Corporate Governance and the Liability of Secondary Actors

One of the most significant issues currently making the rounds in the various federal circuits (and, as we shall discuss, the US Supreme Court) concerns the definition of primary liability under Section 10(b) and Rule 10b-5. This has been an issue since the Supreme Court’s surprise decision in Central Bank more than a decade ago. See Central Bank v. First Interstate Bank of Denver, 511 U.S. 164 (1994). A sleepy case from the Tenth Circuit (involving the application of aiding and abetting liability to an indenture trustee), the Supreme Court used it as a vehicle to address and then discard aiding and abetting liability under the antifraud provisions.  This was no accident.  It was the Supreme Court that asked to have the issue briefed. See 508 US 959 (1993).  

As anyone familiar with this area knows all too well, Central Bank generated immediate pressure on the meaning of primary violator.  The provision most obviously applied to anyone actually making a false statement.  But much of the disclosure litigated in securities class action suits is made by the company.  To the extent limiting the provision to those actually making the statement, the antifraud provisions would not extend to the persons responsible for the false disclsoure. 

As a result, primary liability was extended not just to the person making the statement but to those involved in the drafting process (and as a corollary, to those who signed the disclosure document).  Absent special circumstances, this approach generally exonerated most outside directors (although this could change given the heightened responsibilities of independent directors on the audit committee).

How far the doctrine extended outside the company, however, was a more difficult issue to resolve. In general, the cases decided after Central Bank typically involved accounting firms and lawyers, persons not employed by the company but having some role in the actual disclosure process. The law in the area was divided but in general primary liability required some involvement in the fraudulent disclosure.  

Worldcom, Enron and the fallout from the dot com boom, however, focused attention on other categories of actors. With the issuer of the statement often bankrupt, plaintiffs cast about for deeper, more solvent, pockets.  Looking beyond accountants and lawyers, a number of fraud actions were brought against third party vendors and investment banking firms alleging that each was primarily liable under Rule 10b-5.  Three such cases have been decided at the circuit level over the last year.  In Simpson v. AOL Time Warner, 452 F.3d 1040 (9^th Cir. 2006) and In re Charter Communications, 443 F.3d 987 (8^th Cir. 2006), the two courts addressed allegations of sham transactions between the company and vendors that facilitated the company's ability to commit fraud. In Regents v. Credit Suisse First Boston (USA), Inc ., 2007 U.S. App. LEXIS 6396 (5th Cir. March 19, 2007), the Fifth Circuit addressed the primary liability of investment banking firms employed by Enron.

The cases are attempting to set the boundary of Rule 10b-5 by construing the meaning of primary liability.  They are not about state of mind.  As a result, they assume that the vendors and investment banking firms know that the transactions will result in financial fraud.  In two of the cases, Charter and Credit Suisse, the courts determined that primary liability only extended to those actors that had a duty to disclose.  Since investment banks and third parties did not, they could not be liable under Rule 10b-5 even for allegedly sham transactions used by the issuer to inflate earnings.  Simpson took a different approach, finding that a scheme to defraud under Rule 10b-5 extended to anyone who engaged “in a transaction, the principal purpose and effect of which is to create the false appearance of fact. . .”

The case is before the Supreme Court. The Court took certiorari in Charter Communications. See 127 S. Ct. 1873 (March 26, 2007).  Justices Breyer and Roberts took no part in the decision to grant certiorari, suggesting that they may be recused.  Of the remaining seven, three were in the majority in Central Bank (Kennedy, Scalia and Thomas) and three were in the dissent (Ginsburg, Stevens and Souter). To the extent this line up continues to hold, Justice Alito will decide the outcome. 

We will explore this area over the next several days. Students will contribute a number of posts.