Securities Regulation Daily SCOTUS ponders scheme liability for transmitting false statements
Monday, December 3, 2018

SCOTUS ponders scheme liability for transmitting false statements

By Anne Sherry, J.D.

The Supreme Court heard oral argument in a case that could define the contours of the SEC’s key antifraud rule. An investment banker who sent false statements to clients at the direction of his boss did not "make" the statements under Exchange Act Rule 10b-5(b),but was liable under the two other subsections of the rule. Oral argument coalesced around two main questions: did the petitioner’s transmission of the emails constitute an act for purposes of fraud liability? And does the SEC’s use of Rule 10b-5(a) or (c) to impose scheme liability on an individual for false statements constitute an impermissible end-run around Rule 10b-5(b), which is limited to the "maker" of a statement? (Lorenzo v. SEC, December 3, 2018).

Not a maker, but scheme liability applies. The petitioner worked as the head of the investment banking division at Charles Vista, LLC. Charles Vista was placement agent for an offering by a startup energy company of $15 million in convertible debentures. At the direction of his supervisor, but under his own account and email signature, the petitioner sent two nearly identical emails to two clients related to the offering. The emails said that they were sent at the request of the supervisor and requested that the recipient read the offering memorandum, including risk factors. They then went on to state that the offering had "3 layers of protection"—each of which, the SEC concluded in its initial decision, was false. One of the two recipients eventually invested $15,000 in the offering, resulting in a $150 commission to the petitioner.

A majority of a D.C. Circuit panel largely upheld the SEC’s findings, but determined that the broker did not "make" the statements in the emails for purposes of Exchange Act Rule 10b-5(b). Unlike Rule 10b-5(b), however, Rules 10b-5(a) and (c) and Securities Act Section 17(a)(1) do not speak in terms of an individual’s "making" a false statement. The petitioner’s conduct in producing and sending the emails instead constituted employing a deceptive "device," "act," or "artifice to defraud" for purposes of liability under (a) and (c). The dissenting judge took the majority to task for creating a circuit split by holding that mere misstatements may constitute the basis for scheme liability.

"Three categories of fraud." The argument represented an effort to define the contours of, and relationships between, the three subsections of Rule 10b-5. The petitioner’s counsel maintained that the petitioner could not be liable under (a) or (c) because he took no act besides transmitting the emails at the behest of his boss, and mere misrepresentations are the purview of 10b-5(b). The justices quickly pushed back at the premise of this argument.

Justice Sotomayor noted that the petitioner had conceded scienter to the SEC. "Once you concede that mental state, and he has the act of putting together the email and encouraging customers to call him with questions, not to call his boss with questions, how could that, standing alone, give away your case?" Petitioner’s counsel responded that had customers called with questions, and had the petitioner repeated the false statements or engaged in another type of deceptive conduct, this may have constituted primary liability, but merely sending the emails did not qualify.

Justice Kagan said that under Central Bank, you are primarily liable when your actions fit within the language of the statutory provision you are charged with. The petitioner "fit within that language," she continued. "He engaged in an act that operated as a fraud." Counsel responded that 10b-5 cannot go beyond the bounds of Section 10(b) itself, which refers to a manipulative or deceptive device or contrivance. But this argument works against him, Justice Kagan posited, because to take it to its logical conclusion you would have to conclude that misrepresentations and omissions do not fall within the language of the statute at all, and it is well understood that they do.

A "belt-and-suspenders" rule. A more philosophical discussion followed when petitioner’s counsel cited U.S. v. Naftalin for the proposition that each subsection (there of Section 17(a)) prohibits a different type of conduct. To give meaning to each subsection, you cannot read the statute as allowing every claim to be brought under any of the subsections.

Justice Kagan noted that if you took that view of the Exchange Act, you would also have to believe that Rule 10b-5(a) and (c) are mutually exclusive, and asked petitioner’s counsel what the difference is between them. She posited that there may be a different view of the statute, which is that its subsections overlap: "This is kind of a belt-and-suspenders statute, where it’s like we’re going to find every possible way to say this thing in order to make sure that fraudulent acts are covered." Admitting that there may not be a meaningful difference between (a) and (c), counsel offered that the Court can consider those two subsections as one type of fraud, but (b) as distinct. To sustain the D.C. Circuit would mean wholesale elimination of (b).

Petitioner’s counsel also noted that the government had not cited any cases imposing primary liability simply for sending an email on behalf of another person. Chief Justice Roberts asked the respondent’s counsel to describe a situation to which Janus would apply if the government’s reading of 10b-5 prevailed. Counsel raised a scenario where there was an individual far back in the chain of drafting copy that was not itself deceptive, but that the person knew would be used in a fraud. That person would be an aider and abettor, but would not be primarily liable because Section 10(b) itself requires a deceptive act. Janus is the critical case for distinguishing between primary and secondary liability, he said, which is particularly important in private actions where there is no aiding-and-abetting liability.

What is an "act"? In opening his argument, the respondent’s attorney tried to get away from the discussion of 10b-5(b), clarifying that the government is no longer pressing a charge under this subsection. But Justice Ginsburg noted that the petitioner maintains that the government is attempting an end-run around Janus by repackaging what would have been a 10-b5(b) charge under other provisions. Respondents’ counsel said that Janus would continue to have significant meaning, especially in private actions. Not everyone who has some involvement in a statement would become primarily liable under (a) and (c) or under Section 17(a).

Justice Gorsuch attempted to narrow in on the actus reus that the SEC was alleging here. An act of fraud requires an act that deceives someone, he said, and "the only thing that deceived anybody allegedly here were these emails … and [petitioner] didn’t make them." If the deception derives from the erroneous facts transmitted in the email, is that it? Justice Gorsuch asked. Justice Kagan responded that those facts cannot cause the deception unless they get to the readers, and the government’s counsel agreed. Justice Breyer asked if there is a distinction between conduct and statement, musing, "don’t we make statements all the time through conduct?" Again, the government agreed. But on rebuttal, petitioner’s counsel reiterated that there must be some inherently deceptive conduct, such as creating a phony purchase order or contract—the type of serious conduct Congress had in mind when it drew lines between primary and secondary liability.

The case is No. 17-1077.

Attorneys: Robert G. Heim (Meyers & Heim LLP) for Francis V. Lorenzo. Christopher G. Michel, U.S. Department of Justice, for the SEC.

Companies: Waste2Energy Holdings, Inc.; Charles Vista, LLC

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