Schemes and False Statements: Supreme Court to Consider Scope of Anti-Fraud Liability Under Securities Laws
Legal Sidebari
Schemes and False Statements: Supreme
Court to Consider Scope of Anti-Fraud
Liability Under Securities Laws
November 30, 2018
On December 3, 2018, the Supreme Court will hear oral arguments in Lorenzo v. Securities and Exchange
Commission, a case involving the scope of anti-fraud liability under federal securities law that may have
significant implications for private securities litigation and Securities and Exchange Commission (SEC)
enforcement actions. In Lorenzo, the Court is considering whether individuals who knowingly or
recklessly send false statements to prospective investors in connection with a securities transaction can be
held liable for participating in a fraudulent “scheme” even if they do not possess ultimate authority over
the content of the statements. The Court’s resolution of this question may affect the range of defendants
that private plaintiffs and the SEC can sue for securities fraud.
This Sidebar discusses the Lorenzo case and its broader implications by first providing an overview of the
principal anti-fraud provisions of federal securities law and the distinction between primary and
secondary anti-fraud liability. The Sidebar then reviews the history of the Lorenzo litigation and the main
arguments that the Supreme Court will consider in the case. Finally, the Sidebar discusses the
implications of the Court’s decision for private securities litigation, SEC enforcement actions, and
Congress.
Primary and Secondary Anti-Fraud Liability
After the 1929 stock market crash and ensuing economic depression, Congress enacted the Securities Act
of 1933 (the Securities Act) to ensure “full and fair disclosure of the character of securities sold in
interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof.” One
year later, Congress passed the Securities Exchange Act of 1934 (the Exchange Act) to “provide for the
regulation of securities exchanges and of over-the-counter markets operating in interstate and foreign
commerce and through the mails,” and to “prevent inequitable and unfair practices on such exchanges and
markets.”
Both the Securities Act and the Exchange Act contain prohibitions on fraud related to the sale of
securities. Section 10(b) of the Exchange Act makes it unlawful to “use or employ, in connection with the
Congressional Research Service
https://crsreports.congress.gov
LSB10224
CRS Legal Sidebar
Prepared for Members and
Committees of Congress
Congressional Research Service
2
purchase or sale of any security . . . , any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the [SEC] may prescribe.” SEC Rule 10b-5, which
implements Section 10(b), in turn makes it unlawful “in connection with the purchase or sale of any
security” to (1) “employ any device, scheme, or artifice to defraud,” (2) “make any untrue statement of a
material fact,” or (3) “engage in any act, practice, or course of business which operates or would operate
as a fraud or deceit upon any person.” Similarly, while Section 17(a) of the Securities Act regulates the
“offer or sale” of securities (as opposed to their “purchase or sale”), it contains anti-fraud provisions that
courts have described as “substantially identical” to those in Rule 10b-5. Courts have generally referred to
claims brought under the first and third subsections of Rule 10b-5 as “scheme liability” claims to
distinguish them from “false statement” claims brought under the rule’s second subsection.
In interpreting Section 10(b) and Rule 10b-5, the Supreme Court has distinguished between (1) “primary”
actors who make false statements or participate in a fraudulent scheme, and (2) “secondary” actors who
assist primary actors in violating the law but do not themselves make false statements or participate in a
fraudulent scheme. The Court first addressed this distinction between primary and secondary actors in its
1994 decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. In Central Bank,
investors in public building authority’s bonds brought Section 10(b) claims against the building authority
and its underwriters based on false statements concerning the appraisal of land securing the bonds. The
investors also alleged that a bank that served as a trustee for the bonds was “secondarily” liable under
Section 10(b). Specifically, the investors alleged that the bank aided and abetted the other defendants’
violations of Section 10(b) by delaying an independent review of the appraisal, even though the bank had
not itself made any false statements or participated in a fraudulent scheme. However, the Court rejected
the plaintiffs’ claims against the bank, holding by a 5-4 vote that based on the language of Section 10(b)
and Rule 10b-5, private plaintiffs cannot sue actors who aid and abet violations of those provisions but do
not themselves make false statements or participate in a fraudulent scheme.
The Court again addressed the distinction between primary and secondary actors in its 2011 decision in
Janus Capital Group, Inc. v. First Derivative Traders. In Janus, investors brought Section 10(b) claims
against an investment adviser that had assisted an associated mutual fund in preparing prospectuses
containing false statements. Specifically, the plaintiffs in Janus alleged that the investment adviser had
violated Rule 10b-5(b), the subsection of the rule that makes it unlawful to “make” material false
statements in connection with the sale of securities (as opposed to the “scheme liability” subsections). The
Court rejected the plaintiffs’ claims against the investment adviser by a 5-4 vote, reasoning that the
investment adviser was not the “maker” of the relevant false statements within the meaning of Rule 10b-
5(b) because it had only assisted in the preparation of the prospectuses. Relying in part on the distinction
between primary and secondary actors established in Central Bank, the Court explained that the “maker”
of a false statement under Rule 10b-5(b) is “the person or entity with ultimate authority over the
statement, including its content and whether and how to communicate it.” By contrast, the Court
explained that persons who merely assist in the making of the statement do not “make” the statement
within the meaning of Rule 10b-5(b). According to the Court, a contrary rule under which persons who
merely assist in the making of a false statement qualify as “makers” of the statement would “substantially
undermine” the distinction between primary and secondary actors by making the latter “almost
nonexistent.” Because only the mutual fund that had issued the prospectuses had “ultimate authority” over
their content, the Court concluded that the investment adviser had not violated Rule 10b-5(b) because it
was not the “maker” of the false statements in the prospectuses.
Lorenzo v. Securities and Exchange Commission
In Lorenzo, the Court is considering a question that is closely related to the issues explored in Central
Bank and Janus: whether “scheme liability” claims can be brought against persons who (1) knowingly or
recklessly send false statements to prospective investors in connection with a securities transaction, but
Congressional Research Service
3
(2) do not themselves “make” the false statements within the meaning of Rule 10b-5’s “false statement”
provision because they do not have “ultimate authority” over their content under Janus. In 2013, the SEC
brought an enforcement action alleging that Francis Lorenzo (an investment banker) violated Section
10(b) of the Exchange Act, Rule 10b-5, and Section 17(a) of the Securities Act by sending emails
misrepresenting a company’s assets to prospective investors. In defending himself against these charges,
Lorenzo argued that he had not violated these provisions because he had sent the emails at the request of
his boss, who had drafted them. However, an SEC administrative law judge (ALJ) rejected this argument,
concluding that because Lorenzo had been at a minimum “reckless” in sending the emails, he had indeed
violated the relevant “false statement” and “scheme liability” provisions. After Lorenzo petitioned the full
SEC for review, the Commission sustained the ALJ’s decision on the grounds that Lorenzo “knew each of
[the emails’ key statements] was false and/or misleading when he sent them.” Lorenzo then appealed the
SEC’s decision to the U.S. Court of Appeals for the D.C. Circuit (D.C. Circuit), which reversed the
decision in part. Specifically, a three-judge panel of the D.C. Circuit unanimously reversed the SEC’s
determination that Lorenzo had violated Rule 10b-5’s “false statement” provision—that is, the provision
at issue in Janus—but affirmed its conclusion that Lorenzo had violated the relevant “scheme liability”
provisions by a 2-1 vote.
In reversing the SEC’s finding that Lorenzo had violated Rule 10b-5’s “false statement” provision, the
D.C. Circuit concluded that because Lorenzo had sent the relevant false statements at the request of his
boss, Lorenzo was not the “maker” of the statements under Janus. However, in affirming the SEC’s
determination that Lorenzo had violated the relevant “scheme liability” provisions, the court explained
that unlike Rule 10b-5’s false statement provision, the “scheme liability” provisions “do not speak in
terms of an individual’s ‘making’ a false statement.” Rather, because the “scheme liability” provisions
prohibit “device[s], scheme[s], or artifice[s] to defraud,” and Lorenzo’s conduct “fit[] comfortably within
the ordinary understanding” of those terms, the D.C. Circuit affirmed the SEC’s conclusion that Lorenzo
had violated those provisions. In affirming this aspect of the SEC’s decision, the D.C. Circuit agreed with
the Eleventh Circuit and a number of district courts that securities-fraud allegations involving false
statements can serve as the basis for “scheme liability” even if the alleged conduct does not amount to
“making” a false statement under Janus. However, the court’s decision arguably stands in some tension
with the proposition that “scheme liability” under Rule 10b-5 requires something more than involvement
in the dissemination of false statements, which has been endorsed by the Second, Eighth, and Ninth
Circuits.
The D.C. Circuit’s decision in Lorenzo drew a dissent from then-Judge Brett Kavanaugh, who argued
(among other things) that the court’s interpretation of the “scheme liability” provisions would allow the
SEC “to evade the important statutory distinction between primary and secondary . . . liability” that
Central Bank and Janus established by implying that persons who merely assist in the communication of
a false statement are themselves primary actors guilty of participating in a fraudulent scheme.
Lorenzo filed a petition for a writ of certiorari challenging the D.C. Circuit’s interpretation of the “scheme
liability” provisions with the Supreme Court in January 2018, which the Court granted in June.
Implications of the Court’s Decision
The Court’s decision in Lorenzo may have significant implications for private securities litigation, SEC
enforcement actions, and Congress. As discussed, under Central Bank, private plaintiffs cannot bring
Section 10(b) claims against “secondary” actors who merely assist another actor in violating the securities
laws. Accordingly, if the Court were to agree with the D.C. Circuit that persons who do not “make” false
statements within the meaning of Rule 10b-5’s “false statement” provision (and accordingly cannot
qualify as “primary” actors under that provision) can nevertheless qualify as “primary” actors guilty of
participating in a fraudulent scheme, it would expand the range of defendants that private plaintiffs are
able to sue for securities fraud.
Congressional Research Service
4
A decision reversing the D.C. Circuit’s interpretation of the “scheme liability” provisions may also prove
significant for SEC enforcement actions. Congress responded to the Court’s decision in Central Bank by
enacting Section 20(e) of the Exchange Act, which affirms the SEC’s authority to bring enforcement
actions against “secondary” actors who “substantially assist” others in violating Section 10(b) (without
altering Central Bank’s holding concerning private plaintiffs). The SEC will accordingly retain the
authority to bring enforcement actions against persons who aid and abet “false statement” violations
irrespective of whether such persons can also qualify as “primary” violators of the “scheme liability”
provisions. However, the SEC contends that Lorenzo may nevertheless have important implications for its
enforcement authority. Specifically, the SEC argues that Lorenzo’s proposed reading of the “scheme
liability” provisions would create a “loophole” in cases where the SEC is unable to prove that the
“maker” of a false statement acted with the required mental state. In such cases, the SEC contends, it
would be unable to bring enforcement actions against persons who knowingly or recklessly communicate
the false statement if those persons did not “make” the statement. The SEC argues that it would be unable
to bring enforcement actions in these circumstances under Lorenzo’s proposed interpretation because
such persons would not qualify as (1) “primary” violators of the “scheme liability” provisions, or (2)
“secondary” violators under Section 20(e) of the Exchange Act because there would be no “primary”
violator for them to assist.
While the Supreme Court granted certiorari only with respect to the “scheme liability” issue, a decision
affirming the D.C. Circuit’s holding that Lorenzo did not “make” the relevant false statements under
Janus would also have important implications. Specifically, the D.C. Circuit’s determination that Lorenzo
did not qualify as the “maker” of the false statements despite the fact that he signed the relevant emails
arguably conflicts with at least one court’s conclusion that securities underwriters can qualify as the
“makers” of false statements when their names appear on the cover of a prospectus. Accordingly, if the
Court were to address the issue, a decision affirming the D.C. Circuit’s interpretation of Rule 10b-5’s
“false statement” provision would restrict the range of defendants that private plaintiffs and the SEC can
pursue under that provision.
While Lorenzo accordingly has the potential to alter the scope of anti-fraud liability under the securities
laws, it may also leave existing law undisturbed until the full nine-member Court can consider a similar
case. Because of his participation in the D.C. Circuit’s decision, Justice Kavanaugh has recused himself
from the case, raising the possibility of a 4-4 split. Some commentators have suggested that such a split is
the “most likely outcome” in Lorenzo in light of the close division among the Justices in Central Bank
and Janus. Such a stalemate would result in an affirmance of the D.C. Circuit’s decision, but would leave
contrary decisions of other circuit courts unaffected.
Regardless of the outcome in Lorenzo, Congress could address the issues raised by the case. Specifically,
Congress could clarify the scope of Section 10(b) of the Exchange Act and Section 17(a) of the Securities
Act by amending the underlying statutes, as it has done in response to Central Bank and other securities
law decisions.
Congressional Research Service
5
Author Information
Jay B. Sykes
Legislative Attorney
Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff
to congressional committees and Members of Congress. It operates solely at the behest of and under the direction of
Congress. Information in a CRS Report should not be relied upon for purposes other than public understanding of
information that has been provided by CRS to Members of Congress in connection with CRS’s institutional role.
CRS Reports, as a work of the United States Government, are not subject to copyright protection in the United
States. Any CRS Report may be reproduced and distributed in its entirety without permission from CRS. However,
as a CRS Report may include copyrighted images or material from a third party, you may need to obtain the
permission of the copyright holder if you wish to copy or otherwise use copyrighted material.
LSB10224 · VERSION 2 · NEW