In Malouf v. SEC, the U.S. Court of Appeals for the Tenth Circuit became the first federal court of appeals to apply the Supreme Court's latest securities fraud decision in Lorenzo v. SEC. In doing so, the Tenth Circuit adopted a broad view of the Supreme Court's decision that threatens to significantly expand the scope of liability under Rule 10b-5(a) and (c).

Seizing on Lorenzo, which held that the dissemination of false or misleading statements could trigger liability under Rule 10b-5, Lorenzo v. Sec. & Exch. Comm'n, 139 S. Ct. 1094 (2019), the Tenth Circuit went a step further and held that an individual may be liable under the same rule for failing to correct another's misstatement. Malouf v. Sec. & Exch. Comm'n, 933 F.3d 1248, 1260 (10th Cir. 2019). This decision should be cabined to the unique facts of the Malouf case, chiefly the fact that Malouf himself created the fraud that led to the misstatements and had ultimate authority over the disclosures at issue. If not cabined to its facts, Malouf runs the risk of creating an unwarranted extension of Rule 10b-5 liability that could have far-reaching, unintended consequences for market participants in every sector.

'Malouf' Interprets 'Lorenzo'. Dennis Malouf simultaneously maintained positions with two different firms—as the owner of a Raymond James Financial Services (Raymond James) branch that provided broker-dealer services, and as the CEO, president, and majority owner of UASNM, a New-Mexico based investment adviser. Ultimately, Malouf elected to sell his Raymond James branch in January 2008 to Maurice Lamonde, and continue to serve in an advisory capacity with UASNM.  Malouf used his position at UASNM to route a large percentage of bond trades for UASNM clients through his old Raymond James branch—at above-market commissions. The routing of these bond trades enabled Lamonde to repay Malouf for the sale of his Raymond James branch.

Importantly, as CEO, president and majority shareholder of UASNM, Malouf had "final and ultimate responsibility" for UASNM's Forms ADV. However, he delegated drafting of the forms to other UASNM employees, one of whom actually signed the forms himself. Between 2008 and 2011, at least some of UASNM's Forms ADV did not disclose the fact that Malouf sold his Raymond James branch to Lamonde and was receiving from him ongoing payments. During the same time period, UASNM's website sometimes included statements that suggested it received no commissions and "vigorously maintain[ed] [its] independence." In the Matter of Dennis J. Malouf, Release No. 766, *13 (April 7, 2015).

On June 9, 2014, the SEC instituted administrative and cease-and-desist proceedings against Malouf. An administrative law judge (ALJ) found that Malouf violated: Section 10(b) and Rule 10b-5(a) and 10b-5(c) of the Securities and Exchange Act of 1934, as well §§206(1) and 206(2) of the Investment Advisers Act of 1940, and §§17(a)(1) and 17(a)(3) of the Securities Act of 1933. Malouf was also found liable for aiding and abetting UASNM's violations of the Investment Advisers Act and the rules promulgated thereunder.

While Rule 10b-5(b) speaks in terms of statements, Rule 10b-5(a), (c)—which are sometimes referred to as imposing "scheme liability"—are "not so restricted" and speak of liability in the absence of misstatements or omissions.

In Malouf's view, if the SEC had desired to charge him in relation to the misstatements it could have only done so under the laws specifically targeting false and misleading statements—Rule 10b-5(b). Malouf argued that basing liability on his failure to correct misstatements was improper because his "failure to correct is inseparable from the misstatements themselves," for which he could not be punished because he was not the maker. Malouf, 933 F.3d at 1259. The Tenth Circuit rejected Malouf's challenge, which it largely viewed as a rehash of petitioner's arguments in Lorenzo. In Lorenzo, a director of investment banking sent to prospective investors emails that he knew to contain false financial projections. Lorenzo did not author the emails; rather, they were drafted by his boss. The Supreme Court nevertheless held that the dissemination of false or misleading statements with intent to defraud can fall within the scope of subsections (a) and (c) of Rule 10b-5.

The Tenth Circuit provided limited reasoning as to why Lorenzo supported liability for inaction. Malouf correctly noted that Lorenzo "held that a person could incur liability under [Rule 10b-5(a), (c)] when the conduct involves another person's false or misleading statement." Malouf, 933 F.3d at 1260. However, the Malouf court then leapt to the conclusion that an individual could be held liable under Rule 10b-5(a) and (c) for failing to correct another's misstatements.

In Malouf, the question of liability did not at all turn on dissemination. There were no allegations that Malouf disseminated any false information; he simply failed to correct misstatements or otherwise disclose the conflict of interest.

Cabining 'Malouf' to Its Facts Avoids an Unwarranted Expansion of 'Scheme Liability'. While there is little doubt that Malouf appropriately faced liability for orchestrating a fraud on his clients, the Tenth Circuit's opinion could be read to suggest that an individual's failure to correct another's misstatement, by itself, may subject him or her to Rule 10b-5 liability. If taken at face value and applied broadly, Malouf would create an unwarranted and likely unintended expansion of the federal securities laws.

In noting the substantial breadth of Rule 10b-5(a), (c), the Supreme Court warned that applying subsections (a) and (c) of Rule 10b-5 "may present difficult problems of scope in borderline cases." Lorenzo, 139 S. Ct. at 1101. One can easily imagine situations in which employees at different levels of seniority, with varying degrees of knowledge, failed to correct a misstatement made by a senior executive—in an investor presentation, quarterly report, press release, or countless other disclosures. At one end of the spectrum lies Malouf, a CEO of a registered investment adviser who had "final and ultimate responsibility" over the misleading Forms ADV and intimate knowledge of their inaccuracies, which were tied directly to a fraud of his own making. At the opposite end lies a lower-level employee who may have a suspicion that a statement is false or misleading—or at least is aware of information inconsistent with a particular statement—but nonetheless fails to raise the issue or correct it. The latter scenario, of course, would not and should not give rise to §10(b) liability. Between those two poles lie numerous shades of gray, raising seemingly endless questions of when someone can be held liable for failing to correct a misstatement that he or she did not make.

There are several reasons why Malouf should be confined to its unique facts and not be viewed as supporting an expansion of liability under Rule 10b-5(a), (c) for failing to correct another's misstatement.

To begin with, Malouf created the very fraudulent scheme that led another to make misstatements in the first place. If Malouf had not directed bond trades to his old Raymond James branch, at a markup, in order to facilitate kickbacks, the disclosures at issue would have been accurate. Malouf also took deliberate steps to obscure the conflict such that correcting the misstatement would have been exceedingly difficult, even for well-intentioned actors.

The case is also unique in that Malouf occupied a position of control and influence at the firm that made the statements at issue. Malouf's position arguably bestowed upon him a heightened duty to correct a misstatement that would not exist for a lower-level employee.

Given these facts, courts and litigants should be wary of over-reading Malouf as expanding "scheme liability" to any failure to correct a misstatement or omission. A close reading of the Lorenzo decision suggests that it was in part motivated by a concern that disseminators could escape liability for publishing information they knew to be false. However, that concern was not present in Malouf, and the unique facts of Malouf meant that there were various hooks for liability that did not depend on Malouf's failure to correct the disclosures.

First, an ALJ found that Malouf was secondarily liable, and the Tenth Circuit affirmed, for his role in aiding and abetting UASNM's violations of the Investment Advisers Act and the rules promulgated thereunder. Second, the ALJ found Malouf to be primarily liable for violating §206(2) of the Investment Advisers Act for conduct independent of his failure to correct the misstatements on UASNM's Forms ADV and website—specifically, for violating his duty of best execution, which obligates him as a fiduciary to seek the most favorable terms reasonably available under the circumstances. Third, the Tenth Circuit could have found that Malouf was liable under Rule 10b-5(a), (c) separate and apart from his failure to correct UASNM's misstatements. The Supreme Court in Lorenzo recognized that liability under the so-called scheme provisions may exist independent of false or misleading statements provided that someone was "involved in some other form of fraud." Lorenzo, 139 S. Ct. at 1094. Malouf could have been charged with violating Rule 10b-5(a), (c) for perpetuating an inherently deceptive and fraudulent scheme that involved overcharging customers for his benefit. The fact that Malouf failed to correct UASNM's misstatements, by itself, was not a predicate for liability.

Conclusion

Malouf was the first foray by a federal court of appeals into "scheme liability" post-Lorenzo, but the case involved a highly unusual fact pattern. Although the Tenth Circuit appeared to take a broad view of Lorenzo, lower courts and litigants should be careful not to overread the decision. Extending liability to individuals for a failure to correct the misstatements or omissions of another, absent other involvement in the purported fraudulent scheme, would result in a dangerous and unwarranted expansion of the federal securities laws.

Christopher P. Conniff is a partner at Ropes & Gray, where he is a member of the firm's litigation and enforcement practice group, and co-lead of the firm's securities and futures enforcement group. Gregory L. Demers is counsel and Cole A. Goodman is an associate at the firm.