Will the Supreme Court Widen the Door for Liability Against Secondary Actors for Securities Fraud?
Chances are your company has not recently restated its financial results or been involved with any other company’s issuance of securities. You probably think that your company has no chance of being sued for federal securities fraud. Think again. If your company has done business with a financially troubled company that has used those transactions to improve the appearance of its finances, it could find itself named as a defendant in a federal securities fraud class action under the legal standard being applied by some courts.
With the collapse of companies like Enron and the increasing number of corporate scandals in the marketplace over the past few years, securities plaintiffs are casting wide nets in search of defendants with the resources to pay multi-million dollar judgments or settlements in securities fraud cases. Plaintiffs are increasingly attempting to hold those who assist a financially troubled company responsible for misstatements made about its financial results. These parties—which have historically included professionals such as accountants, investment bankers and lawyers—are often referred to as secondary actors. But this category has recently been expanded by some courts to include vendors who sell products to a financially troubled company when those transactions are used to manipulate that company’s financial results.
Creative plaintiffs’ lawyers have argued that secondary actors can be responsible for securities fraud committed by another company because they were supposedly part of a scheme or device to defraud the shareholders of that other company. Within the past year, three U.S. Circuit Courts of Appeals have issued opinions discussing under what circumstances a secondary actor may be liable for the material misrepresentations of another company because it was part of a scheme to defraud the investors of that other company. The Fifth and Eighth Circuits have taken a fairly narrow view of when secondary actors can be liable as part of a scheme to defraud, while the Ninth Circuit has taken a more expansive view.
In light of these conflicting decisions, the United States Supreme Court agreed to address this issue in its next term and may provide more guidance as to when secondary actors are potentially liable as part of a scheme to defraud.
Federal Securities Fraud Law and Central Bank
Section 10(b) of the Securities Exchange Act of 1934 is the primary statutory provision under which private plaintiffs sue when bringing federal securities fraud claims. It makes it unlawful for any person, in connection with the purchase or sale of a security, to directly or indirectly use or employ "any manipulative or deceptive device or contrivance in contravention" of SEC regulations. SEC Rule 10b-5 is the centerpiece of most securities fraud complaints.
Rule 10b-5 contains the well-known subsection that prohibits material misstatements and omissions in connection with the purchase or sale of securities. In addition, Rule 10b-5(a) prohibits a person from employing a device, scheme, or artifice to defraud, and Rule 10b-5(c) prohibits a person from engaging in any act, practice, or course of business that operates as a fraud or deceit upon any person, in each case in connection with the purchase or sale of any security.
The United States Supreme Court seemingly gave secondary actors a solid defense to charges of securities fraud in its decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. in 1994. In that case, the court ruled there is no aiding and abetting liability for private claims brought under Section 10(b) and Rule 10b-5. After Central Bank, a person who merely helps or assists another in a course of conduct that is alleged to be securities fraud cannot be held liable. Instead, a person must have personally and deliberately engaged in a separate fraudulent act—in other words, they must be a so-called "primary violator"—in order to have broken federal securities law.
Since the Central Bank case, however, courts have taken divergent views on what actions are required for a secondary actor to cross the line from just "aiding and abetting" someone else’s securities law violation to becoming a primary violator itself. The current debate focuses on Rule 10b-5(a) and (c) and asks when a party can be liable as part of a "scheme to defraud" when it did business with or provided services to a public company but made no public statements itself regarding that public company’s financial statements or condition.
Judicial Split on Scheme Liability Under Section 10(b) and Rule 10b-5
In In re: Charter Communications, Inc. Securities Litigation, the Eighth Circuit held that secondary actors can be liable for federal securities fraud only in limited circumstances: when a secondary actor makes or affirmatively causes to be made a fraudulent misstatement or omission, or when a secondary actor directly engages in manipulative securities trading practices.
In this case, the plaintiffs claimed that Charter Communications engaged in a fraudulent scheme to artificially boost the company’s reported financial results. The plaintiffs sued not just the company and several of its officers, but also two equipment vendors of the company. According to the plaintiffs, these vendors entered into sham transactions with the company in which Charter allegedly agreed to pay the vendors an extra $20 per piece of equipment in exchange for the vendors returning this extra payment to Charter in the form of advertising fees. Charter then allegedly used fraudulent accounting for these sales and artificially inflated its cash flow by $17 million in one quarter to meet the expectations of Wall Street analysts. Despite the fact that none of the vendors made any misleading statements about these sales directly to the public, the plaintiffs contended that the vendors could be liable for participating in a scheme to defraud Charter’s shareholders.
The Eighth Circuit disagreed, upholding the dismissal of the plaintiffs’ securities fraud claims against the vendors. The court ruled that the plaintiffs had not alleged a primary violation of federal securities law against the vendors. It refused to impose liability under Section 10(b) and Rule 10b-5 on a business that entered into arm’s-length business transactions with a company that then used those transactions to make false statements about its financial condition to its shareholders.
In rejecting the plaintiffs’ contention that they had alleged a primary violation against the vendors based upon scheme liability, the Eighth Circuit articulated three governing principles for primary violations of Section 10(b), all based upon Central Bank. First, Rule 10b-5 cannot prohibit conduct that would not be prohibited by the language of Section 10(b) and the Supreme Court’s interpretation of that language. Second, a device or contrivance is not deceptive, within the meaning of Section 10(b), absent some misstatement or a failure to disclose by one who has a duty. Third, manipulation, within the meaning of Section 10(b), is a term of art that applies to manipulative securities trading practices, such as wash sales, matched orders or rigged prices.
Following the reasoning of the Eighth Circuit, the Fifth Circuit recently issued a similar decision in Regents of the University of California v. Credit Suisse First Boston (USA), Inc. This decision is part of the ongoing litigation related to Enron’s collapse and involved the plaintiffs’ claims of securities fraud against investment banks that did business with Enron. The plaintiffs alleged that the investment banks participated in a scheme to defraud Enron shareholders by misrepresenting the company’s financial condition. More specifically, the plaintiffs claimed that the investment banks entered into sham transactions with Enron in which they agreed to "buy" certain assets from Enron, but where Enron guaranteed that it would buy back the same asset at a premium at a later date. Enron then improperly accounted for these transactions by treating them as sales, as opposed to loans. This allegedly allowed Enron to fraudulently remove liabilities from its financial statements and improperly book revenue when it was actually incurring debt.
In Regents, the Fifth Circuit overturned the decision of the district court certifying a class action for securities fraud against the investment banks. The decision focused on whether the plaintiffs had satisfied the requirements for class certification under Rule 23 of the Federal Rules of Civil Procedure. In analyzing the plaintiffs’ securities fraud claim in this class certification context, the Fifth Circuit ruled that because the investment banks made no public, material misrepresentations about Enron and because the banks owed no duty to Enron’s shareholders, the district court’s certification of a class action amounted to holding the investment banks potentially liable for aiding and abetting Enron’s securities fraud.
The Fifth Circuit concluded that the district court had based its decision on too broad a definition of a deceptive act within the meaning of Section 10(b). In so doing, the Regents court adopted the reasoning of the Eighth Circuit in Charter. It held that a plaintiff could not establish a Section 10(b) claim unless the defendant engaged in a deceptive or manipulative act. Furthermore, it held that within the context of federal securities fraud, deceptive conduct must involve either a material misstatement of fact or a material omission by one who has a duty to disclose, while manipulative conduct must involve conduct that takes place directly within the market for the relevant security.
By contrast, the Ninth Circuit has taken a much broader view of liability for secondary actors. In Simpson v. AOL Time Warner, Inc., it recognized the validity of scheme liability under Section 10(b) where the defendant did not make a fraudulent statement or omission itself. The Ninth Circuit held that a party can be liable as a primary violator of Section 10(b) for participating in a scheme to defraud if the defendant engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme. Under this rule, it is not enough if the defendant is involved in a transaction with a deceptive purpose and effect. Instead, the defendant’s own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect.
In Simpson, the plaintiffs alleged that the defendants also engaged in a scheme to defraud by overstating the reported revenues of an Internet real estate company, Homestore.com. According to the plaintiffs, Homestore first entered into two legitimate contracts with AOL, one in which Homestore became the exclusive real estate listing product on AOL and the second in which AOL agreed to sell advertising on Homestore’s Web site for a commission. The plaintiffs sued AOL and vendors of Homestore for their participation in "triangular transactions" involving these contracts. The plaintiffs claimed that Homestore entered into sham transactions with certain vendors for products or services it did not need, that these vendors would then contract with AOL for advertising on Homestore’s Web site, and that AOL would then give this money back to Homestore under their advertising reseller agreement. Through these transactions, plaintiffs alleged, Homestore purchased revenue for itself, recorded that revenue in violation of SEC accounting rules, and thus overstated its revenue by $170 million.
In its ruling, the Ninth Circuit rejected the defendants’ arguments that imposing liability for participating in a scheme to defraud would conflict with Central Bank. The court found no justification for limiting liability under Section 10(b) only to those who participate directly in the making of material misrepresentations or omissions. The court also concluded that it was not inappropriately assigning liability for "aiders and abettors" of securities fraud because the focus of the inquiry is on the deceptive nature of the defendant’s own conduct.
With different standards being applied by the circuit courts, it was perhaps not surprising that the Supreme Court recently agreed to hear an appeal of the Charter decision next term. The case is likely to be argued in the fall, with a decision expected
by mid-2008.
Looking Ahead
The Supreme Court’s decision in the Charter case will hopefully provide clarity as to the circumstances under which secondary actors can be liable for securities fraud. Some commentators are already predicting that it could be the most important securities law decision to be issued by the court in many years to the extent that it addresses the circumstances under which secondary actors may be deemed as "primary violators" under the federal securities laws. As a result, this decision may have great significance, not just for those who advise public companies—such as accountants, investment bankers, and lawyers—but also for other companies that provided goods and services to a company accused of committing securities fraud.