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U.S. Supreme Court to Consider Scope of Securities Fraud

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  • Posted on: Jun 25 2018

The U.S. Supreme Court has agreed to hear the appeal of an investment banker barred from the securities industry in a case concerning the scope of investor protection laws. (Here.)  The high court will consider whether an individual who passed along false statements about a company’s financial condition can be found liable for engaging in securities fraud.  In particular, the Court will consider whether the Securities Exchange Commission (SEC) can circumvent the requirements set forth in Janus Capital Group, Inc. v. First Derivate Traders, 564 U.S. 135 (2011), for pleading and proving a claim under Section 10(b) of the Securities and Exchange Act of 1934 (Exchange Act) and Rule 10b-5 promulgated thereunder by recasting its claim as one for “scheme” liability. Lorenzo v. SEC, No. 17-1077 (certiorari granted June 18, 2018).

The Backdrop

In 2015, Francis V. Lorenzo (Lorenzo), a director of investment banking with Charles Vista, LLC (Charles Vista), was fined $15,000 and barred from the industry by an SEC Administrative Law Judge (ALJ) for participating in a scheme to defraud investors. The judge found that Lorenzo solicited investors through two emails that misrepresented the financial condition of a start-up energy company in 2009. The company, Waste2Energy Holdings Inc. (W2E), Charles Vista’s largest investment banking client, was seeking to develop technology that transformed solid waste into energy. In September 2009, W2E sought to raise about $15 million through the sale of 12% convertible debentures. Charles Vista was the exclusive placement agent.

Lorenzo emailed two potential investors “several key points” about W2E’s debenture offering. The emails failed to disclose a recent devaluation of the company’s assets. Instead, the investors were told that there were “3 layers of protection.” One of the messages stated it had been sent at the request of the owner of the firm.

The SEC issued an order charging Lorenzo, Gregg Lorenzo (the owner of Charles Vista) and Charles Vista with fraud in violation of Section 17(a)(1) of the Securities Act of 1933 (Securities Act) and Section 10(b) of the Exchange Act. (Here.) Gregg Lorenzo and Charles Vista agreed to a disgorgement payment of $130,000 and prejudgment interest of $20,000. Additionally, Gregg Lorenzo and Charles Vista agreed to pay a civil penalty of $375,000 and $4,350,000, respectively, in settlement of the charges.

Lorenzo did not settle. During the administrative proceedings, Lorenzo testified that he sent the emails at the behest of his boss – he did not write them. Instead, Lorenzo cut and paste what was written. No other testimony was presented.

In the Initial Decision, the ALJ found that Lorenzo did not read the text of the emails and had sent the emails “without thinking.” Importantly, the ALJ concluded that emails were “staggering” in their falsity. As a result, the ALJ held that Lorenzo had acted willfully with the intent to deceive, manipulate, or defraud and had participated in a “deceptive scheme” in violation of the federal securities laws. The Commission affirmed.

In its opinion, the agency concluded that Lorenzo was responsible for the emails and their content. Notably, the Commission did not accept all the findings of the ALJ. The SEC ordered Lorenzo to pay a $15,000 penalty and barred him for life from the securities industry. (Here.)

In a 2-1 decision, the D.C. Court of Appeals affirmed in part the Commission’s decision; the matter was remanded for reconsideration of the sanctions. Lorenzo v. SEC, 872 F.3d 578 (D.C. Cir. 2017) (here).

In an opinion written by Judge Srinivasan, joined by Judge Griffith, the court concluded that the Commission’s findings (e.g., that each e-mail was materially false and misleading, and that Lorenzo acted with scienter) were supported by the evidence.  Nevertheless, the majority concluded, citing Janus Capital, that “Lorenzo did not ‘make’ the false statements at issue for purposes of rule 10b-5(b) because Lorenzo’s boss, and not Lorenzo himself, retained ‘ultimate authority’ over the statements.” Lorenzo, 872 F.3d at 580. See also id. at 588. Consequently, Lorenzo could not be held liable for violating Rule 10b-5(b) as charged.

However, the majority concluded that “Lorenzo’s particular conduct . . . fits comfortably within the language of Rules 10b-5(a) and (c)”; namely, the scheme liability provisions of the law (i.e., Section 10b-5(a) and (c)). Lorenzo, 872 F.3d at 595. The court rejected the claim that such a holding would undermine the distinctions between primary and secondary (i.e., aider and abettor) liability on which Janus Capital was based. Lorenzo, 872 F.3d at 590-91.  Since the penalty determination could have been impacted by the Commission’s determination on liability, the majority vacated the sanctions and remanded the matter to the SEC for further consideration. Id. at 595-96.

Judge Kavanaugh dissented. While Judge Kavanaugh agreed with the majority’s determination on Janus Capital, he nevertheless dissented, writing: “The good news is that the majority opinion vacates the lifetime suspension. The bad news is that the majority opinion – invoking a standard of deference that, as applied here, seems akin to a standard of ‘hold your nose to avoid the stink’—upholds much of the SEC’s decision on liability. I would vacate the SEC’s conclusions as to both sanctions and liability.” Lorenzo, 872 F.3d at 597.

Judge Kavanaugh based his dissent on three points. First, he questioned the “factual findings and legal conclusions” of the ALJ because they “do not square up.” Lorenzo, 872 F.3d at 597. If Lorenzo did not draft the emails, did not think about their contents and sent them only at the behest of his boss, then he could not have acted “willfully”.  The mens rea is missing, said the dissent. Id. (“If Lorenzo did not draft the emails, did not think about the contents of the emails, and sent the emails only at the behest of his boss, it is impossible to find that Lorenzo acted “willfully.” That is Mens Rea 101.”) Accordingly, Judge Kavanaugh concluded that the “administrative law judge’s decision . . . contravenes basic due process” and, therefore, made “a hash of the term ‘willfully,’ and of the deeply rooted principle that punishment must correspond to blameworthiness based on the defendant’s mens rea.” Id. at 598.

Second, describing the Commission’s actions as “Houdini-like,” Judge Kavanaugh concluded that the Commission manufactured the facts to reach the desired conclusion: assessment of sanctions against Lorenzo: “The Commission’s handiwork in this case is its own debacle. Faced with inconvenient factual findings that would make it hard to uphold the sanctions against Lorenzo, the Commission — without hearing any testimony — simply manufactured a new assessment of Lorenzo’s credibility and rewrote the judge’s factual findings. So much for a fair trial.” Lorenzo, 872 F.3d at 598-99.

Finally, Judge Kavanaugh accused the majority of accepting the “alternative facts” used by the SEC, instead of those found by the ALJ — the person in the best position to assess the credibility of Lorenzo, the only witness in the proceeding — “that Lorenzo did not draft the emails, did not think about the contents of the emails, and sent the emails only at the behest of his boss.” Lorenzo, 872 F.3d at 599. Judge Kavanaugh concluded that the Commission’s “rewriting of the administrative law judge’s findings of fact was utterly unreasonable and should not be sustained or countenanced by this Court.” Id.  He found that “the SEC had no reasonable basis to run roughshod over the administrative law judge’s findings of fact and credibility assessments.” Therefore, he said, “the SEC’s rewriting of the findings of fact deserves judicial repudiation, not judicial deference or respect.” Id. at 600.

Judge Kavanaugh noted that even if he was wrong, the majority nevertheless “create[d]” an unnecessary “circuit split by holding that mere misstatements, standing alone, may constitute the basis for so-called scheme liability under the securities laws — that is, willful participation in a scheme to defraud — even if the defendant did not make the misstatements.”  Lorenzo, 872 F.3d at 600.  Noting that no other circuit court had “concluded that scheme liability must be based on conduct that goes beyond a defendant’s role in preparing mere misstatements or omissions made by others,” Judge Kavanaugh observed that the majority opinion stood alone by allowing the SEC “to evade the important statutory distinction between primary liability and secondary (aiding and abetting) liability.” Such a result, he said, is something “the SEC has tried to erase” “[f]or decades” and the Supreme Court has “pushed back hard against” in cases such as Janus CapitalId. at 601. The majority opinion, he concluded, was an “end-run” around “the Supreme Court.” Id.

Lorenzo appealed. (Here.)

The Briefing Before the U.S. Supreme Court

In his petition before the Supreme Court, Lorenzo presented the following question for review: “In Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), this Court considered the elements of a fraudulent statement claim and held that only the ‘maker’ of a fraudulent statement may be held liable for that misstatement under Section 10(b). . . The question presented is whether a misstatement claim that does not meet the elements set forth in Janus can be repackaged and pursued as a fraudulent scheme claim.” Lorenzo answered the question in the negative.

In seeking certiorari, Lorenzo relied on the fact that there was a split among the circuits, noting “The Second, Eighth and Ninth Circuits have held that a misstatement alone cannot be the basis of a fraudulent scheme claim, while the DC Circuit and the Eleventh Circuit have held that a misstatement standing alone can be the basis of a fraudulent scheme claim.”  Petition at i.

Lorenzo claimed that the majority view among the circuits is that “plaintiffs, including the SEC, cannot repackage Rule 10b-5(b) deceptive statement claims that fail to meet the Janus standards as fraudulent scheme claims under Section 17(a)(1) of the Securities Act or Rule 10b5(a) and (c).” Petition at 17. “The DC Circuit’s holding in this matter is contrary to th[is] view.”

On the merits, Lorenzo argued that he was not the “maker” of the misstatements as defined by the Court in Janus Capital.  Under Janus Capital, liability for a false statement can be imposed only on “the person or entity with ultimate authority on whether and how to communicate the statements . . . .” Thus, without control over the publication of the statement, Lorenzo could not be held liable. Petition at 14.

The SEC opposed the petition for the writ of certiorari. (Here.) First, the agency claimed that the conduct involved fell “comfortably within” the ordinary understanding of the statutory language for Section 17(a)(1) and Section 10(b). Opp. Br. at 9. “Words and phrases like ‘fraud,’ ‘deceit,’ and ‘device, scheme or artifice’ provide a broad linguistic frame within which a large number of practices may fit,” said the Commission. Id. (internal quotation marks and citations omitted). Thus, “[k]nowingly sending ’email messages containing false statements’ about a company’s financial prospects ‘directly to potential investors,’ in order to induce recipients to participate in a debenture offering, is naturally described as employing a device, scheme, artifice, or act to defraud.” Id. (citations omitted).

Second, the SEC maintained that while the D.C. Circuit found that Lorenzo was not the “maker” of the statement and did not have “ultimate authority” over its publication, that did not mean he could not be liable. To the contrary “as the court of appeals explained, a non-maker of a statement can be liable under Section 17(a)(1) and Section 10(b), and subsections (a) and (c) of rule 10b-5 if he carries out a device, scheme, artifice, or act to defraud.” Opp. Br. at 13. “That conclusion,” argued the SEC, “is compelled by the text, structure, history, and purpose of those provisions, and it is fully consistent with Janus, which did not address the scope of liability under any provision other than Rule 10b-5(b).”

The Commission reasoned that “the decision below did not ‘erase[] the distinction between primary and secondary liability’” that the Court “emphasized in Janus and Central Bank of Denver” because Lorenzo “was not found secondarily liable for aiding and abetting his boss’s making of a false statement under Rule 10b-5(b).” Opp. Br. at 14. Instead, Lorenzo “was found primarily liable for his ‘active role in producing and sending misstatements with an intent to deceive, and for thereby employing a deceptive device, act, or artifice to defraud for purposes of liability under Section 10(b), Rule 10b-5(a) and (c), and Section 17(a)(1).” Id. (internal quotation marks and citations omitted).

Third, the SEC argued that there is no real circuit split. This is because “none of the decisions petitioner identifies as forming a ‘majority’ position . . . involved the kind of conduct at issue here – knowing dissemination of a false statement directly to investors with intent to induce a financial transaction. And all the cases that petitioner cites were initiated by private plaintiffs rather than by the Commission. That distinction is significant because different statutory and other standards govern private securities-fraud actions” such as the Private Securities Litigation Reform Act of 1995 (PSLRA). Opp. Br. at 17-18. Under the PSLRA, plaintiffs must meet heightened pleading standards with regard to allegedly false statements and omissions under Rule 10b-5(b). In contrast, some courts have held that those standards do not apply to subsections (a) and (c) of Rule 10b-5. Regardless, contended the Commission, there is no split of authority because “[t]he statutory text does not distinguish between statements or omissions that are fraudulent under Rule 10b-5(b) and statements or omissions that constitute (or are used to carry out) a deceptive device, act, or artifice to defraud under Rule 10b-5(a) or (c). 15 U.S.C. 78u-4(b)(1).” Thus, “[t]here is accordingly no need to exclude false-statement claims from Rule 10b-5(a) and (c) in order to prevent evasion of the PSLRA.” Opp. Br. at 19.

To underscore the point, the SEC noted that the cases relied upon by Lorenzo “rest[ed] on a concern that is wholly absent here, because the PSLRA does not apply to cases initiated by the Commission.” Opp. Br. at 19. “There is accordingly no reason to believe that any other circuit would reach a result different from the court below in an SEC enforcement proceeding. Indeed, the only other court of appeals that has addressed the question presented in a case to which the Commission was a party has reached the same conclusion as the court below.” Id. (citing Big Apple Consulting, 783 F.3d at 795-796; SEC v. Monterosso, 756 F.3d 1326, 1334 (11th Cir. 2014)).

*          *          *

A decision is expected next term.

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