Scheme Liability Alive and Kicking
Litigation & Dispute Resolution Alert 04/11/19 Mark Kornfeld and Nicholas D'Amico
On March 27, the U.S. Supreme Court broadened the scope of potential liability under the SEC's Rule 10b-5 in its decision in Lorenzo v. SEC, 587 U.S. No. 17-1077 (March 27, 2019). Reversing field on what had been a recent trend of limiting the Securities and Exchange Commission's ("SEC") authority, the high court ruled, in a 6-2 decision, that Francis V. Lorenzo, an employee at investment bank Charles Vista LLC, could be held personally and directly liable for sending emails containing deceptive information to investors, even though his boss drafted and approved of the damning emails. This important decision widens the net of potential defendants who can potentially be held liable for "employ[ing] any device, scheme, or artifice to defraud" under SEC Rule 10b-5.
Lorenzo did not dispute the facts alleged by the defrauded investors and the SEC. Waste2Energy Holdings, Inc., an investment banking client of Charles Vista, was planning an issue of $15 million in debentures. The company reportedly had $14 million in assets, including $10 million in intellectual property; however, Lorenzo was skeptical of this valuation, especially the intellectual property. Eventually, Waste2Energy wrote off all of its intellectual property, and Lorenzo was told that the company only had $370,552 in assets. Shortly thereafter, Lorenzo knowingly sent emails written by his boss, but signed with his name, stating Waste2Energy's debentures contained "3 layers of protection," including $10 million in "confirmed assets."
The SEC brought proceedings against Lorenzo and found that he violated Rule 10b-5 by sending false and misleading statements to investors with an intent to defraud. Lorenzo was fined $15,000 and banned for life from the securities industry. Appealing the decision all the way to the Supreme Court, Lorenzo relied on Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), arguing that Lorenzo's boss, not Lorenzo, had "'ultimate authority' over the content of the statement 'and whether and how to communicate it.'" Lorenzo therefore asserted, and the dissenters, Justice Thomas joined by Justice Gorsuch, agreed that he was not the "maker" of the false or misleading statement, as proscribed by Rule 10-b5(b), nor did his conduct rise to the level of participating in a fraudulent scheme under subsection (a).
The majority, however, plainly distinguished Janus and sustained the Commission's findings, describing Lorenzo's conduct as part of a "scheme" to defraud under Rule 10b-5(a). The court recognized that Lorenzo's boss, and not Lorenzo himself, "made" the false statements; however, the court held that "it would seem obvious" that mere dissemination of false and misleading statements would qualify as a fraudulent scheme. The dissenters vehemently opposed this broad interpretation of a scheme, noting importantly that holding Lorenzo primarily liable—rather than secondarily liable as an aidor and abettor of his boss's false statements—allows private investors, in addition to the SEC, to sue Lorenzo directly.
What Does This Mean?
Lorenzo v. SEC highlights the exposure to the financial services industry employees and the broadening potential liability to banks and other financial institutions under an expanded view of primary liability. In the wake of this decision, banks, and others, should expect an aggressive plaintiffs' bar to be pressing more aggressively for "scheme"-related liability.
For more information on scheme liability, please contact your Quarles & Brady attorney or: