INSIGHT: Lawyer Liability: Will We Be in the Cross-hairs, Again?!

Yogi Berra really did say: “It’s déjà vu all over again!” (Yogi’s comment came after Mickey Mantle and Roger Maris hit back-to-back home runs for the umpteenth time.). Three times the U.S. Supreme Court has held that there is no aider and abettor liability for secondary actors (e.g., lawyers): that to establish a 10b-5 claim under the Securities Exchange Act of 1934, the traditional elements of fraud/tort (defendants must speak; plaintiffs must show reliance; etc.) must be pleaded and proven. See Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994); Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc., 552 U.S. 148 (2008); Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011). The Securities and Exchange Commission has never really taken “no” for an answer, however, and has continually tried to work a way around it. The Commission is at it again, this time in a case encaptioned Lorenzo v. S.E.C. (No. 17-1077); oral argument took place at the Supreme Court on December 3, 2018, and a decision will no doubt come down before the end of the Court’s current term in June 2019. Lorenzo is an important (and somewhat unusual) case; it deserves our attention.

First, Some Context

Before diving into Lorenzo, it is important to put some context into the history of seeking to hold secondary actors accountable for fraud. Barker v. Henderson, 797 F.2d 490 (7th Cir. 1986), is a good starting point. It was one the first cases to examine attorneys’ duties (and liabilities) in detail. In Barker, a Michigan religious foundation issued unregistered bonds to unsophisticated investors, who ended up taking a bath. Searching for deep pockets, the plaintiffs’ lawyers sued, among others, the foundation’s lawyers. Two law firms had been hired specifically to review the bonds’ selling materials and to advise the foundation on securities law issues; those two firms wrote settlement checks. Left in the litigation was the foundation’s regular legal counsel, who did not have expertise in securities matters but who also neither blew the whistle on their client nor did anything to stop the sale of the bonds (even after receiving the selling materials).

On behalf of a panel of the U.S. Court of Appeals for the Seventh Circuit, Judge Frank Easterbrook rejected claims that the law firm had aided and abetted fraud. Judge Easterbrook found it factually significant that the firm had not been consulted on any securities issues. There was no evidence, moreover, that the firm had seen any of the selling materials until after they were being utilized. With respect to the law firm’s silence in the face of their client’s actions, Judge Easterbrook wrote that the lawyers were not “required to tattle on their clients in the absence of a duty to disclose.” And because there was no such duty under prevailing professional responsibility rules, he ruled that:

[A]n award of damages under the securities laws is not the way to blaze the trail toward improved ethical standards in the legal… profession[ ]. Liability depends upon an existing duty to disclose. The securities laws must lag behind changes in ethical and fiduciary standards. [emphasis added]

In the aftermath of Judge Easterbrook’s pronouncement that liability under the securities laws had to “lag behind” changes in lawyers’ professional obligations came a number of important (and perhaps confusing) decisions. In Schatz v. Rosenberg, 943 F.2d 485 (4th Cir. 1991), for example, a law firm represented a fraudster. At the closing of a deal, the law firm handed to the other side a document its client had prepared, in which the client represented that nothing material had changed with respect to his financial condition. The representation was false, and the law firm knew it was false.

After the deal cratered (because of the client’s true financial condition), the other side sued the law firm under multiple theories of fraud. The U.S. Court of Appeals for the Fourth Circuit, however, ruled that the law firm had no liability. How could this be?!

First off, Judge Robert Chapman, writing for a unanimous Fourth Circuit, addressed the claim that the firm was a primary violator of Rule 10b-5 fraud (i) by failing to disclose its client’s misrepresentation, and (ii) by making affirmative misrepresentations of its own about the client’s financial condition. With respect to the former, Judge Chapman determined there was no duty to disclose under the federal securities laws or applicable state law; he further ruled that there was no public policy in favor of disclosure (in fact, public policy would be in favor of non-disclosure, so as to enhance lawyers’ fact-finding abilities).

As to affirmative misrepresentations, Judge Chapman determined that the firm had made no independent representations of its own, but had only passed on its client’s. Put another way, the other side’s reliance was on the client’s misrepresentations, not on anything said or written by the law firm (which had “merely ‘papered the deal,’” and whose role was only that of a “scrivener”).

With respect to the claim of aiding and abetting fraud, Judge Chapman gave it short shrift. The law firm did not have the requisite scienter to abet the fraud because the firm owed no duty to the other party to the deal (which was represented by its own counsel). And the law firm did not provide “substantial assistance” to its client’s fraud for the same reasons it was not a primary violator in the fraud.

In 1994, the U.S. Supreme Court stepped into this fray in Central Bank of Denver v. First Interstate of Denver. There, the Court held that since the text of §10(b) does not cover those who aid and abet a §10(b) violation, private plaintiffs seeking money damages could not bring an aiding and abetting claim against a secondary actor. At the same time, the Central Bank Court left open that (i) criminal liability for aiding and abetting was still viable, (ii) an SEC enforcement action based upon aiding and abetting was still viable, and (iii) traditional secondary actors in the capital markets (e.g., lawyers) could be pursued by private plaintiffs as primary violators “assuming all of the requirements for primary liability under Rule 10b-5 are met.”

Just as lawyers began to think it was safe to wade back into the water, the plaintiffs’ bar pounced on the third issue left open by the Supreme Court. There began a wave of new cases, premised upon lawyers (or other secondary actors) being held to the same standard of accountability for fraud as their clients. This attack seemed to reach its height/nadir in Klein v. Boyd, No. 97-01143 (3d Cir. Feb. 12, 1998).

In Klein, the plaintiff (supported by the Securities and Exchange Commission) argued, and a panel of the U.S. Court of Appeals for the Third Circuit agreed, that a law firm could be held liable as a primary violator of securities fraud, even where the lead lawyer did not sign the document(s) at issue and where the investor was never aware of the lawyer’s role in the creation of document(s). In the Third Circuit’s view, the law firm was a primary violator because it “elect[ed] to speak” by its authoring or co-authoring of document(s) with alleged material misrepresentations and/or material omissions; according to the Third Circuit, while the firm did not have an obligation to blow the whistle on its client, it did have a duty to correct its own “statements.”

On an en banc review, the SEC made its position even clearer: a law firm should be held accountable for fraud where it helps to “create” a misrepresentation. Prior to a ruling by the entire court of appeals, the case was settled; but the original precedent lived on, with the SEC (and the plaintiffs’ bar) continuing to espouse such theories of liability, especially in the aftermath of Enron and similar corporate train wrecks.

In the aforementioned corporate train wrecks’ aftermaths, various courts reached different results as to lawyers’ duties to “speak” to third parties. See, e.g., Howard v. Everex Systems Inc., 228 F.3d 1057 (9th Cir. 2000); Ziemba v.Cascade International Inc., 2001 U.S. App. LEXIS 15529 (11th Cir. 2001); In re Enron Corp. Derivative & ERISA Litig., 284 F. Supp. 2d 511 (S.D. Tex. 2003); Simpson v. AOL Time Warner Inc., 452 F.3d 1040 (9th Cir. 2006).These different results (and disparate outcomes on the issue of secondary actor liability) ultimately became so profound that the Supreme Court in 2007 agreed to revisit the same ground it had gone over in Central Bank. In Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc., the Court (i) re-affirmed its prior ruling in Central Bank (noting that Congress had explicitly declined to establish aiding and abetting liability for civil suits when it had passed various securities legislation since 1994), and (ii) rejected the concept of “scheme liability”—a theory consistent with the Klein v. Boyd court’s rationale—because it failed to require a basic element of the cause of action for fraud (i.e., that the aggrieved plaintiff(s) relied upon some act or omission by an alleged primary violator defendant(s).

Four years later, the Supreme Court felt compelled to weigh in once more, this time in Janus Capital Group, Inc. v. First Derivative Traders. In that case, Janus Capital Group (“JCG”) was sued for allegedly making misleading statements in various of Janus funds’ prospectuses. Although the district court dismissed the complaint, the Fourth Circuit reversed, ruling that even if JCG had not actually written the alleged statements in the fund prospectuses, one of its subsidiaries (Janus Capital Management/“JCM”) must have approved those statements (actually made by a different corporate entity in the Janus family— Janus Investment Fund/“JIF—owned entirely by mutual fund investors).

Writing for a five Justice majority, which reversed the Fourth Circuit, Justice Clarence Thomas held that the “maker” of a statement is “the person or entity with ultimate authority over the statement”—in this case JIF, citing the Court’s prior ruling in Central Bank. He further observed that to give “make” a broader meaning would substantially undermine Central Bank by rendering aider and abettor liability a nullity (and would also undermine the Court’s Stoneridge decision on that score). With respect to the Government’s argument that the Court should adopt the SEC’s interpretation of “make” -- i.e., that “make” is the same as “create,” Thomas rejected that argument, writing that such wordsmithing “would permit private plaintiffs to sue a person who ‘provides the false or misleading information that another person then puts into the statement’” (citing the Government’s amicus curiae brief). Such a result, wrote Thomas, would be inconsistent with Stoneridge’s rejection of “scheme liability” and countless other Supreme Court precedents.

On behalf of Justices Ginsburg, Sotomayor, and Kagan, Justice Stephen Breyer wrote a dissent, contending that “the majority has incorrectly interpreted [Rule 10b-5’s] word ‘make’”. After rejecting the direct applicability of Central Bank and Stoneridge, Breyer then opined that the corporate family structure of the various Janus entities was so closely interwoven (even if legally separate) that, based upon the allegations pleaded, it could be held that JCG “made” materially false statements in the prospectuses issued by JIF: “Unless we adopt a firm rule (as the majority has done here) that would arbitrarily exclude from the scope of the word ‘make’ those who manage a firm -- even when those managers perpetrate a fraud through an unknowing intermediary—the management company at issue here falls within that scope.”

Lorenzo

In October of 2009, Francis Lorenzo, the director of investment banking at a registered broker-dealer, sent allegedly false and misleading statements to two investors; the statements had originally been drafted by his boss (the head of the firm) and had been sent at his boss’s behest. At the end of the emails containing the statements, Lorenzo block signed his name and urged the recipients to “call [him] with any questions.”

In September of 2013, the SEC brought an enforcement proceeding against Lorenzo, his boss, and the broker-dealer. The latter two quickly settled with the Commission. Lorenzo decided to fight, and a SEC administrative law judge subsequently ruled that Lorenzo had “willfully violated the antifraud provisions” of the federal securities laws (Rules 10b-5(a), (b) & (c)). She also opined that Lorenzo’s “falsity” had been “staggering” and that his mental state had been at least “reckless.” The full Commission, upon review of the ALJ’s determinations, affirmed her decision, as well as her “imposition of an industry-wide bar, a cease-and-desist order, and a $15,000 civil penalty.” Lorenzo appealed that decision to the D.C. Circuit Court of Appeals.

By a 2 to 1 vote, a D.C. Circuit panel (giving deference to the determinations of the Commission) found that Lorenzo’s statements were false or misleading and that he acted with requisite scienter in sending them. 872 F.3d 578, 580 (D.C. Cir. 2017). At the same time, however, the panel ruled that, under Janus, Lorenzo was not the “maker” of the statements, because they had been sent “on the behest of his boss” who had drafted and approved them (i.e., the boss had the “ultimate authority”). As a result, the panel found that Lorenzo had not violated Rule10b-5(b).

But the panel did not stop there. It also ruled that Lorenzo’s conduct did violate the scheme liability provisions of 10b-5(a) and 10b-5(c). Rejecting Lorenzo’s argument that (at worst) what he had done was to aid-and-abet his boss’s conduct, the panel ruled that he was primarily liable under those other two anti-fraud provisions.

The dissenting vote on the D.C. Circuit panel came from none other than then-Judge Brett Kavanaugh. And his dissent was a passionate one. First off, he noted that the factual record and the SEC ALJ’s legal determinations did not “square up”: “At most, the judge’s factual findings may have shown some mild negligence on Lorenzo’s part…. [I]t is impossible to find that Lorenzo acted ‘willfully.’” Kavanaugh then opined that the Commission had “simply swept the judge’s factual and credibility findings under the rug” in its rush to judgment. In his view, the D.C. Circuit panel should not have given deference to the Commission, but should have instead looked de novo at the record developed before the ALJ to assess whether Lorenzo had in fact willfully engaged in a scheme to defraud.

Alternatively, Kavanaugh opined that the panel’s decision “creates a circuit split by holding that mere misstatement, standing alone, may constitute the basis for so-called scheme liability under the securities laws.” Citing contrary decisions directly on point by other circuits—that a scheme liability claim must be based upon conduct beyond misrepresentations or omissions to be actionable under Rule 10b-5(b), Kavanaugh attributed his then-colleagues’ decision to push the envelope as the result of the “SEC’s attempts to unilaterally rewrite” the antifraud provisions of the securities laws—in the face of the Supreme Court’s rulings which distinguished between primary and secondary liability: Janus, Stoneridge, and Central Bank.

What Comes Next?

On June 18, 2018, the Supreme Court granted Lorenzo’s cert petition. On December 3, 2018, the Court heard oral argument. In between those two dates, now-Justice Kavanaugh recused himself, so only eight Justices heard the argument and only they will decide the case—and those eight Justices split on Janus, four to four!

Many have speculated that the Court granted certiorari to once and for all resolve (for the fourth time) that primary liability for use of misleading statements alone is actionable only under Rule 10b-5(b) (and that there is no end-run around that holding by the scheme liability provisions of Rules 10b-5(a) and 10b-5(c)). This result would be consistent with Central Bank, Stoneridge, Janus, case law following those decisions, and then-Judge Kavanaugh’s dissent; it would also preserve the distinction between primary and secondary liability.

But many observers of the Lorenzo oral argument on December 3^rd seem to believe that the Court’s Janus divide of four to four will likely be the outcome in Mr. Lorenzo’s case, leaving the D.C. Circuit’s decision in place. If that is in fact the outcome, we may have a very strange state of affairs in the short to mid-term. For the time-being, there would be an expansive view of 10b-5 liability, allowing the SEC and private plaintiffs to bring primary liability fraud claims against secondary actor individuals (including lawyers) who did not “make” the alleged material misrepresentations; and then—presumably—when the next case reaches the Court (with Justice Kavanaugh participating), liability exposure would be returned to the Central Bank, Stoneridge, Janus status quo. To paraphrase Bette Davis from the classic movie All About Eve (20th Century Fox 1950), if that is what we (secondary actors) face: “Fasten your seatbelts, it’s going to be a bumpy [ride]!”

Author Information

Mr. Stewart is a senior partner at Cohen & Gresser, as well as a visiting professor at Cornell University and an adjunct professor at Fordham Law School. In 2016, he received the Sandford D. Levy Award from the New York State Bar Association for his contribution to the field of legal ethics.