Lies and Schemes: Supreme Court Expands Securities Fraud Liability
Legal Sidebari
Lies and Schemes: Supreme Court Expands
Securities Fraud Liability
April 24, 2019
The Supreme Court recently held in Lorenzo v. Securities and Exchange Commission that persons who
knowingly disseminate false statements to investors violate the “scheme liability” provisions of federal
securities law even if they do not have ultimate authority over the content of those statements. In reading
the scheme liability provisions to reach this conduct, the Court expanded the scope of “primary” securities
fraud liability and, by extension, the range of defendants that private plaintiffs can sue for fraud. The
Court’s decision—which bucks a trend of recent opinions narrowing the anti-fraud provisions of the
securities laws—highlights a longstanding debate over the proper scope of private causes of action under
those provisions. This Sidebar discusses the Court’s decision in Lorenzo and its implications for
Congress.
“Primary” and “Secondary” Securities Fraud Liability
The federal securities laws contain a variety of anti-fraud provisions. Section 10(b) of the Securities
Exchange Act of 1934 (the Exchange Act) makes it unlawful 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 [SEC] may prescribe.” SEC Rule 10b-5, which
implements Section 10(b), in turn makes it unlawful to “in connection with the purchase or sale of any
security”:
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.
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. Similarly, while Section 17(a) of the Securities Act of 1933 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.
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In interpreting 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. Specifically, the Court has held that because Rule 10b-5 by its terms does not prohibit aiding and
abetting the making of a false statement or the execution of a fraudulent scheme, the Rule does not apply
to secondary actors who merely assist others in violating the law. As a result of this distinction, the SEC
must rely on a separate statutory provision—Section 20(e) of the Exchange Act—to pursue enforcement
actions against secondary actors, while private plaintiffs lack a cause of action against secondary actors
altogether. This limitation on private causes of action makes the precise boundaries of primary fraud
liability highly significant.
The Court has drawn these boundaries narrowly in interpreting Rule 10b-5(b)—the subsection of the Rule
concerning false statements (as opposed to fraudulent schemes). In its 2011 decision in Janus Capital
Group, Inc. v. First Derivative Traders, the Court held that based on the text of Rule 10b-5(b), primary
liability under that subsection is limited to persons who “make” a false statement. Specifically, the Janus
Court held that a person “makes” a false statement and can accordingly be held primarily liable under
Rule 10b-5(b) only if he has “ultimate authority over the statement, including its content and whether and
how to communicate it.” As a result of this limitation, private plaintiffs do not have a cause of action
under Rule 10b-5(b) against persons who help prepare or disseminate false statements when those persons
do not have “ultimate authority” over the statements.
While Janus clarified that primary liability under Rule 10b-5(b) extends only to persons who “make” a
false statement, it did not address whether persons who help prepare or disseminate false statements can
be primarily liable under the Rule’s scheme liability provisions. Courts have traditionally read these
provisions to prohibit various forms of inherently manipulative conduct, including “wash sales,”
“matched orders,” and other trading conduct that distorts a security’s price. However, before Lorenzo, a
number of lower federal courts had interpreted Rule 10b-5’s scheme liability provisions to also
encompass the preparation or dissemination of false statements, even though such conduct does not
amount to “making” a false statement under Janus’s reading of Rule 10b-5(b). By contrast, other courts
had concluded that the scheme liability provisions do not prohibit conduct related only to false statements,
and that Rule 10b-5(b) accordingly provides the sole avenue for claims related to such conduct.
Lorenzo v. Securities and Exchange Commission
In Lorenzo, the Supreme Court resolved this circuit split, holding that persons who knowingly
disseminate false statements to investors violate the relevant scheme liability provisions even if they do
not “make” the statements under Rule 10b-5(b). The Lorenzo litigation involved an SEC enforcement
action against an investment banker who knowingly sent fraudulent emails to prospective investors at the
request of his boss. While the U.S. Court of Appeals for the D.C. Circuit held that the investment banker
had not violated Rule 10b-5(b) because he was not the “maker” of the false statements under Janus, it
affirmed the SEC’s conclusion that the banker had violated the scheme liability provisions by knowingly
disseminating the statements to investors.
The Supreme Court affirmed the D.C. Circuit’s decision by a 6-2 vote (Justice Kavanaugh was recused
from the case because of his participation in the D.C. Circuit’s decision), concluding that the investment
banker had “employ[ed]” a “device,” “scheme,” and “artifice to defraud,” and “engage[d] in a[n] act,
practice, or course of business” that “operate[d] . . . as a fraud or deceit” In holding that the “natural
meaning” of this statutory language encompasses the knowing dissemination of false statements, the
Court rejected the argument that the scheme liability provisions apply “only when conduct other than
misstatements is involved.” Specifically, the Court declined to interpret each subsection of Rule 10b-5 as
prohibiting separate, mutually exclusive categories of conduct. The Court rejected this reading of the Rule
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on the grounds that its previous decisions had explicitly recognized that different securities law provisions
prohibit some of the same behavior. Moreover, the Court noted that Rule 10b-5’s scheme liability
provisions—which prohibit “device[s],” “scheme[s],” and “artifice[s] to defraud,” and “engag[ing] in a[n]
act . . . which operates . . . as a fraud,” respectively—themselves reflect considerable overlap. The Court
further explained that its reading of Rule 10b-5 was “strengthened” by the fact that a contrary
interpretation would permit the “plainly fraudulent” act of “using false representations to induce the
purchase of securities.” According to the Court, such a result would be difficult to reconcile with the
“basic purpose” of the securities laws “to substitute a philosophy of full disclosure for the philosophy of
caveat emptor.”
Finally, the Court rejected the argument that its interpretation of the scheme liability provisions would
“erase” the distinction between primary and secondary fraud liability. The Court rejected this argument—
which Justice Thomas offered in a dissenting opinion—on the grounds that it is “hardly unusual for the
same conduct to be a primary violation with respect to one offense and aiding and abetting with respect to
another” (e.g., when a defendant sells an unregistered firearm in order to assist a bank robbery, making
him primarily liable for the gun sale and secondarily liable for the robbery). As a result, the Court
explained, there is nothing anomalous about the conclusion that certain conduct can amount to a primary
violation of the scheme liability provisions and a secondary violation of Rule 10b-5’s false statement
provision.
Lorenzo’s Implications
While Lorenzo involved an SEC enforcement action, the Court’s decision is most significant for the
plaintiffs’ bar. Under Section 20(e) of the Exchange Act, the SEC retains the authority to pursue
enforcement actions against secondary actors who “substantially assist” others in committing fraud
irrespective of the outcome in Lorenzo. However, by holding that persons who are not primarily liable
under Rule 10b-5(b) can nevertheless violate the relevant scheme liability provisions, the Court extended
the range of defendants that private plaintiffs can pursue in securities fraud actions. Specifically,
commentators have noted that Lorenzo “may open a new front” in private litigation against securities
underwriters, as the Court’s decision makes clear that persons who knowingly disseminate false
statements can be primarily liable for fraud even if they do not have “ultimate authority” over the
statements.
The extent to which primary liability for participation in a fraudulent scheme extends beyond the
dissemination of false statements remains unclear. In its decision, the Court explained that imposing
primary liability on actors who are “tangentially involved” in disseminating a false statement (e.g., a
mailroom clerk) would “typically be inappropriate.” However, the Court did not elaborate on why such
actors would not be primarily liable under the scheme liability provisions when they knowingly
contribute to the dissemination of a false statement. While attorneys in the SEC’s Enforcement Division
have acknowledged this limiting principle in the Court’s opinion, they have also indicated that they read
the decision as extending to “other kinds of deceptive conduct” involving false statements beyond their
dissemination. Lower courts are accordingly likely to confront closer cases where a defendant’s
involvement in a fraudulent scheme falls somewhere between disseminating a false statement and
performing more “tangential[]” administrative functions.
To the extent there is legislative interest, Congress could amend the securities laws to maintain its desired
balance between deterring fraud and preventing excessive litigation. Legislation introduced in 2009 and
2010 would have amended the Exchange Act to create a private right of action against secondary actors
who knowingly or recklessly assist primary violations of the Act. The bills’ supporters argued that such a
cause of action would enhance the deterrent and compensatory functions of the securities laws. By
contrast, the bills’ opponents contended that an expansion of secondary liability would harm economic
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growth by increasing the costs of doing business with publicly traded companies. It remains to be seen
whether the Court’s decision in Lorenzo—which expands the Rule 10b-5 private cause of action—will
prompt renewed congressional interest in the appropriate scope of the securities laws.
Author Information
Jay B. Sykes
Legislative Attorney
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