Courts Tackle Liability Of ‘Secondary Actors’

The liability of so-called “secondary actors”—the investment banks, vendors, and others who might help a company commit securities fraud—is taking center stage in the courtroom these days. Though Compliance Week has covered this issue extensively over the past few years (see box below, right), the topic has again risen to the forefront in recent weeks, as several appeals courts have made split rulings on the issue and the U.S. Supreme Court has agreed to weigh in.

Most recently, the New Orleans-based 5th U.S. Circuit Court of Appeals overturned a decision that would have let Enron stockholders continue a class-action lawsuit against the banks that loaned money to the now-defunct poster child of corporate malfeasance. The appellate panel said such an action was impermissible because there was no showing that the financial institutions had a duty to shareholders. At worst, the banks were aiders and abetters—and consequently, not subject to private litigation under federal securities laws.

The ruling comes at a time when plaintiffs increasingly target secondary actors for civil litigation. Such entities already can be held liable by the Securities and Exchange Commission for aiding and abetting fraud, and some state laws allow similar exposure as well. But for civil litigation in the federal arena, under the Securities Exchange Act the liability of secondary actors is generally limited to circumstances in which they become primary violators of the law.

The 5th Circuit decision came just days before the U.S. Supreme Court agreed to hear an appeal from the St. Louis-based 8th Circuit, involving the question of whether a secondary actor that participated in a deceptive scheme can be treated as a primary actor. That case, Stoneridge Investment v. Scientific-Atlanta, is not expected to be argued until the fall.

Masella

James Masella, a partner with the law firm Blank Rome, calls the 5th Circuit decision in the Enron case “one of the most important in recent years,” and says it “signals that courts will no longer countenance frivolous lawsuits aimed at big-pocket defendants.”

The banks in this case “did nothing more than act like banks,” Masella says. “It was Enron, not the banks, alleged to have defrauded Enron shareholders. There’s no rational justification for imposing on financial institutions the duty to hire hundreds of accountants and lawyers and compliance people to go and monitor each and every one of their clients’ statements to shareholders to make sure those statements are correct.”

Schwinger

Robert Schwinger, a partner with the Chadbourne & Parke law firm, emphasizes that the court wasn’t necessarily approving of the banks’ conduct in the Enron case; “it just was not actionable,” he says. “This case knocks down some of the current techniques that have been flowing around to try to get at banks, lawyers and others.”

False Appearances

The plaintiffs in the suit, Regents of the University of California v. Credit Suisse First Boston were purchasers of Enron securities who accused the financial institutions of entering into partnerships and transactions that allowed Enron to take liabilities off of its books temporarily and to book revenue from the transactions when it was actually incurring debt. The common feature in these transactions, the plaintiffs said, was that they allowed Enron to misstate its financial condition.

The plaintiffs did not allege that the banks had a fiduciary relationship with the Enron shareholders, that they improperly filed financial reports on Enron’s behalf, or that they engaged in manipulative activities directly in the market for Enron securities. But, the plaintiffs said, the banks knew why Enron was engaging in what the court called “seemingly irrational transactions” and intended to profit by the fraud.

The banks moved to dismiss the suit, arguing that at most they only aided Enron’s fraud. But a judge refused to dismiss the suit, finding that the banks faced liability as primary violators because they were alleged to have committed a “deceptive act” by participating in a “transaction whose principal purpose and effect is to create a false appearance of revenues.” The trial judge then gave class certification to all people who had purchased Enron stock between Oct. 19, 1998, and Nov. 27, 2001. The 5th Circuit agreed to hear the banks’ appeal of the class certification before trial.

THE IMPLICATIONS

The excerpt below is from a Gibson, Dunn & Crutcher publication titled, "Fifth Circuit Narrows Scope Of Liability Under Federal Securities Anti-Fraud Statute, And Rejects Class Certification in Enron Securities Litigation," published March 22, 2007.

Please note that references to Charter regard an 8th Circuit decision from 2006 that found a 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 § 10(b) or any subpart of Rule 10b-5." References to Simpson regard a 9th Circuit decision from 2006 that found "[T]o 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.":

Implications of the Fifth Circuit Decision

...The financial press is reporting that the immediate impact of the Fifth Circuit decision is that the trial of the case that was scheduled to commence on April 9, 2007 has been postponed. Bill Lerach, counsel for the plaintiffs, is quoted as saying the Fifth Circuit decision is "unfair and wrong" and has indicated that the plaintiffs likely will appeal to the U.S. Supreme Court.

The Fifth Circuit decision may encourage the U.S. Supreme Court to accept review of the Eight Circuit's decision in Charter or the Ninth Circuit's decision in Simpson, on the issue of the scope of primary liability under Section 10(b). In Charter, as noted earlier, the Eighth Circuit held that there is no primary liability under Section 10(b) unless a defendant actually makes a misrepresentation or omission or directly engages in a manipulative securities trading practice. 443 F.3d at 992. In Simpson, the Ninth Circuit expressed a more expansive view of primary liability, under which a secondary actor who makes no misrepresentation or omission, but who engages in conduct for the principal purpose of creating a false financial appearance, may be held primarily liable under Section 10(b). 452 F.3d at 1048. The Fifth Circuit has aligned itself with the Eighth Circuit. Petitions for certiorari in both Charter and Simpson are currently pending before the U.S. Supreme Court.

Finally, the Fifth Circuit decision may encourage the U.S. Supreme Court to resolve the conflict among the circuits over the standards for class certification under Rule 23 of the Federal Rules of Civil Procedure. In agreeing to consider the "merits" issues presented to the trial court in connection with class certification, the Fifth Circuit effectively aligned itself with the Second Circuit. In its decision in In re IPO Public Offerings Securities Litigation, 471 F.3d 24, 41 (2d Cir. 2006), the Second Circuit held that a district court must resolve factual disputes relevant to each Rule 23 requirement, even if the factual disputes overlap with or are identical to a merits issue. By contrast, in its recent decision in Dukes v. Wal-Mart, 474 F.3d 1214, 1227 (9th Cir. 2007), the Ninth Circuit stated that "arguments evaluating the weight of evidence or the merits of a case are improper at the class certification stage."

Source

Fifth Circuit Narrows Scope Of Liability Under Anti-Fraud Statute, And Rejects Class Certification In Enron Litigation (Gibson, Dunn & Crutcher)

The appellate court said that the merits of the suit had to be addressed to determine whether class certification was proper. The court went on to find that the trial judge improperly presumed individual reliance of the shareholders, and that a class cannot be certified when individual reliance of shareholders on the allegedly fraudulent conduct is an issue.

The banks, the court said, “did not owe plaintiffs any duty to disclose the nature of the alleged transactions” because no fiduciary relationship existed between them. And the plaintiffs couldn’t rely on a “fraud on the market” theory because the banks had no duty to disclose that their conduct might be deceptive. “[T]he facts alleged do not constitute misrepresentations on which an efficient market may be presumed to rely,” the court ruled.

Legal Confusion

Wolff

Sarah Wolff, head of securities litigation for the law firm Reed Smith, says “there is so much confusion” and “so many conflicting opinions” about the liability of secondary actors, that greater certainty is vital—and which, hopefully, the Supreme Court can deliver when it hears Stoneridge Investment next term.

Although other courts have ruled the same way as the 5th Circuit on the issue of scheme liability for secondary actors, the Enron decision “is an important one in an obviously highly sensitive securities case,” Wolff says.

Horowitz

Robert Horowitz, a partner with Greenberg Traurig in New York, says the Enron case is “an example of why you wouldn’t want liability extended” to secondary actors for aiding and abetting fraud. “In this case, the result would have been outrageous,” he says. “The banks were facing absolutely extraordinary liability. The district court had held that each of the banks were liable for the all of the damages suffered by the plaintiffs.”

Richard Hans, a partner with the Thacher Proffitt & Wood law firm, notes that the plaintiffs in the Enron case could still try to maintain individual actions against the banks, just not as a class. But the appellate court’s rulings that the banks’ conduct cannot be classified as deceptive and that there was no duty to disclose would still be a challenge for plaintiffs who “try to reconstruct their cases on an individual basis.”

Hans

Banks and other financial institutions “can definitely take some solace” in the decision despite the unsavory Enron name being attached to it, Hans says. Defendants may also benefit from the willingness of appellate courts to scrutinize class certifications more closely.

“Because of the onerous effect of a class certification and the prospect of an enormous damage award, courts are more often allowing folks to take the class certification rulings up on appeal immediately,” Hans says. He adds that the merits of the underlying claim are being subjected to greater scrutiny during such appeals, as was the case in the Enron ruling.