Frauds usually start with some type of deception that leads victims to hand over their money. But what if false statements are not enough to prove a person engaged in a scheme to defraud?
The Supreme Court will take up that issue this year when it hears an appeal in Lorenzo v. Securities and Exchange Commission, and the justices’ decision could result in cutting back on the scope of Rule 10b-5, the primary federal securities fraud prohibition. The decision could affect how the S.E.C. pursues fraud cases when defendants are accused of making false statements to investors.
Francis V. Lorenzo was the director of investment banking at a brokerage firm when he sent emails to two potential investors in a $15 million convertible debenture offering. The company issuing the debt was working to generate electricity by converting solid waste into gas. A few days before sending the emails, Mr. Lorenzo learned that the “gasification” technology was not working and that the company had written off $11 million worth of intangible assets related to that.
Mr. Lorenzo’s emails failed to mention the accounting change and stated that the company had purchase orders for $43 million. That information came from his boss at the brokerage firm, and Mr. Lorenzo claimed that he had merely copied and pasted it into the emails he sent the investors. The S.E.C. accused him of committing a primary violation of Rule 10b-5, not just being an accomplice to a fraud. The administrative law judge assigned to hear the evidence wrote that the falsity in the emails was “staggering.”
Rule 10b-5 prohibits three types of violations: employing any “device, scheme or artifice to defraud”; making a false statement or omitting information that misleads investors; or engaging in conduct that “would operate as a fraud or deceit.” The S.E.C. found that Mr. Lorenzo had violated all three provisions. It barred him from the securities industry and imposed a $15,000 penalty.
Mr. Lorenzo took his case to the federal appeals court in Washington. The issue was whether an earlier Supreme Court decision, Janus Capital Group v. First Derivative Traders, prevented finding him to be a primary violator of Rule 10b-5. In that case, the justices held that liability for false statements was limited to “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” Mr. Lorenzo argued that he could not be held directly responsible because he had just copied and pasted the false statements, and that only his boss had acted willfully.
The appeals court agreed that he did not make the statement. But it upheld the S.E.C.’s sanctions, finding that he had engaged in a scheme to defraud. That meant he had violated the other two parts of Rule 10b-5. Because Mr. Lorenzo “conveyed materially false information to prospective investors about a pending securities offering backed by the weight of his office as director of investment banking,” the court said, he joined in an effort to defraud investors and was liable.
The problem was that the decision opened a back door around the Janus Capital ruling.
That approach usually does not play well with the Supreme Court justices, who have not been receptive to efforts to avoid its more restrictive readings of Rule 10b-5. In the 2008 decision in Stoneridge Investment Partners v. Scientific-Atlanta, the justices rejected “scheme liability,” which could make third parties responsible for helping a company file misleading financial statements by engaging in sham transactions. The court viewed “scheme liability” as an effort to avoid its earlier rejection of aiding and abetting liability for securities fraud in private cases.
Unlike Janus Capital and Stoneridge, which were private cases, the Lorenzo case involves the S.E.C.’s trying to protect investors through an enforcement action. It is possible the court might be more forgiving and allow the agency to take a broader approach to the law than private litigants can.
But the Supreme Court has rejected the regulator’s broader readings of the securities laws over the past two years, at least outside the context of insider trading. In Kokesh v. Securities and Exchange Commission, decided in June last year, the justices limited the period in which the S.E.C. can seek to compel a defendant to disgorge ill-gotten gains to five years and even questioned whether federal District Courts can order that remedy.
On June 21, the Supreme Court found in Lucia v. Securities and Exchange Commission that the S.E.C.’s method for appointing administrative law judges was flawed. The ruling threw into doubt a number of recent cases decided by its in-house court and caused the agency to stop pending administrative proceedings until it can figure out how to proceed.
These decisions are part of a trend in which the justices have shown greater skepticism to government’s arguments that statutes need to be read expansively. In Marinello v. United States, decided in March, the court rejected the Justice Department’s reading of what constitutes obstructing the Internal Revenue Service. The department’s view would have made a felony out of almost any conduct that made the process of collecting taxes more difficult.
Although the S.E.C. can bring cases against those who aid another in committing a fraud, it prefers to pursue defendants as primary violators so it can impose harsher penalties that require proof of a willful violation. It would not be a surprise to see the Supreme Court read Rule 10b-5 more restrictively in Mr. Lorenzo’s case.
That would mean only those who were directly responsible for a misstatement or who failed to disclose important information would be liable as the primary person engaging in fraudulent conduct. That could make the agency’s job of policing the markets more difficult and could require it to pursue future targets as accomplices to wrongdoing rather than as the principal bad guy.