MLPF&S Admits Violating Securities Laws In Millions of Trades

Since the Commission revamped its enforcement approach there has been no real discussion about requiring admissions to settle an action. To date there has been one settled enforcement action under Chairman Clayton involving admissions. That action involved a recidivist brokerage firm. Now there are two. Again a brokerage firm is involved. In this instance the focus is a years long, intentional scheme to deceive investors. In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Inc., Adm. Proc. File No. 3-18549 (June 19, 2018).

Over a five year period which ended in 2013 Merrill Lynch engaged in a practice known interally at the firm as “masking.” The practice involved deceiving customers – primarily financial institutions such as asset managers, mutual fund investment advisers and pension funds – about the manner in which their trades were executed. Specifically, the brokerage firm often routed customer orders to other broker-dealers, proprietary traders and market makers for execution. The practice was called Electronic Liquidity Partners or ELP. Not only did Merrill Lynch fail to tell customers about the practice, the firm deceived the traders about the manner in which their transactions were executed to the point of altering customer documents. The practice was used even where the broker received express instructions not to execute the transactions using an ELP.

Masking at Merrill Lynch traces to 2008. One of the key functions of a broker-dealer is the routing of customer orders for execution to one of a number of possible trading venues. Following execution the customer is given information about the transaction which may identify where it took place.

In 2007 Merrill Lynch began developing a program to route certain customer orders on an immediate or cancel basis to one or more of its ELPs or “trading partners” after first attempting execution in its dark pool or at other ATSs. One of the goals was to increase trading with the firm’s partners. At the same time the practice gave the ELPs access to customer orders. It also permitted Merrill Lynch to avoid paying the access fees typically charged by exchanges while receiving commissions from the customer. At the same time, it created the misleading impression that Merrill Lynch was a more active trading center.

To “mask” the venue where the transaction took place Merrill Lynch reconfigured certain codes that showed where the execution occurred. The firm also reprogramed its systems to conceal where the execution took place on customer documents. The billing invoices received by the clients were altered to conceal the execution venue.

The masking practice was extended to the trading centers. While clients were provided on request with what the firm called “liquidity maps” supposedly showing where the executions took place with the proviso that the firm thought the information was important for customers, in fact traders were furnished with incorrect facts. This was true even when traders specifically asked Merrill Lynch about the identity of the trade venue.

Masking took place even when the broker was given specific instructions on the manner in which the trade should be executed. Indeed, in some instances traders told the firm not to route orders to ELPs. The instructions were ignored.

Despite the fact that the information about the venue and execution was important to the traders, the firm deceived them and continued the practice. During the five year period of the scheme over 5.4 billion shares were traded in this manner with a notional value of $141 billion.

While customers were deceived, Merrill Lynch knew internally where the transactions were executed. Those records were maintained internally and available for regulators. In 2013 the firm elected to halt the practice but did not inform its customers. The Order alleges violations of Securities Act Sections 17(a)(2) and (3).

To resolve the proceeding Merrill Lynch admitted to the facts alleged in the Order and that its conduct violated the federal securities laws. The firm consented to the entry of a cease and desist order and a censure. It also agreed to pay a penalty of $42 million.

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Supreme Court To Determine if SEC Can Circumvent Janus

The Supreme Court will hear a case which may have a significant impact on SEC enforcement. Specifically, the Court will consider the question of whether the agency can circumvent Janus Capital Group, Inc. v. First Derivate Traders, 564 U.S. 135 (2011) regarding the requirements for pleading and establishing a claim for false statements and/or material omissions under Section 10(b) and rule 10b-5 thereunder by recasting its claim as one for “scheme” liability. Lorenzo v. SEC, No. 17-1077 (certiorari granted June 18, 2018).

Factual background

Frank Lorenzo became a director of investment banking firm Charles Vista, LLC in February 2009. The firm’s largest investment banking client was start-up W2Energy Holdings, Inc. The firm’s business depended largely on the success of certain technology. The technology failed. In September 2009 W2E sought to raise about $15 million through the sale of convertible debentures to escape financial ruin. Charles Vista was the exclusive placement agency.

Mr. Lorenzo emailed two potential investors “several key point” about W2E’s pending debenture offering. The emails failed to mention the recent devaluation of the firm’s assets. To the contrary investors were told that there were “3 layers of protection.” One of the messages stated it had been sent at the request of Gregg Lorenzo, the owner of the firm (no relation to Respondent).

The Commission issued an Order charging Mr. Lorenzo, Gregg Lorenzo and Charles Vista with fraud in violation of Securities Act Section 17(a)(1) and Exchange Act Section 10(b). The firm and its owner settled.

Respondent Lorenzo proceeding to hearing before an ALJ. The only witness at the hearing was Frank Lorenzo. He testified to sending emails at the behest of his boss by cutting and pasting – he did not write them. The Division did not call the owner of the firm to testify. No other testimony was presented.

The Initial Decision found that that Mr. Lorenzo did not read the text of the emails. It also found that Mr. Lorenzo had sent the emails “without thinking.” Nevertheless, the ALJ concluded that Mr. Lorenzo had acted willfully with the intent to deceive, manipulate, or defraud in violation of each statute. A cease and desist order was entered along with a $15,000 penalty and a life time bar from the securities business.

The Commission affirmed. In its opinion the agency concluded that Mr. Lorenzo was responsible for the emails and their content. A footnote stated that the agency need not accept the findings of the ALJ.

On a Petition for Review, the D.C. Circuit largely affirmed in a 2-1 decision, although the case was remanded for reconsideration of the sanctions. The majority opinion, written by Circuit Judge Srinvasan, joined by Judge Griffith, began with an extensive review of the statements in the emails. The court concluded that the Commission’s findings that each e-mail was false and misleading, and that Mr. Lorenzo acted with scienter, were supported by substantial evidence.

Nevertheless, the majority concluded that the Commission’s determination had to be remanded because Mr. Lorenzo had not violated Rule 10b-5(b) as charged in view of the Supreme Court’s determination in Janus Capital Corp., Inc. v. First Derivative Traders, 564 U.S. 135 (2011). There the Court held that only the “maker” of the statement could be held primarily liable under rule 10b-5(b). In this case “Lorenzo did not ‘make’ the false statements at issue for purposes of rule 10b-5(b) because Lorenzo’s boss, and not Lorenzo himself, retained ‘ultimate authority’ over the statements,” the Court concluded.

Despite this determination the majority went on to hold that Mr. Lorenzo’s conduct violated Section 10(b) and rule 10b-5 because the false statements contravened the other subsections of the rule based on a theory of scheme liability. In reaching this conclusion the Court rejected Respondent’s claim that such a holding would undermined the distinction between primary and secondary liability on which Janus is based. Since the penalty determination could have been impacted by the Commission’s incorrect determination on liability however, the sanctions were vacated and the action was remanded to the SEC for further consideration.

Judge Kavanaugh dissented. While the Judge agreed with the determination by the majority on Janus, he dissented writing: “The good news is that the majority opinion vacates the lifetime suspension. The bad news is that the majority opinion – invoking a standard of deference that, as applied here, seems akin to a standard of ‘hold your nose to avoid the stink’—upholds much of the SEC’s decision on liability. I would vacate the SEC’s conclusions as to both sanctions and liability.”

Judge Kavenaugh’s conclusion is based on three key points. First, although the factual findings by the ALJ were very favorable to Mr. Lorenzo, the “legal conclusion [of the ALJ] do not square up.” If Mr. Lorenzo did not draft the emails, did not think about their contents and only sent them at the behest of his boss, he did not act willfully. That means mens rea is missing. Accordingly, the “administrative law judge’s decision in this case contravenes basic due process” by making findings of violation and imposing sanctions.

Second, the Commission’s decision reflects the error of the ALJ. Noting that the agency recognized this issue, the SEC then did a “Houdini-like move . . .[and] rewrote the administrative law judge’s factual findings to make those factual findings correspond to the legal conclusion that Lorenzo was guilty and deserving of a lifetime suspension.” Thus “the Commission – without hearing any testimony – simply manufactured a new assessment of Lorenzo’s credibility and rewrote the judge’s factual findings. So much for a fair trial,” the dissent concluded.

Finally, in accepting the “alternative facts” of the SEC, the court ignored the key principle that “When the case turns on eyewitness testimony . . . the initial decision should be given considerable weight. Perhaps more importantly, the majority created a circuit split “by holding that mere misstatements, standing alone, may constitute the basis for so-called scheme liability under the securities laws . . . No other court of appeals has adopted the approach” taken here. This is because “the Supreme Court has pushed back hard against the SEC’s attempts to unilaterally rewrite” the law in this manner.

In the end the administrative adjudication “of individual disputes is usually accompanied by deferential review from the Article III Judiciary. That agency-centric process is in some tension with Article III of the Constitution, the Due Process Clause of the Fifth Amendment, and the Seventh Amendment right to a jury trial in civil cases . . . That tension is exacerbated when, as here, the agency political appointees – without hearing from witnesses – disregard an administrative law judge’s factual findings. . . I respectfully dissent.”

The briefs before the Supreme Court

Petitioner presented the question for review as follows: “In Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), this Court considered the elements of a fraudulent statement claim and held that only the ‘maker” of a fraudulent statement may be held liable for that misstatement under Section 10(b). . .The question presented is whether a misstatement claim that does not meet the elements set forth in Janus can be repackaged and pursued as a fraudulent scheme claim.” The answer, according to Petitioner, is no.

Petitioner relied primarily on the fact that the circuit court decision is contrary to Janus and on a split among the circuits in urging High Court review. First, Petitioner claimed that Mr. Lorenzo was not a “maker” as defined by Janus. This is because under that decision liability for a false statement can only be imposed on “the person or entity with ultimate authority on whether and how to communicate the statements . . .” Stated differently, without control over the publication of the statement, liability does not attach.

Second, the majority of the circuits have held that a claim for making a false statement cannot be repackaged into a scheme and result in Section 10(b) liability. For example, in Lentell v. Merrill Lynch & Co., 396 F. 3d 161, 177 (2nd Cir. 2005) “the Second Circuit held that misstatements alone could not form the basis of fraudulent scheme claims.” The eighth and ninth circuits have reached similar conclusion. See, e.g., Public Pension Fund Group v. KV Pharmaceutical Co., 679 F. 3d 972 (8th Cir. 2012); Desai v. Deutsche Bank Sec., Ltd., 573 F. 3d 931, 939 (9th Cir. 2009).

Finally, while the D.C. Circuit, in accord with the Eleventh Circuit, has reached an opposite conclusion, those decisions are contrary to Janus. See, e.g. SEC v Monterosso, 756 F. 3d 1326 (11th Cir. 2014). To the contrary, the majority decision by the court below ignores the bright line test for primary liability established by the Court in Janus, according to Petitioner.

The Commission opposed granting the writ. First, the agency claimed that the conduct involved here falls “comfortably within” the ordinary understanding of the statutory language for Section 17(a)(1) and Section 10(b). Petitioner, in this regard, fails to present any argument to the contrary.

Second, while the court below found that Mr. Lorenzo was not the “maker” of the statement and did not have “ultimate authority” over its publication, that does not mean he cannot be liable. To the contrary “as the court of appeals explained, a non-maker of a statement can be liable under Section 17(a)(1) and Section 10(b), and subsections (a) and (c) of rule 10b-5 if he carries out a device, scheme, artifice, or act to defraud.”

Third, there is no real circuit split. This is because “none of the decisions petitioner identifies as forming a ‘majority’ position . . . involved the kind of conduct at issue here – knowing dissemination of a false statement directly to investors with intent to induce a financial transaction. And all the cases that petitioner cites were initiated by private plaintiffs rather than by the Commission. That distinction is significant because different statutory and other standards govern private securities-fraud actions” such as the PSLRA. Under that statute allegations of false statements must meet heightened pleading standards. In contrast, some courts have held that those standards do not apply to subsections (a) and (c) of rule 10b-5. Thus the “decisions cited by petitioner . . . rest on a concern that is wholly absent here, because the PSLRA does not apply to cases initiated by the Commission.”


Lorenzo is significant. It is clear that Janus created a bright line for establishing primary liability under Section 10(b) for making a false statement or a material omission. Equally clear is the fact that to plead a claim for engaging in a fraudulent scheme more than a false statement or omission must be established. Otherwise, the distinction between making a false statement and engaging in a fraudulent scheme would vanish as would any real distinction between the subsections of rule 10b-5.

Since Janus the courts have generally required that the Commission plead specific facts to establish a scheme which go beyond making a false statement. See, e.g., SEC v. Pentagon Capital Management PLC, 725 F. 3d 279 (2nd Cir. 2013). Thus if the Commission can not plead and establish facts which go beyond a misstatement or omission then it cannot plead a fraudulent scheme. If the Supreme Court confirms this point Lorenzo may wipe out what Judge Kavenaugh called decades of effort by the Commission to wipe out the distinction between primary and secondary liability. A ruling in Lorenzo is expected next term.

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