Securities Fraud Liability Ill-Defined Seven Years Post-Lorenzo

The US Supreme Court’s 2019 decision in Lorenzo v. Securities and Exchange Commission addressed a critical question underlying securities fraud claims: whether individuals who didn’t themselves “make” a false or misleading statement could be liable under the securities laws and SEC Rule 10b-5(a) and (c) for participating in a “scheme” to defraud investors. The Supreme Court ruled that they can.

In the seven years since that decision, shareholder plaintiffs have embraced scheme liability as a means of asserting fraud claims where a pure misrepresentation claim under Rule 10b-5(b) may be vulnerable, including against additional company executives and other employees who were somehow involved in events relating to alleged misstatements but didn’t themselves make any public statements.

As plaintiffs continue to push the boundaries of scheme liability, courts will need to draw clear lines around the limited kinds of conduct that qualify as a scheme to defraud investors.

Scheme Claim Elements

In Lorenzo, investment banker Francis Lorenzo emailed prospective investors in an effort to sell debentures for his client. At the time he sent those emails, he knew the client’s intellectual property—its primary asset—was worthless and had been written off. But at his boss’s direction, the emails falsely stated that the client had more than $10 million in confirmed assets.

The Supreme Court held that, although Lorenzo wasn’t the “maker” of the false statements (because his boss had supplied the false content and approved the emails for distribution), he was still liable under the securities laws for having disseminated false statements with intent to defraud—constituting a device or “scheme” to defraud investors.

Lorenzo breathed new life into so-called scheme claims arising under SEC Rule 10b-5(a) and (c). As courts have begun to grapple with scheme claims asserted in its wake, many have reached consensus on the fundamental elements of the claim: plaintiffs must show that a defendant (1) committed a deceptive or manipulative act, (2) in furtherance of a scheme to defraud investors, (3) with scienter, and (4) that the act caused some loss to the plaintiffs who relied on it.

Some of these elements are relatively straightforward. The scienter and causation elements overlap with misrepresentation claims, and there is a well-developed body of law regarding how courts should assess allegations and evidence to support those elements.

In addition, the alleged scheme to defraud must have been aimed at investors. Shareholders can’t piggyback on other underlying schemes targeting groups that aren’t among those the securities laws were intended to protect, such as alleged schemes to inflate a company’s profits by deceiving customers or advertisers.

But courts continue to grapple with challenging issues underlying a critical threshold question: What sorts of conduct constitute a deceptive or manipulative act sufficient to support a scheme claim in the first place?

Borderline Cases

In Lorenzo, the Supreme Court recognized that Rule 10b-5(a) and (c) “capture a wide range of conduct,” and anticipated the “difficult problems of scope” that might arise in “borderline cases.” That prediction has proven true.

Courts across the country have wrestled with how to apply Lorenzo to a range of factual circumstances, resulting in conflicting decisions and unanswered questions. They have contended with—but not fully resolved—the following issues (among many others):

Does a “deceptive act” require conduct distinct from making a misstatement? Courts have split on the issue of whether a defendant can be liable under Rule 10b-5(a) and (c) for only the publication of a false statement—and nothing more.

The US Court of Appeals for the Ninth Circuit concluded that, because Lorenzo discussed potential overlap between scheme and misrepresentation claims, a misstatement alone can support scheme liability without any further deceptive conduct. But the Second and Sixth Circuits determined that although misstatements can form part of a scheme claim, some conduct beyond the misstatements themselves is required.

What extra conduct qualifies? Few courts have evaluated the types of deceptive acts or devices, other than the dissemination of a misstatement addressed in Lorenzo, that are sufficient to support a scheme claim.

One court found that a marketing program designed to drive up stock prices constituted a fraudulent scheme to launder investments. Another found that concealing a bribery scheme from a company’s auditors to falsify public financial statements was sufficient. However, other courts have rejected alleged deceptive schemes based on termination of employees who knew the purported truth or collection of confidential documents bearing on the alleged misstatements. The key distinction is whether the alleged conduct was inherently deceptive or fraudulent.

Can scheme liability be based on a failure to act? While it is well-settled that omission-based misrepresentation claims may be based on the failure to speak, few courts have considered the scheme-claim analogue premised on a failure to act.

The Tenth Circuit accepted that scheme liability may be triggered by a failure to correct a false statement, at least where the defendant knew that investors were falsely informed that he lacked a conflict of interest. However, few cases have broached whether a lack of action may support scheme liability under other circumstances.

Consistent with the logic of Macquarie Infrastructure Corp. v. Moab Partners, L.P., which clarified that Rule 10b-5(b) bars only half-truths and not pure omissions, courts may be reluctant to create an implied duty to act where none exists in the text of the rule.

Unsettled Boundaries

Seven years after Lorenzo, courts still grapple with thorny questions over what exactly qualifies as a scheme or artifice to defraud. As more courts weigh in, each addressing unique facts and circumstances, some of these questions may be answered. Consensus may emerge as to some; additional circuit splits and contradictions may develop as to others.

It seems certain that shareholders, meanwhile, will continue relying on Lorenzo to push the boundaries of scheme claims and attempt to expand the scope of securities fraud.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Heather Benzmiller Sultanian is a partner at Sidley Austin who focuses on securities and shareholder litigation, data breach class actions, and complex business disputes.

Gabrielle J. Zook is an associate at Sidley Austin who focuses her practice on commercial litigation and disputes.

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