Primary Liability and Enron: University of California v. Credit Suisse First Boston

This case arose from the defendant banks’ involvement in the accounting frauds committed by Enron. The banks were accused of perpetuating the fraud by engaging in certain "round-trip transactions" that allowed Enron to record sales of its assets as revenue, only to later buy back those same assets from the banks at a premium. The plaintiffs are former Enron shareholders who filed for class certification with the district court, and after the certification was granted, the banks appealed.

The plaintiffs argued, and the district court held, that they were entitled to a classwide presumption of reliance based on the alleged omissions under Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972), because the banks were under a “duty not to engage in a fraudulent scheme,” and by participating in the transactions with Enron, they had violated that duty. This presumption was critical to class certification, as it allowed the plaintiffs to show reliance as a class instead of individually. However, the Court of Appeals disagreed with the district court’s analysis. In a split decision, the Court determined that to obtain the Affiliated Ute presumption of reliance on an omission the plaintiff must show two things: (1) that the case is based primarily upon an omission; and (2) that the defendant owed the plaintiff a duty to disclose. In this case, the banks were not fiduciaries of the plaintiffs and the plaintiffs “had no expectation that the banks would provide them with information,” and as such, “there is no reason to expect that the plaintiffs were relying on their candor.”

The second major issue on appeal concerned the reach of Section 10(b) and Rule 10b-5.  After Central Bank the provision only extends to primary violators.  See Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994).  The Court of Appeals acknowledged that the Supreme Court had “conclusively foreclosed the application of secondary liability under 10(b)” but had left open the possibility that primary liability can still be applied to “secondary actors such as investment banks and accountants” under certain circumstances.  In deciding what those circumstances are, the court sided with the 8^th Circuit (In re Charter Commc'ns, Inc., 443 F.3d 987 (8th Cir. 2006) a case now pending before the Supreme Court) and concluded that for primary liability to apply, the defendant must either “make or affirmatively cause to be made a fraudulent statement or omission” or “directly engage in manipulative securities trading practices.” 

Since the banks had made no statement and had no duty to disclose, they could not be sued as primary violators under Section 10(b) and Rule 10b-5.  As for manipulation, the Court of Appeals, relying on the Supreme Court’s decision in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 214 (1976), held that “[m]anipulation requires that a defendant act directly in the market for the relevant security.” Here, the banks engaged in transactions that “gave a misleading impression of the value of Enron securities that were already on the market.” This, according to the Court, was not the type of manipulative device the Supreme Court has held that “an efficient market may be legally presumed to rely” upon.

The Court of Appeals reversed the class certification and remanded back to the district court.

The briefs and full text of the Court’s opinion can be found on the DU Corporate Governance website.