Who Commits Securities Fraud?

Capital Markets/Securities Transactions
December 21, 2018
 

Francis (Frank) Lorenzo was employed as the director of investment banking (Vice President – Investment Banking) at a securities firm engaged as exclusive placement agent for a $15 million securities offering by a company on the verge of financial ruin. His boss, the owner of the securities firm, directed Lorenzo to email “several key points” about the pending securities offering to two potential investors. Lorenzo’s boss provided him with the content of the emails, which he sent to the potential investors specifically “at the request” of his boss. The statements in the emails were materially false or misleading. Lorenzo knew that at the time he sent the two emails, but the statements were not his – he did not “make” them. He merely prepared and sent the two emails containing them.

The SEC brought an enforcement action against Lorenzo’s boss who, all agreed, had actually made the false or misleading statements in the emails. A key provision in general antifraud provisions of the federal securities laws makes it unlawful for any person to make any false or misleading statement of a material fact in connection with the purchase or sale of securities. Lorenzo’s boss did that. But the SEC did not stop with Lorenzo’s boss. Lorenzo was himself charged with violating securities law antifraud provisions that much more broadly prohibit any “device, scheme, or artifice to defraud,” or engaging in “any act, practice or course of business which operates or would operate as a fraud or deceit upon any person” in connection with the purchase or sale of any security. Lorenzo may not have made the false or misleading statements in the emails he sent at his boss’s request, but he should nevertheless be liable for conduct amounting to a “scheme” to defraud in violation of securities law antifraud provisions, despite the fact that his asserted liability arose entirely out of the dissemination of false or misleading statements that he did not make.

In SEC administrative proceedings, Lorenzo was found liable and severely sanctioned, with money penalties and a lifetime bar from the securities industry. He appealed to the U.S. Court of Appeals for the D.C. Circuit, which upheld the SEC’s “scheme” liability theory. Lorenzo successfully petitioned the U.S. Supreme Court to hear his appeal from that determination.

On December 3, 2018, the United States Supreme Court heard arguments in Lorenzo’s case, and will determine the scope of liability under antifraud provisions of the federal securities laws prohibiting the use of any manipulative or deceptive or contrivance, and specifically making it unlawful to employ any “device, scheme or artifice to defraud,” in connection with the purchase or sale of a security. With the decision to come in Lorenzo v. Securities and Exchange Commission, the Supreme Court will answer the question who actually commits securities fraud by resolving whether an individual may be directly liable under the antifraud provisions for engaging in a fraudulent “scheme” that centrally involves or derives from communication of a materially false or misleading statements to potential investors, but which statements the individual himself did not make and for which he could not be specifically held liable.

As discussed further below, the viability of “scheme” liability under general antifraud provisions in the federal securities laws based on dissemination of materially false or misleading statements in connection with the purchase or sale of securities has been uncertain since a 2011 decision of the U.S. Supreme Court, which held that only the “maker” of a fraudulent statement may be held liable. Whether broader “scheme” liability under the same antifraud provisions may be imposed in circumstances involving false or misleading statements, or which derives from the fact that such statements were made, may be imposed on one who is not, in fact, the maker has been left an open question since the Supreme Court’s 2011 decision. That is the question Lorenzo has now put before the Court.

LORENZO’S EMAILS

Frank Lorenzo worked as the director of investment banking at Charles Vista, LLC, a registered securities broker-dealer. Charles Vista’s largest client, and Lorenzo’s only investment banking client at the time, was a startup company named Waste2Energy Holdings, Inc. (W2E), which claimed to have developed a “gasification” technology that could generate electricity by converting solid waste to gas. W2E’s conversion technology never materialized, and the great majority of the company’s assets were written off. It sought to escape financial ruin by offering investors up to $15 million in convertible debentures.

At the request of his boss, Lorenzo emailed messages to two potential investors summarizing the debenture offering that contained misrepresentations about key features of the debenture offering. The emails stated that the company had $10 million in confirmed assets. The emails further stated that W2E had outstanding purchase orders or letters of intent for over $43 million in orders, and that Charles Vista had agreed to raise additional monies to repay the debenture holders if necessary. It was undisputed that Lorenzo sent the emails at the direction of his boss, with content that was provided by his boss. Lorenzo was not the maker of the statements in the emails. In both messages he did, however, urge the recipients to “please call [him] with any questions.” He signed both messages with his name and title as “Vice President – Investment Banking.”

The statements in the emails were false. Indeed, by the time Lorenzo sent the email messages W2E had entirely written off its intangible assets and its remaining assets were worth less than $1 million. W2E also had no outstanding purchase orders, and letters of intent referenced in the emails in fact included just one from a potential customer that did not obligate its drafter to do anything. It is undisputed that Lorenzo knew the statements in the emails were false or misleading, and that in sending the e-mails at his boss’s request he acted with a state of mind (referred to in securities law as “scienter”) amounting to an intent to deceive or defraud the recipients of the emails.

LORENZO’S SECURITIES LAW FRAUD LIABILITY

The U.S. Securities and Exchange Commission (SEC) brought an enforcement action against Lorenzo, alleging he violated securities law fraud provisions, particularly §10(b) of the Securities Exchange Act of 1934 which prohibits the use of deceptive devices or contrivances, as implemented by SEC Rule 10b-5, which provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange,

  1. to employ any device, scheme, or artifice to defraud,
  2. to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
  3. to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

    in connection with the purchase or sale of any security.

The SEC alleged that by sending the emails Lorenzo violated all three subsections of Rule 10b-5. Although his boss was the “maker” of the false statements in the emails, the SEC alleged, and the U.S. Court of Appeals for the D.C. Circuit ultimately agreed, Lorenzo played an active role in perpetrating the fraud by folding the false statements into the emails he sent directly to investors in his capacity as director of investment banking, and by doing so with an intent to deceive. In this manner, it is alleged that he employed a scheme to defraud and engaged in acts which operated as a fraud and deceit. Because he was not the “maker” of the false statements, Lorenzo did not violate Rule 10b-5(b), but the Court of Appeals sided with the SEC to conclude his conduct nevertheless violated Rule 10b-5(a) and (c), thus recognizing “scheme” liability as the basis for imposing primary liability.

“Primary” liability means that by his own conduct Lorenzo directly committed the violations. Primary liability under securities laws is contrasted with “secondary” liability, for example “aiding and abetting,” in which liability is based on substantial facilitation of a violation committed by another who is the primary actor, where the secondary actor does not engage in any deceptive conduct of her own. Lorenzo’s asserted liability is primary, based on the assertion that he directly committed deceptive conduct by personally sending false or misleading statements to potential investors, despite the fact he did not himself make those statements.

Recognizing “scheme” liability as a basis for imposing primary liability on Lorenzo under SEC Rule 10b-5 in a case in which the main focus is on false statements made by his boss, both the SEC and the U.S. Court of Appeals necessarily addressed the permissible scope of Rule 10b-5 primary liability deriving from false statements by someone other than the maker of those statements. Lorenzo maintained and now argues in the U.S. Supreme Court, that he cannot be held as a violator of Rule 10b-5 because his asserted liability is necessarily based only on false statements and that only those who actually make the statements can be held liable under Rule 10b-5. “Scheme” liability under Rule 10b-5 deriving from false or misleading statements, he argues, flies in the face of the rule of law previously articulated by the Supreme Court in 2011 which imposed that limitation. As the significance of the upcoming decision of the Supreme Court on this question is considered, some further insight into the issue of scheme liability under securities law antifraud provisions is helpful, and follows below.

THE “SCHEME LIABILITY” CONUNDRUM

The scope of primary liability for violations of Securities Exchange Act §10(b) and SEC Rule 10b-5 in circumstances outside subsection (b) of Rule 10b-5, which expressly focuses on making materially false or misleading statements in connection with the purchase or sale of securities, has never been easily determined. Acts or conduct amounting to a “device, scheme or artifice to defraud,” or “acts, practice, or course of business which operates or would operate as a fraud or deceit upon any person” require a quite different assessment from that well developed under Rule 10b-5(b) focusing specifically on making false or misleading statement of a material fact, and how far culpability for that may extend. In that specific context, the Supreme Court spoke most recently in Janus Capital Group, Inc. v. First Derivative Traders (Janus) decided in 2011. Janus is the Rule 10b-5 “maker” case, in which the Court held that liability for violation of Rule 10b-5(b) for making false or misleading statements of material facts necessarily extends only to the maker of the false or misleading statement, or to the person(s) with ultimate authority over it. In Lorenzo’s case, for example, his boss.

In the Janus case the Supreme Court did not look beyond the scope of “maker” liability for materially false or misleading statements to consider any broader Rule 10b-5 “scheme” liability deriving from or involving such statements that might be imposed under the broader subparts of Rule 10b-5. The SEC, ultimately supported by the U.S. Court of Appeals, moved against Lorenzo on the theory that his dissemination of messages containing false information constituted a paradigmatic “device, scheme, or artifice to defraud” within the ambit of Rule 10b-5(a) and (c). The fact that Lorenzo did not “make” the false or misleading statements was inconsequential. His overall conduct in sending the emails containing false information (and that he did so over his name and title and inviting inquiries) was fraudulent even though he did not make the statements.

Since Janus, courts and legal scholars generally agree that “scheme” liability for violation of Rule 10b-5(a) and (c) must be premised on acts or conduct which stand alone as fraudulent or deceitful, separately from making materially false or misleading statements constituting violations of Rule 10b-5(b). That, however, has been a conundrum faced by federal courts where the asserted scheme liability is tied to the dissemination of false information.

In the Supreme Court, Lorenzo vigorously argues that in order for him to be held liable under Rule 10b-5(a) and (c) for a fraudulent “scheme” it must be shown that he engaged in something in addition to just emailing the false information per his boss’s request. As he has argued to the Supreme Court, he must be found to have engaged in a type of fraud that is different than his mere dissemination of his boss’s false statements in the emails. His argument is not without persuasive force. Some courts have underscored that where the primary purpose of a purported scheme is to make false or misleading statements, any attempt to bypass the elements necessary to impose liability under Rule 10b-5 (b) (not the least of which in Lorenzo’s case being that the person charged is the maker) by labelling the alleged misconduct a scheme rather than making false or misleading statements, it will be rejected.

That is not to say, however, as the SEC argues with equal force in Lorenzo, that fraudulent acts or conduct constituting “devices” or “schemes” making one liable under Rule 10b-5(a) or (c) exclude dissemination of false statements of material facts. Courts have recognized, for example, that attempting to induce investment by sending a message falsely representing a company’s financial condition plainly constitutes a Rule 10b-5(c) act or practice operating as a fraud or deceit on the recipient. To uphold “scheme” liability of Lorenzo the Supreme Court must resolve uncertainty concerning the scope of Rule 10b-5 in its entirety and finally conclude that liability under the broader subparts of Rule 10b-5(a) and (c) may arise out of, indeed be based upon, materially false or misleading statements. The decision will most likely come in the first half of 2019.

CONCLUDING THOUGHTS

The decision in Lorenzo will be made by eight Justices of the Supreme Court. The Court’s newest member, Justice Brett Kavanaugh, recused himself. He was the dissenting judge on Lorenzo’s case in the U.S Court of Appeals. Then Judge Kavanaugh concluded that Lorenzo should not be found liable for participation in a scheme to defraud based on the emails – that mere misstatements, standing alone, which Lorenzo did not make, should not be the basis for Rule 10b-5 liability. ”Scheme liability,” he said “must be based on conduct that goes beyond a defendant’s role in preparing mere misstatements or omissions made by others.” It makes little sense, he added, to conclude that while “Lorenzo’s boss asked Lorenzo to send the emails, supplied the central content, and approved the distribution,” Lorenzo “nonetheless willfully engaged in a scheme to defraud solely because of the statements made by his boss.”

In deciding Lorenzo, the remaining Justices also will consider the distinction between primary and secondary liability in SEC enforcement actions under Rule 10b-5. There is no secondary liability, aiding and abetting, claim in the case against Lorenzo. The Court will consider whether simply sending the emails is conduct sufficient to make Lorenzo a primary violator of Rule 10b-5(a) or (c) in contrast, for example to giving substantial assistance to another who actually committed the violation and for which secondary liability would be the focus. In the end, however, the Court must answer the question whether liability for a fraudulent “scheme” made unlawful by Rule 10b-5(a) or (c) may be separately premised on fraudulent statements made specifically unlawful in Rule 10b-5(b) and subject to required elements including the “maker” requirement.

Bob Rapp Photo
Guest author Bob Rapp is a retired Partner with Calfee's Securities and Capital Markets Practice Group and a Visiting Assistant Professor of Law at the Case Western Reserve University School of Law, where he teaches courses in securities and financial market regulation and supervises international student doctoral level research and dissertation work. He is a frequent writer and presenter on capital markets regulatory issues; he most recently delivered the Louis C. Greenwood CWRU Law Lecture at the Cleveland City Club on “Digital Assets and Blockchain Technology: Assessing the Magnitude of Disruption in Securities and Capital Market Regulation” (Nov. 7, 2018).


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