Dante put fraudsters in the 8^th Circle of Hell. They are herded naked along ten concentric moats by "demons - horned and carrying large scourges," on their way to the center pit, which is, quite literally in Robert Pinsky's great verse translation, a cesspool. There they spend eternity in the slop. The fraudsters are worse than all other sinners, save the betrayers in the 9^th and lowest circle. The others engaged in physical acts like animals. Fraudsters, however, misuse the uniquely human faculties of reason and speech.

And so, we assume we know what fraud is. But we must be careful applying our common sense to federal securities fraud. Securities fraud not something Dante would recognize. It is purely statutory. Most federal securities fraud derives from either section 17(a) of the Securities Act of 1933 or section 10(b) of the Securities Exchange Act of 1934.

Focusing on section 10(b), it is toothless by itself. It proscribes, "in connection with the purchase or sale of any securities," the use or employment of "any manipulative or deceptive device or contrivance." But - it does so only if done "in contravention of such rules and regulations as the Commission may prescribe." The crown jewel of those is Rule 10b-5.

Rule 10b-5 is short enough to quote in full:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(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 necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, 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,

in connection with the purchase or sale of any security.

Books have been written about those 118 words. Some of those words, like "material," deserve their own volumes. But here let's focus on "device, scheme, or artifice" from subparagraph (a), and "act, practice or course of business" from subparagraph (b). To employ the first and/or to engage in the second generally defines what has come to called "scheme liability." They are generally cited in tandem for good reason: there is no linguistically principled distinction between the two. What is the difference between a "scheme . . . to defraud" and a "practice, or course of business which operates . . . as a fraud or deceit"? Text me if you know.

Unlike the others, however, subparagraph (b) is precise. To violate it, one must "make" an untrue statement of or omit to state a material fact, "in connection with the purchase or sale of any security." What it means to "make" or "omit" a statement was one of the many metaphysical questions that Rule 10b-5 spawned -  I actually wrote a law review article about it back in 2004, https://www.jstor.org/stable/40688215. A few years later in 2011, the Supreme Court (agreeing with me, thank you very much) ruled that only the person who takes responsibility for a statement "makes" it. Janus Capital Group, Inc. v. First Derivatives Traders  https://www.supremecourt.gov/opinions/10pdf/09-525.pdf. That means that if the CEO of a company puts out a false statement, he is responsible for it - not the aide who wrote the first draft, nor the secretary who typed it, nor the PR firm who posted it, regardless they certainly had a role in putting it out there.

However, even if you aren't the "maker" of a misrepresentation, you can still be engaged in a "scheme" to defraud if you disseminate a false statement that someone else made. So the Supreme Court held in its 2019 decision in Lorenzo v. SEC. https://www.supremecourt.gov/opinions/18pdf/17-1077_21o3.pdf  See "Lorenzo's Oil Slick by Aegis Frumento Esq." (BrokeAndBroker.com Blog / April 4, 2019)
https://www.brokeandbroker.com/4520/aegis-frumento-lorenzo/

But can you be charged with a scheme if all you've done is made a material misrepresentation or omission?

This is not a mere academic quibble. Most of securities fraud jurisprudence has developed around Rule 10b-5's subparagraph (b). It is relatively easy to prove that a statement is true or false, and who made it. "Schemes" are harder to prove because they require some concerted action. Recently, the SEC tried to avoid the extra work by charging a "scheme" based only on a material omission. It didn't end well. The Second Circuit Court of Appeals, in a decision last Friday, said, "Uh, no." See  SEC v. Rio Tinto plc., et al., https://www.ca2.uscourts.gov/decisions/isysquery/6f01d676-5a5e-41ad-a518-ebcf299c82e3/1/doc/21-2042_opn.pdf.

Rio Tinto is an international mining company whose ADRs trade on the New York Stock Exchange. It bought a coal mine in Mozambique. However, it soon became clear to a couple of the officers that the mine was worth a lot less than they paid for it - the coal was of lesser quality, there wasn't as much of it, and Mozambique was not about to pay for the infrastructure needed to ship it out. It was what MBA's call a clusterf*ck.

Whether out of embarrassment or just waiting for a miracle to happen, those two execs hid the problem mine from the company's board and auditors. So Rio Tinto continued to issue financial statements and reports that effectively overvalued the company by at least $3 billion.

In 2017, the SEC charged Rio Tinto and the two execs with a "scheme liability" under Rule 10b-5 subparagraphs (a) and (c). https://www.sec.gov/litigation/complaints/2017/comp-pr2017-196.pdf. The SEC did not charge the execs with "making" a material misrepresentation or omission, because they did neither - they just withheld what they knew from the board and the auditors. Of course, their silence raises other issues - Rio Tinto's filings were surely inaccurate as a result -- but fraud under Rule 10b-5(b) was not one of them.

Not to be deterred, the SEC argued that hiding bad information from the board and auditors knowing that would make the filed financials inaccurate amounted to a "scheme" to defraud under subparagraphs (a) and (c) even if the misrepresentation or omission can't be charged under subparagraph (b).

The SEC lost that case in the district court, and took the matter to the Second Circuit. Last week, that court ruled that "scheme liability" under Rule 10b-5(a) and (c) could not be based solely on the existence of a material misrepresentation or omission - there had to be more, like the dissemination that the Supreme Court referred to in Lorenzo. But in the Rio Tinto case, "There is no allegation that the Rio Tinto defendants disseminated false statements; the SEC alleged 'only that [the defendants] failed to prevent misleading statements from being disseminated by others.' "

This all makes sense. Sure, the SEC, as lazy as the rest of us, will do what it can to make life easy for itself. But if the mere making of a misrepresentation or omission can prove a scheme, then there really is no difference between any of the three subdivisions of Rule 10b-5. And so, for now, if all you do is lie and sit back to see what happens, you aren't violating Rule 10b-5.

And yet, it's a loophole. There's no question that Rio Tinto's 2 execs sitting on their bad information, knowing the investing public is being deceived, was morally suspect. Rio Tinto fired them when the board found out, and Dante's circles may still await them. Hell catches all kinds like that, even when the securities laws don't.

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