Supporting Actor Role
Five years after the 2001 corporate accounting scandals, the story starts to sound like just another day at the office.
The Securities and Exchange Commission and private plaintiffs lawyers, fueled by public outrage, attempt to haul as many defendants as possible into court to increase the chances of meaningful financial recovery for securities fraud victims.
Meanwhile, investment bankers, auditors, lawyers and other outsiders targeted as defendants struggle to distance themselves legally from the failing companies they advise.
Few doubt that responsibility extends beyond the directors and executives who publicly lied about their companies’ financial positions to sell stock. But there is considerably less agreement on the degree of blameworthiness for “secondary actors,” who, from behind the scenes, issue legal opinions, revenue forecasts and other documents that companies may use in efforts to swindle investors.
Business leaders say they’re victims of overaggressive enforcement inspired by the SEC. Outside professionals say naming them as defendants chills their ability to counsel their clients effectively.
SEC lawyers declined comment. But in a series of cases, they argue, both as parties and amici, that without such a broad view of liability, “large swaths of fraudulent activity could go unremedied.”
DIVERGENT INTERPRETATIONS
The first appellate decision over the issue of who belongs in court and who doesn’t may come from the San Francisco-based 9th U.S. Circuit Court of Appeals. A trial judge dismissed allegations against outside defendants because the defendants themselves didn’t lie to the investing public, regardless of how involved they may have been in preparing the financial documentation used to support the statements. In re Homestore.com Inc. Securities Litigation, 252 F. Supp. 2d 1018 (C.D. Cal. 2003).
A Boston trial judge last year reached the opposite conclusion and allowed plaintiffs to sue outsiders. Quaak v. Dexia S.A., 357 F. Supp. 2d 330 (D. Mass. 2005). The Boston-based 1st U.S. Circuit Court of Appeals sent the appeal back in late March to the trial judge because the complaint had been amended since the dismissal.
As the SEC and private lawyers try to expand the universe of available defendants, buzz is coming from the other side of the bar after a little-noticed grant of summary judgment to a corporate director. In ruling for Steven Angel, U.S. District Judge Thomas P. Griesa held that the government must show actual knowledge of fraud, not simply reckless conduct, as the SEC had urged. SEC v. Cedric Kushner Promotions Inc., No. 04 CV 2324 (S.D.N.Y. Feb. 17).
“It’s a new issue, and I’m afraid it’s going to make some bad law for the SEC,” says Angel’s lawyer, Bruce A. Schoenberg of New York City.
But suing outsiders in securities fraud cases is not new. Indeed, the law on secondary actor liability was regarded as well-settled until the unprecedented corporate failures of 2001 called for a fresh look.
The issue is crucial for investor plaintiffs because no one wants to sue an insolvent corporation without boosting chances for recovery by including outsiders who may have participated in the fraud and—more important—have money.
“Just take a look at Enron,” says Boston lawyer Glen DeValerio, who represents the plaintiffs in Quaak. “But for the liability of the investment banks, the plaintiffs would get nothing. Zero.”
The handful of trial judges who have ruled on the issue must resolve the SEC’s expansive theory as against a U.S. Supreme Court decision and federal legislation from the 1990s that tried to restrain class action plaintiffs lawyers in securities cases.
Before the Supreme Court and Congress acted, plaintiffs typically brought fraud lawsuits under section 10(b) of the 1934 Securities Exchange Act and accompanying SEC rule 10b-5, which outlaw lies and omissions in connection with sales of securities.
Using class actions, plaintiffs would sue company officials or others making public statements as primary violators, then tack on as aiders and abettors outsiders who assembled the materials the main violators used to support their statements.
In 1994, the Supreme Court thwarted that approach, holding 10(b) aiding and abetting liability off-limits to private plaintiffs. Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164. However, the SEC retains the ability to sue for aiding and abetting.
Congress clamped down the next year with the Private Securities Litigation Reform Act, which significantly raised the level of detail required for pleadings, including a heightened standard for intent, called scienter in securities fraud cases. With aiding and abetting gone as a private cause of action, potential outside defendants figured they merely had to keep their mouths shut to avoid being sued as primary violators over false statements or omissions.
BEYOND LIES AND OMISSIONS
No one made much of the new restrictions until the late 2001 collapse of Enron Corp. But as the Enron debacle and other high-profile scandals revealed intricate accounting frauds accomplished with the help of legions of outside advisers, government and private plaintiffs set to work trying to get around Central Bank and the PSLRA.
They dusted off section 10(b) and its rule and started suing outside players under other provisions that go beyond lies and omissions and reach conduct by forbidding “any device, scheme or artifice to defraud” and “any act, practice or course of business” that operates as a fraud.
Defendants complain that the new theory, called scheme liability, merely repackages the aiding and abetting allegations banned by Central Bank. Before Enron, courts weren’t so sympathetic, either, with the majority adopting a bright-line standard that requires publicly identified secondary actors to make misstatements or omissions that they should know will reach investors, even though those defendants may not speak directly to them.
With Enron, however, courts began to see the approaches taken by Central Bank and the PSLRA as overly rigid. In response, the SEC instead wants appeals courts to expand primary liability beyond outright lies and omissions to anyone “who directly or indirectly engages in a manipulative or deceptive act as part of a scheme to defraud.” The commission also would eliminate the public identification requirement.
That made sense to U.S. District Judge Melinda F. Harmon in Houston, who has been trudging through the Enron case almost since day one. Harmon became the first federal judge to embrace the new view when she allowed claims to proceed against a bank, a law firm and accountants. The accusations included participating in phony initial public offerings, drafting phony SEC filings and press releases, destroying documents, and violating generally accepted accounting principles. In re Enron Corp. Securities, Derivative and ERISA Litigation, 235 F. Supp. 2d 549 (S.D. Tex. 2002).
“The court finds that the SEC’s approach to liability under section 10(b) and rule 10b-5(b) is well-reasoned and reasonable, balanced in its concern for protection for victimized investors as well as for meritlessly harassed defendants (including businesses, law firms, accountants and underwriters),” Harmon wrote.
Still, the SEC could come out on the short end if outside defendants manage to apply Judge Griesa’s Kushner holding requiring actual knowledge to satisfy scienter.
“That’s requirement No. 1,” says plaintiffs lawyer DeValerio. “Regardless of whether it’s primary or secondary liability, you always have to have scienter.” Griesa was unimpressed with an SEC argument that recklessness should suffice for inside director Angel because he owed a fiduciary duty to the company and its shareholders.
As he described Angel as essentially a “gofer” who fetched paperwork for other defendants, Griesa concluded that the SEC hadn’t even adequately alleged recklessness. The controlling New York City-based 2nd U.S. Circuit Court of Appeals precedent defines recklessness in securities matters as “highly unreasonable conduct” that represents such an obvious departure from ordinary standards of care that the defendant knows or should know about the danger to investors.
With Griesa’s published opinion already on the books, defense lawyer Schoenberg predicts it will command a broad following, especially for truly marginal outside directors and advisers caught up in the SEC’s sweep. “It really does have something beyond this case.”
