Four Opinions in Search of an Answer: Did a Broker “Make” a Fraudulent Statement?


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Beauty, they say, is in the eye of the beholder, and apparently so is securities fraud. An SEC administrative law judge (ALJ), the full Commission (back in those halcyon days when there was a full Commission) and three federal judges examined the case of Frank Lorenzo, a New York-based broker formerly with the firm of Charles Vista, LLC. As alleged, Lorenzo knowingly sent email messages to investors containing multiple misrepresentations about key features of a securities offering by a company in financial distress.

The ALJ, all five commissioners and two of the three circuit court judges concluded that Lorenzo violated provisions of the federal securities laws, while one circuit court judge called for the dismissal of the charges against him. The four opinions produced by these arbiters presented significantly different characterizations of the law and the facts of the long-running case, however, and the consequences for Frank Lorenzo. The case also raises questions about the continuing impact of the Supreme Court’s decision in Janus Capital Group., Inc. v. First Derivative Traders.

The action is already four years old, it has been seven years since the alleged wrongdoing took place, and the D.C. Circuit panel remanded the matter to the SEC for further proceedings last month. Initially, the ALJ issued a cease and desist order, barred Lorenzo from the securities industry for life, and ordered him to pay a civil money penalty of $15,000. The SEC took a slightly different view of the facts of the case, but affirmed the ALJ’s decision.

On appeal to the D.C. Circuit, the majority of the three-judge panel found that Lorenzo violated Exchange Act 10b-5(a) and 10b-5(c), as well as Securities Act §17(a)(1). The majority stated that “Lorenzo played an active role in perpetrating the fraud by folding the statements into emails he sent directly to investors in his capacity as director of investment banking, and by doing so with an intent to deceive.”

The panel concluded, however, that the SEC could not establish a violation of Rule 10b-5(b) because under Janus, Lorenzo did not “make” the fraudulent statements. Because “the Commission chose the level of sanctions based in part on a misimpression that Lorenzo was the ‘maker’ of false statements in violation of Rule 10b-5(b),” and “we have no assurance that the Commission would have imposed the same level of penalties in the absence of its finding of liability for making false statements under Rule 10b-5(b),” the court vacated the sanctions and remanded the case to the SEC for further consideration.

A Start-Up Gone Bad

The case emerged from financing arrangements for a start-up, Waste2Energy Holdings, Inc. (W2E), that claimed to have a new technology that could generate electricity by converting solid waste to gas. The problem with W2E was simple and obvious to those familiar with the company—its “revolutionary” technology simply did not work, and could not be made to work. On the verge of collapse, W2E decided to try to stay afloat by issuing $15 million in convertible debentures. The company retained Lorenzo’s firm, Charles Vista, LLC, to serve as the exclusive placement agent for its debenture offering.

In SEC filings, W2E claimed that its intangibles were worth just over $10 million as of the end of 2008. On Sept. 9, 2009, W2E issued a private placement memorandum for potential investors in the debentures that claimed the company had "a significant IP portfolio." Lorenzo helped W2E prepare the PPM, and at least twice during the process of preparing the disclosures had asked W2E to disclose the $10 million of intangible assets in the document.

On Oct. 1, 2009, though, the company filed an amended Form 8-K in which it reported a total "impairment" of its intangible assets because "management made a determination that the value of the assets acquired were of no value." The company stated that its gasification technology was worthless and that it had only $370,552 in total assets.

There is no question that Lorenzo was well aware of these facts when he sent the emails to the two potential investors. His secretary informed him of W2E's amended Form 8-K filing, and Lorenzo emailed all Charles Vista brokers links to the SEC documents. On October 5, he received an email from W2E's Chief Financial Officer explaining the reasons for "the accumulated deficit we have reported," and adding that “W2E had written off all of our intangible assets . . . of about $11 million due to "our assessment of the value of what those asset[s] are worth today."

Knowing W2E’s dire story, Lorenzo emailed a pitch to two investors at the request of Gregg Lorenzo (no relation to Frank), the firm’s owner. The emails ignored the adverse news and highlighted the non-existent $10 million in assets and a promising order pipeline that was largely wishful thinking.

“Staggering” Falsity

ALJ Carol Fox Foelak readily found Lorenzo liable for fraud, as she stated that "the falsity of the representations in the emails is staggering." She did state, almost in an aside, that “Frank Lorenzo sent the emails without even thinking about the contents.” She was addressing Lorenzo’s mental state, and not the Janus issue of whether or not Lorenzo “made” the statements in question. She found that Lorenzo acted at least recklessly when he sent the emails to potential investors in light of his knowledge of W2E’s financial and operational problems, even if he did not read the content composed by his superior. She also held that “he cannot escape liability by claiming that Gregg Lorenzo ordered him to send the emails ... the fact that Gregg Lorenzo contributed to the misrepresentation does not relieve Frank Lorenzo from responsibility.”

The SEC affirmed ALJ Foelak’s conclusions and the sanctions she imposed. The Commission agreed with her conclusions on culpability, and directly addressed the Janus issue, finding that Lorenzo was the maker of the fraudulent statements. His testimony indicated that his superior asked him to email certain customers about the debenture offering and that he provided Lorenzo with the email addresses to do so. “It does not establish that anyone other than Lorenzo was ultimately responsible for the emails' content ... nor do the emails themselves establish this.” The SEC noted that Lorenzo testified at the hearing that he remembered authoring the emails himself. The Commission concluded that Lorenzo was “ultimately responsible for the email’s content and dissemination and was thus the maker of the misstatements within the meaning of Rule 10b-5(b).”

Janus and the D.C. Circuit

As noted above, the D.C. Circuit panel majority readily agreed with the SEC that the email statements were false and that Lorenzo acted with scienter, but found that he had not made an untrue statement of a material fact in violation of Rule 10b-5(b). The holding is a curious extension of a curious Supreme Court decision.

The Supreme Court held in Janus that “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.” When the high court decided the case in 2011, many observers thought that the impact of the holding might be relegated to the byzantine world of the relationship between investment companies and their advisers, and that the impact of the ruling could be mitigated by SEC rulemaking requiring registered advisers to sign the filings of the funds they advise. Lower courts have, however, regularly applied the holding to operating companies to limit the liability of secondary actors.

The Lorenzo case, however, appears to be an unlikely subject for Janus review. While Lorenzo’s supervisor composed some of the wording of the email statements, Lorenzo himself had control over the “content and whether and how to communicate it.” He could have changed the wording, omitted the false statements or declined to send the messages. While he likely would have faced employment repercussions if he did not follow his superior’s instructions, Lorenzo still voluntarily decided to deliver the messages containing false statements over his signature and in his professional capacity.

In the Janus opinion, Associate Justice Clarence Thomas stated that:

This rule might best be exemplified by the relationship between a speechwriter and a speaker. Even when a speechwriter drafts a speech, the content is entirely within the control of the person who delivers it.  And it is the speaker who takes credit—or blame—for what is ultimately said.

The example certainly does not fit the facts of the Lorenzo case. The firm owner is the speechwriter, composing the false statements, while Lorenzo is the speaker who chose to deliver the words as they were written. Those who hear a speech don’t know who wrote it. The customers who received the misleading emails certainly knew that they came from Frank Lorenzo.

The Dissent

Circuit Judge Brett Kavanaugh asserted that ALJ Foelak "should have cleared Lorenzo of any serious wrongdoing under the securities laws." He added that:

I hope that the SEC on remand pays attention, comes to its senses, and (at a minimum) dramatically scales back the sanctions in this case. Indeed, notwithstanding the majority opinion, I hope that the SEC, on its own motion, goes further than that: The SEC should vacate the order against Lorenzo in its entirety and either end this case altogether or (if appropriate and permissible) fairly start the process anew before the administrative law judge.

Judge Kavanaugh appears to make too much of both the fact that Lorenzo’s superior told him to send the emails and the ALJ’s statement that Lorenzo acted without thinking about their contents. Neither of these factors is particularly compelling in light of the fact that Lorenzo is a 25-year veteran of the securities industry, and that he knew the emails concerned W2E, a company seeking to raise capital while in the midst of financial collapse.

Much Ado About Nothing?

The D.C. Circuit’s recognition of what amounts to a “my boss made me do it” defense to securities fraud charges is a troubling precedent, but it is not clear how much practical impact the decision will have on Frank Lorenzo. The liability findings under Securities Act §17(a) and Exchange Act Rule 10b-5(a) and (c) remain undisturbed by the ruling. Commissioner Kara Stein voted in favor of sustaining all of the sanctions, while Commissioner Michael Piwowar (and former Commissioner Daniel Gallagher) voted to uphold most of the penalties. He joined in the opinion sustaining the cease and desist order, the civil penalty and the bar from association with any brokers, dealers, investment advisers and transfer agents, and from participating in penny stock offerings. Commissioner Piwowar did dissent from the part of the order sustaining the bar from association with municipal advisors and nationally recognized statistical rating organizations.

It would not be surprising if the SEC declined to follow Judge Kaufmann’s recommendations and enters comparable sanctions to those imposed by the ALJ. In denying Lorenzo’s petition for rehearing, the Commission directly addressed the appropriateness of the remedies and the culpability of his conduct. The SEC expressly found that Lorenzo acted egregiously by "grossly misleading, if not outright lying" to, retail customers about the significant risks involved in purchasing W2E's debentures. According to the Commission, Lorenzo’s conduct “demonstrated a complete disregard for his professional and ethical responsibilities." Those are difficult words for the SEC, even under new leadership, to walk away from.

The SEC twice concluded that Frank Lorenzo was unfit to be part of the securities industry. Even with significant changes to the Commission’s personnel since 2015, it is doubtful that the third time will be a charm.