On July 15, 2022, a panel of the United States Court of Appeals for the Second Circuit ruled against the Securities and Exchange Commission (“SEC”) in an interlocutory appeal the SEC had brought seeking to expand the scope of “scheme liability” under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5(a) and (c) thereunder. SEC v. Rio Tinto plc, No. 21-2042 (2d Cir. Jul. 15, 2022). Specifically, the SEC had urged the Second Circuit, in a case it had brought against a mining company and certain of its former executives (the “Defendants”), to hold that the Supreme Court’s decision in Lorenzo v. SEC, 139 S. Ct. 1094 (2019), abrogated the Second Circuit’s prior decision in Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005), which had found that a defendant can only be liable for scheme liability under Rule 10b-5(a) and (c) where they engage in misleading conduct beyond misstatements and omissions. The Second Circuit panel ruled that Lentell remains good law, and that any expansion of the scheme liability provisions of Rule 10b-5(a) and (c) would need to come either from the Second Circuit en banc or the Supreme Court.
The decision originates from a 2017 securities fraud enforcement action brought by the SEC against Defendants that included claims pursuant to Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5(a) and (c) thereunder, and pursuant to Section 17(a)(1) and (3) of the Securities Act of 1933. The SEC alleged that Defendants engaged in a scheme to defraud investors with respect to the value of an exploratory coal mine it had acquired in Mozambique in 2011. In essence, the SEC claimed that the reported purchase price and valuation was premised on certain assumptions Defendants later knew or were reckless in not knowing were inaccurate.
In 2019, the United States District Court for the Southern District of New York dismissed the scheme liability claims on the grounds that “scheme liability does not exist when ‘the sole basis for such claims is alleged misrepresentations or omissions,’ and that [in the Complaint], all of the alleged ‘actions’ and ‘conduct’ forming the basis for scheme liability were misstatements or omissions.” Shortly after the district court’s decision, the Supreme Court of the United States held in Lorenzo that an individual who disseminated a false statement (but who did not make it), and thus could not be liable under Rule 10b-5(b), could nevertheless be held liable for scheme liability under Rule 10b-5(a) and (c).
The Supreme Court’s decision in Lorenzo prompted the SEC to file a motion for reconsideration of the dismissal of the scheme liability claims, arguing that Lorenzo expanded the scope of the scheme subsections such that misstatements and omissions alone could form the basis for scheme liability. The district court declined to reconsider, ruling that Lorenzo held that the dissemination of false information provides a basis for scheme liability—not that “misstatements alone are sufficient to trigger scheme liability.” The district court further explained that the SEC did not allege Defendants disseminated false statements; it only alleged that Defendants “failed to prevent misleading statements from being disseminated by others.” Id.
After the district court denied the SEC’s motion for reconsideration, the SEC certified the issue for interlocutory appeal pursuant to 28 U.S.C. § 1292(b). The Second Circuit granted the petition for leave to appeal an interlocutory order but ruled against the SEC, holding that its prior decision in Lentell remained controlling law, even after Lorenzo.
In Lentell, the district court held that misstatements and omissions are insufficient to form the “sole basis” for liability under the scheme subsections. Although the Supreme Court subsequently held in Lorenzo that the “dissemination of false or misleading statements with intent to defraud” does come within the scheme subsections, the Second Circuit noted that the dissemination of those misstatements with intent to defraud was integral to the Supreme Court’s decision and concluded that the holdings of Lentell and Lorenzo are not inconsistent with one another.
Furthermore, the Second Circuit explained that in the SEC’s “substantial effort to shoehorn its allegations into a claim for scheme liability,” its position to expand the scope of scheme liability would undermine two key features of Rule 10b-5. First, it would result in expanding primary liability under Rule 10b-5(b) from the maker of a statement (i.e., the person with authority over a false statement) to individuals who participated in the preparation of misstatements. This would exceed the scope of primary liability under Rule 10b-5(b). See Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011). Second, it would result in lowering “the bar for primary liability for securities fraud, along with the pleading standard in cases involving private plaintiffs” when the heightened pleading standard of the Private Securities Litigation Reform Act is inapplicable to allegations of scheme liability that does not require the defendant to have made a statement.
While the Second Circuit’s decision is an important clarification of the limits of scheme liability, we expect that both the SEC and private plaintiffs will continue to press this area, and the decision may not be the last word on the interplay between Rule 10b-5(b) on the one hand and Rule 10b-5(a) and (c) on the other hand.
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SEC v. Rio Tinto plc
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