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The dividing line between
primary and secondary liability in securities fraud actions has been a key
subject of debate since 1994 when the Supreme Court handed down its decision in
Central Bank of Denver, N.A. v. First
Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) [enhanced version (lexis.com subscribers) / lexisONE unenhanced version]. There, the high court held
that Exchange Act Section 10(b), the antifraud weapon of choice for the SEC as
well as private litigants, did not reach aiding and abetting. In the wake of
that decision, the circuits have split on the question of primary and secondary
liability. Some have adopted the "bright line" test, initially fashioned by the
Tenth Circuit and later developed and amplified by the Second Circuit. The
Ninth Circuit, in contrast, used the "substantial participation test." Both
tests are discussed
Congress partially addressed
the issue by restoring the SEC's aiding and abetting authority in the PSLRA.
Nevertheless, the issue continues to be of importance in its enforcement
actions. Congress has declined to extend aiding and abetting authority to
private securities fraud plaintiffs.
Many thought that the
Supreme Court would resolve the question Central
Bank created in deciding Stoneridge
Investment Partners, LLC. v. Scientific-Atlanta, Inc., 552 U.S. 148
(2008) [both versions available] two years ago. While the high court's decision
offers some guidance on the question, it left the issue unresolved.
Last week, the Second
Circuit in Pacific Investment Management v.
Mayer Brown, Case No. 09-1619 (2nd Cir. April 27, 2010) [both versions available]clarified a portion of its jurisprudence on the
question and harmonized its decisions with Stoneridge.
Pacific Investment arises out
of the collapse of Refco, one of the world's largest providers of brokerage and
clearing services in the international derivatives, currency and futures
markets as discussed
here. Defendants Mayer Brown, and firm partner Joseph Collins, were the
primary outside counsel for Refco. Plaintiffs purchased securities from Refco
prior to its collapse.
According to the complaint,
Refco engaged in a massive fraud. To conceal huge trading losses at the end of
each accounting period, the firm engaged in a series of sham loan transactions.
Those transactions were designed to transfer the losses to a privately held
company controlled by Refco's CEO. After the accounting period, the
transactions were reversed. Mayer Brown attorneys, under the direction of Mr.
Collins, documented those transactions. As a result of these transactions,
Refco's financial statements were false.
Mayer Brown and Mr. Collins
also are responsible, according to plaintiffs, for false statements which
appear in: 1) an Offering Memorandum for an unregistered bond offering; 2) a
Registration Statement for a subsequent registered bond offering; and 3) a
Registration Statement for Refco's initial public offering of common stock in
August 2005. According to plaintiffs, each of these documents are false because
they conceal the true financial condition of the company. Mayer Brown and Mr.
Collins helped draft these documents and reviewed them. No statements in any of
the documents are specifically attributed to the law firm or any of its
attorneys, although both the Offering Memorandum and the IPO registration
statement list Mayer Brown as outside counsel.
The district court
dismissed the complaint. That court held that the claims against the law firm
and Mr. Collins were essentially aiding and abetting, for which there is no
private right of action under Exchange Act Section 10(b). The district court
also rejected the contention that defendants could be held liable on a theory
of "scheme liability."
The Second Circuit
affirmed. The court began its analysis by reviewing its precedents on primary
liability. Generally the circuit's decisions require that there be attribution
of the claimed false statement to a defendant who is outside the corporation
under its leading case, Wright v. Ernst
& Young, LLP, 152 F.3d 169 (2nd Cir. 1998) [enhanced / unenhanced version not available]. Where the
defendant is a corporate insider however, the circuit has not required
attribution. In re Scholastic Corp. Sec.
Litig., 252 F.3d 63 (2nd Cir. 2001) [enhanced / unenhanced]. In this case involving those outside the
company, the court reaffirmed Wright
and its bright line test including its attribution requirement. Stated
differently, a false statement must be attributed to the particular defendant
for that person to be held liable under Section 10(b) at least where the person
is outside the company.
In reaching its conclusion,
the court rejected a "creator" test urged by the plaintiffs as well as the SEC
in an amicus brief. Under this
standard, those who "create" a false statement are within the ambit of Section
10(b) even if there is no public attribution of the statement to the person.
After noting that the views of the SEC are entitled to little deference in
private suits, the court concluded that the "creator" test is even broader than
the Ninth Circuit's "substantial participation" test of primary liability,
which it has consistently rejected as inconsistent with Central Bank.
In contrast, the
attribution requirement of the bright line test is consistent with Stoneridge. While the Supreme Court did
not specifically consider the bright line test, critical to its holding is the
element of reliance. In this regard, the Stoneridge
Court specifically rejected claims of liability for those alleged to have been
involved in the fraud where plaintiffs could not demonstrate that they relied
upon the defendant's own deceptive conduct. The attribution requirement of the
bright line test fortifies the reliance requirement by requiring that the
plaintiffs actually rely on the false statement of the defendant.
Likewise, the attribution
requirement fortifies the overall "bright line" approach to liability the
circuit has used - it helps draw a clear line. This contrasts sharply with the
"substantial participation" and "creator" tests which are essentially open
ended. Indeed, prosecutors and regulators such as the SEC often favor rules
which are overbroad which tend to render "'capital markets less rather than
more efficient,'" quoting Ralph K. Winter, Paying Lawyers, Empowering Prosecutors,
and Protecting Managers: Raising the Cost of Capital in America, 42 Duke L.J. 945, 962 (1993) [lexis.com subscribers, no
unenhanced version available].
Dismissal of plaintiffs'
claims is appropriate here because none of the statements alleged to have been
false are specifically attributed to either the law firm or its former partner.
The fact that the firm's name appeared on two of the documents as outside
counsel is not sufficient to attribute the specific claimed false statements to
the law firm.
Finally, the court agreed
with the district court that plaintiffs could not use a "scheme liability"
test. That approach was rejected by Stoneridge.
Accordingly, Mayer Brown and Mr. Collins could not be held liable under Section
In reaching its
conclusions, the circuit court specifically noted that its bright line test
does not apply to SEC enforcement actions. This follows from the fact that
reliance is only an element of a private damage action, not a Commission
enforcement case. At the same time the court did not reconcile its holding with
In re Scholastic Corp. Sec. Litig.
Accordingly whether attribution is required for corporate insiders remains an
open question in the Second Circuit.
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