Determining the Scope of Primary Liability in Securities Fraud Litigation

by Charles Bloom*

For decades, the private right of action for securities fraud has been narrowed, both by Congress and in the courts. In this Contribution, Charles Bloom (’21) considers the extent to which the Supreme Court’s most recent decision in a securities fraud case reverses that trend. Ultimately, this Contribution will argue that the Court has permissibly expanded private liability for securities fraud, closing certain loopholes created by its earlier precedents.

---

Fraud is fundamentally about deception. Deception cannot happen without communication, so there must always be someone who “makes”² a deceptive statement. This proposition is simple enough in straightforward business transactions, but in the securities law context, this idea alone fails to capture the “countless and variable schemes devised by those who seek the . . . money of others on the promise of profits.”³

In 1934, Congress broadly proscribed the use of “any manipulative device or contrivance” in securities transactions and empowered the newly-formed Securities and Exchange Commission (“SEC” or “the Commission”) to define and enforce this expansive prohibition.⁴ The SEC, in turn, promulgated Rule 10b-5 (“the Rule”), which sets out in expansive language the “device[s] or contrivance[s]” that are unlawful under the Act.⁵ The Rule’s capacious language supports the Commission’s broad authority, but it also raises questions concerning precisely what conduct violates the Rule, and who may bring an action against a violator. All securities transactions require participation from numerous individuals, so questions of which parties may be liable for fraud—and relatedly who may impose that liability—are particularly significant.

This Contribution will argue that an individual may be primarily liable under Rule 10b-5(a) or (c) for inserting false or misleading statements into investor materials, even if that individual is not considered the “maker” of those statements as required for primary liability under Rule 10b-5(b).

* * * * *

Courts have consistently recognized a private right of action within Rule 10b-5.⁶ However, the Supreme Court has been unwilling to expand private liability for secondary actors—such as lawyers or accountants—who play a role in a fraudulent transaction⁷ but do not make a “public statement” on which the plaintiff could rely.⁸ This reasoning foreclosed various theories of scheme liability, and effectively cast subsection (b), which concerns only the “making” of a false statement, as the cornerstone of Rule 10b-5. Combined with the narrow definition of “make” set forth in Janus Capital Group Inc. v. First Derivative Traders,⁹ the viability of private actions under subsections (a) or (c) appeared dubious until recently in Lorenzo v. Securities and Exchange Commission, where the Court held that one who disseminates false statements may be liable even if they did not “make” the statement as defined in Janus.¹⁰ Since the Court in Lorenzo specifically addressed dissemination, the central question is whether it should be read as a broad affirmation of expansive scheme liability, or a narrow proscription on fraudulent dissemination alone. Since private plaintiffs cannot impose secondary liability, the question of how far Lorenzo reaches directly affects the scope of the private right of action for securities fraud.

Since Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.,¹¹ courts have diverged in their application of Rule 10b-5(a) and (c) in private securities litigation.¹² Subsection (a) broadly contemplates “any device, scheme or artifice to defraud,” and likewise, subsection (c) covers “any act, practice or course of business which operates . . . as a fraud or deceit.”¹³ Indeed, the Supreme Court has described the repeated use of the word “any” as evincing clear congressional intent of the law’s breadth.¹⁴ Securities transactions are necessarily multifaceted, requiring varying levels of input from a wide range of individuals and entities. Many of these actors, while secondary to the ultimate transaction, could arguably employ a “device, scheme or artifice” under subsection (a), or engage in an “act, practice or course of business” under subsection (c). As mentioned previously, the prohibition of private aiding-and-abetting claims¹⁵ is meant to curb the theoretically limitless liability that such a reading would produce.¹⁶ However, this prohibition merely shifts the question from whether a private individual may bring a secondary claim, to what one must demonstrate to make out a primary claim. Looking exclusively at the broad language of subsections (a) and (c), the answer is anything but clear.

The most straightforward concern is that a permissive reading of subsections (a) and (c) swallows subsection (b) by allowing plaintiffs to repackage a secondary claim as a primary one.¹⁷ Courts are understandably concerned by the prospect of frivolous litigation under Rule 10b-5,¹⁸ and that concern has spurred judicial efforts to limit the meaning of subsections (a) and (c) without rendering them toothless.

Concerning subsection (a), the Court has noted that its terms have historically connoted both “knowing or intentional practices.”¹⁹ Intentionality as a requirement here is straightforward and tracks with the element of scienter required to make out any claim under Rule 10b-5.²⁰ Relatedly, “practice” is typically understood to mean either an act that is performed habitually, or is a customary occurrence within an industry.²¹ While the intentionality idea is intuitive due to its implicit inclusion in the terms of the statute, the concept of “practice” requires reading additional historical meaning into the words of subsection (a). Additionally, such an understanding may unduly narrow the subsection’s reach by paradoxically requiring that the fraud be part of some accepted business practice.²² Although judicial guidance on the terms of subsection (a) can be helpful, this should not supplant the plain meaning of the terms themselves.

Courts rely on canons of statutory interpretation in applying the language of these subsections.²³ First, the rule against surplusage, which the Supreme Court has described as “the cardinal rule” of statutory interpretation, states that “if possible, effect shall be given to every clause and part of a statute.”²⁴ As applied to Rule 10b-5(c), this canon cautions against reading terms such as “any . . . course of business”²⁵ in such a way as to render the prohibition on false statements in subsection (b) meaningless. Inversely, the general/specific canon instructs that specific terms in a rule, such as the “untrue statement” of subsection (b), narrow the scope of general ones, such as the “course of business” of subsection (c).²⁶

Applied to Lorenzo, where the petitioner had disseminated untrue statements he had not made, the argument follows that he could not be liable under Rule 10b-5(a) or (c).²⁷ The theoretical underpinning of this argument, as set forth by the Second, Eighth and Ninth Circuit Courts prior to Lorenzo, is that primary liability will only lie under subsections (a) or (c) if subsection (b) does not fully cover the alleged conduct.²⁸ If this reasoning is persuasive, then the import of the majority opinion in Lorenzo is clear: primary liability imposed under a broad provision that otherwise fails under a relevant narrower provision “eviscerates” the “clear line between primary and secondary liability in fraudulent-misstatement cases.”²⁹ More specifically, this argument also implicates Janus, where the court defined the narrow scope of “maker liability” under Rule 10b-5(b).³⁰ As Justice Thomas noted in dissent in Lorenzo, the Court’s definition of maker liability stemmed from a desire to avoid imposing primary liability on individuals with ancillary roles in the creation of a false statement.³¹ Accepting this argument, it theoretically follows that under Lorenzo, those ancillary individuals could still be primarily liable, albeit under a different subsection.

* * * * *

Lorenzo unquestionably settles the issue of whether a party who disseminates but does not “make” false statements is liable under Rule 10b-5, but it leaves open the inverse: whether an individual can be liable for drafting false statements that they did not disseminate.³² Naturally, this fact-reversal begs two distinct questions: whether the Court decided Lorenzo correctly on its own terms, and if so, whether its reasoning extends to drafting false statements. Looking at the plain meaning of the Rule, as well as the Court’s securities fraud precedents, the answer to both questions must be yes.

First, the Lorenzo decision rests on a strong foundation of plain meaning textual analysis. The ordinary meanings of terms such as “scheme” in subsection (a) or “course of business” in subsection (c) “capture a wide range of conduct.”³³ As a simple matter of applying the law to facts, knowingly disseminating a false statement is certainly a “scheme”—which commonly includes any “plan or program of action”³⁴—under subsection (a) or a “course of business” under subsection (c).³⁵

Second, the application of interpretive canons to narrow subsections (a) and (c) is unpersuasive. As a threshold matter, the canons are for resolving ambiguity, and when a rule’s language is unambiguous, “judicial inquiry is complete.”³⁶ Even assuming the overlapping terms here create ambiguity, applying the canons is still inappropriate. The surplusage canon should only apply where the overlap is so severe that “one subsection renders another meaningless.”³⁷ Here, there are certainly some false statements “covered by subsection (b) [that] remain outside the grasp of . . . subsections (a) and (c).”³⁸ Likewise, the general/specific canon should only apply where the relevant provisions are comparable in terms of scope. A “scheme” is no more general or specific than a “misstatement;” they are simply different types of conduct.³⁹ Indeed, Justice Thomas’s dissent in Lorenzo supported applying the general/specific canon with only a citation to a case concerning a narrow bankruptcy provision that does not cause this issue.⁴⁰

The majority in Lorenzo was unpersuaded both by Justice Thomas’s construction of the Rule and his assertion that the Court had blurred the critical distinction between primary and secondary liability.⁴¹ Instead, the Court proceeded from their longstanding recognition of the “considerable overlap” of the subsections, noting that “[t]he idea that each subsection of Rule 10b–5 governs a separate type of conduct is . . . difficult to reconcile with the language of subsections (a) and (c).”⁴² Further, the Court found that applying the canons used in dissent did not truly help reconcile the superfluity concerns that motivated its analysis.⁴³ A more straightforward reading must allow for overlap. In turn, that overlap will necessarily implicate situations like Lorenzo, where there can be multiple ways to frame deceptive conduct.⁴⁴

Another way to view Lorenzo is as a simple affirmation of what the Court has said all along concerning securities fraud: the line between primary and secondary liability should be drawn with regard to the overall weight of a deceptive act within a fraud, rather than just the narrow role of the actor.⁴⁵ Even before Janus solidified the definition of “make,” courts were hesitant to find drafters of false statements primarily liable under subsection (b).⁴⁶ Nonetheless, courts were comfortable imposing liability under subsection (a) or (c) as long as they were satisfied that the conduct constituted “substantial participation or intricate involvement in the preparation of fraudulent statements.”⁴⁷

This “substantial participation” standard strikes the right balance by looking at the overall culpability of an act. Moreover, it completely obviates the common concern that a secretary or mailroom clerk who is “tangentially involved” in some fraud will be unjustifiably hauled into court by a jilted investor.⁴⁸ Admittedly, the notions of “substantial participation” or “intricate involvement” are not well-defined, but this concern is somewhat overstated. For a plaintiff to prevail under any subsection of Rule 10b-5, they must not only prove elements like scienter and reliance,⁴⁹ but must also overcome significant procedural hurdles imposed by Congress to curb frivolous litigation.⁵⁰ The hypothetical mailroom clerk or secretary will rarely, if ever, satisfy these elements.

A lawyer or accountant, on the other hand, is a different story. Where a lawyer or accountant drafts false statements that implicitly carry the weight of their authority, the fact that they did not “make” those statements under Janus should not excuse them from liability. Narrow interpretation of Rule 10b-5 comes at the cost of allowing a gaping loophole where one who is intricately involved in creating false statements can escape liability as long as they neither made a statement for purposes of subsection (b), nor disseminated one for the purposes of subsections (a) or (c).⁵¹ Further, this negative effect is even more egregious in the SEC enforcement context, where a drafter of false statements would escape primary liability, but could still be subject to secondary aiding-and-abetting liability. Because secondary liability must anchor to a primary violation,⁵² a drafter of false statements would escape secondary liability whenever the SEC fails to prove all the elements of the  primary violation.⁵³ Failure to impose liability in these kinds of situations is plainly contrary to the text and purpose of the securities laws.⁵⁴

* * * * *

The tension between the divergent interpretations of Rule 10b-5 stems from a fundamental disagreement about how its subsections should appropriately interact. In general, interpreting rules to avoid overlap and superfluity is an admirable goal, but it should never be the only goal. As such, it is vital to carefully consider whether such an interpretation is warranted in the first instance; and second, whether the result comports with the primary purpose of the Rule itself. Lorenzo appropriately reminds us that these laws are meant to “root out all manner of securities fraud.”⁵⁵ Reading Rule 10b-5 in a way that eliminates liability for those who disseminate or draft fraudulent statements is plainly contrary to that mandate.

---

* Charles Bloom is a J.D. Candidate (2021) at New York University School of Law. This piece is a commentary on the 2020 problem from the Irving R. Kaufman Memorial Securities Law Moot Court Competition in New York, NY, hosted by Fordham University School of Law. Oral arguments for the competition were canceled due to ongoing efforts to stem the spread of COVID-19. Instead, the competition was judged solely on the content of competitors’ briefs. The question presented asked whether an employee who inserts a false or misleading statement into investor materials is subject to primary liability under Rule 10b-5(a) or (c), even if that individual is not the “maker” of the statement for purposes of Rule 10b-5(b). The views expressed in this article do not necessarily represent the views of the author. Rather, they are a distillation of arguments that would likely have been presented on the author’s side at the Kaufman Securities Law Competition.

2. See Lorenzo v. SEC, 139 S. Ct. 1094, 1108 (2019) (Thomas, J., dissenting) (noting that defendant who merely transmitted a message written by his superiors, did not “make” a fraudulent statement within the meaning of Rule 10b-5).

3. SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946).

4. Securities Exchange Act of 1934, 15 U.S.C. § 78j.

5. 17 C.F.R. 240.10b-5 states:

It shall be unlawful for any person, directly or indirectly . . .

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

6. Kardon v. Nat’l Gypsum Co., 69 F. Supp. 512, 514 (E.D. Pa. 1946); see also, e.g., Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258, 267 (2014) (citing Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 730 (1975)).

7. See Central Bank of Denver, N.A., v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 191 (1994) (holding there is no private aiding and abetting liability under § 10(b)).

8. Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148, 149 (2008) (holding no liability under § 10(b) where the respondent did not communicate a deceptive statement to investors).

9. 564 U.S. 135, 142 (2011) (defining the maker of a statement for purposes of Rule 10b-5 as one who has “ultimate authority” over it).

10. 139 S. Ct. 1094, 1100–01 (2019).

11. 511 U.S. 164 (1994).

12. See In re Longfin Corp. Sec Class Action Litig., No. 18cv2933 (DLC), 2019 WL 1569792 at *1 (S.D.N.Y. April 11, 2019) (finding that a co-defendant “may be liable regardless of whether it ‘made’ any misrepresentations or omissions” where it knowingly facilitated another co-defendant’s fraudulent offering); Malouf v. SEC, 933 F.3d 1248, 1259 (10th Cir. 2019) (finding that Rule 10b-5(a) and (c) encompass investment adviser’s failure to correct firm’s false or misleading statements); cf. Pub. Pension Fund Grp. v. KV Pharm. Co., 679 F.3d 972, 987 (8th Cir. 2012) (finding that company’s individual officers were not subject to scheme liability where plaintiffs only alleged that they had knowledge of company’s misrepresentations). See also The Private Securities Litigation Reform Act, 15 U.S.C. § 78u–4 et seq. (1995), (codifying the threshold requirements for private securities litigation under Section 10(b)).

13. 17 C.F.R. 240.10b-5.

14. Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 151 (1972).

15. See Central Bank, 511 U.S. at 191.

16. See, e.g., Stoneridge, 552 U.S. at 149–50,

17. See, e.g., Lorenzo, 139 S. Ct. at 1107 (Thomas, J., dissenting) (expressing concern that the Court had found conduct typically characterized as aiding and abetting to constitute a primary violation).

18. See Jonathan Stempel, A Lawsuit a Day: U.S. Securities Class Actions Soar, Reuters (Jan. 29, 2018), https://www.reuters. com/article/us-stocks-classaction/a-lawsuit-a-day-u-s-securities-class-actions-soar-idUSKBN1FI2FM.

19. Aaron v. SEC, 446 U.S. 680, 696 (1980) (noting that the terms of the statute evince an intent requirement).

20. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 186 (1976); In re Int’l Bus. Machines Corp. Sec. Litig., 163 F.3d 102, 106 (2d Cir. 1998).

21. Practice, The Merriam-Webster Dictionary, https://www.merriam-webster.com/dictionary/practice (last visited June 21, 2020).

22. See SEC v. Capital Gains Research Bureau, 375 U.S. 180, 195 (1963) (noting that Congress intended securities fraud legislation to be construed “flexibly to effectuate its remedial purposes”); but see United States v. Naftalin, 441 U.S. 768, 769 (1979) (noting that these terms contemplate “fraudulent scheme[s],” meaning business practices—such as short-selling—that are conducted fraudulently (emphasis added)).

23. See, e.g., SEC v. Familant, 910 F. Supp. 2d 83, 95 (D.D.C. 2012).

24. D. Ginsberg & Sons v. Popkin, 285 U.S. 204, 208 (1932) (finding that a statute vesting bankruptcy courts with broad authority did not supersede a narrower one that specifically governs arrest and detention of bankrupts).

25. 17 C.F.R. 240.10b-5.

26. See Antonin Scalia & Bryan A. Garner, Reading Law: The Interpretation of Legal Texts 51 (1st ed. 2012).

27. See Lorenzo, 139 S. Ct. at 1108 (Thomas, J., dissenting) (citing RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 566 U.S. 639, 645–46 (2012)).

28. See Pub. Pension Fund Grp. v. KV Pharm. Co., 679 F.3d 972, 987 (8th Cir. 2012) (holding that a fraudulent scheme must include deceptive conduct apart from false statements); WPP Lux. Gamma Three Sarl v. Spot Runner, Inc., 655 F.3d 1039, 1057 (9th Cir. 2011) (same); Lentell v. Merrill Lynch & Co., 396 F.3d 161, 177 (2d Cir. 2005) (same).

29. Lorenzo, 139 S. Ct. at 1106 (Thomas, J., dissenting).

30. Janus, 564 U.S. at 142.

31. Lorenzo, 139 S. Ct. at 1110. (Thomas, J., dissenting).

32. This fact pattern necessarily assumes that the drafter is not also the “maker” of the statements, which would instead bring them under the ambit of Janus.

33. Lorenzo, 139 S. Ct. at 1101.

34. Scheme, The Merriam-Webster Dictionary, https://www.merriam-webster.com/dictionary/scheme (last visited Oct. 18, 2020).

35. Id.

36. Rubin v. United States, 449 U.S. 424, 430 (1981) (treating a “pledge of stock” as plainly within the meaning of “offer or sale,” as described in the 1933 Securities Act).

37. Familant, 910 F. Supp. 2d at 95 (noting that where incomparable categories of proscribed conduct are described in a statute, one cannot render the other meaningless).

38. Id.

39. Id. at 96.

40. Lorenzo, 139 S. Ct. at 1108–09 (Thomas, J., dissenting) (citing RadLAX, 566 U.S. at 645).

41. Lorenzo, 139 S. Ct. at 1103.

42. Id. at 1102.

43. See Lorenzo, 139 S. Ct. at 1102 (noting that the same analytical framework used in the Dissent does little to resolve superfluity concerns as between subsections (a) and (c)).

44. See also Malouf v. SEC, 933 F.3d 1248, 1260 (10th Cir. 2019) (finding that investment advisor’s failure to correct misstatements concerning conflict of interest could trigger primary liability under Rule 10b-5(a) or (c)); SEC v. Monterosso, 756 F.3d 1326 (11th Cir. 2014) (holding falsification of financial records is actionable under Rule 10b-5(a) despite the fact that the conduct involves a false statement); Familant, 910 F. Supp. 2d at 83 (holding that scheme to conceal poor financial performance is a violation of Rule 10b-5(a), despite the fact that it could be an omission under subsection (b)).

45. See Central Bank, 511 U.S. at 191 (“[A]ny person . . . including a lawyer, accountant, or bank . . . may be liable as a primary violator under 10b-5. . . .”); Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148, 165–66 (2008) (noting that “secondary actors who commit primary violations” are primarily liable).

46. See In re Zoran Corp. Derivative Litig., 511 F. Supp. 2d 986, 1011 (N.D. Cal. 2007) (finding that administering backdated stock options did not lead to liability under Rule 10b-5(b) but was nonetheless sufficient under subsections (a) or (c)).

47. Id. (quoting Howard v. Everex Sys., Inc., 228 F.3d 1057, 1061 n.5 (9th Cir. 2000)).

48. See Lorenzo, 139 S. Ct. at 1111 (Thomas, J., dissenting).

49. See In re Int’l Bus. Machines Corp., 163 F.3d at 106 (listing the required elements to state a cause of action under Rule 10b-5).

50. See generally, Private Securities Litigation Reform Act, 15 U.S.C. § 78u–4 et seq. (1995) (imposing heightened pleading standards on private plaintiffs including requiring proof of loss causation, and imposing a stay of discovery during the pendency of a motion to dismiss).

51. See Lorenzo v. SEC, 872 F.3d 578, 594 (D.C. Cir. 2017), aff’d, 139 S. Ct. 1094 (2019) (citing WPP Lux. Gamma Three Sarl v. Spot Runner, Inc., 655 F.3d 1039, 1057–58 (9th Cir. 2011) (noting that the dissent found Lorenzo’s conduct to be outside the scope of Rule 10b-5(a) and (c) despite his substantial role in the fraud).

52. See 15 U.S.C. § 78t(e).

53. See Lorenzo, 139 S. Ct. at 1104.

54. See id.; SEC v. Capital Gains Research Bureau, 375 U.S. 180, 195 (1963) (noting that Congress intended securities fraud legislation to be construed “flexibly to effectuate its remedial purposes”).

55. Lorenzo, 139 S. Ct. at 1104.