Rule 10b-5 and Secondary Liability: Simpson v. AOL/Time Warner and Third Party Vendors

We are examining the reach of the antifraud provisions under the Exchange Act. As we have noted in prior posts, Section 10(b) and Rule 10b-5 do not encompass aiding and abetting liability. The question, therefore, is how far an actor must be from the actual disclosure process and still be treated as primarily liable under these provisions.

As noted, courts had little difficulty extending the concept of primary liability not just to those who made the statement, but also those involved in the drafting process. This allowed courts to hold accountable those officers and directors responsible for issuing the false disclosure. See Howard v. Everex Sys., Inc ., 228 F.3d 1057, 1061 n.5 (9th Cir. 2000) (“substantial participation or intricate involvement in the preparation of fraudulent statements is grounds for primary liability even though that participation might not lead to the actor's actual making of the statements."). Lawyers and accountants presented a harder case.

With companies going bankrupt and unable to compensate shareholders for their own false disclosure, plaintiffs searched for other actors who might provide the deep pocket necessary to recover. In Simpson v. AOL/Time Warner, 452 F.3d 1040 (2^nd Cir. 2006), plaintiffs, shareholders of the defunct company, Homestore.com, alleged that a number of vendors committed fraud by entering into transactions that enabled Homestore to misstate its revenues. In general, the transactions involved payments by Homestore for nothing in return, with the funds returned to the company, often through the purchase of advertising.

The vendors had no role in the disclosure made by Homestore. To be liable as primary actors, therefore, they had to come within the language in Rule 10b-5 extending the provision to those participating in a “scheme to defraud.”  The Second Circuit held that “to be liable as a primary violator of § 10(b) for participation in a ‘scheme to defraud,’ the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme." Participation alone would not suffice.  “[T]he defendant's own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect.”  With respect to vendors, the court noted that transactions without a legitimate business purpose could meet the test while those that did “would not typically be considered to have the purpose and effect of creating a misrepresentation.” This was true even if the vendor knew that the company would use the legitimate transaction to effectuate a fraud.

In analyzing the vendors at issue, the court concluded that none met the test of primary violator. Officials at AOL allegedly helped Homestore set up the transactions but “helping” was not enough. No act performed by AOL was alleged to have been a sham. Homestore provided funds to vendors who returned the funds to Homestore by purchasing advertising through AOL. In fact the advertising contracts were legitimate transactions, with AOL acting “as a conduit for the flow of revenue between the Third Party Vendors and Homestore as an advertising agent, in accord with AOL's advertising reseller agreement with Homestore.”  In ther deals involving Cendant, the court concluded that the fraudulent appearance did not arise from the transactions themselves but from Homestore's treatment of them. 

The decision, therefore, allowed actors directly responsible for fraudulent behavior to be sued for securities fraud but essentially required that the transactions themselves perpetuate the fraud.  In other words, the transactions had to have no real business purpose beyond creating false disclosure.  In Simpson, the court indicated that this would include payments to vendors for nothing of value with the expectation that the funds would be funneled back to the company, again for no goods or services.

The test in Simpson is a tough one to meet but provides that third party vendors can be liable where they facilitate fraud through sham transactions.  As it turns out, the cases that would follow make this test seem easy to meet by comparison.