In blow to SEC and plaintiffs' bar, 2nd Circuit refuses to expand ‘scheme liability'

(Reuters) - False statement allegations, by themselves, cannot be the basis of claims of a scheme to defraud investors, according to a ruling on Friday from the 2nd U.S. Circuit Court of Appeal.

The decision will deter both the U.S. Securities and Exchange Commission and private plaintiffs from asserting expansive “scheme liability” theories in securities litigation.

In Securities and Exchange Commission v. Rio Tinto PLC, the appeals court held the SEC cannot claim that the international mining company and its former CEO and CFO engaged in a fraudulent scheme based only on the SEC’s allegation that the defendants made false statements and failed to disclose key information about problems with Rio Tinto’s multibillion-dollar 2011 acquisition of a coal mine in Mozambique.

The SEC had argued in this interlocutory appeal that the U.S. Supreme Court, in 2017 ruling in Lorenzo v. SEC, endorsed an expansive interpretation of the antifraud provisions in federal securities laws. So, according to the SEC, Lorenzo justifies both allegations of misrepresentations and overlapping claims that those allegedly false statements were the basis of a scheme to defraud investors.

The 2nd Circuit, however, sided with defense arguments that the SEC was misconstruing the Supreme Court’s holding in Lorenzo, in which the justices ruled that investment banker Frank Lorenzo was liable for participating in a fraud scheme because he knowingly sent investors false information about a client’s debt offering. Lorenzo did not write the misleading description, which was drafted by his boss, but the Supreme Court held he was on the hook for spreading the false information.

The 2nd Circuit acknowledged that the Supreme Court's Lorenzo precedent signifies “leakage” between the various antifraud provision in federal securities laws. But the decision didn’t go as far as the SEC argued, the appeals court said.

“Lorenzo addressed only circumstances involving fraudulent conduct beyond misstatements or omissions,” wrote Judge Dennis Jacobs for a unanimous panel that also included Judges Richard Wesley and William Nardini. “It thus did not alter this court's longstanding rule that misstatements or omissions cannot be ‘the sole basis,’ for scheme liability," Jacobs said, citing the 2nd Circuit’s 2005 decision in Lentell v. Merrill Lynch & Co Inc.

The SEC declined to comment on the decision or on the possibility of en banc review, which is almost never granted in the 2nd Circuit. Rio Tinto counsel Thomas Dupree of Gibson, Dunn & Crutcher declined to comment, as did Kannon Shanmugam of Paul, Weiss, Rifkind, Wharton & Garrison, who represents former Rio Tinto CFO Guy Robert Elliott. Sarah Levine of Jones Day, who is counsel to former CEO Guy Albanese, did not respond to my query. The defendants are still facing SEC fraud claims based on their allegedly false statements about operations at the Mozambique mine.

The 2nd Circuit’s reasoning in Friday's decision reflects the court’s acute awareness of the interplay between SEC enforcement actions and private securities fraud litigation. Congress, as you know, set a high pleading standard for securities class actions in its 1995 reform law, requiring plaintiffs to prove defendants’ fraudulent intent for alleged misstatements. And the Supreme Court has set strict limits on who can be sued in private securities class actions in a series of decisions including 2008’s Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc and 2011’s Janus Capital Group Inc v. First Derivative Traders. Under precedent from those cases, shareholders cannot sue defendants who did not have ultimate responsibility for false statements.

The Rio Tinto defendants warned the 2nd Circuit that adopting the SEC’s interpretation of Lorenzo would “nullify” the Supreme Court’s clear distinction between primary liability for those who make allegedly false statements and secondary liability for those who facilitated misrepresentations. It would also, the defendants said, contravene Congress’ mandate by allowing “private parties to evade heightened pleading requirements for misstatements liability.”

The 2nd Circuit agreed on both points. Even in the Lorenzo decision, the 2nd Circuit said, the Supreme Court emphasized that scheme liability was not intended to blur the line between primary and secondary liability. But the SEC approach would permit plaintiffs to “repackage their misstatement claims as scheme liability claims to evade the pleading requirements imposed in misrepresentation cases,” Jacobs wrote.

That outcome, the 2nd Circuit said, would be wrong in a host of ways. “In sum," the appeals court said, "a widened scope of scheme liability would defeat the congressional limitation on the enforcement of secondary liability, multiply the number of defendants subject to private securities actions and render the statutory provision for secondary liability superfluous.”

Friday’s ruling won’t really change the status quo for private plaintiffs. Shareholder lawyers haven’t generally put much faith in Lorenzo and scheme liability. I told you back in 2019, when the Lorenzo decision first came out, that plaintiffs' lawyers believed the ruling would be more useful for the SEC than for them. There’s been no groundswell since then of class actions alleging scheme liability, though Lorenzo does pop up from time as the basis for backup allegations. I recently covered an unusual securities class action asserting scheme liability against six crypto venture capital firms that backed the collapsed TerraUSD stablecoin, but that’s an outlier case.

As a securities litigation observer, I’d have been interested in the fallout if the 2nd Circuit had adopted the SEC’s theory of scheme liability. But after Friday’s ruling, it looks like this particular show is over.

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