Recent Developments in Secondary Liability Under Section 10(b) and Rule 10b-5 - Central Bank Encounters the 'Perfect Storm'

Article by Douglas C. Conroy & Ryan K. Roth Gallo

Introduction

In 1994, the United States Supreme Court eliminated "aiding and abetting" liability in private federal securities fraud actions. Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U. S. 164, 168 (1994) (hereinafter, Central Bank).1 That decision also sounded the death knell for "conspiracy" allegations.2 Since Central Bank, the courts have struggled with various species of line-drawing between "primary" involvement sufficient for liability under Central Bank and "secondary" involvement exempted under that decision's reasoning. In 1995, Congress enacted the Private Securities Litigation Reform Act ("PSLRA"), in an effort to raise the bar for securities fraud plaintiffs hoping to survive motions to dismiss.

A long-awaited recent decision issued in In re Enron Corp.3 denying most of the secondary actors' motions to dismiss, despite the barriers created by Central Bank and the PSLRA, may herald the arrival of new and inherently elusive standards for attributing liability to the banks, law firms, and accounting firms, which had enjoyed substantial degrees of immunity to certain types of Rule 10b-5 claims post-Central Bank. Ironically, for a legal standard and statutory structure contemplating uniform application by federal courts across the United States, judicial interpretations of Central Bank and the PSLRA have led to an increasing number of inter-circuit and intra-circuit conflicts as to numerous controlling principles of liability. These numerous conflicts are also highlighted in the Enron court's approach to both Central Bank and to other key issues on which it based its rulings.

The In re Enron Corp. Ruling - "Aiding and Abetting" Liability In Disguise?

On December 20, 2002, the United States District Court for the Southern District of Texas issued its Memorandum and Order Re Secondary Actors' Motions to Dismiss (the "Order"). The Order signals at least one jurisdiction's movement toward a more lenient standard than those adopted by other federal courts post-Central Bank for plaintiffs attempting to bring securities fraud claims against secondary actors. It also reflects a significant success by the SEC in achieving judicial adoption of a narrow interpretation of Central Bank for private civil actions in an important case - a result it has sought for a number of years. Although the In Re Enron ruling provides additional weaponry for the plaintiffs' securities bar, the possible "silver lining" is that it may alleviate continuing pressure to overturn Central Bank legislatively, as described in the final portion of this Alert.

The Enron court found that claims for primary securities fraud were sufficiently pleaded against a number of secondary actors, including Enron's outside law firm, its auditor, and a number of commercial and investment banks. In so ruling, the Enron court adopted the SEC's proposed "creator" test for primary liability of secondary actors under Section 10(b) of the Securities Exchange Act of 1934 ("Section 10(b)") and Exchange Act Rule 10b-5 ("Rule10b-5"). This test proposes that persons who "create" misrepresentations on which investors rely, whether or not the misrepresentations are attributed to them at the time of public dissemination, can be held liable as primary violators if they act with scienter (i.e., knowledge or recklessness). Thus, secondary actors, such as law firms, accounting firms, and investment banks, can be liable for primary violations if all of Rule 10b-5's requirements have otherwise been satisfied.4

In the Enron litigation, the plaintiffs alleged that Enron's lawyers, accountants, underwriters, and bankers participated with the company in a "Ponzi" scheme to enrich themselves at the expense of Enron's shareholders and to keep funds flowing into the company. They allegedly did this using a series of securities sales and analysts' statements concerning Enron's business and prospects. Specifically, the complaint alleged that the secondary actors, Enron, and its accountants manipulated Special Purpose Entities ("SPEs") and caused Enron to violate Generally Accepted Accounting Principles ("GAAP") and SEC rules in order to overstate corporate assets, shareholder equity, and net income. This was accomplished while understating debt and using the proceeds of securities sales to repay debt owed to the secondary actors.5

The Enron court determined that the PSLRA's significance as a protective shield for businesses must be viewed within the context of the decades old private right of action granted to defrauded investors as well as the recent, overwhelming corporate scandals that have placed Congress' goal in enacting the PSLRA in a much wider perspective.6

As a factor common to all the secondary actors it found potentially liable, the court concluded that the plaintiffs had satisfied the scienter pleading requirement through allegations of a pattern of related conduct involving the creation of unlawful Enron-controlled SPEs, and the sale of unwanted corporate assets to those entities in non-arms length transactions, to shift debt off of Enron's balance sheet and add sham profits onto its books at critical times when SEC filings were due.7 These transactions were alleged to be part of a common scheme through which all defendants profited, including, in many instances, through investments (and substantial returns thereon) by individual executives at the investment banks in question. One of the primary defenses asserted was that Enron's accountants, Arthur Andersen, had passed on the accounting treatment of these SPEs and related transactions. Their very pattern, including quarter or year-end timing, said the court, undermined defenses of mere negligence or lack of knowledge and supported allegations of scienter, or intent to defraud.8

The Enron court also emphasized that securities professionals, like lawyers and accountants, when they take affirmative steps of speaking out, whether individually or as an author or co-author of a statement about their client's financial condition - whether personally identified in the statement or not - have a duty to third-parties not to issue misleading statements on which they intend, or have reason to expect, those third-parties will rely.9 Recognizing the danger of opening the professional liability floodgates to any potential investor who might obtain and rely on a secondary actor's statement, the court favored restricting the group of potential plaintiffs to those to whom the attorney or accountant owes a duty. However, in the Enron litigation, the court found that the investors who alleged the specific scheme of wrongdoing were part of the group that these secondary actors allegedly intended, or might reasonably have expected, to rely on the misrepresentations and who allegedly did rely and suffer loss.10

Legal Bases For The Decisions

In reaching its decision with respect to secondary actors, the Enron court made three critical legal determinations. The combined effect of these three legal determinations is a narrow reading of Central Bank's proscription against aider and abettor liability and an expansive view of primary liability under Section 10(b) and the various subsections of Rule 10b-5.

First, the court rejected both the "bright line" test, which has been adopted by the majority of the federal appellate and district courts that have considered the issue,11 and questioned the viability of the somewhat looser "substantial participation" test, which was...