• Advisory Professionals Can Be Held Liable for Securities Violations
  • April 29, 2003
  • Law Firm: Pillsbury Winthrop LLP - Office
  • District Court Takes Middle Ground

    The Supreme Court sharply limited secondary actor liability in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1993). The Court there noted that neither the Securities Act of 1933 nor the Securities Exchange Act of 1934 expressly provided for a private cause of action against those who aid and abet primary violators of those statutes. Accordingly, the Court held that there was no basis for aiding and abetting liability for securities fraud claims under §10(b) of the 1934 Act.

    Since Central Bank, the question of primary liability for secondary actors has become more significant, but courts have diverged over the appropriate standard. The Second Circuit follows a "bright line" rule: (i) a secondary actor must make material misrepresentations regarding a securities purchase or sale, (ii) the statements must be publicly attributed to the secondary actor, and (iii) the secondary actor must have known or should have known that its statements would be made public. In contrast, other courts, including the Ninth Circuit, have used a "substantial participation" test. Under this more liberal rule, a secondary party may be primarily liable if it is found to have "substantial participation or intricate involvement" in preparing fraudulent statements, even if another party actually issues those statements and they are not attributed to the secondary party.

    The SEC, in 1998, in an amicus brief filed with the Third Circuit Court of Appeals, advocated a middle ground. The case was settled before the Third Circuit addressed the SEC's position. The SEC rarely submits briefs to district courts in cases in which it is not a party; however, it resubmitted its Third Circuit amicus brief to the Enron court. In the SEC's view, a secondary actor can be primarily liable for making material misrepresentations whether the actor is publicly identified or not. The SEC argued that a secondary player is primarily liable when he, she, or it, "acting alone or with others, creates a misrepresentation . . . ."

    Enron's Professionals Alleged to Have Violated SEC Rules

    This ruling arose from the highly publicized Enron meltdown. On October 22, 2001, holders of bonds issued by Enron filed a class action suit against the company in Texas district court. Plaintiffs alleged that, beginning in 1997, Enron, in a series of transactions, transferred overvalued assets in illusory "sales" to shell companies whose close relationship to Enron was concealed. The result was to remove liabilities from Enron's balance sheet and generate false profits, permitting Enron to meet projected financial goals and maintain high credit ratings. Plaintiffs also sued a number of investment banks, two law firms, and the accounting firm Arthur Andersen for their alleged complicity in these schemes. On May 8, 2002, these defendants (the Advisor Defendants) moved to dismiss the claims against them, asserting that they had no primary liability under § 10(b) and SEC Rule 10b-5.

    Plaintiffs, however, claimed that the Advisor Defendants were primary actors in the fraud schemes and had intimate knowledge (or were reckless in not knowing) of Enron's faltering finances. The investment banks' analysts allegedly fraudulently touted Enron securities to the investing public, while the banks underwrote securities sales and assisted in financing and structuring Enron's numerous shell companies.

    The law firms purportedly helped to structure shell entities, issued false opinions, and represented the shell entities in their dealings with Enron. Arthur Andersen was claimed to have structured illicit transactions and issued reports falsely certifying Enron's financial stability. The Advisor Defendants purportedly did this to gain and maintain the lucrative fees that Enron provided in exchange for their services.

    District Court Offers Guidance on the Reach of Liability

    Although Judge Harmon agreed that aiding and abetting a securities violation would not give rise to liability for securities fraud, she noted that the Supreme Court also acknowledges that secondary actors are not immune from primary liability. Observing that the SEC was expressly delegated the authority to promulgate rules to implement § 10(b), Judge Harmon adopted the middle-ground SEC-proposed standard. The district court rejected the Second Circuit's bright-line test, stating that the test allowed secondary actors to escape primary liability by merely concealing their role from the public. The court concluded that the Second Circuit failed to interpret the SEC rules so as to effectuate their purpose. The "substantial participation" test was, however, too broad, according to the court. Without a more precise definition of "substantial participation" or "intricate involvement," the test left open a large grey area between primary and accessory liability.

    Judge Harmon viewed the SEC interpretation as providing sufficient flexibility of enforcement while avoiding the vagueness of the substantial participation test. Under the SEC test, the secondary actor need not be the initiator of the misrepresentation, although it must have drafted the disclosure at issue. A party who prepares a truthful statement would not be liable for misrepresentations elsewhere in the document, even if he or she knew the other statements were false, according to the SEC. For a secondary party to be liable, the court emphasized that a plaintiff must still plead and prove scienter and reliance on the false statement (although not on the fact that the secondary actor drafted the statement). Further, the court observed that under the Private Securities Litigation Reform Act, Pub. L. No. 104-67, 109 Stat. 737 (codified in scattered sections of 15 U.S.C.), a reckless secondary actor will only be liable for the damage caused by his or her misstatement, and not for damages caused by others' misstatements. A knowing participant in a fraudulent scheme, however, might face greater liability.

    Although the court adopted the SEC interpretation, backed by the state Attorneys General, it refused to accept the Attorneys General's argument that conspiracy liability still existed.

    Application of Test Results in Dismissal of Some Claims

    Judge Harmon, applying the SEC test, dismissed the complaint against Lehman Brothers, Bank of America, Deutsche Bank, and Kirkland & Ellis. With respect to the investment banks, she found that high returns alone on an investment in a shell company did not demonstrate participation in a scheme to defraud. Regarding Kirkland & Ellis, a law firm that represented the shell companies in their dealings with Enron, Judge Harmon held that, because the firm's statements were not communicated to the public, the firm could not be held primarily liable for securities fraud.

    Judge Harmon, however, did not dismiss the claims against JP Morgan Chase & Co., Citigroup, CSFB, CIBC, Barclays, Vinson & Elkins, and Arthur Andersen. She found that JP Morgan, Citigroup, and CIBC's alleged knowledge of Enron's poor finances made its analysts' touting of Enron securities to the public misleading and potentially fraudulent. With respect to JP Morgan and CSFB, the court decided that sham loans disguised as commodities trades to Enron were sufficient allegations of manipulative acts. For CSFB, CIBC, and Barclays, she determined that participation in the structuring and funding of shell companies and high-risk deals while misleading the public about their true nature gave rise to a viable claim of securities fraud. Vinson & Elkins' help in structuring shell companies and allegedly communicating false information (via misrepresentations in SEC filings drafted and approved by the firm) would be communication with the public sufficient to support a claim of primary liability. For Arthur Andersen, alleged misrepresentations in financial statements that the firm approved for use in public documents satisfied the requirement for primary liability.

    Indirect Communication With Public May Expose Professionals to Liability

    Prominent cases, like the federal government's antitrust case brought against IBM, often generate headlines, but sometimes prove to have little impact on the development of the law. It is accordingly hard to assess at this time how influential Judge Harmon's decision will be on future cases. Moreover, it is unclear whether the decision will ever be reviewed by the Fifth Circuit because large cases like Enron are often settled before they reach the appellate stage. Perhaps the more significant aspect of the Enron case is that the SEC continues to feel so strongly about the appropriateness of its test that it was willing to make an exception to its policy of not submitting amicus briefs to district courts. The state Attorneys General also were prepared to lobby the court to adopt the SEC's view. Given this, a third party should not assume that anonymous participation in the drafting of an allegedly false statement concerning a securities transaction could not result in a primary liability claim for securities fraud.