Courts from the United States Supreme Court on down have long grappled with what, precisely, constitutes "scheme liability" under the federal securities laws, and to what extent a scheme can be based solely on false or misleading statements. Rule 10b-5—promulgated under the Securities Exchange Act of 1934—provides multiple paths to liability, with only subsection (b) specifically referencing "untrue statement[s] of a material fact." The Supreme Court made clear in Lorenzo v. SEC, 139 S. Ct. 1094 (2019), however, that such statements also may support violations of subsections (a) and (c), the antifraud provisions traditionally considered as addressing fraudulent "schemes." But can false statements alone support scheme liability, or do Rules 10b-5(a) and (c) require something more?

In SEC v. Rio Tinto PLC, et al., through an opinion authored by Judge Dennis Jacobs, the Second Circuit Court of Appeals held that "something" beyond untrue statements, even assuming scienter and materiality, is required to support scheme liability in the Second Circuit: "[M]isstatements and omissions can form part of a scheme liability claim, but an actionable scheme liability claim also requires something beyond misstatements and omissions, such as dissemination."1 The Court declined, however, to define exactly what "something beyond" misrepresentations is needed to support scheme liability, virtually guaranteeing that the Court of Appeals will be asked to weigh in again on this issue in the future.

Key Takeaway

Rio Tinto highlights the uncertainty that remains post-Lorenzo regarding what actions, or even inaction, can transform a false statements case into a fraudulent scheme case under Rule 10b-5, and leaves such questions to be resolved another day. That day may come soon. For example, briefs filed in the SEC's pending action against Archegos Capital Management and certain of its principals seek to clarify the reach of Rule 10b-5's scheme liability provisions. In the interim, the Rio Tinto Court has reaffirmed that scheme liability claims require something more than misstatements alone, providing a path for defendants facing SEC fraud allegations to defeat claims where the SEC overzealously pursues under Rule 10b-5(a) and (c) claims that rely too heavily, or perhaps entirely, on false or misleading representations.

Background

The SEC's dispute with Rio Tinto has a long history, with a complaint filed in 2017 alleging conduct beginning in 2011. In short, as relevant to the SEC's scheme liability claims, certain Rio Tinto entities allegedly acquired an exploratory coal mine in 2011 for $3.7 billion. Shortly thereafter, Rio Tinto learned the quality of the coal in that mine was poorer than expected and transport of that coal would be more difficult and expensive than Rio Tinto initially anticipated. The SEC alleged that Rio Tinto failed to timely disclose these and other known problems or to correct its valuation of the coal mine in various financial statements and audit papers.

In addition to pursuing misstatements and omissions claims under Section 10(b) of the Exchange Act and Section 17(a) of the Securities Act of 1933, the SEC pursued "scheme liability" claims, citing what the Second Circuit described as "corruption of the auditing process—specifically, the failure to correct statements made to the Audit Committee and auditors." The district court twice held the SEC's allegations were insufficient to support such scheme liability claims.

Scheme Liability Requires More than Misstatements

One week before the Supreme Court issued its 2019 decision in Lorenzo, Southern District of New York Judge Analisa Torres ruled that scheme liability does not exist when "the sole basis for such claims is alleged misrepresentations or omissions." In Rio Tinto, Judge Torres found, all of the alleged "actions" and "conduct" forming the basis for scheme liability were misstatements or omissions, so no scheme liability claims could proceed.2

Judge Torres's decision was well grounded in Second Circuit precedent—in particular, Lentell v. Merrill Lynch & Co., where the Court of Appeals made clear that misstatements and omissions alone do not suffice for scheme liability claims under Rule 10b-5(a) and (c).3 The SEC asked Judge Torres to reconsider her ruling in light of Lorenzo, but Judge Torres declined to do so, holding that while Lorenzo made clear the "dissemination" of false information provides a basis for scheme liability, that should not be read to mean that misstatements without more are sufficient to trigger liability.4

In Lorenzo, the Supreme Court had held that "[t]hose who disseminate false statements with the intent to defraud are primarily liable under Rules 10b-5(a) and (c) . . . even if they are [only] secondarily liable under Rule 10b-5(b)."5 But in Rio Tinto, the SEC did not allege that defendants disseminated false statements, only that their process "failed to prevent misleading statements from being disseminated by others." That is not sufficient, Judge Torres ruled, to support scheme liability.

The Second Circuit agreed. The Court of Appeals framed the question before it as whether Lorenzo abrogated Lentell, and held that it did not. The SEC, the Court explained, had "exerted substantial effort to shoehorn its allegations into a claim for scheme liability," but that did not convert a statements case into a scheme case. Any other conclusion would be difficult to reconcile with Lorenzo and the Supreme Court's decision in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), which held that primary liability under Rule 10b-5(b) is reserved for "makers" of false or misleading statements. Mere "participation" in such statements, the Second Circuit explained, is insufficient to establish primary liability under subsection (b), which would be undermined if scheme liability is expanded to encompass such participation. Under Janus, "individuals who helped draft, research, print, or wordsmith [a] statement at some point in time, but who lacked ultimate control, cannot be primarily liable." Read alongside the Supreme Court's Janus decision, the Rio Tinto Court explained, Lorenzo "signaled that it was not giving the SEC license to characterize every misstatement or omission as a scheme."

The Rio Tinto Court further cautioned that expanding scheme liability to reach actors other than the "makers" of misstatements would lower the bar for private plaintiffs, who face a heightened pleading standard for Rule 10b-5(b) cases under the Private Securities Litigation Reform Act (PSLRA) that does not apply to scheme liability cases. Similarly, limiting statements cases to subsection (b) would maintain the distinction between cases the SEC could pursue from those private plaintiffs could bring—i.e., the SEC, but not private plaintiffs, may pursue aiders and abettors of Section 10(b) violations. Embracing the "SEC's reading of Lorenzo," the Second Circuit explained, would be contrary to Supreme Court precedent and would undermine "Congress' determination that this class of defendants should be pursued by the SEC and not private litigants."

The Second Circuit Expressly Limited Its Holding, Signaling More Litigation to Come

The Second Circuit was careful to cabin its holding as announcing only that misstatements alone do not support scheme liability in SEC actions. As the Court explained, Lorenzo instructs that dissemination of such statements "is one example of something extra that makes a violation a scheme," but the Rio Tinto Court did not opine on what else might constitute that something extra to support scheme liability.6 The Court expressly did "not consider, for example, whether corruption of an auditing process is sufficient for scheme liability under Lorenzo, or allegations that a corporate officer concealed information from auditors." Instead, the Court acknowledged that the extent to which Lorenzo "blur[s] the distinctions between the misstatement subsections and the scheme subsections is a matter that awaits further development."

Conclusion

Given the Second Circuit's explicit acknowledgment that "further development" is needed to clarify the bounds of Rule 10b-5's various subsections, we expect this issue to continue to be hotly contested in and out of the Second Circuit. Until those decisions are handed down, it is now clear in the Second Circuit that recasting material misrepresentations and omissions as the sole components of a "scheme" to defraud will not be sufficient to survive a motion to dismiss.

Footnotes

1. SEC v. Rio Tinto plc, No. 21-2042, 2022 WL 2760323, at *1 (2d Cir. July 15, 2022).

2. Id., (citing SEC. v. Rio Tinto plc, No. 17 CIV. 7994 (AT), 2019 WL 1244933, at *15-16 (S.D.N.Y. Mar. 18, 2019)).

3. SEC. v. Rio Tinto plc, No. 17 CIV. 7994 (AT), 2019 WL 1244933, at *15 (S.D.N.Y. Mar. 18, 2019) (citing Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005)).

4. Rio Tinto plc, 2019 WL 1244933, at *15-16.

5. Lorenzo v. SEC, 139 S. Ct. 1094, 1104 (2019).

6. SEC. v. Rio Tinto plc, No. 17 CIV. 7994 (AT), 2019 WL 1244933, at *17 (S.D.N.Y. Mar. 18, 2019).

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved