Primary Liability, Insider Trading, and SEC v. Schwinger

In Regents v. Credit Suisse, an appeal arising out of the Enron debacle, the 5^th Circuit concluded that primary liability under Rule 10b-5 only extended to those persons with a duty to disclose. In general, this requires a fiduciary duty toward the shareholders of the affected company. Because the investment banking firms were found not to have the requisite duty, the Court of Appeals reversed the decision to grant class certification.  A petition for certiorari is currently pending at the US Supreme Court. 

In arriving at the remarkable conclusion, the 5th Circuit relied mostly on an entirely inapposite case, US v. Chiarella, an insider trading case. Insider trading cases are, by definition, non-disclosure cases and require proof that the bad actor had a duty to disclose.  Primary liability (the issue in Credit Suisse) arises where a fraudulent misstatement or omission has already occurred and the court confronts the task of dilineating those responsible.  The two areas are entirely different.

So, Chiarella is not good authority for resolving the boundaries of primary and secondary liability.  Another reason that Chiarella ought to be avoided is that it contains analytically unsound reasoning.  The Court, more or less out of whole cloth, concluded that a duty to disclose required proof of a fiduciary duty. As Professor Langevoort at Georgetown described: “Disingenuously citing state law to support a rule that had long since ceased to apply, the Court held that a duty of disclosure to the marketplace would not arise absent a pre-existing fiduciary relationship between buyer and seller.” Words From on High About Rule 10b-5: Chiarella's History, Central Bank's Future, 20 Del. J. Corp. L. 865 , 872 (1995).

In the area of insider trading, the reasoning of Chiarella left out more than it left in.  Any number of persons routinely obtained inside information but lacked the requisite fiduciary obligation. This included, for example, law firms, investment banking firms and accounting firms hired by the issuer. Employees with those entities had a contractual relationship with the issuer but were not fiduciaries. Recognizing the size of this loophole, the Supreme Court filled some of it three years later in Dirks v. SEC when it made up the doctrine of temporary insider (see Footnote 14). Temporary insiders, a group that included third parties with some kind of confidential relationship with the issuer, were held to have a fiduciary relationship and a duty to disclose.

Even with this effort at back and fill, the Supreme Court’s reasoning in Chiarella and Dirks still left a gaping hole in insider trading law. Under the case law, officers or directors in an acquirer could buy shares in a target company without engaging in insider trading because they had no fiduciary obligation to the shareholders of the target company.

It was this gap that the SEC filled with the misappropriation doctrine (based in part upon the reasoning of Chief Justice Burger in his dissent in Chiarella).  The doctrine provided that anyone with a duty of trust and confidence could not trade on material nonpublic information received as a result of that relationship.  The Supreme Court approved the misappropriation theory in O’Hagan, a case involving a lawyer in a firm retained by an acquirer who traded in shares of the target.

We bring this up (and apologize to those who know this already) in the context of an SEC insider trading case settled last week, SEC v. Schwinger, Litigation Release No. 20152 (D DC June 13, 2007).  The complaint is posted on the DU Corporate Governance web site.

Schwinger, the defendant, was the managing partner in the Washington, D.C. office of Katten Muchin Rosenman and had the  responsibility for interviewing prospective hires.  An in house attorney at Vastera, Inc. contacted Schwinger in May 2004 about possibly joining the firm.  At a subsequent meeting a month of so later, Schwinger asked the attorney the reasons for leaving Vastera.  According to the complaint, the in house attorney explained that "it was due in part to an anticipated strategic transaction involving Vastera that might impact on his future employment at the company." 

Later that summer, in August 2004, Vastera retained Katten Muchin to "perform corporate work relating to the amendment of Vastera's credit facility with a bank."  The complaint contains no other description of legal work, indicating that it was an isolated matter. 

The in house lawyer continued the conversations with Schwinger about joining the firm.  The complaint noted that he "spoke frankly" about the possibility of an acquisition and, by October 27, had informed Schwinger that an acquisition was imminent.  On November 5, Schwinger bought 10,000 shares of Vastera at an average price of $1.70 a share.  In January 2005, JP Morgan Chase announced an acquistion offer for $3 a share.  Schwinger earned "imputed illicit profits of $13,027.00."

The SEC charged Schwinger with insider trading, relying upon the misappropriation theory.  The SEC alleged that Schwinger violated a duty of trust and confidence to his law firm by trading on the information provided by the in house lawyer about the acquisition during the job interviews.  The complaint stressed that Vastera was a client and that Schwinger knew this. 

The facts in this case illustrate the analytical confusion that has arisen by the faulty reasoning in Chiarella and the bandaid provided by O'Hagan. 

Schwinger did not obtain the information about the "imminent" acquisition in an improper manner.  He did not obtain the information in a relationship of confidentiality.  It did not come to him as a result of a client matter. 

Moreover, the case could easily have been written to make others appear to be the wrongdoer.  After all, it was the in house counsel who blurted out the highly confidential information about an imminent acquisition to someone outside the company.  

The case, therefore, could easily have resulted in the SEC charging the in house counsel with insider trading by violating his fiduciary duty to Vastera when he told Schwinger about the acquisition.  The SEC did not.  Why not?  Perhaps the SEC could not establish all of the elements required by Chiarella and Dirks.  To violate his or her fiduciary duty, the insider had to gain some type of pecuniary benefit.  So, despite leaking highly material information to persons outside the company, the SEC may not have been able to make the case.  Had the SEC used the "classic" insider trading law from Chiarella, Schwinger would not have been guilty of insider trading.  Dirks made clear that tippee liability required liability by the tipper.

So, despite exonerating the insider who tipped the information, the SEC chose to charge Schwinger, the interviewing partner, with insider trading.  To do so, the agency had to establish that Schwinger violated a duty of trust and confidence to his employer, in this case the law firm.  Ordinarily, this requires proof that the employee used information that belonged to the employer and was intended to be kept confidential.  Is that the type of information used by Schwinger? 

He got the information in an interview with a prospective employee.  While keeping information learned in an interview confidential may be appropriate, it is unclear that this is always required.  Moreover, information obtained in an interview is not automatically proprietary and subject to requirements of confidentiality.  For example, had Schwinger learned from the in house counsel that there was a legal position open at Vastera, it would stretch credulity to argue that he had an obligation to give the information to the law firm and forego an application.

The complaint seemed to recognize this and stressed that Vastera was a client of the firm, as if Schwinger had a duty to keep the information confidential because it involved a client.  The information, however, did not come in the context of a client matter.  Moreover, Vastera was apparently a client for a single discrete matter.  In other words, Schwinger had no duty to Vastera nor did the law firm with respect to the information provided by the in house counsel.  

Schwinger may have shown very bad judgment in trading on the information given to him by the in house counsel at Vastera.  But is it insider trading?  Hardly.  And, in any event, the analysis is made extraordinarily complex by the poor reasoning in Chiarella and the doctrines that sprang up to compensate for the deficient analysis.

Secondary Liability and Credit Suisse: Enron and the Petition for Certiorari

Lost in the discussion over Stoneridge v. Scientific Atlanta (In re Charter Communications) and the failure of the Solicitor General to file a brief on behalf of the SEC, Monday, June 11 was also the date that the Petitioners (the Regents of the University of California) filed their reply to the opposition brief with respect to their petition for certiorari in Regents v. Credit Suisse (the Enron case).  All of these briefs are at the DU Corporate Governance web site. 

In opposing the cert petition, the Investment Banks argued that the petition was duplicative (given that the Supreme Court will already address the same legal issue in Stoneridge) and therefore a waste of resources, was an "inferior vehicle" to address the secondary liability issue because it involved the review of an interlocutory denial of class certification, and the "strained merits argument do not justify the extraordinary measure of granting a tag-along petition."  The opposition brief described the Regent's arguments as "recycled" and an attempt to nullify Central Bank. 

The briefs by the two sides at least factually read like entirely difference cases.  The briefs for the Investment Banks described their behavior this way:  "Respondents entered into a variety of financial transactions with Enron at different times and with varying degrees of frequency."  That's it.  No mention of Nigerian barges or making debt look like equity.  The Regents, in their reply brief, not only described a litany of bad behavior by these Investment Banks but they took the time to remind the Court that they "are the very actors whose misconduct involving public companies and our securities markets led to the stock-market Crash of 1929 and was a primary motivation for enacting our federal securities laws". 

The arguments to the contrary notwithstanding, this case is a superior vehicle for reviewing the definition of primary liability.  It is still the case that, despite problems with the application of the facts, the 8th Circuit in Stoneridge adopted a test that imposed primary liability not only on those that made false statements but also on those that caused false statements to be made.  As the 8th Circuit itself suggests, this test would reach vendors that engaged in sham business transactions designed to facilitate financial fraud.  The 5th Circuit went further.  By requiring a duty to disclose, the court exonerated even those actors that engaged in a sham transaction for the sole purpose of facilitating securities fraud.  Regents, therefore, contains the clearest (and most restrictive) limitation on the reach of Rule 10b-5, making it an appropriate vehicle for determining the boundaries of the provision. 

Secondary Liability and Stoneridge: The View from the Academy

We want to note on more amicus brief filed in Stoneridge v. Scientific America on Monday.  It came from a prominant group of law faculty, including James Cox of Duke, Jill Fisch of Fordham, Donald Langevoort at Georgetown, Richard Buxbaum at Boalt, Melvin Eisenberg, also from Boalt, and Hillary Sale at Iowa.   The brief is posted at the DU Corporate Governance web site. 

The brief argues forcefully that the Court should not limit Rule 10b-5 to disclosure but should extend to those who "actively engag[ed] in a deceptive scheme of sham transactions".  The Law Faculty make extensive use of SEC v. Zandford, 535 U.S. 813 (2002).  The case involved a broker who stole money from the account of one of his clients, selling securities to do so.  The Fourth Circuit dismissed the SEC action, determining that the fraud had not occurred "in connection with" the purchase or sale of a security.  The Supreme Court ultimately reversed, concluding that "the sales are properly viewed as a 'course of business' that operated as a fraud or deceit on a stockbroker's customer."  The case relied on the "scheme" language in Rule 10b-5, interpreted the language broadly, and seemed to apply the language to conduct.  The opinion was recent (2002) and unanimous. 

What makes Stoneridge frustratingly difficult from a legal perspective is that the 8th Circuit announced a test that in fact would result in the application of primary liability not only to those who made false statements.  The test extended primary liability to those who made false statements and to those who caused false statements to be made.  The "cause" language on its face covers others involved in the fraud, not just those who made the false statement. 

The problem is in the application of the facts to the test.  The 8th Circuit essentially treated the transactions between Charter Communications and the vendors as "arm's length" transactions.  As such, they did not "cause" the fraud and result in primary liability.  The Law Faculty address this contention, asserting that the opinion failed to credit allegations in the complaint alleging "that the vendors agreed to unlawful kick-backs and phony advertising fees that were complete shams."  In other words, the 8th Circuit ignored the allegations in the complaint in reaching its determination. 

This is not a law review article, it is not pontification from the ivory tower.  This is academic involvement at its best, attempting to influence the debate on, and direction of, the law.  

Stoneridge v. Scientific America: The SEC Speaks, Sort Of

One of the more interesting briefs filed on Monday in Charter (Stoneridge v. Scientific America) was the one written by the Regents of the University of California, with Lerach Coughlin the authors. The brief is posted on the DU Corporate Governance web site. 

Much has been written about whether the Supreme Court will grant cert in Credit Suisse, the case arising out of the Enron.  The Regents (who are plaintiffs in that case) are making sure that the Justices get a dose of that case no matter what they decide with respect to the cert petition.  The brief addresses the fraud in that case and the analysis used by the 5th Circuit in resolving the issue. 

Moreover, while the Solicitor General declined to file a brief representing the views of the SEC in Stoneridge, the Regents made sure the Supreme Court would be made aware of the SEC's views.  The brief makes bountiful use of the Commission's amicus brief (a copy of which is at the DU Corporate Governance web site) in Simpson. The views of the agency have not, therefore, gone unmentioned.

The case tackles head on the reasoning in Credit Suisse, particularly its reliance on Chiarella and O'Hagan, two insider trading cases.  The Fifth Circuit relied on these cases in taking the position that only those making misrepresentations can be liable under Section 10(b).  As the brief notes:

• "The Enron majority’s opinion misreads this Court’s precedents. Chiarella’s discussion of duty assumes a claim based on a failure to speak: 'This case concerns the legal effect of the petitioner’s silence.' 445 U.S. at 226. In an insider trading case like Chiarella, the claim of fraud is grounded in an insider’s failure to make required disclosures in connection with a specific securities transaction. Chiarella and O’Hagan did not at all address whether deliberately deceptive conduct can qualify as a deceptive device under §10(b)."

The point is accurate and one that we have noted. 

It makes good strategic sense to bring up the facts in Credit Suisse.  Even without granting certiorari in the case, the Supreme Court could be influenced by the reasoning.  Moreover, the case for reversal is even stronger than in Charter, thereby presenting the Court with another set of facts that illustrate the implications of a narrow interpretation of the concept of primary liability.    

George Bush and Secondary Liability

In the drama over the failure of the Solicitor General to file a brief in favor of plaintiffs in Charter Communications (Stoneridge v. Scientific Atlanta), a position favored by the Securities and Exchange Commission, the Wall Street Journal Law Blog has at least a partial explanation.   It seems that President Bush thinks that weighing in on the side of shareholders would generate "unnecessary lawsuits" and be bad for investors. 

Secondary Liability and Stoneridge: Plaintiffs Make Their Case

The plaintiffs filed their briefs in Charter on Monday. A copy is at the DU Corporate Governance web site.  The case technically turns on the meaning of the word deceptive in Section 10(b) and the phrase scheme to defraud in Rule 10b-5. 

The brief characterizes the 8th Circuit as limiting primary liability to those making a misrepresentation and omissions, emphasizing that no such limiting language appears in Section 10(b).  Moreover, Congress knew how to make such limits, having done so in other sections of the Securities Laws (such as Section 14(e), the antifraud provision in the Williams Act).  This is a particularly appealing argument since Central Bank turned entirely on the fact that Congress did not include the language "aiding and abetting" in Section 10(b).  Plaintiffs argue that the word "deceptive" in Section 10(b) and scheme to defraud in Rule 10b-5 encompass the type of conduct that occurred in this case:  sham business deals and backdated documents.

Assuming that deception includes conduct (a seemingly obvious proposition), the case will turn upon the type of conduct that will suffice.  Plaintiffs emphasize over and over that the transactions between Charter and the vendors were shams.  As a result, they take issue with the appellate court's characterization of the transactions as "arms length."  Describing this as a mischaracterization, plaintiffs note that this "is not a case involving an 'arm’s length transaction' in which a party acted honestly but perhaps with knowledge that the transaction would be used to mislead investors. This is a case in which Respondents themselves engaged in fraud.  Respondents engaged in transactions that they knew were shams, and Respondents then lied about those transactions."

The transactions were not, however, entirely without substance.  Charter overpaid for the black boxes by $20 and the vendors cycled the $20 back to Charter.  The vendors apparently did receive some actual services (advertising) in return for the payments, albeit services that were overpriced (four or five times the going rate).  In other words, the transactions did not entirely lack economic substance but, counter to the 8th Circuit's characterization, were not arms length. 

The case may, therefore, turn on facts emphasized in the brief and all but ignored by the 8th Circuit.  Whatever deception might mean under Section 10(b), it ought to cover those who actually deceive by falsifying documents that facilitate the fraud.  As the brief noted: 

• "In 2000, Charter was facing a shortfall in anticipated revenue and cash flow relative to Wall Street expectations. To close this gap, Charter agreed to overpay Respondents by a total of $17 million for set-top boxes that it had already agreed to purchase from them at lower prices, if Respondents would use those additional funds to “purchase” unwanted advertising from Charter. To create a false appearance that these transactions were legitimate, Respondents: (i) issued documentation falsely stating that Respondents demanded the price increases because of higher costs; (ii) falsely backdated contracts; and (iii) agreed to “purchase” advertising at four to five times regular rates using Charter’s funds."

No doubt the vendors will argue that the contracts had economic substance and a business purpose (although, on the motion to dismiss, they will be stuck with the facts alleged by plaintiffs).  But it is much harder to make the same case with respect to falsified documents.   

Secondary Liability and Rule 10b-5: The Bottom Line

We have been writing about a trilogy of cases testing the boundaries of primary liability under Rule 10b-5:  Simpson v. AOL, In re Charter and Regents v. Credit Suisse.  They deal with the application of the antifraud provisions to vendors and investment banking firms.  Moreover, the cases are particularly topical now that the Supreme Court has agreed to hear Charter and may yet agree to hear Credit Suisse.

These cases have provoked predictions of a litany of horrors that will occur if the Supreme Court fails to agree with the 8th Circuit in Charter and the 5th Circuit in Credit Suisse and adopt a highly restrictive definition of primary liability.  They have invoked reference to Bill Lerach, the dean of the securities class action bar, as if the mere mention of his name would somehow justify a narrow definition of primary liability. 

These commentators, however, overstate the consequences of any such decision.  Even if the Supreme Court adopts a formulation for primary liability broader than the one used by the 8th Circuit in Charter, few if any vendors or third parties will find themselves parties to a fraud suit that won't be resolved on a motion to dismiss.  Let us look at why this is the case.

First, plaintiffs still must plead scienter against any vendor, no easy matter given the onerous pleading requirements of the PSLRA.  Think about all of the evidence that must be produced to show scienter by the company making the fraud.  In issuer cases, scienter often turns upon evidence of unusual trading activity by corporate insiders.  For vendors, this type of evidence will almost never be present.  It will be the rare circumstance that this level of information will be available to establish scienter for a person or entity that merely does business with the issuer.     

Second, plaintiffs must show that the transaction was material.  A small sham transaction knowingly done may not amount to fraud.  

Knowledge and materiality are not enough.  For there to be primary liability, the Ninth Circuit test in Simpson, the broadest formulation, essentially requires direct participation in the fraud by engaging in a transaction that has as its principal purpose to effect the fraud.  Moreover, the court suggested that this would only occur where the transaction lacked economic substance.  See 452 F3d at 1050 ("Conduct by the defendant that does not have a principal legitimate business purpose, such as the invention of sham corporate entities to misrepresent the flow of income, may have a principal purpose of creating a false appearance.").  The facts in Simpson did not meet this test.  Moreover, the facts in Charter probably wouldn't as well.  While the vendors in that case allegedly knew that the transaction would facilitate fraud, the deal had economic substance:  The payment of additional $20 with the expectation that the sum would be returned in the form of additional services.  See 443 F3d at 993 (describing transaction by vendors as "arm's length non-securities transaction"). 

Even the infamous Nigerian barge transaction at issue in Credit Suisse might not meet the test in Simpson for primary liability.  While it is true that Merrill Lynch bought the barge subject to an undisclosed guarantee by Enron to repurchase it, the securities firm still held title, had to operate the barge, and presumably assumed the risk of loss.  It was a real purchase, not a sham, albeit one with a guaranteed return if the barge were still in existence. 

In other words, even if the Supreme Court rejects the tests in Charter and Credit Suisse and adopts the one in Simpson, it will be the rare case that a vendor will be primarily liable under Rule 10b-5.  

Secondary Liability and the Limits of SEC Independence (Continued)

Having just written about the need of the SEC to convince the Solicitor General to file an amicus brief at the Supreme Court in Charter (because, although an "independent agency," the SEC cannot represent itself before the High Court), a case involving the meaning of primary liability under Rule 10b-5, we have come to learn that the deadline passed for filing briefs and none was filed by the Solicitor General.  An article on the subject in the Washington Post ishere and in the WSJ Law bloghere. 

This demonstrates that the SEC failed to convince the Solicitor General of its position, no doubt a result of a disagreement between an independent agency and the Bush Administration.  In deciding the case, therefore, the Supreme Court will lack any insight into the issue from the agency responsible for regulating the securities markets. 

This should, however, not be viewed entirely as a loss for the plaintiffs in Charter.  It could easily have been worse.  The Solicitor General could have filed a brief taking positions opposite of those taken by the Commission.  It has happened before.  In CTS Corp. v. Dynamics Corp., a case back in the 1980s involving the constitutionality of a control share acquisition statute, the Solicitor General took a position on preemption inconsistent with the views of the Commission. 

The Commission's decision to recommend support for the plaintiffs in Charter may, therefore, have created sufficient disagreement to cause the Solicitor to take a pass on the case entirely and not write a brief supporting the reasoning of the 8th Circuit.  Silence from the federal government may have been the best plaintiffs could have expected.  It does raise the issue of whether the SEC, like the FTC, ought to have the right to represent itself at the Supreme Court, at least where the Solicitor General's Office refuses.  This authority was considered in the 1970s but never adopted.

Secondary Liability and the Limits of SEC Independence

As the discussion continues about the SEC’s involvement in Charter and Credit Suisse, we thought we would take a few moments and discuss the inter-governmental dynamics involved in the SEC's participation in these cases.  In fact, although an independent agency, the SEC cannot represent itself at the Supreme Court but must go through the Solicitor General's Office.     

Independence when used to describe an administrative agency connotes independence from the President.  In other words, these agencies have some ability to take positions or engage in actions that do not reflect the policies and views of the executive branch. The independence generally arises from restrictions placed on the President’s ability to remove the head of an independent agency (or heads, in the case of a commission). See 4 USC 41 (creating the Federal Trade Commission and providing that “Any commissioner may be removed by the President for inefficiency, neglect of duty, or malfeasance in office.”). This means that, unlike other executive branch agencies, those running independent agencies know that the President cannot fire them over policy disputes.  This provides greater independence in making policy determinations.   

The Securities and Exchange Commission is headed by a five person commission, no more than three of which can be from the same political party. See 15 USC 78d(a). The Exchange Act provides for five year terms and otherwise provides no explicit right of the President to remove commissioners, even for neglect or malfeasance. See SEC v. Warner, 652 F. Supp. 647, 649 (SD Fla 1987)(“ Although the statute establishing the Commission is silent regarding the removal of Commissioners, members of independent agencies such as the SEC are generally removable by Congress only for impeachable offenses.”).

When it comes to litigation, the SEC has the authority to litigate its own cases, including appeals. Thus, a decision to participate as amicus in a case at the US court of appeals is something the SEC decides on its own, without any obligatory consultation with the Justice Department. This is what occurred in connection with the amicus brief filed in Simpson when it was before the Ninth Circuit.

With respect to litigation at the Supreme Court, however, the rules are different. In most instances, agencies do not have the authority to represent themselves before the Supreme Court. The general rule is that all litigation involving the US government at the Supreme Court is handled by the Solicitor General’s Office within the Department of Justice. The practices are not, however, uniform.  The Federal Trade Commission, for example, may represent itself at the Supreme Court when the Solicitor General otherwise refuses to do so. See 15 USCS § 56.  The Commission, however, has no such authority and may not, without approval, litigate before the Supreme Court.

Thus, to get its views before the Court, the SEC must convince the Solicitor General’s Office to file the certiorari petition or amicus brief. This is what is going on with respect to participation in Charter and Credit Suisse. In both instances, the Commission must determine its own position then try to convince the Solicitor General to represent those views to the Supreme Court. And, despite some history of independence, the Solicitor General is likely to watch out for the interests of the President.

The result is that the Solicitor General can refuse to promote the views of the Commission.  In some instances, this has forced the Commission to water down its views in order to get the consent of the Solicitor General.  This occurred, for example, in CTS v. Dynamics, where the Commission had to give up on its argument that the Indiana control share acquisition statute was preempted by the Williams Act (the brief specifically stated that the United States did not believe that the Williams Act preempted the statute).  A copy of the brief is at the DU Corporate Governance web site.  Finally, in rare circumstances, the Solicitor General has given the SEC permission to file its own brief where the differences were too great. This apparently occurred in Dirks v. SEC.

It is, therefore, only the first hurdle to get agreement from the five person commission on the litigation position of the SEC.  The second is to get agreement from the Department of Justice.  Now that the Commission has apparently resolved the former issue, it is the latter where all attention will focus. 

Secondary Liability Gets Personal: The WSJ and Bill Lerach

The Wall Street Journal ran an editorial, a lead editorial, on Saturday, decrying the recommendation by the SEC that the government weigh into In re Charter (we have discussed this case here) on the side of shareholders.  That is the case that involves the definition of primary liability under Rule 10b-5.  Oddly, the editorial contained no real legal analysis (except for a few vague inapposite references to Central Bank) and mostly amounted to a diatribe about Bill Lerach, the dean of the plaintiffs class action bar. 

Why did the editorial use Lerach analysis rather than legal analysis?  Because, as we will discuss in a day or so, those opposing Charter have a hard case on the merits.  Charter, at the end of the day, addresses whether anyone other than the issuer (and perhaps officers and directors) can be liable under Rule 10b-5.  The 8th Circuit, interestingly, answered by agreeing that others could.  The court extended liability to anyone who made a misstatement or "cause[d]" a misstatement to be made.  The court, however, went on to apply the test in a way exonerated anyone not directly involved in the drafting process, including vendors and other third parties who otherwise facilitated the fraud.  

To understand this approach, let's look at an example.  Assume a vendor agrees, in return for a bribe, to provide the issuer with documentation of a material transaction that in fact never occurred.  The company then reflects the transaction on its financial statements, committing securities fraud and harming investors.  Under Charter (and Credit Suisse), the vendor providing the false documentation is not subject to liability under Rule 10b-5 despite the sham nature of the transaction, the bribe, and the direct relationship to the fraud committed by the issuer.

To contend that this level of involvement in the fraud is aiding and abetting, the mere providing of assistance, is far fetched.  It directly causes the fraud, something covered by the "scheme to defraud" language in Rule 10b-5.  At the same time, it is the case that courts are rightfully nervous about extending antifraud liability to vendors, suppliers, and other persons or entities doing business with a company that commits securities fraud.  The test adopted in Simpson by the 9th Circuit, however, makes it clear that vendor liability will rarely if ever occur for transactions that have economic substance.  So, if it's not the merits, what is it?  In the case of the Wall Street Journal, it's personal.    

Enron and Secondary Liability: Regents v. Credit Suisse

We have been examining the recent spate of cases involving primary liability under Rule 10b-5. The cases involve the extension of antifraud liability to vendors. The 9th Circuit held that vendors could be liable where the principal purpose of their business transaction was to effect a fraud. The 8th Circuit held that a third party could be liable for making a false statement or causing a false statement to be made. In application, however, the 8th Circuit did not extend the test to vendors who allegedly engaged in sham transactions aware that they would be used to commit financial fraud. The case is now pending at the US Supreme Court.

The last of the trilogy involves the appeal from the investment banking firms in Enron.  As we shall see, it goes much further than the 8th Circuit. 

The appeal was actually the granting of class certification but the reasoning goes to the merits. With the failure of Enron, plaintiffs have targeted a number of third party deep pockets, particularly investment banking firms. A number settled, with Citibank for example agreeing to pay $2 billion rather than risk the wrath of a jury. For a list of the settlements (totalling almost $7.2 billion), go here. A number of investment banking firms, however, chose not to settle and appealed the district court's decision to grant class certification. See Regents v. Credit Suisse, 482 F.3d 372 (5th Cir. 2007). 

In that case, the plaintiffs alleged that the investment banking firms entered into transactions that allowed Enron to avoid disclosing the total amount of debt outstanding.  The court gave as an example the infamous Nigerian Barge Transaction where plaintiffs allege that Enron "sold" the barges to an investment banking firm in order to book revenue after it could find no "legitimate buyer" and agreed to repurchase the barges at a profit six months later, which it did.  The plaintiffs alleged that the investment banking firms knew the reasons for these "seemingly irrational transactions".   

The court, in a 2-1 opinion, determined that primary liability was only limited to those with a duty to disclose.  In arriving at the conclusion, it did not rely on Central Bank but on Chiarella, emphasizing that there can be no fraud based upon nondisclosure "absent a duty to speak. . . . We hold that a duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic market information."  445 US at 234-35.  As the court noted:  "The transactions in which the banks engaged at most aided and abetted Enron's deceit by making its misrepresentations more plausible. The banks' participation in the transactions, regardless of the purpose or effect of those transactions, did not give rise to primary liability under Section 10(b)."   

The holding is breathtakingly broad.  It means that Rule 10b-5 does not reach anyone who does not have a duty to disclose to shareholders.  Not only does that exonerate vendors and investment banks, it is hard to ascertain how accounting firms, law firms, and even many employees of the issuer itself could ever be considered primary violators under this approach.  Any third party that knowingly enabled the fraud to occur (by, for example, accepting a bribe in return for documentation of a transaction that never occurred) would not be liable. 

The court got to this remarkable place by relying on Chiarella and O'Hagan, two insider trading cases.  Chiarella, the case brought against an employee of a financial printer, did suggest that insider trading was predicated upon a duty to disclose and that the duty arose out of fiduciary obligations.  Almost before the ink was dry the Supreme Court began backing off the doctrine.  As the case in Credit Suisse,  the doctrine arguably excluded anyone outside of the issuer, such as investment banks or accounting firms.  Neither had a fiduciary obligation to shareholders and, as a result, arguably did not have a duty to disclose. 

A few years later, the Supreme Court addressed this obvious anomaly in Dirks v. SEC by inventing the doctrine of "temporary insider" and extending it to those outside the issuer.  See 463 U.S. 646, 655 n. 14 ("Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders. The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes."). 

Thus, while Chiarella may suggest the need for a fiduciary duty to be charged under Rule 10b-5, the Supreme Court subsequently made it clear that such a duty extended to anyone in a confidential relationship with the issuer.  The investment banking firms in Credit Suisse likely fall within that category.  Moreover, O'Hagan applied the misappropriation theory to a lawyer employed by the bidder in a tender offer.  In other words, the duty to disclose extended outside the issuer to a law firm.  These cases if anything demonstrate a willingness on the part of the Supreme Court to extend the reach of Rule 10b-5 to those entities that have some type of confidential relationship with the issuer.  The vendors in Charter might not have that type of relationship but the investment banking firms in Credit Suisse likely do.

Second, and more importantly, O'Hagan and Chiarella involve an entirely different issue than the one confronted by the court in Credit Suisse.  As is always the case with insider trading, Chiarella and O'Hagan involve a fraud that arises where there has been no disclosure.  In other words, the need for a duty to disclose is critical (this is always the case where fraud is predicated upon silence).  Chiarella and O'Hagan are cases best understood as attempting to prevent the imposition of liability for insider trading merely as a result of the possession of material nonpublic information.  As a result, the Supreme Court conditioned liability upon both possession and a duty to disclose.  

In Credit Suisse, in contrast, someone did speak, Enron.  Enron issued false financial statements.  The case, therefore, does not turn upon a need for a duty to disclose but seeks to determine who can be liable for making the false statements.

As a matter of legal analysis, Credit Suisse is a poorly reasoned case.  It purports to draw from the cases law that is not there.   It goes far beyond the decision by the 8th Circuit, which at least captured in its test those who "cause" the false disclosure. 

The Commission has apparently opted to side with the plaintiffs in their petition for certiorari.  The Court has already decided to hear In re Charter.  If it takes Credit Suisse, the two cases will be decided by a slightly different set of justices, with the possibility (but not a likely one) of inconsistent outcomes.  I have discussed that issue here.   Primary materials on the case can be found at the DU Corporate Governance web site.

Primary Liability and Enron: University of California v. Credit Suisse First Boston

This case arose from the defendant banks’ involvement in the accounting frauds committed by Enron. The banks were accused of perpetuating the fraud by engaging in certain "round-trip transactions" that allowed Enron to record sales of its assets as revenue, only to later buy back those same assets from the banks at a premium. The plaintiffs are former Enron shareholders who filed for class certification with the district court, and after the certification was granted, the banks appealed.

The plaintiffs argued, and the district court held, that they were entitled to a classwide presumption of reliance based on the alleged omissions under Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972), because the banks were under a “duty not to engage in a fraudulent scheme,” and by participating in the transactions with Enron, they had violated that duty. This presumption was critical to class certification, as it allowed the plaintiffs to show reliance as a class instead of individually. However, the Court of Appeals disagreed with the district court’s analysis. In a split decision, the Court determined that to obtain the Affiliated Ute presumption of reliance on an omission the plaintiff must show two things: (1) that the case is based primarily upon an omission; and (2) that the defendant owed the plaintiff a duty to disclose. In this case, the banks were not fiduciaries of the plaintiffs and the plaintiffs “had no expectation that the banks would provide them with information,” and as such, “there is no reason to expect that the plaintiffs were relying on their candor.”

The second major issue on appeal concerned the reach of Section 10(b) and Rule 10b-5.  After Central Bank the provision only extends to primary violators.  See Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994).  The Court of Appeals acknowledged that the Supreme Court had “conclusively foreclosed the application of secondary liability under 10(b)” but had left open the possibility that primary liability can still be applied to “secondary actors such as investment banks and accountants” under certain circumstances.  In deciding what those circumstances are, the court sided with the 8^th Circuit (In re Charter Commc'ns, Inc., 443 F.3d 987 (8th Cir. 2006) a case now pending before the Supreme Court) and concluded that for primary liability to apply, the defendant must either “make or affirmatively cause to be made a fraudulent statement or omission” or “directly engage in manipulative securities trading practices.” 

Since the banks had made no statement and had no duty to disclose, they could not be sued as primary violators under Section 10(b) and Rule 10b-5.  As for manipulation, the Court of Appeals, relying on the Supreme Court’s decision in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 214 (1976), held that “[m]anipulation requires that a defendant act directly in the market for the relevant security.” Here, the banks engaged in transactions that “gave a misleading impression of the value of Enron securities that were already on the market.” This, according to the Court, was not the type of manipulative device the Supreme Court has held that “an efficient market may be legally presumed to rely” upon.

The Court of Appeals reversed the class certification and remanded back to the district court.

The briefs and full text of the Court’s opinion can be found on the DU Corporate Governance website.

Secondary Liability and Vendors: In re Charter Communications

We have been tracing the development of primary liability under Rule 10b-5.  After Central Bank in 1994, actors who merely aid and abet securities fraud can no longer be sued under the antifraud provision. 

In the aftermath of Central Bank, it became more important to know who fell within the definition of primary violator.  Having said that, the issue was only of modest importance.  With securities fraud suits alleging false disclosure by the issuer (an unmistakable primary violator), other players did not matter as much so long as the company was solvent and could pay any settlement amount.  To a lesser extent, accountants, as available deep pockets and to some degree involved in the disclosure process, found themselves involved in these suits.  As a result, much of the case law attempting to draw lines between primary and secondary liability involve accounting firms.  For a recent example, take a look at Overton v. Todman, 478 F.3d 479 (2nd Cir. 2007)(concluding that an accountant can be primarily liable under Rule 10b-5 for failing to correct a certified opinion that it later learns was false).   

But with the spectacular corporate failures of the new millennium, including those arising out of the dot com bubble, pressure on the definition increased.  The insolvent companies weren't able to pay any settlement amount.  Plaintiffs, as a result, began to search for additional deep pockets.  In Simpson v. AOL/Time Warner, 452 F.3d 1040 (9th Cir. 2006), the 9th Circuit addressed the meaning of primary liability in the context of vendors.  The court found that vendors could be sued where they engaged in transactions, the purpose and effect was to create a false appearance of fact in furtherance of the scheme to defraud.  While the test was a tough one (largely concluding that vendors could not be sued unless the transactions were a sham designed to facilitate fraud), the court still allowed for vendors to be sued even though they did not make the false disclosure and were not involved in the drafting or editing process.

In In re Charter Communications, 443 F.3d 987 (8th Cir. 2006), the 8th Circuit took another approach.  Charter was not a bankrupt company but it was one in serious distress, with some speculating that it would fail.  Perhaps as a result, plaintiffs opted to sue two equipment vendors, Scientific-Atlanta and Motorola.  Plaintiffs alleged that the vendors engaged in sham transactions designed to facilitate fraud by Charter.  As the court described: 

• "At the time in question, Charter delivered cable services through set-top boxes installed on customers' TV sets. Charter purchased the set-top boxes from third-parties, including the Vendors. In August 2000, although Charter had firm contracts with the Vendors to purchase set-top boxes at a set price sufficient for its present needs, Charter agreed to pay the Vendors an additional $ 20 per set-top box in exchange for the Vendors returning the additional payments to Charter in the form of advertising fees."

Plaintiffs alleged that the $20/box in advertising fees was treated as revenue while the additional $20 paid for the boxes was capitalized.  Plaintiffs asserted that these transactions were a sham, had no economic substance, and were used only to allow Charter to meet Wall Street expectations.   The vendors did not, however, play "any role in preparing or disseminating the fraudulent financial statements and press releases through which Charter published its deception to analysts and investors." 

The 8th Circuit adopted a narrow reading of liability under Rule 10b-5.  "Thus, any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable" under the antifraud provisions.  With respect to the vendors, they did not meet this standard:

• "However, neither Motorola nor Scientific-Atlanta was alleged to have engaged in any such deceptive act. They did not issue any misstatement relied upon by the investing public, nor were they under a duty to Charter investors and analysts to disclose information useful in evaluating Charter's true financial condition. None of the alleged financial misrepresentations by Charter was made by or even with the approval of the Vendors."

The test employed by the 8th Circuit is not all that different from the one used by the 9th Circuit in Simpson.  The 8th Circuit brought within the definition of primary liability not just those who made the statement but anyone who "cause[d]" a fraudulent misstatement to be made.  Presumably actors who deliberately facilitated fraudulent financial statements by, for example, providing false documentation, would "cause" a violation.

The astounding part of the decision is its application.  As the plaintiffs make clear in their briefs (which are available at the DU Corporate Governance web site), they alleged that the transactions with the vendors had no bona fide business purpose.  Instead, the "raison d'etre was to inflate Charter's cash flow and satisfy analysts' expectations."  Add in that the vendors allegedly "falsified documentation to lend the appearance of legitimacy."  

In other words, these were transactions without economic substance and designed to allow Charter to inflate its earnings.  Yet the 8th Circuit concluded that such behavior was not a "cause" of Charter's misstatements.  This suggests that any vendor or other third party not actually engaging in the drafting process would escape liability.  This would be true even where the transaction was a sham and the third party knew that the only purpose was to commit securities fraud.   Moreover, this would be a particularly difficult type of fraud for accountants to uncover since everything would appear, as a matter of paper work, in order.

There is no doubt that extending Rule 10b-5 liability to vendors would create enormous problems, as the comment by Marc Hodak reflects.  (His blog, by the way, is here ).   At the same time, exonerating all persons not directly involved in the actual disclosure process would likewise permit a considerable amount of fraudulent activity to escape the reach of Rule 10b-5.  Understand that even if the vendors and other third parties fit within the definition of primary violator, all other elements of fraud must be proven, including scienter.  Many many vendors will ultimately escape suits because of the difficulty plaintiffs will have showing this element. 

The Supreme Court has accepted certiorari in this case.  Tomorrow we will discuss the 5th Circuit's decision in Enron. 

Primary Liability and In re Charter Communications

We bring readers today the first post written by a student seeking credit in class.  This is written by Seth Gomm, a JD/MBA student who participated in my course on the Securities Exchange Act of 1934, which I taught this Spring.  In addition to a forum for exploring issues of corporate governance, the Blog is a teaching tool, with many of the posts used to generate discussion of relevant legal issues.

On March 26, 2007, the Supreme Court of the United States granted certiorari to a case directly stemming from In re Charter Communications.

In Charter, the plaintiffs claimed that vendors of Charter, who provided Charter with set-top cable television boxes, violated §10(b) of the 1934 Exchange Act. The vendors agreed to charge Charter a $20 premium over their regular market price, the vendors then agreed to return the $20 premium to Charter in the form of advertising fees. Charter allegedly misreported the $20 premium in an attempt to inflate the company’s cash flow by $17,000,000 in the fourth quarter of 2000 in order to meet Wall Street analyst expectations.

The plaintiff’s in Charter claimed that the vendors were primarily liable for the alleged fraud under §10(b). The Supreme Court in Central Bank of Denver v. First Interstate Bank of Denver clarified that §10(b) does not extend to aiding and abetting violations. The Court nonetheless acknowledged that “[a]ny person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5 . . .”

The 8th Circuit concluded that the vendors could not be sued as primary violators under Section 10(b). The court concluded that to engage in a fraudulent scheme or contrivance required a “misstatement or a failure to disclose by one who has a duty to disclose.” The vendors were not accused of issuing any statements to the investing public and had no duty to disclose any information about Charter’s true financial condition or accounting practices. As the court stated “we are aware of no case imposing §10(b) or Rule 10b-5 liability on a business that entered into an arm’s length non-securities transaction with an entity that then used the transaction to publish false and misleading statements to its investors and analysts.” The court explained that such a finding “would introduce far-reaching duties and uncertainties for those engaged in day-to-day business dealings.”

The Supreme Court has agreed to take up the issue. Chief Justice Roberts and Justice Breyer have recused themselves so that only a majority of 4 is required to decide the potentially far-reaching liability toward vendors and other secondary parties that may have traditionally been viewed simply as aiding and abetting a primary culpable party.

If the Supreme Court rules in favor of the plaintiff in Charter, the decision could impose a heavy burden on businesses since secondary parties such as vendors could be liable under Section 10(b), greatly widening the circle of potential “deep pocket” defendants.  Secondary parties could conceivably find themselves liable for acts that had effect on companies several stages down the supply chain. An entity’s duty could be effectively extended not only to its own shareholders, but also to the shareholders of remote outside companies that it may have done business with.

For primary material on this case, go to the DU Corporate Governance web site.

Rule 10b-5 and Secondary Liability: Simpson v. AOL/Time Warner and Third Party Vendors

We are examining the reach of the antifraud provisions under the Exchange Act. As we have noted in prior posts, Section 10(b) and Rule 10b-5 do not encompass aiding and abetting liability. The question, therefore, is how far an actor must be from the actual disclosure process and still be treated as primarily liable under these provisions.

As noted, courts had little difficulty extending the concept of primary liability not just to those who made the statement, but also those involved in the drafting process. This allowed courts to hold accountable those officers and directors responsible for issuing the false disclosure. See Howard v. Everex Sys., Inc ., 228 F.3d 1057, 1061 n.5 (9th Cir. 2000) (“substantial participation or intricate involvement in the preparation of fraudulent statements is grounds for primary liability even though that participation might not lead to the actor's actual making of the statements."). Lawyers and accountants presented a harder case.

With companies going bankrupt and unable to compensate shareholders for their own false disclosure, plaintiffs searched for other actors who might provide the deep pocket necessary to recover. In Simpson v. AOL/Time Warner, 452 F.3d 1040 (2^nd Cir. 2006), plaintiffs, shareholders of the defunct company, Homestore.com, alleged that a number of vendors committed fraud by entering into transactions that enabled Homestore to misstate its revenues. In general, the transactions involved payments by Homestore for nothing in return, with the funds returned to the company, often through the purchase of advertising.

The vendors had no role in the disclosure made by Homestore. To be liable as primary actors, therefore, they had to come within the language in Rule 10b-5 extending the provision to those participating in a “scheme to defraud.”  The Second Circuit held that “to be liable as a primary violator of § 10(b) for participation in a ‘scheme to defraud,’ the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme." Participation alone would not suffice.  “[T]he defendant's own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect.”  With respect to vendors, the court noted that transactions without a legitimate business purpose could meet the test while those that did “would not typically be considered to have the purpose and effect of creating a misrepresentation.” This was true even if the vendor knew that the company would use the legitimate transaction to effectuate a fraud.

In analyzing the vendors at issue, the court concluded that none met the test of primary violator. Officials at AOL allegedly helped Homestore set up the transactions but “helping” was not enough. No act performed by AOL was alleged to have been a sham. Homestore provided funds to vendors who returned the funds to Homestore by purchasing advertising through AOL. In fact the advertising contracts were legitimate transactions, with AOL acting “as a conduit for the flow of revenue between the Third Party Vendors and Homestore as an advertising agent, in accord with AOL's advertising reseller agreement with Homestore.”  In ther deals involving Cendant, the court concluded that the fraudulent appearance did not arise from the transactions themselves but from Homestore's treatment of them. 

The decision, therefore, allowed actors directly responsible for fraudulent behavior to be sued for securities fraud but essentially required that the transactions themselves perpetuate the fraud.  In other words, the transactions had to have no real business purpose beyond creating false disclosure.  In Simpson, the court indicated that this would include payments to vendors for nothing of value with the expectation that the funds would be funneled back to the company, again for no goods or services.

The test in Simpson is a tough one to meet but provides that third party vendors can be liable where they facilitate fraud through sham transactions.  As it turns out, the cases that would follow make this test seem easy to meet by comparison.

Simpson v. AOL: defendants' conduct, not transactions are the focus in the 9th Circuit

This 9^th Circuit Court of Appeals case arose from fraudulent accounting practices employed by Homestore.com, a real estate website, in 2001. It was alleged that during the first two quarters of that year, Homestore.com entered into a series of “triangular transactions”. In these transactions, “Homestore paid a company, the company returned part of the money to Homestore by way of a different transaction, and Homestore recorded these returned funds as revenue.” The complaint alleged that an exclusive advertising agreement between Homestore and AOL was the avenue by which these improper transactions took place. According to the plaintiff, Third Party Vendors would enter into advertising contracts with AOL as the return payment for Homestore’s purchases, and AOL would then share these revenues with Homestore as part of their 1998 agreement. The plaintiff argued that this practice by the defendants; AOL, several AOL officers, another website company that was acquired by Homestore, a Third Party Vendor, and several of the Vendor’s officers, made them primary violators under §10(b) by “engaging in a scheme to defraud.”

Defendants relied on the Supreme Court’s decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 114 S.Ct. 1439 (1994) to make the argument that primary liability under §10(b) is limited “to defendants who personally made a public misstatement, violated a duty to disclose or engaged in manipulative trading activity, and not to those engaged in a broader scheme to defraud.” According to the defendants, their conduct did not give rise to primary liability because the transactions they engaged in were not deceptive in themselves, that they only became deceptive after Homestore improperly recorded them as revenues.

Recognizing that Central Bank prohibited aiding and abetting liability under §10(b) and 10b-5, the court analyzed whether or not the defendants could be held liable as primary violators “for participation in a scheme to defraud.” The court first held that primary liability requires that the defendant’s “own conduct” must have a deceptive purpose and effect; it is insufficient “that a transaction in which a defendant was involved had a deceptive purpose and effect.”

In a footnote, the court expanded on the test for “principal purpose”. According to the court, the test focuses on whether the defendant’s conduct “had a principal purpose, and not just an accidental effect, of creating a false appearance as part of a deceptive transaction or fraudulent scheme.” The court went on to distinguish this examination from the scienter requirement; explaining, “Unlike the scienter requirement, the ‘purpose and effect’ test is focused on differentiating conduct that may form the basis of a primary violation under §10(b) from mere aiding and abetting activity that the Supreme Court has held does not constitute a primary violation.”

Citing to the 8^th Circuit case In re Charter Commc’ns, Inc., Sec Litig., 443 F.3d 987, 992 (8th Cir. 2006), the court emphasized that participation in a legitimate business transaction that is lacking deceptive purpose or effect shields a party from primary liability. This is the case “even if the defendant knew or intended that another party would manipulate the transaction to effectuate a fraud.”

Applying these standards to the case at hand, the court determined that none of the defendants were liable as primary violators of §10(b). The court emphasized that the transactions themselves were not illegitimate, that they only became so after Homestore fraudulently accounted them as revenues. Merely “helping” or “assisting” the deception by Homestore was insufficient to give rise to primary liability.

The court's opinion and amicus briefs filed by the SEC can be found on the DU Corporate Governance website.

Simpson v. AOL: The SEC, an Amicus, and the Definition of Primary Liability under Rule 10b-5

The SEC has apparently agreed to support the cert petition filed by the shareholders in Regents v. Credit Suisse.  The case involves the meaning of primary liability under Rule 10b-5.

This will not be the first case involving this issue where the SEC has filed an amicus brief.  The Commission also did so in Simpson v. AOL/Time Warner.  In the brief, the Commission proposed the following test for determining when a person is considered a primary violator:

• "Any person who directly or indirectly engages in a manipulative or deceptive act as part of a scheme to defraud can be a primary violator of Section 10(b) and Rule 10b-5(a); any person who provides assistance to other participants in a scheme but does not himself engage in a manipulative or deceptive act can only be an aider and abettor."

The Commission also stated its belief that “engaging in a transaction whose principal purpose and effect is to create a false appearance of revenues” qualifies as a deceptive acts.  As the Commission opined, “[n]othing in the rules of causation suggests that only the final act in a scheme to defraud meets the causation requirement… Thus, a prior deceptive act, from which the making of the false statements follows as a natural consequence, can constitute a sufficient step in the causal chain to support a finding of reliance.”

The Court of Appeals agreed with the Commission’s that transactions intended to “create a false appearance of revenues” are deceptive acts. However, the court held this alone is not enough for primary liability. Instead, the court determined that the defendant’s “own conduct” must have the “principal purpose and effect of creating a false appearance of fact in furtherance of the scheme.”

The court’s opinion and the full text of the SEC’s amicus brief can be found on the DU Corporate Governance website.

Corporate Governance, Rule 10b-5 and Secondary LIability: What has Central Bank Wrought?

As noted yesterday, the SEC has apparently decided to weigh in to support shareholders in their effort to get the US Supreme Court to take certiorari in Regents v. Credit Suisse, a case arising out of the collapse of Enron.  The case involves the reach of Section 10(b) and Rule 10b-5 of the Exchange Act.  We are discussing these cases over the next week or so. 

We begin with a review of the relevant law.  Section 10(b) of the Exchange Act prohibits “any person, directly or indirectly,” from employing a “manipulative or deceptive device or contrivance” in contravention of any rules of the Commission. Rule 10b-5 in turn prohibits a person from making an “untrue statement of material fact” or from employing “any . . . scheme . . . to defraud.”

The starting place in this area isCentral Bank v. First Interstate of Denver, 511 US 164 (1994). The case is not an easy precedent.  Despite unanimity by all of the circuits considering the issue, the Supreme Court found, in a 5-4 vote, that Section 10(b) and Rule 10b-5 did not encompass liability for aiding and abetting securities fraud.  In reaching the conclusion, the Court did not rely on any language in the relevant relevant rules or sections but the absence of language.  See Id. at 177 (“If, as respondents seem to say, Congress intended to impose aiding and abetting liability, we presume it would have used the words "aid" and "abet" in the statutory text.  But it did not.”).

The only slight exception was the discussion of the language in Section 10(b) that prohibited fraud committed “directly or indirectly.”  The majority noted that this language did not encompass "aiding and abetting" liability.  “[A]iding and abetting liability extends beyond persons who engage, even indirectly, in a proscribed activity; aiding and abetting liability reaches persons who do not engage in the proscribed activities at all, but who give a degree of aid to those who do.”  The Court, therefore, concluded that the two phrases were not synonymous but otherwise provided little guidance into what the phrase actually meant.

Nor did the analysis of the facts of the case provide much insight into the reach of the provision.  Central Bank was an indenture trustee for an earlier set of bonds issued by a Building Authority largely controlled by a developer. In advance of a second issue of bonds, Central Bank (which would serve as indenture trustee for this issuance as well) learned that an appraisal for property to be used as collateral for the second issue appeared “optimistic.”   Moreover, Central Bank allegedly knew that the appraisal would be used by purchasers.  The Court did not analyze these facts and explain why they resulted in secondary rather than primary liability.  Instead, the majority viewed the characterization of the Plaintiffs as conclusive.  

• “Respondents concede that Central Bank did not commit a manipulative or deceptive act within the meaning of § 10(b). Instead, in the words of the complaint, Central Bank was ‘secondarily liable under § 10(b) for its conduct in aiding and abetting the fraud.’ Because of our conclusion that there is no private aiding and abetting liability under § 10(b), Central Bank may not be held liable as an aider and abettor.”

In other words, since the Plaintiffs argued only that Central Bank met the definition of primary violator (and why should they, since all circuits recognized aiding and abetting liability), the Court would not go beyond that characterization.  See 511 US at 193 ("While we have reserved decision on the legitimacy of the theory in two cases that did not present it, all 11 Courts of Appeals to have considered the question have recognized a private cause of action against aiders and abettors under § 10(b) and Rule 10b-5.") (Stevens, J., dissenting).

The only real insight into primary liability was an off-handed piece of dictum. The Court noted that secondary actors in the securities markets were not entirely exonerated from liability under the antifraud provisions.  “Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5, assuming all of the requirements for primary liability under Rule 10b-5 are met.”  And, as the Court reasoned, in “any complex securities fraud, moreover, there are likely to be multiple violators; in this case, for example, respondents named four defendants as primary violators.”   The persons named by the plaintiffs as primarily violators included the Building Authority, two underwriters and a director of the developer.  Thus, the Court seemed untroubled by the notion that liability extended beyond the issuer at least to those selling the securities. 

The case, therefore, contains little affirmative insight into the type of behavior that will suffice to establish primary liability beyond those who actually make the false statement.  It is possible, however, that the Court viewed the facts in the case as insufficient to establish primary liability.  If so, they tell us something about the limits of primary liability.  Unfortunately, there are several possible lessons.   

First, it is possible that Central Bank was not primarily liable because it made no affirmative statement about the appraisal to prospective investors.  While some language in the case suggests this interpretation, it is contradicted by the Court's approving reference to the decision by Plaintiffs to treat the underwriters and director of the developer as primary violators. 

Second, it is possible that Central Bank was not subject to primary liability because, as an indenture trustee, it had no role in the bond offering (although it did benefit by serving as trustee once the bonds were sold). Central Bank did not participate in the drafting of the offering circular, had no right to review the disclosure, and was not a seller or underwriter. In this context, Central Bank was in a better position than most accountants and lawyers who to some degree participate in the disclosure process or underwriters who sell the bonds and distribute the disclosure documents.

Third, Central Bank may have avoided primary liability because it played no affirmative role in the fraud.  The appraisal was prepared by the developer, not Central Bank. Moreover, Central Bank was responsible for the appraisal of the property in the first bond offering, not the impending second offering.  Moreover, Central Bank did not know the appraisal was false but was only “aware of concerns” about its accuracy. In other words, Central Bank’s role was to fail to interject itself into a disclosure process over information that it had not provided and was not known to be false.

These interpretations lead to very different results.  The need to make an actual misstatement (or omission) would exonerate those who drafted but did not make the statement.  The need to have actual involvement in the disclosure process extends liability to those who drafted but exonerates those who knowingly provided false information used to commit the fraud.  The need to play an integral role in the fraud would extend liability to those who knowingly participated in the fraudulent behavior.  

Subsequent posts will examine the path taken by the lower courts in the aftermath of Central Bank. 

The SEC Speaks: Corporate Governance and Secondary Liability under the Antifraud Provisions

We note that the Washington Post is reporting today that the SEC has decided to ask the solicitor general to file a brief supporting the cert petition sought by shareholders in the Enron case, Regents v. Credit Suisse, 482 F.3d 372 (5th Cir. 2007).  In that case, the 5th Circuit adopted a restrictive interpretation of primary liability under Rule 10b-5, one that excluded the investment banking firms sued in connection with the collapse of the energy giant.  The Supreme Court has already taken a case that will address this issue, In re Charter (Stoneridge v. Scientific-Atlanta), 443 F.3d 987 (8th Cir. 2006).  For a discussion of the possible line up of the Justices on these cases, go to my post on the Harvard Corporate Governance Blog.  We will be writing about these cases as the week progresses. 

Corporate Governance and the Liability of Secondary Actors

One of the most significant issues currently making the rounds in the various federal circuits (and, as we shall discuss, the US Supreme Court) concerns the definition of primary liability under Section 10(b) and Rule 10b-5. This has been an issue since the Supreme Court’s surprise decision in Central Bank more than a decade ago. See Central Bank v. First Interstate Bank of Denver, 511 U.S. 164 (1994). A sleepy case from the Tenth Circuit (involving the application of aiding and abetting liability to an indenture trustee), the Supreme Court used it as a vehicle to address and then discard aiding and abetting liability under the antifraud provisions.  This was no accident.  It was the Supreme Court that asked to have the issue briefed. See 508 US 959 (1993).  

As anyone familiar with this area knows all too well, Central Bank generated immediate pressure on the meaning of primary violator.  The provision most obviously applied to anyone actually making a false statement.  But much of the disclosure litigated in securities class action suits is made by the company.  To the extent limiting the provision to those actually making the statement, the antifraud provisions would not extend to the persons responsible for the false disclsoure. 

As a result, primary liability was extended not just to the person making the statement but to those involved in the drafting process (and as a corollary, to those who signed the disclosure document).  Absent special circumstances, this approach generally exonerated most outside directors (although this could change given the heightened responsibilities of independent directors on the audit committee).

How far the doctrine extended outside the company, however, was a more difficult issue to resolve. In general, the cases decided after Central Bank typically involved accounting firms and lawyers, persons not employed by the company but having some role in the actual disclosure process. The law in the area was divided but in general primary liability required some involvement in the fraudulent disclosure.  

Worldcom, Enron and the fallout from the dot com boom, however, focused attention on other categories of actors. With the issuer of the statement often bankrupt, plaintiffs cast about for deeper, more solvent, pockets.  Looking beyond accountants and lawyers, a number of fraud actions were brought against third party vendors and investment banking firms alleging that each was primarily liable under Rule 10b-5.  Three such cases have been decided at the circuit level over the last year.  In Simpson v. AOL Time Warner, 452 F.3d 1040 (9^th Cir. 2006) and In re Charter Communications, 443 F.3d 987 (8^th Cir. 2006), the two courts addressed allegations of sham transactions between the company and vendors that facilitated the company's ability to commit fraud. In Regents v. Credit Suisse First Boston (USA), Inc ., 2007 U.S. App. LEXIS 6396 (5th Cir. March 19, 2007), the Fifth Circuit addressed the primary liability of investment banking firms employed by Enron.

The cases are attempting to set the boundary of Rule 10b-5 by construing the meaning of primary liability.  They are not about state of mind.  As a result, they assume that the vendors and investment banking firms know that the transactions will result in financial fraud.  In two of the cases, Charter and Credit Suisse, the courts determined that primary liability only extended to those actors that had a duty to disclose.  Since investment banks and third parties did not, they could not be liable under Rule 10b-5 even for allegedly sham transactions used by the issuer to inflate earnings.  Simpson took a different approach, finding that a scheme to defraud under Rule 10b-5 extended to anyone who engaged “in a transaction, the principal purpose and effect of which is to create the false appearance of fact. . .”

The case is before the Supreme Court. The Court took certiorari in Charter Communications. See 127 S. Ct. 1873 (March 26, 2007).  Justices Breyer and Roberts took no part in the decision to grant certiorari, suggesting that they may be recused.  Of the remaining seven, three were in the majority in Central Bank (Kennedy, Scalia and Thomas) and three were in the dissent (Ginsburg, Stevens and Souter). To the extent this line up continues to hold, Justice Alito will decide the outcome. 

We will explore this area over the next several days. Students will contribute a number of posts.