Scheme Liability: A Reply to Grundfest

Abstract:     
This paper responds to Professor Joseph Grundfest's recent paper opposing recognition of scheme liability under Section 10(b)/Rule 10b-5 - Scheme Liability: A Question for Congress, Not for the Courts. In responding to Professor Grundfest's cogent arguments, this article tries to simplify the issue. Section 10(b) is indisputably valid, and it broadly authorizes the SEC to issue rules to protect the investing public from fraud. The Commission issued Rule 10b-5, using Congress's own words from the antifraud provisions of the 1933 Act, including the scheme to defraud language. No one suggests that Rule 10b-5 is invalid, so that should largely end the debate. A valid agency rule that Congress authorized expressly outlaws schemes to defraud in the sale of securities. Q.E.D.

It may be telling that Professor Grundfest's paper neither quotes Section 10(b) (or Rule 10b-5) nor sets forth the facts of the case. As other opponents of scheme liability, Professor Grundfest tries to divert attention from the wording of the statute and rule to the holding in Central Bank. However, Central Bank did not address scheme liability or the proper scope of primary liability under Section 10(b). It held only that there is no express cause of action for aiding and abetting liability, with the Court stressing the absence of aiding and abetting language in Section 10(b)/Rule 10b-5. However, the necessary language for scheme liability is present in Section 10(b)/Rule 10b-5.

The Supreme Court has properly noted that divining what Congress would have intended in 1934 often requires historical reconstruction. Such a reconstruction clearly demonstrates that Congress in 1934 would have expected joint tort liability to be visited upon those who knowingly participated in a fraudulent scheme to sell securities.

The scheme liability language of Rule 10b-5 was borrowed from Congress's own words in Section 17(a) of the '33 Act which, in turn, were derived from the federal mail fraud statute. Case law under both that statute and the common law of fraud (to which the Supreme Court has also looked for guidance in interpreting Section 10(b)) indicate that in 1934: (a) all who knowingly participated in fraudulent schemes were held liable (with no distinction being made between primary and secondary liability), and (b) liability was consistently imposed in cases that are nearly identical factually (A knowingly participates in B's fraudulent scheme by entering into a fake transaction that enables B to defraud C) to recent scheme liability cases, including the Stoneridge case currently before the Supreme Court.

Much of Professor Grundfest's article is, in stark contradiction to his title, composed of policy arguments that should be largely irrelevant to the Supreme Court's determination of Stoneridge. These policy arguments apply equally to the misrepresentation and manipulation provisions of Section 10(b)/Rule 10b-5, which are indisputably valid.

Number of Pages in PDF File: 44

Keywords: Securities law, securities fraud, primary liability, scheme liability

JEL Classification: K22

working papers series