duties to his clients, which included a duty to correct. If that’s the case, then this duty to correct can be limited to investment advisers with their special obligations of candor, and wouldn’t apply outside of that context. This was also part of the Commission’s opinion: “because nondisclosure in violation of a fiduciary duty involves ‘feigning fidelity’ to the person to whom the duty is owed and is therefore deceptive, we find that failing to correct a material misstatement in violation of a fiduciary duty to do so also falls within the prohibitions of Rule 10b-5(a) and (c).”
Or, you could argue that a duty to correct arose here because of Malouf’s influence, as controlling shareholder and CEO, over the conduct of a single firm. The firm certainly had a duty to correct its own misstatements – that’s indisputable – so we might say that Malouf’s level of involvement with the firm made the duty run against him personally to ensure that the firm took action. (The Janus defendants were deemed by the Supreme Court to be independent of the Funds who actually issued the false statements in that case).
Or, you could argue that within a single firm, one executive with high-level/controlling/speaking responsibilities has a duty to correct misstatements by another executive – exactly as the Fifth Circuit suggested.
And of course, you could argue that the duty to correct – whatever its scope – only arises if the defendant was the one who somehow caused the misstatement in the first place (as Malouf did by withholding information from the compliance officer). That, too, appears to have been part of the Commission’s reasoning (pre-Lorenzo): “we conclude that subsections (a) and (c) also proscribe making, drafting, or devising a material misstatement.” Malouf’s involvement in causing the misstatement in the first place, then, was critical to the finding of liability.
So, all of this awaits further development, which, basically, was kind of what Lorenzo suggested in the first instance. We know fraud when we see it, and we have to see it to know.