Scheme Liability: Talk is Cheap

POMERANTZ MONITOR | NOVEMBER DECEMBER 2022

By Brian P. O’Connell

The Second Circuit Court of Appeals recently showed that talk is cheap when it comes to the reach of “scheme liability” claims for investors.

Pursuant to the scheme liability subsections of the federal securities laws, plaintiffs may bring claims involving “any device, scheme or artifice to defraud,” and for “engag[ing] in any act, practice, or course of business which operates… as a fraud.”

However, on July 15, 2022, in Securities and Exchange Commission v. Rio Tinto PLC (“Rio Tinto”), the appeals court held that the SEC could not allege a claim against an international mining company for scheme liability based only on its assertion that the mining company made false statements and failed to disclose key information about the company’s acquisition of a coal mine in Mozambique. The court ruled that scheme liability claims required more than merely alleging a false statement or misleading omission.

The facts in Rio Tinto center on the defendants’ delayed acknowledgment of a major impairment of the value of the mine. In 2011, the defendants purchased an exploratory coal mine in Mozambique for $3.7 billion. The purchase price assumed that the mine would produce high quality and large volumes of coal, that the coal could be barged down the Zambezi River, and that the rest could be transported using existing rail infrastructure. However, the defendants soon learned that the coal quality was worse than expected, that the Mozambican government would not allow transportation of coal by barge, and that the rail infrastructure would require a $16 billion upgrade. On May 11, 2012, management from the mine informed company executives in a meeting that the coal mine’s net present value was negative $680 million.

In the months before and after the meeting, the defendants were issuing financial statements and preparing audit papers. The complaint alleged that these documents contained representations about transportation options and the quality and volume of coal reserves. The statements included the company’s 2011 annual report, which valued the mine at the $3.7 billion acquisition price, a half-year 2012 report, bond offerings, and statements made during meetings and investor calls. The SEC alleged that none of the documents disclosed that the mine’s value was impaired. Meanwhile, the company’s in-house valuation team disagreed with the over-$3 billion valuation. In August 2012, the team valued the mine in the range of negative $4.9 billion to negative $300 million. On January 15, 2013, the company’s board approved an 80% impairment, valuing the mine at $611 million. After once again impairing the mine, the company sold the mine in October 2014 for $50 million.

In 2017, the SEC brought an enforcement action under the Securities Exchange Act’s (“Exchange Act”) scheme liability provisions alleging, among other claims, that the company made false statements about coal transportation options and the amount and quality of coal reserves, and the company failed to disclose that the mine’s valuation was impaired. In 2019, the trial court dismissed the scheme liability claims on the grounds that the conduct constituted misstatements and omissions only and was therefore an insufficient basis for scheme liability. In 2005, the U.S. Supreme Court had ruled in Lentell v. Merrill Lynch that misstatements and omissions cannot form the “sole basis” for liability under the scheme subsections.

About one week after the trial court’s decision in Rio Tinto, the Supreme Court released Lorenzo v. SEC, which held that an individual who disseminated a false statement (but did not make it) could be liable under the scheme liability section of the Exchange Act. In Lorenzo, the defendant director of an SEC-registered brokerage firm, Francis Lorenzo, sent two emails to prospective Lorenzo’s boss and described a potential investment in a company that had “confirmed assets” of $10 million. Mr. Lorenzo knew, however, that the company had recently disclosed that its total assets were under $400,000. Lorenzo held that the transmission of emails, or “dissemination,” could sustain a claim under the scheme section of the Exchange Act, which prohibits a “device,” “scheme,” “artifice to defraud,” and/or fraudulent “practice.” Lorenzo thus concluded that the scheme subsections of the Exchange Act can cover misstatements even if the defendant was not a maker of the statement.

Citing Lorenzo, the SEC moved the trial court in Rio Tinto for reconsideration, but the court denied it. On appeal, the Second Circuit held that misstatements and omissions, on their own, cannot support a scheme liability claim under the Exchange Act and affirmed the lower court’s decision dismissing the scheme liability claims. The court noted that the Supreme Court’s decision in Janus Capital Group v. First Derivative Traders limits primary liability under the Exchange Act’s false statement section to the “maker” of a statement, but that scheme liability does not require an allegation that a defendant made a statement.

The court cautioned that expanding the scope of scheme liability would lower the bar for primary liability for securities fraud claims, which requires that a complaint alleging misleading statements specify each statement alleged to be misleading, and the reasons why the statement is misleading. The court warned that “an overreading of Lorenzo might allow private litigants to repackage their misstatements claims as scheme claims to evade pleading requirements imposed on misrepresentation claims.”

The Rio Tinto court concluded that because Lorenzo did not break “the link on which [the court] premised its prior decision,” it would not reverse the trial court’s decision. The appellate court’s analysis was premised on the trial court’s characterization of the scheme liability counts as a collection of misstatements and omissions. The court held that because Lentell withstands Lorenzo and because the dismissal order stated that the complaint alleged misstatements and omissions only, the trial court did not abuse its discretion in declining to reconsider the dismissal of scheme liability claims. The court ruled that under Lorenzo, although misstatements and omissions can form part of scheme liability, an alleged “actionable scheme liability claim requires something beyond misstatements and omissions.”

The court acknowledged, however, the possibility that there are ramifications from the Lorenzo decision that “blur the distinctions” between the misstatements subsections and the scheme liability subsections of the Exchange Act. For example, the court declined to consider whether the corruption of an auditing process or allegations that a corporate officer concealed information from auditors is sufficient for scheme liability under Lorenzo.

The court further noted that overreading Lorenzo could muddle the distinction between primary and secondary liability—as aiding and abetting liability is allowed in SEC actions but not by private plaintiffs. The court cautioned against reviving an implied cause of action against all aiders and abettors, including those who assist in the preparation of a statement.

The ramifications of Lorenzo remain to be fully played out, but this decision foreshadows coming battles over whether concealment claims are “omissions” under the misstatements/omissions subsections of the Exchange Act or more properly viewed as scheme claims under the scheme liability subsections, as well as the judiciary’s fleshing out what constitutes dissemination. On September 2, 2022, the Southern District of New York held in In Re Turquoise Hill Resources Ltd. Securities Litigation that a drafter of a statement who “disseminates” the statement to another who then published the statement did not constitute “dissemination” under Lorenzo. On October 11, 2022, however, the Southern District of New York, in SEC v. Stubos, held that the SEC alleged a scheme liability claim by claiming a defendant engaged in a pump and dump stock promotion. The SEC alleged the defendant concealed his ownership in the company, broke his trades into small blocks to avoid market scrutiny, and directed other traders via encrypted messages to strategically buy stock to inflate the price—without making a false or misleading statement. In doing so, the court cited Rio Tinto language that “dissemination is [just] one example of something extra that makes violation a scheme.”

Expect more decisions setting the parameters of scheme liability in the years to come. Plaintiffs will want to allege scheme claims as including something more than mere statements in future scheme actions.