Orchestra Performances and Basic Honesty Analysis in Rule 10b-5 Cases

In an orchestra, it wouldn’t work if individual musicians played whatever notes they wanted. They need to play the notes the composer wrote.

It also wouldn’t work for individual orchestra musicians to infuse their own musical interpretations into the music. The conductor is the ultimate arbiter of musical interpretation. It is the orchestra musicians’ job to perform the music accurately and to deliver the conductor’s interpretation. Orchestra musicians who don’t follow the conductor are likely to find themselves without a job.

Therefore, music reviewers commonly comment on the conductor’s or music director’s leadership and interpretation. Reviewers also might comment on the composer’s work, particularly if the music is a premiere.

Music reviewers and audiences rarely comment on individual orchestra members unless they have a notable solo part or do something that interferes with the performance. Individual musicians aren’t considered responsible for the musical composition or interpretation, even if the musicians, themselves believe them to be lacking.

In Janus Capital Group Inc. v. First Derivative Traders, the US Supreme Court appeared to apply a similar standard to Rule 10b-5 securities fraud cases. Under Janus, the Court appeared to hold that only someone who has the ultimate authority over a statement can be held responsible for securities fraud under Rule 10b-5

That all changed this year. The US Supreme Court recently held in Lorenzo v. Securities and Exchange Commission, an individual may be found liable for securities fraud by distributing false statements, even though that individual did not create the content. This article briefly discusses these cases and how their interpretations of Rule 10b-5 can be reconciled with each other.

What Happened in the Janus Case?

In Janus, the Supreme Court held that “For purposes of Rule 10b-5 the maker of a statement is the person or entity with ultimate authority over the statement, including the content and whether and how to communicate it. … One who prepares or publishes a statement on behalf of another is not its maker.”

Using the music comparison, the issuer who prepared the prospectus might be the composer who had ultimate authority over its content. The supervisor might be like the conductor, who decides how to communicate the music (or prospectus) to prospective investors. And Lorenzo, might be compared to the orchestra musician, who had to do what his supervisor (conductor) directed or risk losing his job.

Janus involved the sale of mutual funds (Janus Funds) issued by Janus Investment Fund (Janus Investment). Janus Investment hired Janus Capital Management (Janus Management) as investment advisor and administrator for the Janus Funds. Although all the entities include the Janus name, Janus Management had different ownership from Janus Investment, as it was a subsidiary of Janus Capital Group (Janus Capital), which was owned by mutual fund investors.

Janus Management assisted Janus Investment in preparing prospectuses for Janus Funds. The prospectuses Janus Investment prepared for Janus Funds stated they were not intended for market timing and had limitations on excessive trading. But Janus Capital had secret arrangements allowing market timing in some funds managed by Janus Management.

The Supreme Court held that Janus Investment was legally responsible for filing the prospectuses for Janus Funds. Therefore, Janus Investment had ultimate authority over the prospectus content, and Janus Management was not considered to have made the statements in the prospectus. Janus Investment was the composer, and Janus Management was an orchestra musician who might have performed the music but had not penned its content.

Lorenzo’s Wrongful Act

Francis Lorenzo (Lorenzo) was director of investment banking at Charles Vista, LLC (CV), a registered broker dealer. Lorenzo’s sole client was a company called Waste2Energy Holdings, Inc. (Waste2Energy). In 2009, Waste2Energy hired CV to sell $15 million of debentures (Waste2Energy Securities) to investors.

In July 2009, Waste2Energy made a public securities filing stating total assets of $14 million, including $10 million in intellectual property, consisting of technology developed to convert solid waste into clean, renewable energy. In October 2009, Waste2Energy publicly disclosed that its technology didn’t work. Waste2 Energy wrote off the intangible assets and revised its financials to show total assets of less than $400,000 as of March 31, 2009.

Despite being aware that the intellectual property was worthless, Lorenzo sent two emails about the Waste2Energy Securities to prospective investors. Lorenzo did not prepare the email content; that was his supervisor’s responsibility. Lorenzo’s supervisor also approved the emails.

Lorenzo’s emails described the Waste2Energy as having $10 million in “confirmed assets.” The emails also described the Waste2Energy Securities as having “3 layers of protection,” even though they were unsecured debt securities and Waste2Energy’s assets were worth less than $400,000.

Lorenzo, his supervisor, and CV were charged with violations of antifraud provisions in the federal securities laws. Eventually, Lorenzo received a fine of $15,000 and was barred for life from working in the securities industry.

Who is Responsible for Securities Fraud?

Lorenzo reasoned that under Janus, he shouldn’t be held responsible for the misleading emails. Even though Lorenzo clicked on send to transmit his emails, he didn’t have ultimate approval over the content. Lorenzo viewed his actions as similar to Janus Management’s in that neither of them prepare the content which contained misstatements. Therefore, Lorenzo contended only CV and his supervisor, who approved the email content, should be held responsible under Rule 10b-5.

But the Supreme Court held otherwise. Although Justices Thomas and Gorsuch believed that the majority decision undermined the Janus ruling, the majority didn’t agree. Although the public doesn’t get a seat at the table during Supreme Court deliberations, the Lorenzo decision provides clues to this mystery.

How is Lorenzo Different from Janus?

Lorenzo differs from Janus in several respects:

  • Janus was brought by investors as a private right of action. The SEC brought Lorenzo under its own authority.  

  • Janus Management assisted in preparing the prospectus. Lorenzo does not appear to have been involved in preparing Waste2Energy’s prospectus. 

  • Lorenzo directly solicited investors based upon information in the Waste2Energy prospectus. It’s not clear from Janus that Janus Management directly solicited investors.

  • Janus focuses on allegations that Janus Management made an “untrue statement of a material fact” in violation of subsection (b) of Rule 10b-5. Lorenzo focuses also on subsections (a) (employing a ”device, scheme or artifice to defraud”) and (c) (engaging in an “act, practice or course of business which operates . . . as a fraud or deceit”). 

  • In Janus, Janus Management had non-public information that market timing was occurring despite the prospective stating otherwise. In Lorenzo, Waste2Energy had made a public statement correcting its financial report.

That Janus Management had non-public information that the prospectus contained a false statement might give Janus Management a heightened obligation to disclose that information. But the Court didn’t rule that way. That’s because the focus in Janus was solely on whether Janus Management made a false statement. And, from the Supreme Court decision it appears that Janis Management’s only communication with prospective investors may have been passive, through posts of the prospectus on its website.

Lorenzo is broader in scope than Janus. In Lorenzo the Court didn’t consider whether Lorenzo made false statements. Rather, the Court considered liability for individuals “who disseminate false or misleading statements to potential investors with the intent to defraud.”

The Court found that Lorenzo’s dissemination of false information via an email with the intention of getting people to invest in worthless securities violated subjections (a) and (c) of Rule 10b-5. And the Court found that Lorenzo could be held responsible under subjections (a) and (c) even though he did not “make” the false statements under the Janus standard.

Takeaways for Individuals Distributing Securities Disclosure Documents

This is just a summary of two Court cases in a complicated area of securities law. In both cases, even the Supreme Court justices didn’t agree on the result. The Janus decision was a 6-3 decision, with the opinion written by Justice Thomas and Justice Breyer writing the dissent. In Lorenzo, those justices’ roles were reversed. Justice Breyer wrote the majority 6-2 decision, and Justice Thomas wrote the dissent. That apparent shift in position is interesting but is beyond the scope of this article.

Yet, it should not be surprising that the Court found Lorenzo’s solicitation of investors based upon information the issuer had publicly disclaimed to violate antifraud provisions of federal securities laws. Lorenzo clarifies that people who knowingly disseminate prospectuses, private placement memoranda, and other securities disclosure documents containing false or misleading statements can be held responsible for those statements even though they did not author or even authorize them.

Lorenzo also reminds us that in addition to strict compliance with legal requirements, individuals involved in soliciting investors need to evaluate their actions against practical concepts of honesty and fair dealing. If personal integrity isn’t a motivator for those soliciting investors, then knowledge that dishonesty can violate subsections (a) and (c) of Rule 10b-5 should be.

Following are guidelines broker-dealers, registered representatives, issuer agents, investment advisors, and anyone else who distributes information (whether written or oral) in connection with investment in securities should follow these guidelines:

  • If you know the prospectus, private placement memorandum, or other securities disclosure document contains false statements, don’t distribute it in an attempt to obtain investors.

  • If your supervisor instructs you to send a letter, email, or brochure or to give a presentation that is misleading to prospective investors, don’t do so.

  • Evaluate documentations you distribute and your own behavior against securities law and regulations.

  • Have personal integrity. Don’t do something you believe isn’t honest even if you think it might not technically violate securities law or regulations.

  • Practice what I call “gastrointestinal law.” If you get a sick feeling in your stomach when you think about doing something but can’t say for sure it is illegal, then don’t do it. It’s probably wrong, and deep inside you know it.

Orchestra musicians rarely will be fired and find themselves unable to earn a living anywhere just because the conductor’s interpretation was lacking. The same is not true for securities professionals or others involved in the sale of securities. Like Lorenzo, those who violate antifraud provisions may find themselves barred from life from their profession.


 © 2019 by Elizabeth A. Whitman

Any references clients and their legal situations have been modified to protect client confidentiality

DISCLAIMER: The content of this blog is for informational purposes only and does not provide legal advice to any person. No one should take any action regarding the information contained in this blog without first seeking the advice of an attorney. Neither reading this blog nor communication with Whitman Legal Solutions, LLC or Elizabeth A. Whitman creates an attorney-client relationship. No attorney-client relationship will exist with Whitman Legal Solutions, LLC or any attorney affiliated with it unless and until a written contract is signed by all parties and any conditions in such contract are fully satisfied.