bainbridgeFeatured Expert Contributor, Corporate Governance/Securities Law

Stephen M. Bainbridge, William D. Warren Distinguished Professor of Law, UCLA School of Law.

Rule 10b-5 long has been the centerpiece of the Securities and Exchange Commission’s antifraud enforcement efforts. At times, in fact, the SEC’s interpretation of the Rule has been so broad that the rule threatened to “become a universal solvent, encompassing not only virtually the entire universe of securities fraud, but also much of state corporate law.”[1] In a long series of cases, however, the U.S. Supreme Court has gradually imposed a series of important limits on the SEC’s scope.[2] By taking cert in Lorenzo v. SEC, the Court has given itself an opportunity to impose another such limit.

Rule 10b-5 prohibits three potentially distinct forms of fraud: Subsection (a) prohibits “any device, scheme, or artifice to defraud”; Subsection (b) prohibits material misrepresentations or omissions; and Subsection (c) prohibits “any [fraudulent] act, practice, or course of business.” The three subsections are “distinct,”[3] with the first and third being “much broader.[4] Importantly, those subsections are “not restricted, as [is] the second, to the making of an untrue statement of material fact and/or the omission to state a material fact.”[5] It is that limitation upon which the issues in Lorenzo will turn.

Francis Lorenzo was an investment banker whose bank was representing a startup called Waste2Energy Holdings, Inc. (W2E), which was preparing for a private placement of debentures. Lorenzo sent two investors emails about W2E, which allegedly contained what an administrative law judge called “staggering” misrepresentations and omissions. Among other defenses, Lorenzo argued that he had not “made” the fraudulent statements as required by Rule 10b-5(b).

In Janus Capital Group, Inc. v. First Derivative Traders, the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” 564 U.S. 135, 142 (2011). As an example, the Court offered the distinction between a speechwriter and a speechmaker. Only the latter makes the statement, because only the latter has the requisite ultimate authority.

The Janus opinion explained that its rule followed from the Court’s earlier decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N. A., 511 U.S. 164 (1994), which held that liability for aiding and abetting a fraud does not give rise to liability in private party suits under Rule 10b–5: “If persons or entities without control over the content of a statement could be considered primary violators who “made” the statement, then aiders and abettors would be almost nonexistent.”[6]

The Janus opinion found further support for its ruling in Stoneridge Inv. Partners, LLC v. Sci.-Atlanta, Inc., 552 U.S. 148 (2008). Defendants in that case were third parties who were charged with violating Rule 10b-5 by engaging in a pervasive and continuous fraudulent scheme intended to artificially boost the Charter Communications’ reported financial results. The plaintiffs invoked so-called scheme liability, arguing that anyone who committed a deceptive act in the process of providing assistance to a primary violator could also be treated as a primary actor. The Supreme Court rejected scheme liability, holding that it was an attempt to end run the ban on aiding and abetting liability.

At least insofar as private party litigation is concerned, these precedents established a critical distinction between primary and secondary liability. A plaintiff may only bring a Rule 10b-5 claim against primary violators and may not sue for aiding and abetting or otherwise facilitating a primary violation. The question presented by Lorenzo is the extent to which these rules apply to SEC enforcement actions.

In assessing Lorenzo’s arguments based on those precedents, the U.S. Court of Appeals for the D.C. Circuit agreed that he had not made the fraudulent statements in question. Lorenzo’s boss had supplied the statements, which Lorenzo had simply cut and pasted into the emails. Accordingly, it was the boss who “made” the statements.

The court of appeals, however, held that Lorenzo could still be held liable under Rule 10b-5(a) and 10b-5(c), neither of which require that the defendant had “made” fraudulent statements. Lorenzo’s active and knowing role in sending the emails constituted both a “device, scheme, or artifice to defraud” for purposes of subsection (a) and an “act, practice, or course of business which operates or would operate as a fraud or deceit upon any person” for purposes of subsection (c). In a strong dissent, however, Judge Brett Kavanaugh argued that Lorenzo could not be held liable because all he did was to make false statements and that liability under both subsections (a) and (c) requires something more than mere misstatements. Judge Kavanaugh further argued that the Second, Eighth, and Ninth Circuits had so held.

In unsuccessfully opposing the petition for a writ of certiorari, the SEC pointed out that the line of Supreme Court cases upon which Lorenzo relied all involved private party litigation. As the Court held in Janus, the ban on suits “against entities that contribute ‘substantial assistance’ to the making of a statement but do not actually make it” applies only to private party cases. Such suits, however, “may be brought by the SEC.”[7] As such, allowing the SEC to proceed against Lorenzo poses no risk on the ban on aiding and abetting liability in private party suits. The SEC also argued that liability for knowing and active participation in disseminating false statements was not limited to subsection (b), but rather could be part of a fraudulent scheme for purposes of subsections (a) and (c).

The Supreme Court nevertheless granted cert, which raises a number of very interesting questions. The first set involves dissenting Judge Kavanaugh. Will he be confirmed to the Supreme Court? If so, will he be on the Court in time to hear Lorenzo? And, if so, will he recuse himself or participate? With respect to the latter question, though Supreme Court justices decide for themselves whether or not to recuse, it is highly likely that a Justice Kavanaugh would recuse himself from a case in which he had previously heard arguments and on which he ruled.

If that is the case, there is a high probability of a 4-4 split in Lorenzo. The Janus decision was 5-4, with Chief Justice Roberts and Justices Alito, Kennedy, Scalia, and Thomas (who wrote the opinion) in the majority. Justice Breyer wrote a vigorous dissent, which was joined by Justices Ginsburg, Kagan, and Sotomayor. With Kennedy retired, unless Gorsuch joins the liberals or the liberals change their minds, a 4-4 split seems probable.

Turning to the substantive issues raised by Lorenzo, will the Court extend the definition of “made” used in Janus to SEC civil cases (and, presumably, criminal cases)? Will the Court preserve the distinction between private party and SEC cases with respect to secondary liability? Will the court accept that merely disseminating fraudulent statements (without making them) gives rise to liability under Rule 10b-5(a) or 10b-5(c)? Although only the latter is formally part of the question presented in the petition for a writ of certiorari, the others are inevitably intertwined with it.


[1] Stephen M. Bainbridge, Insider Trading Regulation: The Path Dependent Choice Between Property Rights and Securities Fraud, 52 SMU L. Rev. 1589, 1651 (1999). The universal solvent analogy is usually attributed to the late William Painter. See Betsy Palmer Collins, Dirks v. Sec: Tipping Congress Toward the Federalization of Corporation Law?, 36 Ala. L. Rev. 297, 322 (1984) (noting “the humorous analogy by William Painter that rule 10b-5 was like the ‘medieval alchemist’s “universal solvent” which was so potent that it dissolved every container employed to hold it’”).

[2] For an excellent review of these cases, see Mark J. Loewenstein, The Supreme Court, Rule 10b-5 and the Federalization of Corporate Law, 39 Ind. L. Rev. 17 (2005).

[3] In re Smith Barney Transfer Agent Litig., 884 F. Supp. 2d 152, 161 (S.D.N.Y. 2012).

[4] In re Enron Corp. Securities, 529 F. Supp. 2d 644, 680 n.49 (S.D. Tex. 2006).

[5] Id.

[6] Janus, 564 U.S. at 143.

[7] Janus, 564 U.S. at 143.