In writing about the series of cases at the Supreme Court on primary liability (the Court has accepted certiorari in Stonebridge and has not ruled on the petition in Regents v. Credit Suisse), the focus has been on whether Rule 10b-5 reaches vendors, investment bankers, and other third parties.  Lost in the discussion is how far Rule 10b-5 can reach within the corporation itself. 

Alleged fraud at issue in securities class action law suits is usually based upon disclosure made by the company.  In general, the courts have allowed suits against those officers and directors who participated in the drafting process and/or signed the false statements.  Nonetheless, it is also unclear how far Rule 10b-5 reaches within the company. 

An interesting case in this context is SEC v. Todd, a case out of the Northern District of California.  In that case, the SEC brought an action against, among others, John Todd, the former Senior Vice President and CFO of Gateway.  The Commission alleged a violation of Section 17(a) of the Securities Act.  Specifically, the Commission claimed that Todd made false statements in connection with a prospectus supplement filed with the Commission on September 15, 2000.  Todd did not sign the supplement or otherwise participate in the drafting.  Instead, the supplement incorporated by reference a Quarterly Report on Form 10-Q that the Commission alleged was inaccurate.  Todd signed the Quarterly Report. 

The jury returned a guilty verdict, finding, among other things, that Todd violated Section 17(a)(1)(language substantially identical to Rule 10b-5(a)), with the verdict specifically stating that he had violated the section "through a prospectus supplement dated September 15, 2000, which incorporated Gateway's second quarter 2000 Form 10-Q"  The jury verdict will be on the DU Corporate Governance web site later today.  Todd moved for a directed verdict, which the court granted.  The court found that the signing of a quarterly report that was incorporated into the supplement by reference was not enough to establish liability. 

• "The SEC asserts that 'the fact that Todd did not physically file the Supplement himself is irrelevant.' The Court agrees with this statement, and if the only piece of evidence missing was Todd's walk to the mailbox with the supplement, the statement would be relevant. But that is not the case. The sole connection between Todd and the prospectus supplement was the Q2 2000 10-Q which he signed and which was incorporated by reference in the supplement. There was no evidence presented at trial that Todd had even seen the prospectus supplement before, let alone been involved in its preparation, directly or indirectly."

The court went on the describe the dire consequences that would occur if the decision had been different.  "If the Court were to allow the verdict to stand on this claim, it would in essence allow potential liability in perpetuity for documents signed by an officer of a company, regardless of whether that officer has any knowledge or control over their future use."

Liability in perpetuity?  Hyperbole.  There are statute of limitations.  Besides, the report would eventually be superseded by later filings. 

More importantly, the analysis conflicts with the notion of incorporation by reference.  The purpose of the doctrine is to facilitate offerings by allowing companies to incorporate periodic reports into a registration statement without having to repeat the information.  The material incorporated into the prospectus is generally considered to be part of the prospectus, subject to liability as if it had appeared in the document itself.  See Securities Act Release No. 8591 (July 19, 2005) ("Once a communication or other document is made part of or incorporated by reference into a registration statement, Section 11 applies to it as part of the registration statement, whether or not it is an offer.").  Had there been no incorporation by reference, the prospectus supplement would have had to include the relevant information directly.  In those circumstances, it would seem that Todd could be liable for the false disclosure in the supplement, whether included directly or incorporated by reference. 

The court in Todd never discussed the primary liability cases.  The court did, however, decline to extend liability to someone who, while not responsible for the drafting process, provided information used in the false disclosure.  Sound familiar?  It's more or less what the vendors allegedly did in Stoneridge.  Whatever the Supreme Court says about vendors in that case, it may have considerable repercussions for those who provide false information that becomes part of the fraud committed by the company.