Supreme Court Decision ‘Greatly Expands’ SEC 10b-5 Liability

Who is liable when a brokerage firm staffer knowingly transmits false information at the behest of a superior? A recent Supreme Court ruling offers some answers, while raising some critical questions.

In conversation with PLANADVISER, Steve Wilkes, partner at the Wagner Law Group, suggested the recent Supreme Court ruling in Lorenzo vs. SEC greatly expands the range of individuals, under certain circumstances, who can be found liable under the Securities and Exchange Commission’s Rule 10b-5.

As Wilkes explained, on March 27, 2019, the U.S. Supreme Court ruled in Lorenzo v. SEC that a party who is not a statement “maker” under Securities and Exchange Commission (SEC) Rule 10b-5(b) can nevertheless be found to have violated Rule 10b-5(a) and (c) and other securities laws including Section 17(a)(1) of the Securities Act of 1933. 

For context, Rule 10b-5 makes it unlawful for advisers or brokers “to employ any device, scheme, or artifice to defraud; to make any untrue statement of a material fact; or to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit.”

As Wilkes recalled, in 2011, prior to Lorenzo, the U.S. Supreme Court held in Janus Capital Group, Inc. vs. First Derivative Traders that, with respect to Rule 10b-5(b) liability, 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. In Lorenzo, the director of investment banking at a broker/dealer firm sent two emails to potential investors that contained false information about a debenture offering. These emails stated that the issuer had $10 million in confirmed assets when, in fact, the assets were worth less than $400,000.

“Under the Janus rationale, the director would not have been found to be the ‘maker’ under Rule 10b-5(b) of the untrue statement,” Wilkes said. “However, in Lorenzo, the Supreme Court held that those who do not make statements, but who disseminate false or misleading with intent to deceive or defraud can be found primarily liable under Rule 10b-5(a) and (c) and secondarily liable under Rule 10b-5(b).”

On the Wagner Law Group’s analysis, the Supreme Court decision in Lorenzo is significant and should be reviewed closely by advisers and brokers operating under the SEC’s jurisdiction. Wilkes said the decision greatly expands the range of individuals, under certain circumstances, who can be found liable under Rule 10b-5.

“This group will likely see increased activity from the SEC and private litigants,” Wilkes noted. “Not only primary actors but secondary persons such as broker/dealers, bankers and even attorneys may be subject to Rule 10b-5 liability if there is a knowing or reckless disregard of the truth of a statement and intent to defraud is linked to that act.”

Wilkes said it’s possible that class action lawsuits could reach these secondary players, though it will take some time for the full impact of Lorenzo to be seen. One immediate and practical step concerned parties can take is to ensure that materials disseminated as part of ongoing selling efforts are accurate and contain no material misrepresentations.  

Broader Implications of Lorenzo Ruling

Thinking about the broader implications of this ruling, Wilkes said it is significant both for what it does and what it doesn’t do.

“The ruling does open up the door to new liabilities, but what it doesn’t do is define exactly how wide the door has been opened,” Wilkes said. “As the decision notes, there are certain factual circumstances that may be present or not from one future case to another which could limit how this ruling is applied to the circumstances. But it is a very important case and the financial services community should take note of it. It opens up a lot of possibilities, but again, there is no bring line test to show us how this issue will ultimately land in the future.”

At Wagner Law Group, the main interest in this case relates mainly to broker/dealers that are distributing products in the marketplace, Wilkes noted.

“Every broker/dealer firm has a duty to conduct product due diligence for what’s going on its shelf. If you’re putting a mutual fund on your shelf, you have a duty to conduct a reasonable investigation of the issuer about securities that are being offered,” he said. “The protocols and the steps you take are going to vary depending on the nature of the security.”

As an extreme example, a popular mutual fund requires a different due diligence process compared with a private placement, which has very clearly stipulated due diligence parameters under FINRA guidance. Variable annuities are another example of product type that requires a different (i.e., more sophisticated) due diligence process.

“Firms should take Lorenzo as a chance to review their due diligence processes,” Wilkes said. “An important caveat is that this case had an element of fraudulent intent involved which triggered the liability. Nevertheless, even if there is no intent to defraud, you still do not want false or inaccurate information floating around your system. It just begs the question of, what do your due diligence processes look like? What kind of supervision and control do you have over information shared both internally and externally?”

To the extent that Lorenzo does not establish a specific bright line test or rule for what due diligence should look like in this area, this is both a challenge and an opportunity, Wilkes said.

“It’s challenging because of the uncertainty, obviously. Firms would like, in one sense, to be able to draw the line and know where they stand with a high degree of confidence,” he explained. “But it’s also an opportunity in that it allows for the fact that different actors are involved in different platforms with different situations and different clients, all with different factual backdrops. It makes sense then, that there is not a one-size-fits-all prescription from the high court.”

In the end, Wilkes said, Lorenzo “reminds us that due diligence is not a one-time event; it’s ongoing and it requires firms to be proactive.”

“Some firms have procedures in place but don’t fully follow them. Some might start out with the greatest procedures in place but over the years, you can become a little bit too comfortable with the status quo and start to overlook your duties,” Wilkes concluded. “Especially when you’re dealing with the same fund families and the same products year-over-year. In one sense this builds a sense of confidence in the issuer when no big issues come up, but on the other hand, it’s a red flag to get too comfortable. In the world we live in, you have a challenge yourself and you can’t fall asleep at the wheel, even when the seas are calm. You can’t let yourself be lulled into a false sense of confidence based only on familiarity with the issuer.”