By  Stephen Hall (this op-ed first appeared in Law360 on November 30, 2018)

Consider the following scenario: An investment banker circulates multiple emails to investors knowing that they contain three outright lies: (1) that the company seeking funds “has over $10 million in confirmed assets;” (2) that the company “has purchase orders and letters of intent for over $43 million”; and (3) that the investment banking firm “has agreed to raise additional monies to repay” investors. The investment banker is aware not only that these representations are false, but also that in fact, the company’s technology “didn’t really work” and that the company’s financial condition was “horrible.” Although the text of the email was drafted by his boss, the investment banker willingly signs the emails in his own name as “vice president” and director of investment banking and sends them out. He even includes his personal phone number along with an invitation that investors call him if they have any questions.

Should the investment banker described above, in fact a real person named Francis Lorenzo, be held accountable for securities fraud? It would seem that the obvious answer is yes, but the legal answer won’t be known until the U.S. Supreme Court hears oral argument in the case on Dec. 3 and issues its decision sometime thereafter.

SEC Made the Right Call

The U.S. Securities and Exchange Commission’s administrative law judge who first considered the evidence got it right, holding that Lorenzo had “willfully violated the antifraud provisions” in the securities laws and observing that “the falsity of the representations in the emails … [was] staggering.” The ALJ, based on extensive findings of facts, issued a cease-and-desist order, imposed a fine, and barred Lorenzo from the securities business for life. The SEC thoroughly reviewed the case and affirmed the ALJ’s decision. It then went up to the D.C. Circuit.

D.C. Circuit Needlessly Scaled Back SEC Decision, But Held Firm on “Scheme Liability”

The circuit court pared back the SEC’s decision by holding that Lorenzo didn’t actually “make” the false statements and therefore couldn’t be held liable under Rule 10b-5(b), which provides that it is unlawful to “to make any untrue statement of a material fact” in connection with the purchase or sale of a security. The circuit court felt bound by a 2011 Supreme Court case known as Janus, which established the counterintuitive rule that a person doesn’t “make” false statements within the meaning of Rule 10b-5(b) unless they have “ultimate authority” over what was said and how it was communicated — even if they prepared the statement and published it on behalf of another. The circuit court’s ruling on this issue was lamentable and unnecessary, since Lorenzo’s role in issuing the fraudulent emails was sufficiently prominent and authoritative to justify treating him as the maker of the statements, even under the Janus decision.

Fortunately, however, that wasn’t the end of the matter, because the anti-fraud provisions in the securities laws also more broadly prohibit schemes to defraud, whether or not misstatements are involved (under subsections (a) and (c) of Rule 10b-5). The circuit court had no trouble finding that Lorenzo’s actions fit plainly and “comfortably” within those provisions. The court rejected Lorenzo’s core contention that if someone isn’t guilty of “false statement” fraud under Rule 10b-5, then they can’t be held accountable under the other two sections on scheme liability — because, supposedly, the three parts of Rule 10b-5 cover mutually exclusive types of fraud. In dismissing Lorenzo’s tortured reading of the rule, the court observed that some overlap in the securities laws is, quoting from another case, “neither unusual nor unfortunate” and that schemes to defraud may also involve false statements.

The circuit court also rejected Lorenzo’s argument that he was at most an aider and abettor. The court saw no risk that holding him accountable would stretch aider and abettor liability beyond the current boundaries, since Lorenzo was clearly a principal violator in the scheme to defraud, given his role in circulating the emails and his direct contact with investors. This aspect of the decision was important because the Supreme Court held 25 years ago that aiders and abettors cannot be held liable in private actions. Thus, any decision that overly expands the definition of aider and abettor threatens to immunize even primary wrongdoers from private enforcement of the securities laws.

A Reminder: Then-Judge Kavanaugh Defended Lorenzo and Criticized SEC

A significant portion of the circuit court’s opinion was devoted to refuting the assertions of the lone dissenter, then-Judge Brett Kavanaugh. Kavanaugh strenuously fought to liberate Lorenzo from the consequences of his fraudulent actions.¹ Kavanaugh second-guessed the findings made by the agency about Lorenzo’s culpability (notwithstanding the considerable deference courts usually do and should give to such findings); he complained that the holding would ultimately erode the Supreme Court’s rule that aiders and abettors are not accountable in private lawsuits (even though Lorenzo was clearly a primary violator in the scheme to defraud); and he even expressed sympathy for Lorenzo in light of his treatment at the hands of the SEC (while fully acknowledging that Lorenzo was possibly “guilty of negligence (or worse)”).

Why It Matters So Much

Lorenzo appealed to the Supreme Court and oral argument is set for Dec. 3. The case — Lorenzo v. SEC – is enormously significant, for at least two reasons. 

First, and above all, it will largely determine the scope of key anti-fraud provisions in the securities laws for years to come. It will either confirm that “scheme liability” can be applied broadly in accordance with Congress’ plain language and remedial intent, or very narrowly interpret the law and significantly limit the ability of the SEC and private plaintiffs to hold con men liable if they don’t technically “make” fraudulent statements.

If the court holds that scheme liability doesn’t apply to cases involving false statements, then the Lorenzos of the world will avoid any accountability, at least in private actions: (1) They won’t be liable for false statement fraud because they didn’t “make” the statements under the Janus decision; (2) they won’t be liable for aiding and abetting the maker’s fraud because the Supreme Court has eliminated that possibility in private actions; and (3) if the Supreme Court gets it wrong this time, they won’t even be subject to the broader prohibition against schemes to defraud. In short, if the court sides with Lorenzo and narrows the law, the decision will create a road map fraudsters can use to structure their conduct and evade liability. The result will be more victims and more fraud that goes unpunished.

In a somewhat hopeful sign, Justice Kavanaugh recused himself, a step that will leave the case in the hands of the other eight justices. If, as some expect, the court comes out evenly divided in a 4-to-4 tie, then the D.C. Circuit’s opinion will remain intact, and at the very least, the law will cover a broad range of schemes to defraud whether or not the violator is also the “maker” of false statements. Finally, the case is also significant because the court’s decision will provide some additional insight into the way it approaches financial cases. Those cases attract little public attention but nevertheless affect the financial well-being and quality of life of virtually every American — anyone with a bank account, credit card or mortgage loan.

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Stephen W. Hall is legal director and securities specialist at public interest group Better Markets Inc. In 2010, he served as senior counsel to the Committee on Financial Services of the U.S. House of Representatives.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] As detailed in Better Markets’ August 2018 report on Kavanaugh’s anti-consumer and pro-corporate jurisprudence.