Assessing Impact Of Second Circuit's Rio Tinto Decision On Scheme Liability

Published date26 August 2022
Subject MatterCorporate/Commercial Law, Litigation, Mediation & Arbitration, Corporate and Company Law, Trials & Appeals & Compensation, Securities
Law FirmHolland & Knight
AuthorScott Mascianica and Catherine Rowsey

Highlights

  • A recent ruling by the U.S. Court of Appeals for the Second Circuit in SEC v. Rio Tinto plc shows that the U.S Supreme Court's 2019 decision in Lorenzo v. SEC did not completely settle the debate over whether misrepresentations can serve as the sole basis for "scheme liability" violations of the antifraud provisions of the Securities Exchange Act of 1934.
  • The Rio Tinto holding makes clear that, within the Second Circuit, "something extra" is required beyond misstatements for there to be violations of the scheme liability subsections, although the court was clear that the issue is one that "awaits further development."
  • Though the Second Circuit's ruling brings some clarity to the issue within the circuit for now, the narrow holding and divergent opinions outside the circuit reveal that this may be an issue that ends up back at the U.S. Supreme Court.

When it comes to the federal securities laws, clear answers can occasionally be hard to find. There may be no better example than the question around the overlap of the "misstatement liability" and "scheme liability" subsections of the antifraud provisions of the Securities Exchange Act of 1934. For decades, courts have grappled with the degree of overlap and reached divergent conclusions. The U.S. Supreme Court's 2019 decision in Lorenzo v. SEC seemingly brought some measure of clarity to the debate. However, the U.S. Court of Appeals for the Second Circuit's recent decision in SEC v. Rio Tinto plc proved that the waters remain muddied. In this client alert, we'll provide a brief overview of federal court decisions on scheme liability, detail the Rio Tinto matter and the Second Circuit's opinion, and provide some key takeaways.

Background of Scheme Liability in the Second Circuit

Rule 10b-5 makes it unlawful: "(a) To employ any device, scheme, or artifice to defraud, (b) [t]o make any untrue statement of a material fact ..., or (c) [t]o engage in any act, practice, or course of business which operates or would operate as a fraud or deceit ... in connection with the purchase or sale of any security."1 To state a claim under subsection (b) (the "misstatement liability" subsection) the plaintiff has the burden to plead and prove that the defendant was the "maker" of the false statement'"the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it."2 A plaintiff asserting a claim under subsection (b) must also meet the heightened pleading standards of the Private Securities Litigation Reform Act (PSLRA).

Concerning subsections (a) and (c)'the "scheme liability" subsections'the Second Circuit has long held that there is no claim "where the sole basis of the claims is alleged misrepresentations or omissions[.]"3 In other words, a defendant may be liable under the scheme liability subsections only when the conduct also encompasses conduct beyond those misrepresentations or omissions.

Similarly, for U.S. Securities and Exchange Commission (SEC) enforcement matters, courts within the Second Circuit have held that "where the primary purpose and effect of a purported scheme is to make a public misrepresentation or omission, courts have routinely rejected the SEC's attempt to bypass the elements necessary to impose 'misstatement' liability under section (b) by labeling the alleged misconduct a 'scheme' rather than a 'misstatement.'"4 District courts within the Second Circuit historically have drawn a distinction between "conduct that is itself deceptive" and "conduct that became deceptive only through ... misstatements ..."5 Courts have held that the SEC recasting misrepresentations as a scheme is tantamount to a "back door" for imposing liability on those "who did no more than facilitate preparation of material misrepresentations or omissions actually communicated by others ..."6 Such a result "would swallow" the bright-line test between primary and secondary liability.7

Lorenzo v. SEC

In 2015, following an appeal from an administrative law judge finding, the Commission found that Francis Lorenzo had violated Section 10(b) of the Exchange Act and each subsection of Rule 10b-5 by sending false and misleading statements to investors with an intent to defraud.8 Lorenzo, the director of investment banking at a registered broker-dealer, sent two emails to prospective investors describing a debt offering.9 Lorenzo sent the emails at the direction of his boss, who supplied the content and "approved" the messages.10 The emails described an investment as having, among other things, $10 million in "confirmed assets."11 The emails omitted the fact that the company had publicly stated that its assets were in fact worth less than $400,000.12 The Commission found such conduct violated both the misrepresentation and scheme liability subsections of Rule 10b-5.

Lorenzo appealed to the U.S. Court of Appeals for the District of Columbia Circuit, which reversed, in part, holding that, under Janus, Lorenzo could not be held liable for the misrepresentations as a "maker" under subsection (b) of the Rule because his boss "asked Lorenzo to send the emails, supplied the central content, and approved the messages for distribution."13 However, the D.C. Circuit affirmed the Commission's scheme liability finding under subsections (a) and (c) of the Rule.14 Lorenzo, acting with scienter, produced email messages containing misstatements, sent the messages directly to potential investors, and encouraged...

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