RULE 10b-5 LIABILITY, PART III:
THE SECOND CIRCUIT AND RIO TINTO
By
Prof. Anthony Michael Sabino
In our first two installments, we exposited Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), and Lorenzo v. S.E.C., 587 U.S. ___, 139 S. Ct. 1094 (2019), respectively, both essential to understanding S.E.C. v. Rio Tinto PLC, 41 F.4th 47 (2d Cir. 2022), the Second Circuit’s most recent holding regarding Rule 10b-5 “scheme” liability. See 17 C.F.R. §240.10b-5. Now we examine how the “Mother Court” of federal securities law has tended to that branch of the mighty judicial oak rooted in that venerable regulation. See Morrison v. National Australia Bank Ltd., 561 U.S. 247, 276 (2010) (Stevens, J., concurring).
Rio Tinto, a global titan in metals and mining, was founded in 1873. Notwithstanding its distinctly Anglo-Australian heritage, its name is derived from the site of its original mining operation in Spain. In early 2011, the corporation paid $3.7 billion to acquire a coal mine in Mozambique. Unfortunately, expectations of profit evaporated when the firm discovered the poor quality of the coal, the prohibitive expense to transport it, and the unfriendliness of the host government.
These setbacks presented a new problem: valuing the mine for purposes of financial disclosures. Internal opinions ranged far and wide, and changed over time.
The 2011 annual report to shareholders relied upon the original $3.7 billion acquisition price. Then in May, 2012, Rio Tinto’s chief executive and chief financial officers were told by local managers that the mine should be revalued at an astoundingly negative $680 million.
Four months later, in-house experts proposed a figure somewhere within the incredibly broad range of anywhere from a negative $4.9 billion to $300 million. In January, 2013, the corporation’s directors, instead of assigning a negative value to the mine, approved a write-down to a positive $611 million.
One year later, the asset’s value was revised downward to $119 million. The mine was finally sold in October, 2014 for a paltry $50 million.
In a subsequent enforcement action, the Securities and Exchange Commission asserted that the company and its top officers failed to prevent the dissemination of misleading statements while they dithered over devaluing the mine, and charged them with violating Rule 10b-5’s prohibition against deceptive scheming. Relying upon circuit precedent which requires such a claim to allege more than misstatements and omissions, the lower court dismissed. This neatly framed the issue on appeal: did the Second Circuit’s existing scheme liability jurisprudence survive the Supreme Court’s holding in Lorenzo?
Circuit Judge Jacobs opened with the wry observation that “the SEC has exerted substantial effort to shoehorn its allegations into a claim for scheme liability,” which might be explained by the Commission’s lack of averments that the defendants themselves disseminated falsities. Unfortunately for the regulators, its viewpoint was soundly rejected by the panel.
The august tribunal declared that the SEC’s position “would undermine two key features” of Rule 10b-5. First, the regulation’s subsection imposing primary liability for misstatements and omissions was strictly delimited by Janus to the “makers” of such falsities, and neither the CEO nor the CFO of Rio Tinto fell within that category. If the circuit court were to acquiesce to the agency’s “expanded conception of scheme liability,” the Commission might then seek to prove these individuals primarily liable pursuant to that accompanying prohibition against fraudulent maneuvering, solely for participating in, but not actually “making,” alleged misrepresentations.
Secondly, the Private Securities Litigation Reform Act (the “PSLRA”) requires private plaintiffs to allege misleading statements and omissions with great specificity (although the panel admitted in a parenthetical that this stricture does not apply to cases brought by the SEC. See 15 U.S.C. § 78u-4(a)(1)). Yet this heightened pleading standard does not apply to assertions of deceitful strategems, and so “[e]xpanding the scope of scheme liability would thereby lower the bar for primary liability” charges. That settled, the Second Circuit progressed toward its central determination: “whether, post-Lorenzo, misstatements and omissions alone can form the basis for scheme liability.”
To that end, the appeals court reminds that the aforementioned Supreme Court landmark had disabused any notion that wrongs involving misrepresentations could only be regulated by that subpart of Rule 10b-5 aimed directly at the “makers” of false statements. Lorenzo decreed that, in light of the “considerable overlap” amongst the regulation’s components, it cannot be said that scheme liability is precluded with respect to conduct involving misrepresentations, even when the accused is not the actual “maker” of the falsity.
For these reasons, the august tribunal concluded that the high bench had not abrogated Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005), the Second Circuit’s controlling precedent with regard to scheme liability, which determined that misrepresentations and omissions cannot form the solitary grounds for alleging a scheme prohibited by Rule 10b-5. Given that Lorenzo did not impose such liability for misstatements alone, but rather focused upon their dissemination, “Lentell and Lorenzo are consistent with one another, [and] Lentell remains vital.”
The circuit judges left for another day “[w]hether there are ramifications or inferences from Lorenzo that blur the distinctions” between Rule 10b-5’s proscriptions against misrepresentations and schemes. Yet such circumspection did not hinder the panel from making specific reference to “corruption of an auditing process” or duping innocent auditors as possible grounds for alleging fraudulent conniving. “For now,” it is enough that Lentell, on the one hand, stipulates that misleading statements or omissions, without more, do not suffice for scheme liability, while Lorenzo, on the other, makes it clear that “dissemination is one example of something extra that makes a violation a scheme.”
In almost an aside, the appellate bench then firmly rejected the SEC’s contention that Lentell was confined to private litigation. First, noted Circuit Judge Jacobs, the Commission had advanced no credible basis for its claim, and, second, the courts of the Second Circuit have routinely applied said decision to the agency’s enforcement actions.
Rio Tinto commenced the final component of its analysis by invoking one of the “most basic interpretative canons” of statutory construction: a law must be read to give effect to all of its provisions, so that no part is rendered superfluous. Applying that maxim to the matter at hand, the tribunal concluded that if misstatements and omissions were, by themselves, enough to constitute a deceptive plot, then Rule 10b-5’s scheme liability subsection “would swallow” the adjacent prohibition against misrepresentations.
Such an outcome would be antithetical to Lorenzo, notwithstanding that the Supreme Court had therein acknowledged the regulation’s overlapping strictures. The Second Circuit declared that, by affirming the continued vitality of Lentell, it is respecting the designs of Congress.
Furthermore, the sharp demarcations the high Court has drawn between the subparts of Rule 10b-5 were undeniable, when one considers Lorenzo’s emphasis upon the persistent vigor of Janus, the latter having adroitly assigned primary liability to “makers” of a misstatement, while excluding those who lack ultimate control over a fraudulent utterance. This prompted Circuit Judge Jacobs to characterize Janus as a “backstop” for Lorenzo’s warning to regulators that not every misrepresentation or omission can be prosecuted as a scheme.
In addition, the panel observed that upholding these differences “also assures that private plaintiffs remain subject to the heightened pleading requirements” imposed by the PSLRA. The tribunal expressed genuine concern that an overly generous reading of Lorenzo would likely embolden private litigants to craft their allegations as ones for scheme liability, in order to avoid the far more stringent demands for averring misrepresentations.
The Second Circuit posited an additional reason why overextending Lorenzo must be assiduously avoided; it would “muddle” the distinctions between primary and secondary liability, an error of some consequence, as only the government, and not private parties, can bring an action for aiding and abetting securities fraud. See Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). Circuit Judge Jacobs opined that courts must “respect the line that Congress has drawn between primary and secondary liability,” and ensure that litigants cannot transmogrify secondary actors, particularly those linked to misstatements, into primary violators.
And in a last rebuke to the regulators, the appellate bench once more refuted the SEC’s reading of Lorenzo, this time out of concern that adopting the agency’s viewpoint would resuscitate an implied cause of action against aiders and abettors, thereby defeating the legislative intent to vest the Commission with the exclusive authority to pursue such malefactors. See Stoneridge Investment Partners, LLC v. Scientific-Atlanta, 552 U.S. 148 (2008). Rio Tinto’s closing observation was that “[i]t is telling that Lorenzo preserves the distinction between primary and secondary liability.” Understandably, this tribunal could do no less.
As we end this three-part series on Rule 10b-5 liability, our denouement likewise forms a triad. First, there is Janus, with its exacting definition of who is liable as a “maker” of a false statement, followed by Lorenzo, which differentiates scheme liability pursuant to yet another subpart of the same regulation.
And, finally, there is Rio Tinto, a successful reconciliation of these distinguished and distinguishable high Court landmarks, but, moreover, a hallmark of stability within the decisional law of the circuit court which oversees nearby Wall Street. When all is considered, this recent Second Circuit holding does much more than reaffirm the vitality of its predecessor Lentell; in truth, it is yet another powerful reminder of the need for a discriminating parsing of Rule 10b-5’s potent, yet admittedly overlapping, prohibitions against all species of securities fraud.
Prof. Anthony Michael Sabino, partner, Sabino & Sabino, P.C., is also a Professor of Law, Tobin College of Business, St. John’s University. Anthony.Sabino@sabinolaw.com.
FINAL Rio Tinto Part III AMS v.1