Second Circuit on Stating a Claim for Scheme Liability

Israel David and Samuel P. Groner are partners and Harrison D. Polans is an associate at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on their Fried Frank memorandum.

On July 15, 2022, the U.S. Court of Appeals for the Second Circuit issued a decision holding that Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005)—in which the court previously held that misstatements and omissions alone do not suffice for scheme liability under Rule 10b-5(a) and (c) of the federal securities laws—continues to retain its vitality after the Supreme Court’s decision in Lorenzo v. SEC, 139 S. Ct. 1094 (2019). Some further conspiratorial-like act in furtherance of the “scheme” is required. In Lorenzo, the Supreme Court had held that an individual who knowingly disseminated a false statement but did not create it could be found liable under subsections (a) and (c) of Rule 10b-5, which are often referred to as the “scheme liability” subsections of Rule 10b-5.

In SEC v. Rio Tinto plc, et al., No. 21-2042, 2022 WL 2760323 (2d Cir. July 15, 2022), the Second Circuit affirmed the dismissal of scheme liability claims against a company and its senior officers relating to their alleged misstatements and omissions concerning the valuation of an exploratory coal mine the company had acquired in Mozambique. Applying Lorenzo, the court held that while “misstatements and omissions can form part of a scheme liability,” an “actionable scheme liability claim requires something beyond misstatements and omissions” (such as dissemination of those statements).

The Supreme Court’s Decision in Lorenzo 

Following the Supreme Court’s decision in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), which famously held that only the “maker” of a statement can be liable for violations of Rule 10b-5(b), the Court in Lorenzo considered whether a defendant who is not the “maker” of a statement under Rule 10b-5(b) could nevertheless be held liable under subsections (a) and (c) of Rule 10b-5 when the only conduct involved concerns a misstatement or a corresponding omission. In Lorenzo, the defendant, an investment banker at a broker-dealer and investment banking firm, sent an email to two potential investors concerning one of the firm’s clients. The email falsely touted the safety of the potential investment and included a statement that the subject company had $10 million in assets, which the defendant knew to be inaccurate. The email was drafted by, and sent at the request of, the defendant’s boss.

The Supreme Court in Lorenzo held that someone who was not a “maker” of a misstatement or omission under Janus can nevertheless be found to have violated the scheme liability subsections of Rule 10b-5 in respect of a misstatement or omission. The Court reasoned that the language of subsections (a) and (c) was broad enough to include within their scope the dissemination of false or misleading information with an intent to defraud. The Court found that by sending emails that he knew to contain materially false statements, the defendant “employ[ed]” a “device,” “scheme,” and “artifice to defraud” within the meaning of subsection (a) of the Rule, and that through that the same conduct, he also “engag[ed] in a[n] act, practice or course of business” that “operate[d] . . . as a fraud or deceit” under subsection (c) of the Rule. The Court rejected the argument that, under its earlier decision in Janus, only the “maker” of the misstatement under subsection (b) can violate Rule 10b-5, describing Rule 10b-5 as “includ[ing] both a general proscription against fraudulent and deceptive practices and, out of an abundance of caution, a specific proscription against nondisclosure,” and found it “difficult to see how [the defendant’s] actions could escape the reach of those provisions,” given that scienter was undisputed.

Background of Rio Tinto 

In April 2011, Rio Tinto acquired an exploratory coal mine in Mozambique for $3.7 billion. The purchase price was premised upon certain assumptions, and Rio Tinto and its senior officers allegedly learned that those assumptions were faulty and that the mine was not worth $3.7 billion. Following an investigation, Rio Tinto’s board of directors approved an 80 percent impairment charge in January 2013, valuing the mine at $611 million. In 2014, Rio Tinto again wrote down the mine, this time to $119 million, and the company ultimately sold the mine in October 2014 for $50 million.

In October 2017, the SEC brought a twelve-count enforcement action in the U.S. District Court for the Southern District of New York, including scheme liability claims under subsections 10b-5(a) and (c), alleging that Rio Tinto should have taken an impairment charge on the mine earlier than it did. Notably, with respect to the scheme liability claims, the SEC did not allege that the defendants disseminated false statements; the SEC alleged “only that [the defendants] failed to prevent misleading statements from being disseminated by others.”

Relying on Lentell, which held that “scheme liability does not exist when ‘the sole basis for such claims is alleged misrepresentations and omissions,’” the district court dismissed the scheme liability claims because “here, all of the alleged ‘actions’ and ‘conduct’ forming the basis for scheme liability were misstatements and omissions.” The SEC moved the district court to reconsider its dismissal of the scheme liability claims in light of Lorenzo, which the Supreme Court had issued about a week after the district court’s ruling. The district court declined to reconsider, finding that Lorenzo had merely held that the dissemination of false information can provide a basis for scheme liability, not that misstatements alone are sufficient to trigger scheme liability.

The Second Circuit’s Decision in Rio Tinto 

On appeal, the Second Circuit held that misstatements and omissions alone cannot form the basis for scheme liability under Rule 10b-5 (a) and (c). The court emphasized that “misstatements or omissions were not the sole basis for scheme liability in Lorenzo,” that “Lorenzo held that the ‘dissemination of false or misleading statements with intent to defraud’ does come within the scheme subsections,” and that “[t]he dissemination of those misstatements was key” to the Lorenzo decision. In other words, under Lorenzo, something more than the mere making of a statement or omission is required to trigger scheme liability, and “dissemination is one example of something extra that makes a violation a scheme.”

The Second Circuit provided a number of reasons for its holding:

  • First, the court explained that its holding was “consistent with the text” of the federal securities laws because “[w]ere misstatements and omissions alone sufficient to constitute a scheme, the scheme subsections [10b-5(a) and (c)] would swallow the misstatement subsections [10b-5(b)],” and Lorenzo “did not announce that the misstatement sections were subsumed.”
  • Second, the court noted that Lorenzo “preserved the lines between the subsections” by “emphasiz[ing] the continued vitality” of Janus’s limitation of primary liability under Rule 10b-5(b) to the “maker” of a false statement. The court explained that Lorenzo “did not go so far as to create primary liability for ‘participation in the preparation’ of misstatements.”
  • Third, the court stated that “[p]reserving the distinctions between the subsections also assures that private plaintiffs remain subject to the heightened pleading requirements for Rule 10b-5(b) claims.” The court reasoned that “[a]n overreading of Lorenzo might allow private litigants to repackage their misstatement claims as scheme liability claims to ‘evade the pleading requirements imposed in misrepresentation cases,’” but “courts have prohibited plaintiffs from recasting their pleadings in this way” and “Lorenzo did not announce a rule contravening this ”
  • Finally, the court found that “overreading Lorenzo would muddle primary and secondary liability,” which matters because “[a]iding and abetting liability is authorized in actions brought by the SEC but not by private parties” (citing Stoneridge Inv. Partners, LLC v. Sci.-Atlanta, 552 U.S. 148, 162 (2008)). The court explained that “[t]he SEC’s reading of Lorenzo would likely ‘revive in substance the implied cause of action against all aiders and abettors’” and “defeat the congressional limitation on the enforcement of secondary liability, multiply the number of defendants subject to private securities actions, and render the statutory provision for secondary liability superfluous.”
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