Scheme Liability Under Rule 10b-5 and Section 17(a) Still Requires Something “More” than Mere Misstatements: Analysis of the Second Circuit’s Opinion in SEC v. Rio Tinto
On July 15, 2022, the United States Court of Appeals for the Second Circuit affirmed the dismissal by the United States District Court for the Southern District of New York of a Securities and Exchange Commission (“SEC”) enforcement action alleging that Rio Tinto plc, Rio Tinto Limited, and its executive officers had engaged in securities fraud. In so doing, the Second Circuit held that a 2019 Supreme Court decision, Lorenzo v. SEC, did not change the scope of scheme liability under Rule 10b-5 and Section 17(a). That is, merely making a materially misleading statement, without something more, cannot constitute scheme liability.
This blog post examines the facts underlying the decision and the holding’s implications for comparable securities fraud claims.
Scheme Liability Under Rule 10b-5 and Section 17(a)
Section 17(a) of the Securities Act of 1933 and Rule 10b-5 promulgated thereunder describe three forms of unlawful conduct. Rule 10b-5 declares that it is unlawful for any person, in connection with the sale of any security, to use interstate commerce 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,” 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.” Section 17(a) contains three nearly identical prongs. While the middle prong specifically mentions materially misleading statements and omissions, the first and third prongs describe fraudulent conduct more generally. Courts typically analyze the first and third prongs together and refer to them as “scheme liability.”
The Second Circuit has long held that plaintiffs cannot plausibly allege scheme liability “where the sole basis for [scheme liability] claims is alleged misrepresentations or omissions.” That is, plaintiffs may not conflate the “misstatement” liability outlined in subsection (b) of Rule 10b-5 and Section 17(a) with “scheme” liability. This distinction serves in part as a rejection of the SEC’s attempt to use subsections (a) and (c) as a “back door into liability for those who help others make a false statement of omission in violation of subsection (b).” Therefore, scheme liability must involve “performance of an inherently deceptive act that is distinct from an alleged misstatement.” Examples of such conduct include a scheme where one broker would send a price to a second broker, who would then report the same price back to the first broker as an “independent” quote, or where a defendant defrauded customers into paying prices that included excessive markups. But the SEC may not use scheme liability merely as an attempt to hold a defendant responsible for misstatements, particularly where the defendant did not actually “make” those misstatements.
The Supreme Court’s Holding in Lorenzo v. SEC
In 2019, the Supreme Court opined on scheme liability in Lorenzo v. SEC. In that case, the director of investment banking at a brokerage firm, Francis Lorenzo, sent two emails to prospective investors that inflated the value of a company’s intangible assets by over $9.5 million. Although the email was written by Lorenzo’s boss, Lorenzo was aware that the valuation was false.
The Supreme Court held that the transmission, or “dissemination,” of false or misleading information may constitute a device, scheme, artifice to defraud, and/or fraudulent practice, and therefore give rise to scheme liability. In so doing, the Court rejected the notion that only subsection (b) of Rule 10b-5 can regulate conduct relating to false or misleading statements, acknowledging that there is “considerable overlap” between the three prongs.
Factual Background of SEC v. Rio Tinto
SEC v. Rio Tinto pertains to Rio Tinto’s acquisition of an exploratory coal mine in Mozambique. Initially valued at a $3.7 billion purchase price, the mine’s worth was heavily dependent on its ability to “produce a certain volume and quality of coal” and to transport that coal by both barge and rail. Subsequently, Defendants came to learn that, due to difficulties with transport, Rio Tinto would need to invest billions of dollars in infrastructure to be able to operate the mine, downgrading the mine’s net present value to negative $680 million. Statements in financial statements both before and after these developments allegedly failed to disclose this decrease in valuation, giving rise to the SEC’s allegations of securities fraud. The misstatements were fueled in part by the fact that reports submitted to Rio Tinto’s audit committee did not timely disclose the impairments.
In 2019, the district court granted in part and denied in part Defendants’ motion to dismiss, and found that the SEC had plausibly alleged securities fraud under Rule 10b-5(b) as to a subset of Defendants’ statements about the value of the acquisition. Relevant here, the district court also held that the SEC had failed plausibly to allege scheme liability, finding that the alleged deceptive conduct was not distinct from alleged misstatements regarding the valuation of the mine. In so doing, the district court relied heavily on the Second Circuit’s holding in Lentell v. Merrill Lynch.
In 2020, following the Supreme Court’s decision in Lorenzo, the SEC moved for reconsideration of the district court’s 2019 ruling regarding scheme liability. The SEC argued that Lorenzo abrogated Lentell, making additional misstatements actionable. The district court disagreed, holding that Lorenzo only suggested that scheme liability applies where defendants have actually “disseminated” misstatements, not where defendants have merely “failed to prevent misleading statements from being disseminated by others.” According to the district court, with regard to the Rio Tinto Defendants, the SEC had only alleged the latter. Therefore, the alleged facts were distinguishable from Lorenzo, and scheme liability did not apply. After entering an Order denying the SEC’s motion for reconsideration, the district court certified the issue for interlocutory appeal to the Second Circuit, under 28 U.S.C. § 1292(b), as a “controlling question of law as to which there is substantial ground for difference of opinion,” and the Second Circuit granted the petition for leave to appeal an interlocutory order.
The Second Circuit Decision
The Second Circuit agreed with the district court’s narrow reading of Lorenzo. First, the Second Circuit emphasized that basic principles of statutory interpretation aligned with such a reading. Without a meaningful distinction between the two broad categories of liability under Rule 10b-5, “the scheme subsections would swallow the misstatement subsection.” Acknowledging the Supreme Court’s statement that there is “considerable overlap” between the three subsections of Rule 10b-5, the Second Circuit concluded that, nevertheless, there was no indication that it is acceptable for one category of conduct to subsume another.
Second, the Second Circuit pointed out that the Lorenzo Court was careful to emphasize the continued validity of Janus Capital Group v. First Derivative Traders, the Supreme Court case that limited primary liability under Rule 10b-5 to the “maker” of the misstatement, as opposed to individuals who may have helped draft or edit the statement at some point but ultimately lacked control as to its use. Because Janus remains good law, the Supreme Court could not have been giving the SEC permission to “characterize every misstatement or omission as a scheme.” Instead, something more, like active dissemination of misstatements, must exist to support scheme liability.
Third, the Second Circuit pointed out that a broad reading of Lorenzo risked muddying the distinction between primary and secondary liability. Because only the SEC—and not private litigants—may allege aiding and abetting liability, this distinction is important to maintain. Indeed, the Lorenzo Court itself stated that it did not believe that its holding “weakens the distinction between primary and secondary liability.”
Ultimately, the Second Circuit held that the district court did not abuse its discretion in declining to reconsider the dismissal of the SEC’s scheme liability claims. However, it noted that its holding was “limited” to the legal question of whether Lorenzo abrogated Lentell, and accordingly, it did not make any ruling as to the “ultimate impact of Lorenzo” on the facts of Rio Tinto, including whether corrupting an auditing process constitutes a fraudulent scheme.
Until Rio Tinto, it was an open question whether the Second Circuit would modify its approach to scheme liability in light of the Supreme Court’s holding in Lorenzo. Now, it is clear that Lentell v. Merrill Lynch remains good law, and the court will continue to distinguish between allegations of material misstatements and conduct that could constitute a fraudulent scheme. However, allegations of “dissemination” of misstatements will likely suffice to allege scheme liability. It is important to keep in mind that, while Rio Tinto established the contours of the law in the Second Circuit, it did not expressly apply it to the alleged facts of the case. Accordingly, whether the alleged misconduct in this particular case could constitute “dissemination” of misstatements or otherwise give rise to scheme liability remains an open question.
 Sec. & Exch. Comm’n v. Rio Tinto plc, 41 F.4th 47 (2d Cir. 2022).
 17 C.F.R. § 240.10b-5.
 See 15 U.S.C. § 77q.
 Lentell v. Merrill Lynch & Co., 396 F.3d 161, 177 (2d Cir. 2005) (emphasis added).
Sec. & Exch. Comm’n v. Kelly, 817 F. Supp. 2d 340, 343 (S.D.N.Y. 2011) (emphasis added).
 Id. at 344.
 See id.
 139 S. Ct. 1094, 1099 (2019).
 Id. at 1099-1100.
 Id. at 1101.
 Id. at 1102.
 Rio Tinto, 41 F.4th at 50.
 See id.
 See id. at 50-51.
 See id. at 50-51.
 Sec. & Exch. Comm’n v. Rio Tinto plc, No. 17-cv-7994, 2019 WL 1244933, at *15 (S.D.N.Y. Mar. 18, 2019).
 Sec. & Exch. Comm’n v. Rio Tinto plc, No. 17-cv-7994, 2021 WL 818745, at *2-3 (S.D.N.Y. Mar. 3, 2021).
 Id. at *2-3.
 See Rio Tinto, 41 F.4th at 52; 12 U.S.C. § 1292(b).
 Rio Tinto, 41 F.4th at 54.
 See id.; see also Janus Cap. Grp., Inc. v. First Deriv. Traders, 564 U.S. 135 (2011).
 Rio Tinto, 41 F.4th at 54.
 See id. at 55.
 Id.; Lorenzo, 139 S. Ct. at 1103.
 Rio Tinto, 41 F.4th at 54.