Different Federal Court Approaches to Scheme Liability
In this New York Law Journal article, partner Stefan Atkinson and associate Yi Yuan discussed a circuit split that has emerged over the scope of Lorenzo’s holding, which reflects a fundamental disagreement about the relationship between scheme liability and Rule 10b-5(b).
Historically, federal courts generally agreed that scheme liability under SEC Rule 10b-5(a) and (c) requires something more than a misstatement or omission—with misstatements and omissions typically being litigated under Rule 10b-5(b) instead. The Supreme Court in Lorenzo v. SEC, 139 S. Ct. 1094 (2019), however, held that an individual who disseminates a misstatement, without other fraudulent conduct, is potentially liable under the scheme liability provisions of Rule 10b-5. Subsequently, a circuit split has emerged over the scope of Lorenzo’s holding, which reflects a fundamental disagreement about the relationship between scheme liability and Rule 10b-5(b).
The Second Circuit, like several other circuits, has long held that misstatements and omissions cannot form the “sole basis” for a scheme liability claim. Lentell v. Merrill Lynch & Co., 396 F.3d 161, 171 (2d Cir. 2005). In other words, the scheme must “also encompass conduct beyond those misrepresentations or omissions.” WPP Luxembourg Gamma Three Sarl v. Spot Runner, 655 F.3d 1039, 1057 (9th Cir. 2011). Some courts adopted this rule to discourage private plaintiffs from attempting to evade some of the PSLRA’s heightened pleading requirements by recasting their Rule 10b-5(b) allegations as scheme liability claims. Lentell, 396 F.3d at 177. Courts have also justified the rule as safeguarding the distinction between primary and secondary liability. The private right of action under Rule 10b-5 does not include aiding-and-abetting liability, Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 180 (1994), but permitting scheme liability claims based solely on misstatements or omissions, without other actionable conduct, may allow private plaintiffs to sue aiders and abettors, SEC v. Rio Tinto plc, 41 F.4th 57, 55 (2d Cir. 2022).
The distinction between scheme liability and Rule 10b-5(b) claims was tested by the Supreme Court’s decision in Janus Capital Group v. First Derivative Traders, 564 U.S. 135 (2011). In Janus, the Supreme Court limited the scope of Rule 10b-5(b) liability to persons or entities who had “ultimate authority” over the misstatement or omission. Id. at 142. As a result, someone who published or prepared a misstatement or omission might not be liable under Rule 10b-5(b), if she lacked “ultimate authority.” And because courts did not permit repackaging of a misstatement or omission as a scheme liability claim, that person might also not be liable under Rule 10b-5(a) and (c), unless there was some allegation of additional conduct beyond the misstatement or omission. Thus, it was possible that an individual who issued a misstatement or omission, with intent to defraud, might nonetheless avoid liability altogether.
The Supreme Court decided Lorenzo to address this situation. Lorenzo involved a defendant who, at the direction of his boss, sent two emails to prospective investors containing misstatements about a company’s assets. 139 S. Ct. at 1099. The content of the emails was supplied and approved by his boss, so the defendant was not liable under Rule 10b-5(b) as he did not have “ultimate authority” over the misstatements. Id. However, the Supreme Court held that sending misleading emails with intent to defraud clearly constituted a “device,” “scheme,” or “artifice” to defraud, and thus the defendant was potentially liable under Rule 10b-5(a) and (c). Id. at 1101.
In so holding, the Supreme Court rejected the defendant’s argument that permitting liability for misstatements under Rule 10b-5(a) and (c) would leave Rule 10b-5(b) with no exclusive sphere of conduct to govern, making subsection (b) superfluous. Instead, the Supreme Court explained that there is “considerable overlap” among the subsections, and that each succeeding prohibition was “not [meant] to narrow the reach of the prior sections.” Id. at 1102. But the Supreme Court also emphasized that no liability would attach where “an individual neither makes nor disseminates false information—provided, of course, that the individual is not involved in some other form of fraud.” Id. at 1103 (emphasis in original).
At least three circuits—the Second, Ninth and Tenth Circuits—have had occasion to interpret the scope of Lorenzo. The Second Circuit in SEC v. Rio Tinto plc, 41 F.4th 47 (2d Cir. 2022), focused on Lorenzo’s discussion of dissemination, and concluded that the dissemination in Lorenzo was the additional conduct that turned the misstatement allegations into a valid scheme liability claim. Id. at 53. According to the Second Circuit, Lorenzo did not abrogate the rule that scheme liability requires something more than misstatements and omissions; Lorenzo simply identified an example of the additional conduct that is required. Id.
By contrast, the Ninth and Tenth Circuits appear to have interpreted Lorenzo more expansively. According to the Ninth Circuit, Lorenzo “rejected the … argument that Rule 10b-5(a) and (c) … are violated only when conduct other than misstatements is involved” and thus abrogated prior Ninth Circuit precedent. In re Alphabet Sec. Litig., 1 F.4th 687, 709 & n.10 (9th Cir. 2021). Similarly, the Tenth Circuit concluded that Lorenzo’s holding means an individual may be liable under the scheme liability provisions of Rule 10b-5 “when the only conduct involved concerns a misstatement.” Malouf v. SEC, 933 F.3d 1248, 1259-60 (10th Cir. 2019). The Tenth Circuit considered the defendant’s argument that such an expansive interpretation of Lorenzo would make Rule 10b-5(b) superfluous, but it concluded that the Supreme Court had already rejected the argument in Lorenzo. Id. at 1260.
Thus, the Second Circuit appears intent on preserving the separation between scheme liability and Rule 10b-5(b) claims, as the courts have historically done. On the other hand, the Tenth Circuit (and perhaps the Ninth Circuit) may be willing to do away with the distinction, under the view that scheme liability serves as the general proscription against fraud that subsumes the more specific and potentially superfluous Rule 10b-5(b) within its ambit.
In practice, these conflicting views about Rule 10b-5 are most likely to be felt in cases involving failure-to-act allegations, that is, allegations that an individual failed to prevent the dissemination of misstatements or omissions. The Tenth Circuit has already held that allegations that an individual failed to correct misstatements are sufficient for scheme liability. Malouf, 933 F.3d at 1259-60. But other circuits are yet to weigh in on the issue and, when they do, the results may be different.
For example, the Second Circuit in Rio Tinto, which likewise involved allegations that the defendants failed to correct misstatements, did not rule on whether such allegations constituted sufficient additional conduct to trigger scheme liability. 41 F.4th at 54. But it is possible that the Second Circuit draws the line at failure-to-act allegations, so that scheme liability claims cannot arise solely out of allegations that an individual failed to correct misstatements or omissions. That would cohere with its interpretation of Lorenzo, because many affirmative acts by a defendant involving a misstatement or omission are likely to qualify as a dissemination, but allegations that an individual failed to correct misstatements or omissions, such as those in Rio Tinto, likely would not involve dissemination.
The scope of scheme liability after Lorenzo remains far from settled, and many federal courts have yet to weigh in. But until then, the takeaway from this emerging circuit split is that forum selection matters, especially in situations where defective Rule 10b-5(b) allegations could be repackaged as scheme liability claims.
