A sea change in the antifraud provisions of the federal securities laws may be coming soon—and they may be coming to a federal courthouse near you. Congress’s recent round of financial legislation left intact, for the moment, the U.S. Supreme Court’s line of cases prohibiting a private right of action against those who aid and abet a securities fraud. Future legislation and periodic assaults by securities plaintiffs, however, may slowly erode or remove altogether that prohibition and bring federal liability to a broad range of third parties who are not participants in the securities markets. Those who interact with publicly traded companies only as vendors or customers could be subjected to federal securities lawsuits by private plaintiffs even where those vendors or customers have no input into the financial reporting of those public companies.
Who should be concerned about these potential changes? Any person or company that does business with an issuer of public securities could potentially become a target of private plaintiffs in a federal securities action if they provide “substantial assistance” to someone who commits fraud. What constitutes “substantial assistance” remains to be seen and will likely be decided by administrative regulation and future judicial decisions. Regardless of their ultimate scope, any amendments allowing private plaintiffs the right to bring federal securities fraud claims against secondary (and remote) actors will greatly expand the dragnet of potential defendants well beyond the scope of current law.
The recent and continuing economic crisis has provided justification for a panoply of new state and federal laws and regulations that dramatically increases federal regulation over the financial services industry. Citing “[y]ears without accountability for Wall Street and big banks,” Congress recently passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Among other things, Dodd-Frank provides more federal protections for consumers and increases oversight of Wall Street by creating an independent financial consumer protection agency, attempting to avoid the need for taxpayer bailouts of financial institutions by preempting the possibility that institutions will become “too big to fail,” and instituting advance warning systems to identify and address systematic risks before they become catastrophic. Whether one sees these changes as needed reforms to a broken system or the scapegoating of an entire industry for the nation’s economic woes, one thing is clear: The current legislative and regulatory environment is one in which the federal government’s sights are keenly trained on the financial markets, financial investors, and securities issuers.
While Dodd-Frank enacted several sweeping laws designed to curb fraud in the financial and consumer credit markets, Congress stayed its hand—at least for now—on one that would have worked broad changes in the area of private lawsuits against those who aid and abet violators of the antifraud provisions of federal securities laws. Since passing the bulk of today’s existing securities legislation in the early 1930s following the stock market collapse, Congress has increasingly empowered the Securities and Exchange Commission (SEC) to sue those primary violators who commit fraud “in connection with” the purchase or sale of securities. Almost 40 years ago, the Supreme Court broadened that same law by implying a right for private litigants to sue as well. As recently as 1995, Congress further authorized the SEC (but not private plaintiffs) to sue those who aid and abet securities fraud, but the Supreme Court and, more recently, Congress have shown their reluctance to take the next step by allowing private litigants the right to pursue securities fraud claims against so-called secondary actors. As recently explained by the Supreme Court, allowing private litigants to bring suits against remote third parties would extraordinarily extend liability beyond the securities markets and into “the realm of ordinary business operations,” about which Congress is now thinking long and hard.
Fraud Liability under Section 10(b) and Rule 10b-5
Section 10(b) of the Securities Exchange Act of 1934 is the general antifraud provision of the federal securities laws. It prohibits any person “directly or indirectly,” by use of interstate commerce, the mail, or a national securities exchange, from using or employing a manipulation or deception “in connection with the purchase or sale of any security.” The SEC’s administrative Rule 10b-5 tracks this statute’s language, though it does not broaden the type of conduct prohibited by § 10(b).
Although not specified in the text of Section 10(b), the Supreme Court has found that a right for private plaintiffs (other than the SEC) to sue primary violators is “implied” in the statute and Rule 10b-5. A private plaintiff suing for securities fraud under § 10(b) must prove a material misrepresentation or omission by the defendant, scienter or a defendant’s knowledge of wrongdoing, a connection between the misrepresentation or omission and the purchase or sale of a security, reliance upon the misrepresentation or omission, economic loss, and loss causation. It’s important that the plaintiff must prove reliance on a statement or an omission that can be shown to have caused the alleged loss—seemingly precluding liability for any persons other than those primary actors who made the alleged omission or misstatement.
Supreme Court Makes Decision on Section 10(b)
Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.
The Supreme Court has periodically considered—and rejected—aiding and abetting liability under Section 10(b). The Court’s 1994 decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. arose from a suit by bond investors against Central Bank, a trustee for bonds issued by a defaulting Colorado municipal authority in connection with private real estate development. The investors alleged that Central Bank aided and abetted a fraud perpetrated by the authority, the bond underwriters, the real estate developer, and one of its directors by agreeing to delay an independent review of the developer’s appraisal of the value of the property underlying the bonds that was required by the bond covenants. The review was triggered when Central Bank received the developer’s appraisal and decided that it appeared optimistic given the poor conditions of the local real estate market.
The Court granted certiorari to resolve confusion created by a number of lower courts and commentators who questioned whether aiding and abetting liability was still available after the Court’s decisions in two previous cases defining the scope of conduct prohibited by Section 10(b). The Court recognized that the Exchange Act and the Securities Act of 1933 create an “extensive scheme of civil liability” that encompasses express and implied private rights of actions, as well as administrative actions and injunctive proceedings enforceable by the SEC.
The gravamen of the Court’s analysis in Central Bank was its focus on the importance of adherence to the text of Section 10(b) in defining the conduct covered under the statute. The Court rejected the plaintiff’s argument that the “directly or indirectly” language of Section 10(b) encompassed aiding and abetting and concluded that the text of the Exchange Act “does not itself reach those who aid and abet a § 10(b) violation.” Rather, the Court reasoned, the statute “prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act” but “does not include giving aid to a person who commits a manipulative or deceptive act.”
In addition to its textual analysis, the Court concluded that Congress did not intend to impose private aiding and abetting liability because none of the other provisions of the Exchange Act or the 1933 Act that provided private causes of action allowed private causes of action for aiding and abetting liability. The Court concluded that imposing private aiding and abetting liability would allow recovery without proving the necessary element of reliance—that the plaintiff relied on some misstatement or omission of the defendant—thereby disregarding the limits on Section 10(b) and Rule 10b-5 liability established by earlier Supreme Court jurisprudence.
The Court in Central Bank rejected the notion that Congress implicitly intended to include aiding and abetting liability in the Exchange Act and dismissed the policy considerations advanced by plaintiffs and interested parties. It was well aware of the practical costs, including the litigation costs to innocent defendants in fighting even weak claims, in extending liability. Noting that ”[s]econdary liability for aiders and abettors exacts costs that may disserve the goals of fair dealing and efficiency in the securities markets,” the Court explained that “[l]itigation under 10b-5 thus requires secondary actors to expend large sums even for pretrial defense and the negotiations of settlement.” The Court held that “a private plaintiff may not maintain an aiding and abetting suit under § 10(b).”
In the wake of Central Bank, Congress rejected calls to create an express private right of action against aiders and abettors. Instead, in enacting the Private Securities Litigation Reform Act of 1995 (PSLRA), Congress amended the Exchange Act by directing the SEC (though not private litigants) to prosecute aiders and abettors.
Stoneridge Investment Partners, LLC v. Scientific Atlanta, Inc.
In 2008, the Supreme Court was again asked to consider the reach of the implied private right of action under Section 10(b) and Rule 10b-5. In Stoneridge Investment Partners, LLC v. Scientific Atlanta, Inc., the plaintiffs filed a class-action lawsuit on behalf of purchasers of company stock seeking to impose liability on two of the defendant company’s customers and suppliers whose private dealings with the public company had aided the company in misleading its auditor and issuing misleading financial statements to the market. The Court granted certiorari to resolve a conflict among the circuit courts as to when an investor may recover from a party that does not make a misstatement or an omission but participates in a “scheme” to violate Section 10(b)—that is, the imposition of liability on defendants who participate in a chain of conduct that results in a public misstatement.
Noting again that Rule 10b-5 encompasses only conduct prohibited by Section 10(b), the Court in Stoneridge confirmed that Section 10(b) does not expressly provide a private cause of action, though the Court had earlier implied one. With respect to holding any secondary actor liable as a primary violator, the Court reiterated that a plaintiff must satisfy each of the elements necessary to prove primary Section 10(b) liability. In particular, a plaintiff must allege and prove reliance upon a defendant’s deceptive conduct. There is a rebuttable presumption in two circumstances: where there is an omission of a material fact by someone who has a duty to disclose (so the investor does not need to provide specific proof of reliance) and under the “fraud on the market” doctrine, where reliance is presumed when the statements at issue become public. The Court found that neither presumption applied in Stoneridge under the circumstances alleged and no member of the public directly relied upon any alleged misrepresentations by the defendants.
The Court also specifically rejected the plaintiffs’ attempt to impose “scheme” liability, reasoning that the adoption of this concept of attenuated reliance in a new implied cause of action “would reach the whole marketplace in which the [primary violator] did business; and there is no authority for this rule.” The Court expressed its concern that by adopting the plaintiff’s concept of attenuated reliance, the Section 10(b) private cause of action would broadly reach conduct that occurs in the “realm of ordinary business operations,” which is governed by state law. Additionally, this interpretation would contravene Congress’s response to the Central Bank decision via the PSLRA because it would revive the implied cause of action against all aiders and abettors, despite the fact that Congress determined that these secondary actors should only be pursued by the SEC, not private litigants. As it did in Central Bank, the Court raised practical concerns about the proposed expansion of Section 10(b) liability to alleged aiders and abettors, such as the excessive cost of litigation and the potential to shift securities offerings away from the U.S. capital markets.
The Court further relied on the doctrine of separation of powers as militating against judicial expansion of the implied private cause of action, which Congress did not enact in the 1933 and 1934 Acts. In holding that plaintiffs’ claims were deficient given their inability to show reliance, the Court stated that:
This conclusion is consistent with the narrow dimensions we must give to a right of action Congress did not authorize when it first enacted the statute and did not expand when it revised the law.
Congress Moves Toward Liability for Aiders and Abettors
Recent congressional action demonstrates an attempt by Congress to revive private causes of action for aiding and abetting liability. In July 2009, Senator Arlen Specter introduced the Liability for Aiding and Abetting Securities Violations Act of 2009. The bill would have created an express private right of action against any person who “knowingly or recklessly provides substantial assistance to another person” in violation of the Exchange Act. The Senate Judiciary Committee held a hearing on the bill in September 2009. Representative Maxine Waters introduced an identical bill in April 2010, and it was referred to a House subcommittee in July 2010.
Although these efforts to establish express private rights of action for aiding and abetting liability did not become part of the Dodd-Frank Act, the act provided for “a study on the impact of authorizing a private right of action against any person who aids or abets another person in violation of the securities laws.” The act requires the comptroller general to conduct a study that includes a review of the role of secondary actors in the issuance of securities, an analysis of courts’ interpretation of the scope of secondary actor liability after Stoneridge, and the types of cases decided under the PSLRA. The study must be submitted to Congress within a year of the enactment of Dodd-Frank.
Dodd-Frankdid not establish an express private right of action against aiders and abettors as proposed by Senator Specter and Representative Waters; however, it did expand the government’s ability to bring securities fraud claims against aiders and abettors. Specifically, the law loosened the scienter standard of culpability in the Exchange Act from “knowingly” providing substantial assistance to a primary violator of securities laws to a standard of “knowingly or recklessly” providing such assistance.
Secondary Actors in the Appeals Courts
Recent decisions suggest that the federal appellate courts are respecting the narrow boundaries of liability against secondary actors that the Supreme Court established in Central Bank and Stoneridge—though some argue that recent decisions expanding the definition of “primary” violators undercuts these boundaries. In SEC v. Tambone, the U.S. Court of Appeals for the First Circuit considered the SEC’s appeal from a dismissal of a Rule 10b-5 action brought against two senior executives of a mutual fund complex. Both were alleged to have overseen the marketing and sale of mutual funds, using prospectuses that understated or omitted the existence of market timing practices. The SEC alleged that the defendants “made” a material misstatement or omission for purposes of Rule 10b-5 by using statements, authored by others, in connection with the sale of securities and directing the sale of securities on behalf of an underwriter, thereby making an implied statement that the prospectus was truthful and complete.
The First Circuit rejected the SEC’s broad-based theory of liability as being inconsistent with the text of Rule 10b-5 and Section 10b “and in considerable tension with Supreme Court precedent.” The Court stated that because Central Bank distinguished between primary and secondary violators, “courts must be vigilant to ensure that secondary violations are not shoehorned into the category reserved for primary violations.” The Court reasoned that the SEC’s attempt to broaden Rule 10b-5 liability through a tortured construction of the word “make” threatened “the integrity of the dichotomy” between primary and secondary violators and would “impose primary liability . . . for conduct that constitutes, at most, aiding and abetting (a secondary violation),” which would be “unfaithful to the taxonomy of Central Bank.” The Court also rejected the SEC’s attempt to impose on securities professionals “a free-standing and unconditional duty to disclose” material information not included in a prospectus as “fl[ying] in the teeth of Supreme Court precedent.”
Similarly, in Pacific Inv. Mgmt. Co., LLC v. Mayer Brown, LLP, the U.S. Court of Appeals for the Second Circuit considered whether a corporation’s outside counsel could be held liable for a Rule 10b-5 violation in connection with a private action brought by investors in the defunct corporation’s securities. The plaintiffs alleged that counsel drafted, reviewed, and negotiated public documents and the terms of sham transactions designed to underestimate the corporation’s liabilities. The plaintiffs urged the Court to impose liability on these secondary actors based on their extensive participation in the creation of these false statements. The Court rejected this argument as contravening the “attribution” requirement established under Second Circuit jurisprudence, i.e., that liability did not attach because statements in the documents were not directly attributable to counsel at the time they were made. The Court held that in light of the decisions in Central Bank, post-Central BankSecond Circuit decisions, and Stoneridge, secondary actors could only be liable in a private action under Rule 10b-5 for statements that are explicitly attributed to them. The rule is consistent with the Supreme Court’s holding in Stoneridge, which “stands for the proposition that reliance is the critical element in private actions under Rule 10b-5.” Absent the requisite attribution, the Court reasoned that reliance on a secondary actor’s participation can “only be shown through an indirect chain too remote for liability.” Relying on Stoneridge, the Court also rejected the plaintiff’s attempt to impose scheme liability because nothing counsel did made it necessary or inevitable for the corporation to engage in the sham transactions.
More recently, in Malack v. BDO Seidman, LLP, the U.S. Court of Appeals for the Third Circuit rejected an investor’s attempt to impose liability under Rule 10b-5 on an accounting firm that provided audit opinions to a subprime mortgage originator. The plaintiff-investor claimed it had purchased notes that were later rendered worthless. The Third Circuit rejected the investor’s attempt to impose a presumption of reliance for purposes of section 10(b) under a “fraud-created-the-market theory” as impermissibly expanding “§ 10(b) liability far beyond its current contours” in contravention of the Supreme Court’s instruction in Stoneridge. The Court also cited policy concerns, such as encouraging frivolous litigation that drives up the costs to market participants, as militating against judicial acceptance of the reliance theory proposed by the plaintiff.
Expanding the Definition of “Primary Actor”
While respecting the Supreme Court’s rulings prohibiting liability for secondary actors, some federal appeals courts—most recently the U.S. Court of Appeals for the Fourth Circuit—have expanded the definition of primary actors to such a degree that primary liability is befalling parties who are arguably secondary actors. A split in the circuit courts on this issue was recently argued in the Supreme Court following the June 2010 grant of certiorari in First Derivative Traders v. Janus Capital Group, Inc., a decision by the Fourth Circuit allowing Section 10(b) securities claims to proceed against a party that made no directly attributable statements.
Janus Capital involved securities fraud claims against Janus Capital Group, Inc., and its wholly owned subsidiary (and investment advisor) Janus Capital Management, LLC, arising out of a failure to disclose alleged market timing in Janus investment funds. Specifically, the plaintiffs alleged that market timing was secretly allowed by the Janus entities, despite statements to the contrary in the prospectuses of the various Janus funds. Noting that the federal appeals courts had “diverged over the degree of attribution [of representations or omissions to third parties] required to plead reliance,” the Fourth Circuit quoted the Supreme Court’s Central Bank admonition that “[t]he absence of § 10(b) aiding and abetting liability does not mean that secondary actors . . . are always free from liability” under the securities law. The Second and Eleventh Circuits adopted a more narrow view of “attribution” focusing solely on whether the alleged misstatement or omission was “publicly attributable to the defendant at the time that the plaintiff’s investment decision was made.” The Ninth Circuit, however, concluded that “public attribution is not required to plead reliance; substantial participation or intricate involvement in preparing the misleading statement is sufficient to state a primary violation” of Section 10(b).
Adopting neither of these extremes, the Fourth Circuit held that plaintiffs seeking to prove reliance based on the fraud-on-the-market presumption “must ultimately prove that interested investors (and therefore the market at large) would attribute the allegedly misleading statement to the defendant.” Of great importance to the court was the publicly known relationship between the defendant and the actual issuer of the misleading statement—a plaintiff might reasonably expect that the defendant was the actual source of the statement, regardless of whether the statement was expressly or “publicly attributable” to that defendant.
The various methods in the courts of appeal for analyzing primary liability based on the level of “attribution” of statements or omissions is ripe for resolution by the Supreme Court. The expected pronouncement from the Court in the Janus Capital case is likely to clarify the boundaries between primary and secondary actors and determine whether the Central Bankand Stoneridge firewall that protects secondary actors from liability will stand firm or continue to erode based on judicial expansions of the scope of primary liability.
By eroding the fundamental securities fraud concepts of reliance and loss causation, efforts to allow private rights of action against secondary aiders and abetters resemble less of a reasoned response to an intractable problem and more of an attempt to provide a type of broad investor insurance via the federal securities laws. As the Supreme Court points out in Stoneridge, there are already adequate remedies in state law that render unnecessary the extension of federal power into “areas already governed by functioning and effective state-law guarantees.” Though free to change the securities laws, Congress already spoke in the negative on this issue 15 years ago, giving authority only to the government to pursue secondary actors under the PSLRA—and the SEC’s enforcement efforts between 2002 and 2008 are estimated to have collected over $10 billion in disgorgement and penalties against secondary actors. Further, the PSLRA’s heightened pleading standards and loss-causation requirement also address these issues without further need to expand the class of defendants.
In addition, the amount and cost of discovery and the potential for uncertainty in “expos[ing] a new class of defendants” to the risk of claims would be disruptive in “allow[ing] plaintiffs with weak claims to extort settlement from innocent companies.” Foreign corporations with no other exposure to federal securities laws may be reticent to do business in the United States, thereby “raising the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.” In short, there are many negatives, beyond the simple issue of fairness, to broadening liability for violations to a large class of persons with little or no involvement in the securities markets.
Time will tell. By this summer, the comptroller general’s office is required to conclude its study and issue its report, and it is likely that the Supreme Court will have issued an opinion in Janus Capital. In the meantime, the anger over the financial meltdown and Wall Street’s perceived role as its primary cause will only increase the legislative and judicial moves toward private rights of action against secondary actors. Anyone advising companies or persons who do business with public companies should pay close attention to what is happening and realize that private companies with no direct connection to the public markets may soon find themselves defendants in federal securities fraud cases.
Editor’s Note: After this article was submitted, the Supreme Court heard argument in Janus Capital Group, Inc. v. First Derivative Traders, No. 09-525 (U.S. Dec. 7, 2010). The Court was troubled by two competing issues: first, that reversing the Fourth Circuit’s ruling would provide bad actors with a “road map” to avoid liability under Section 10(b) by simply structuring “puppet” companies that could disseminate misleading statements to the public and, second, that expanding the notion of what it is to “make” a false or misleading statement under Section 10(b) would create unintended liabilities for those who innocently provide services to public companies, such as lawyers who draft public disclosures.
The petitioners seemed to allay the fears of certain justices (Sotomayor and Ginsberg, primarily) by pointing out that there were already laws providing liability for aiders and abettors, including Sections 20(a) and (b) of the Securities Exchange Act and state fiduciary and fraud common laws. Justice Scalia, joined by the Chief Justice and Justice Alito, were concerned that “making” a statement under Section 10(b) could be broadened to include the simple “creation” of a statement, without any public attribution or dissemination, which was the government’s position at argument. Justice Scalia rejected this, reasoning that a speechwriter who writes a speech that he himself delivers cannot be said to have “made” the speech.
Questioning by the Court pointed either to a reversal of the Fourth Circuit’s ruling of liability under Section 10(b) in such a case and a reaffirming of the Stoneridge and Central Bankdecisions denying private rights of action for aiding and abetting liability or an affirming of the appeals court on narrow grounds and on the particular facts of the case.
Keywords: litigation, business torts, liability, aiding, abetting
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