Supreme Court Review of 'Lorenzo' Case Could Narrow Rule 10b-5 Scope


Supreme Court Blog

We first met Frank Lorenzo here on the blog back in October 2017. As alleged, Lorenzo knowingly sent email messages to investors containing multiple misrepresentations about key features of a securities offering by a startup company in acute financial distress. The SEC’s administrative law judge, all five commissioners and two of the three D.C. Circuit judges concluded that Lorenzo violated some of the antifraud provisions of the federal securities laws.

The D.C. Circuit found that Lorenzo violated Exchange Act Rule 10b-5(a), which prohibits the use of “any device, scheme, or artifice to defraud,” and 10b-5(c), which prohibits engaging in “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.” The panel found, however, that the SEC incorrectly concluded that Lorenzo had made fraudulent statements under Rule 10b-5(b), because he was not the “maker” of the statements under the Supreme Court’s decision in Janus Capital Group., Inc. v. First Derivative Traders. Because this error may have influenced the sanctions imposed by the Commission, the appellate panel remanded the case to the SEC for further consideration.

The final act of this long-running drama (Lorenzo sent the ill-fated email in 2009) will be played out next year before the U.S. Supreme Court, as the high court granted Lorenzo’s certiorari petition. As phrased by Lorenzo in his request for review, the Court will consider “whether a misstatement claim that does not meet the elements set forth in Janus can be repackaged and pursued as a fraudulent scheme claim.”

Judge Kavanaugh and the Recusal Question

The case is interesting for several reasons. Initially, the SEC has not fared well recently before the Court with regard to its enforcement program. The agency lost cases involving the constitutionality of its ALJ selection process and on the proper limitations periods applicable to claims for civil penalties and disgorgement actions. Additionally, Judge Brett Kavanaugh, the president’s choice to fill the high court seat of retiring Associate Justice Anthony Kennedy, sat on the panel that heard the previous review of Frank Lorenzo’s case, and wrote a spirited dissent from the majority holding. If Judge Kavanaugh is confirmed, he will face a decision on recusal when Lorenzo’s case comes before the court. That recusal decision could have a significant impact on the scope of SEC fraud enforcement authority.

The Code of Conduct for United States Judges specifically calls for recusal in the event that “the judge has served in governmental employment and in that capacity participated as a judge (in a previous judicial position), counsel, advisor, or material witness concerning the proceeding or has expressed an opinion concerning the merits of the particular case in controversy.” The Code of Conduct by its own terms, however, does not apply to the Supreme Court. Chief Justice John Roberts has stated, though, that the Code of Conduct is a useful tool for the justices to use in reaching their recusal decisions. According to the Chief Justice, “the Court has had no reason to adopt the Code of Conduct as its definitive source of ethical guidance. But as a practical matter, the Code remains the starting point and a key source of guidance for the Justices as well as their lower court colleagues.”

Assuming Judge Cavanaugh is confirmed, a potential recusal presents the possibility of a deadlocked 4-4 court. Such a result would allow the D.C. Circuit’s liability finding to stand. The crystal ball on this question is rather cloudy, though. It is not a given that the Court’s more liberal justices would all rule for the SEC. The recent Lucia case on ALJs was a 7-2 decision written by Justice Elena Kagan, and both limitations cases, Gabelli and Kokesh, were unanimous. Justices Stephen Breyer, Ruth Bader Ginsburg, Sonia Sotomayor, and Kagan all joined in a dissent from the Court’s Janus opinion, so they may well not want to see an expansion of that case’s restrictive holding.

The Circuit Split

The key question is whether subsections (a) and (c) of the rule, and Rule 10b-5(b) apply to distinct forms of conduct, one involving material misrepresentations and omissions (Rule 10b-5(b)) and the other involving conduct beyond making or failing to make statements (Rule 10b-5(a) and (c). The Second, Eighth, and Ninth Circuits have held that a misstatement alone cannot be the basis of a fraudulent scheme claim, while two courts, the D.C. Circuit and the Eleventh Circuit, reached the opposite conclusion. As stated in 2011 by the Ninth Circuit in WPP Luxembourg Gamma Three Sarl v. Spot Runner, Inc., “a defendant may only be liable as part of a fraudulent scheme based upon misrepresentations and omissions under Rules 10b-5(a) or (c) when the scheme also encompasses conduct beyond those misrepresentations or omissions.”

In reaching a different conclusion, the D.C. Circuit stated that Lorenzo’s conduct went beyond “making” the relevant statements. According to the D.C. Circuit panel, “We therefore consider the case on the understanding that  Lorenzo, having taken stock of the emails' content and having formed the requisite intent to deceive, conveyed materially false information to prospective investors about a pending securities offering backed by the weight of his office as director of investment banking. On that understanding, the language of Sections 10(b) and 17(a)(1), and of Rules 10b-5(a) and (c), readily encompasses Lorenzo's actions.”

The D.C. Circuit majority also concluded that “we know of no blanket reason, however, to treat the various provisions as occupying mutually exclusive territory, such that false-statement cases must reside exclusively within the province of Rule 10b-5(b).” The panel rejected the notion of a bright-line distinction between the coverage of the rule subsections, stating that “securities fraud allegations involving misstatements can give rise to liability under related provisions even if the conduct in question does not amount to ‘making’ a statement under Janus.” As the SEC stated in its response brief to Lorenzo’s certiorari petition, “nothing in the text, structure, history, or purpose of the relevant provisions suggests that the references to `statements’ in Section 17(a)(2) and Rule 10b-5(b) mean that a fraud claim based on false statements can proceed only under those two provisions.”

Looking Ahead

The Supreme Court granted Lorenzo’s certiorari petition just a few days before Justice Kennedy announced his retirement. The changing makeup of the Court, and the potential of a recusal if Judge Cavanaugh is confirmed, make it difficult to predict what will happen with the case next year. The opportunity is there for the Court to scale back the ability of the SEC to prosecute fraud claims in cases where the party could not be charged under Janus as the maker of the statement, and engaged in no other conduct in furtherance of an alleged scheme.

The stakes are high for Frank Lorenzo. While he received a relatively minor civil penalty of $15,000 (the maximum third-tier penalty the ALJ could have imposed was $150,000), ALJ Carol Fox Foelak found that “Lorenzo's business provides him with the opportunity to commit violations of the securities laws in the future. The record shows a lack of recognition of the wrongful nature of the violative conduct. His attempts to deflect blame onto others are aggravating factors.” As a result, she barred him for life from the securities industry.