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Monday, December 19, 2005
SECURITIES LITIGATION
REGULATION
SECURITIES LITIGATION
REGULATION&
This fact pattern has arisen in
many of the recent accounting
scandals such as Enron, Parmalat and
Homestore, and the courts have
taken divergent approaches to
defining what constitutes a primary
violation. Two recent district court
decisions—in the Homestore and
Lernout & Hauspie cases—are now
pending before the Ninth and First
Circuit Courts of Appeals, respectively,
and their ultimate disposition may
have far-reaching implications for
secondary actor liability.
A Watershed Decision
In 1994, in Central Bank of Denver
v. First Interstate Bank of
Denver1 the Supreme Court
ruled that there is no private
cause of action for aiding
and abetting securities fraud
under Section 10(b) of the
Exchange Act and Rule
10b-5.2 The decision is of
great significance to
“secondary actor” defendants that,
prior to Central
Bank, often were
sued as aiders and
abettors. Signifi-
cantly, however,
the Supreme
Court in Central Bank left open the
possibility that secondary actors
could be held liable under §10(b)
as primary violators where “all of the
requirements for primary liabili-
ty under Rule 10b-5 are met.”3
In the wake of Central
Bank, securities fraud
plaintiffs began alleging
that secondary actors
themselves were pri-
mary violators, rather
than aiders and abettors.
The courts’ treatment of such
allegations has resulted
in a split among federal
circuits, at least in cases
BY HERBERT S. WASHER AND ADAM S. HAKKI
AFTER THE U.S.Supreme Court ruled in1994 that the securitieslaws do not permit civil
claims for aiding and abetting, litigantshave vigorously debated the questionof when a secondary actor—such as abanker, lawyer or accountant—may beconsidered a primary violator of thesecurities laws. This article focuses onthe recent evolution of that debate incases where secondary actors did notthemselves make misstatements uponwhich investors relied but, instead, participated in transactions that impact-ed an issuer’s financial statements.
Herbert S. Washer and Adam S. Hakkiare partners of Shearman & Sterling and specialize in securities litigation.Monique A. Gaylor, a litigation associate with the firm, assisted in the preparation of this article.The authors represent MerrillLynch in the Enron classaction securities litigationand various other Enron-related cases.
‘Scheme’ TheoryEvolves Under Rule 10b-5
Alleged pursuant to subsections (a) and (c), its application—and the results in two pending
appeals—have potentially far-reaching implications for secondary actor securities fraud liability.
where plaintiffs
rely on Rule 10b-5(b), which creates
liability for untrue statements or
omissions of material fact.4
A majority of the circuit courts that
have addressed the question, including
the Second Circuit, have applied a
bright line test, holding that the
secondary actor must itself directly
or indirectly make the false statement
or omission.5 Thus, for example, reviewing,
editing, or approving a statement
attributed to others is insufficient to create
primary liability in those circuits.6
In contrast, the Ninth Circuit has held
that a secondary actor whose conduct
amounts to substantial participation in
making the false statement (such as
playing a significant role in its drafting)
can be liable as a primary violator.7
‘Scheme’ Theory Evolves
Apparently due to the difficulty
of pleading and proving a primary
violation by a secondary actor under
Rule 10b-5(b), plaintiffs increasingly
have turned to allegations of so-called
“scheme” liability under subsections (a)
and (c) of Rule 10b-5 as an alternative
to claims under subsection (b).
Until recently, subsections (a) and (c)
rarely were invoked in cases involving
false statements in or omissions from
a company’s financial statements and
disclosures. Subsection (a) makes it
unlawful to “employ any device, scheme,
or artifice to defraud,” and subsection
(c) makes it unlawful to “engage in
any act, practice or course of business
which operates or would operate as
a fraud or deceit upon any person, in
connection with the purchase or sale
of any security.”8
Recently, plaintiffs have aggressively
pursued scheme theories of liability
against secondary actors under subsection
(a) and/or (c) in cases involving major
accounting scandals such as Homestore,
Lernout & Hauspie, Parmalat, and Enron.
In those cases, plaintiffs allege that
secondary actor defendants—who did
not make the misleading financial
statements and disclosures—are liable
under subsections (a) and/or (c) for
knowingly or recklessly participating
in “schemes” with insiders that
allowed the companies to misstate their
financial condition.
A threshold question presented in
these cases is whether a secondary actor
who participates in a scheme intended to
generate false financial results, but does
not itself participate in generating the
company’s financial statements, can be
held liable under Rule 10b-5.
In In re Homestore.com Inc. Securities
Litigation,9 the U.S. District Court for the
Central District of California held,
among other things, that where a plaintiff
had suffered injury through its reliance
on false and misleading financial
statements, it was the statements—and
not the underlying scheme to generate
false revenues—that were actionable.10
The court’s decision is now on appeal
to the Ninth Circuit. Notably, the
Securities and Exchange Commission
has submitted an amicus brief on the
appeal, arguing for a more expansive
view of secondary actor liability under
subsections (a) and (c) of Rule 10b-5.
In direct contrast to the district court’s
decision in Homestore, the U.S. District
Court for the District of Massachusetts
ruled, in In re Lernout & Hauspie
Securities Litigation11 that, even where
a defendant is not alleged to have
made or participated in the false and
misleading statement, that defendant
can still be liable as a scheme participant
where it has knowingly or recklessly
engaged in a sham transaction that
allowed an issuer to record false revenue
in its financial statements.12
The court found sufficient allegations
of reliance on the secondary actors’
conduct by viewing the alleged
scheme “as a whole” rather than by
viewing the alleged sham transactions
and subsequent financial statement
disclosures separately from each other.13
Recognizing the importance of the
issue, the district court has certified the
matter for interlocutory appeal to the
First Circuit.14
The U.S. District Court for the
Southern District of Texas reached a
similar result (albeit through somewhat
different reasoning) in the Enron
securities litigation in denying motions to
dismiss by secondary actor defendants
who were alleged to have participated in
transactions designed to manipulate
Enron’s financial results, but who were
not alleged to have helped prepare the
financial statements themselves.15
More recently, Judge Lewis Kaplan of
the U.S. District Court for the Southern
District of New York, ruling in the
Parmalat litigation, essentially followed
the court’s decision in the Lernout &
Hauspie case in denying motions to
dismiss claims under subsections (a) and
(c) of Rule 10b-5.16 In so doing, Judge
Kaplan noted that his scheme “analysis
is not a back door into liability for those
who help others make a false statement
or omission in violation of subsection
(b) of the Rule 10b-5,” which, in
Judge Kaplan’s view, is different from
“whether a defendant’s challenged
conduct in relation to a fraudulent
scheme constitutes the use of a deceptive
device or contrivance.”17
The use of scheme liability under
subsections (a) and (c) of Rule 10b-5
against secondary actors in such cases
where (i) plaintiffs allegedly relied on
false and misleading financial statements,
and (ii) the secondary actors did not
prepare or substantially participate in
preparing the financial statements has
broad implications for the continuing
application of Central Bank, pleading the
NEW YORK LAW JOURNAL MONDAY, DECEMBER 19, 2005
elements of reliance and loss causation,
and the scope of joint and several liability
for knowing violations of Rule 10b-5.
Reliance and Loss Causation
The rise of scheme allegations raises
a fundamental question: How direct
a relationship must there be between
a “primary” violator’s conduct and a
plaintiff ’s losses?
As discussed above, the Supreme
Court in Central Bank held that
secondary actors could be primary
violators under §10(b) only if plaintiff
were able to plead and prove “all of the
requirements for primary liability
under Rule 10b-5.”18 The Court empha-
sized that this requirement is essential
because to hold otherwise would subject
defendants to liability “without any
showing that the plaintiff relied upon
the aider and abettor’s statements or
actions.”19 The Court concluded that
“[a]llowing plaintiffs to circumvent the
reliance requirement would disregard
the careful limits on 10b-5 recovery
mandated by our earlier cases.”20
Since Central Bank, however, a
number of courts that have found
secondary actors potentially liable as
primary participants in a scheme
(including in the Lernout, Enron and
Parmalat cases discussed above) have
done so by requiring only a loose
connection between the secondary actor
defendants’ conduct and plaintiffs.
In these cases, the element of
reliance often is satisfied by showing
that plaintiffs relied on other defendants’
conduct; the element of loss causation
occasionally is not addressed at all.
In short, it is not clear that all courts
are adhering rigorously to the Supreme
Court’s requirement that plaintiffs
prove “all of the requirements for
primary liability.”
For example, the divergent results in
the Homestore and Lernout cases may be
attributed, at least in part, to the courts’
treatment of the element of reliance.
The district court’s opinion in
Homestore—finding that plaintiffs
directly relied only on the financial
statement misrepresentations, rather
than the underlying alleged scheme—
embodied a rigorous and defendant-
specific requirement of reliance. In
contrast, the Lernout decision found a
less direct connection to be sufficient,
holding that primary liability could
apply to “any person who substantially
participates in a manipulative or
deceptive scheme…even if a material
misstatement by another person creates
the nexus between the scheme and the
securities market.”21
Courts’ views also diverge on the loss
causation requirement in the context of
a scheme case. In a broadly defined
scheme case, the question will arise as to
whether plaintiffs must show that each
defendant committed a securities law
violation that directly caused a portion
of plaintiffs’ losses or whether, instead,
plaintiffs merely need to show that the
scheme, considered in the aggregate,
caused those losses.
Although few courts have addressed
the issue squarely, plaintiffs contend
that some decisions have focused on the
loss causation impact of the overall
scheme, rather than on the impact of
each defendant’s individual conduct,
thereby tacitly adopting plaintiffs’ view
that a showing of “scheme-wide” loss
causation is sufficient.22
Defendants interpret such cases
differently and contend that such an
approach would effectively eliminate
the element of loss causation and
undermine the Central Bank decision.
Defendants’ argument begins with
the language of the Private Securities
Litigation Reform Act, which places
upon plaintiffs the burden of proving
that the “act or omission of the
defendant alleged to violate this chapter
caused the loss for which plaintiff seeks
to recover damages.”23
Defendants also cite to both pre- and
post-PSLRA cases holding that loss
causation must be traced to each
defendant’s conduct, even in the
context of a multiple-defendant,
broad-based scheme.24
Joint and Several Liability
Many expect that the Ninth Circuit
in Homestore, and the First Circuit
in Lernout, will provide guidance
concerning the degree to which a
primary violator and a plaintiff must be
connected for purposes of reliance and
loss causation. Until then, however, it
seems likely that plaintiffs will continue
to push for broadly defined schemes
under Rule 10b-5(a) and (c), raising a
final and perhaps most controversial
issue: the application of the joint and
several liability provisions of the PSLRA
in the context of a scheme case.
Courts have only recently begun to
grapple with this issue. The PSLRA
provides that “[a]ny covered person
against whom a final judgment is
entered in a private action shall be
liable for damages jointly and severally
only if the trier of fact specifically
determines that such covered person
knowingly committed a violation of
the securities laws.” In the context of a
scheme in which many defendants
were aware of and participated in only
limited aspects of the overall scheme,
the question becomes “joint and several
liability for what?”
Clearly, the PSLRA is intended to
provide for joint and several liability
against a knowing violator for losses
caused by the transaction in which it
was a primary participant. But is such a
defendant also responsible for losses
caused by other transactions that,
although part of the alleged overall
NEW YORK LAW JOURNAL MONDAY, DECEMBER 19, 2005
scheme, it did not even know about,
much less participate in?
Plaintiffs have argued in a number
of cases that any defendant who
knowingly commits a primary violation
in furtherance of a larger scheme should
be jointly and severally liable for the
entire scheme. The rather straightforward
argument is that under the PSLRA,
defendants who are found to be primary
participants in a scheme under Rule
10b-5(a) are jointly and severally liable if
they “knowingly committed a violation of
the securities laws.”25
Plaintiffs reject any notion of unfairness
in applying joint and several liability,
noting that Congress specifically considered
the potential plight of a defendant who
contributes in an insignificant way to
the overall violation by providing for
contribution26 and verdict or judgment
reduction27 within the PSLRA.
Defendants argue that the notion of
joint and several liability for conduct
known and unknown to the defendant is
plainly inconsistent with the “knowing”
language of the PSLRA, as well as the
loss causation requirement.
In the context of a more traditional
and narrowly defined “scheme,” no issue
arises because the conduct in which the
defendant knowingly participates is the
same conduct that “causes” plaintiffs’
losses. But where a knowing violation of
the securities law is used to propel a
defendant into a larger scheme, that
connection may not exist.
Indeed, in such a circumstance, the
vast majority of plaintiffs’ losses may have
been caused by aspects of the scheme
about which a particular defendant
knew nothing. In that circumstance,
defendants argue, there was no “knowing”
conduct that would justify joint and
several liability.
Although few cases have directly
addressed this issue, differences in
approach already are evident.
In Parmalat, for example, plaintiffs
alleged a multi-year scheme to
falsify Parmalat’s financial statements.
Plaintiffs’ complaint sought damages
“against all Defendants, jointly and
severally, for all damages sustained as a
result of the Defendants’ wrongdoing.”28
In ruling on defendants’ motions to
dismiss, however, Judge Kaplan declined
to treat the defendants as participants
in a single overarching scheme, for
which joint and several liability could
apply. Instead, Judge Kaplan analyzed
each defendant’s individual role in each
relevant transaction to determine
whether that defendant was a primary
violator with respect to each transaction
or act only.29
Confronted with similar allegations
in Enron, Judge Melinda Harmon did
not necessarily reject the notion of an
overarching scheme, but she did not
accept plaintiffs’ argument that one
who commits a knowing violation in
furtherance of that overarching scheme
can be jointly and severally liable for
all losses caused. Rather, she observed
that the PSLRA’s “knowing” requirement
for joint and several liability “seems
incompatible with Lead Plaintiff ’s
argument that a participant is liable for
damages caused by all participants,
known or unknown in the scheme.”30
Ultimately, courts’ willingness to
predicate §10(b) liability on broad-
based, multi-year schemes, and to
impose joint and several liability for such
schemes, will have a significant impact
on the continued meaningfulness of the
Supreme Court’s Central Bank decision
and the balance of power among the
parties in settlement negotiations.
Should the guidance provided by the
Ninth and First Circuits differ materially,
it is conceivable that the Supreme
Court would accept an opportunity to
further clarify the distinction between
actionable primary violations and
nonactionable aiding and abetting.
•••••••••••••••••••••••••••••••
1. 511 U.S. 164 (1994).2. Id. at 177.3. Id. at 191.4. 17 C.F.R. §240.10b-5.5. See Ziemba v. Cascade Int’l, Inc., 256 F.3d 1194, 1205
(11th Cir. 2001); Shapiro v. Cantor, 123 F.3d 717, 720 (2d Cir.1997); Anixter v. Home-State Prod. Co., 77 F.3d 1215, 1225(10th Cir. 1996).
6. See, e.g., Wright v. Ernst & Young LLP, 152 F.3d 169, 175(2d Cir. 1998). But see In re Global Crossing, Ltd. Sec. Litig., 322F.Supp.2d 319, 334 (S.D.N.Y. 2004) (finding allegations thatauditor “reviewed every public filing, earnings release, and quar-terly report” and “materially assisted in preparation of all pub-lic disclosures” sufficient to state a claim even though nomisrepresentations in these documents were attributed to theauditor).
7. See In re Software Toolworks Sec. Litig., 50 F.3d 615, 628n.3 (9th Cir. 1994).
8. Section 240.10b-5.9. 252 F.Supp.2d 1018 (C.D. Cal. 2003).10. Id. at 1041 (finding that “the plaintiff suffered damage
through its reliance on false or misleading statements, not fromthe ‘scheme’ itself [which was] one step removed from theinjured party”).
11. 236 F.Supp.2d 161 (D. Mass. 2003).12. Id. at 173.13. Id. at 174.14. See Order and Memorandum, Quaak v. Dexia, D. Mass.
No. 03 Civ. 11566, Doc. No. 79, at 3, 6-9.15. In re Enron Corp. Sec., Deriv. & ERISA Litig., 235
F.Supp.2d 549, 577-82 (S.D. Tex. 2002). 16. In re Parmalat Sec. Litig., 376 F.Supp.2d 472, 502-03
(S.D.N.Y. 2005).17. Id. at 503.18. Cent. Bank of Denver v. First Interstate Bank of Denver,
511 U.S. 164, 191 (1994). 19. Id. at 180. 20. Id.21. In re Lernout & Hauspie Sec. Litig., 236 F. Supp. 2d 161,
173 (D. Mass. 2003).22. See, e.g., In re Blech Sec. Litig., 961 F. Supp. 569, 576
(S.D.N.Y. 1997) (“With respect to loss causation, the princi-pal question is whether the loss is a reasonably foreseeable con-sequence of the fraudulent actions. Here, the economic harmto the Plaintiffs from the ultimate collapse of the price of theBlech securities that were inflated by the actions of Bear Stearns(and Blech and his confederates) was a foreseeable consequenceof Bear Stearns’ alleged conduct. Accordingly, loss causationis also adequately pleaded.”).
23. 15 U.S.C. §78u-4(b)(4) (emphasis added).24. See, e.g., Bloor v. Carro, Spanbock, Londin, Rodman &
Fass, 754 F.2d 57, 61 (2d Cir. 1985) (affirming dismissal ofclaims against a law firm defendant for participation in broad-based scheme to defraud where plaintiffs failed to allege the“loss causation” connection between defendant’s actions andplaintiffs’ losses); Baxter v. A.R. Baron & Co., No. 94 Civ. 3913,1995 U.S. Dist. LEXIS 14882, at *19 (S.D.N.Y. Oct. 6, 1995)(stating that “[e]ven where a 10(b) claim is based not on spe-cific misrepresentations or omissions, but rather on a ‘com-prehensive scheme to defraud,’ the plaintiff must stilldemonstrate causation in fact by showing that defendant’sallegedly fraudulent activities were actually responsible forplaintiff’s injuries”).
25. Section 78u-4(f)(2)(A).26. See §78u-4(f)(8).27. See §78u-4(f)(7)(B).28. Second Amended Consolidated Class Action Com-
plaint, In re Parmalat Sec. Litig., D. Mass. No. 04 M.D. 01653,Doc. No. 213, at 387.
29. See In re Parmalat Sec. Litig., 376 F.Supp.2d 472, 505(S.D.N.Y. 2005). Judge Kaplan also looked at the schemes indi-vidually when discussing loss causation. See id. at 510.
30. In re Enron Corp. Sec., Deriv. & ERISA Litig., 235 F.Supp. 2d 549, 593 (S.D. Tex. 2002).
This article is reprinted with permission from the December 19, 2005 edition of the NEW YORKLAW JOURNAL. © 2005 ALM Properties, Inc.All rights reserved. Further duplication withoutpermission is prohibited. For information, contactALM Reprint Department at 800-888-8300 x6111.#070-12-05-0050
NEW YORK LAW JOURNAL MONDAY, DECEMBER 19, 2005
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