Secondary Liability and Rule 10b-5: The Bottom Line

We have been writing about a trilogy of cases testing the boundaries of primary liability under Rule 10b-5:  Simpson v. AOL, In re Charter and Regents v. Credit Suisse.  They deal with the application of the antifraud provisions to vendors and investment banking firms.  Moreover, the cases are particularly topical now that the Supreme Court has agreed to hear Charter and may yet agree to hear Credit Suisse.

These cases have provoked predictions of a litany of horrors that will occur if the Supreme Court fails to agree with the 8th Circuit in Charter and the 5th Circuit in Credit Suisse and adopt a highly restrictive definition of primary liability.  They have invoked reference to Bill Lerach, the dean of the securities class action bar, as if the mere mention of his name would somehow justify a narrow definition of primary liability. 

These commentators, however, overstate the consequences of any such decision.  Even if the Supreme Court adopts a formulation for primary liability broader than the one used by the 8th Circuit in Charter, few if any vendors or third parties will find themselves parties to a fraud suit that won't be resolved on a motion to dismiss.  Let us look at why this is the case.

First, plaintiffs still must plead scienter against any vendor, no easy matter given the onerous pleading requirements of the PSLRA.  Think about all of the evidence that must be produced to show scienter by the company making the fraud.  In issuer cases, scienter often turns upon evidence of unusual trading activity by corporate insiders.  For vendors, this type of evidence will almost never be present.  It will be the rare circumstance that this level of information will be available to establish scienter for a person or entity that merely does business with the issuer.     

Second, plaintiffs must show that the transaction was material.  A small sham transaction knowingly done may not amount to fraud.  

Knowledge and materiality are not enough.  For there to be primary liability, the Ninth Circuit test in Simpson, the broadest formulation, essentially requires direct participation in the fraud by engaging in a transaction that has as its principal purpose to effect the fraud.  Moreover, the court suggested that this would only occur where the transaction lacked economic substance.  See 452 F3d at 1050 ("Conduct by the defendant that does not have a principal legitimate business purpose, such as the invention of sham corporate entities to misrepresent the flow of income, may have a principal purpose of creating a false appearance.").  The facts in Simpson did not meet this test.  Moreover, the facts in Charter probably wouldn't as well.  While the vendors in that case allegedly knew that the transaction would facilitate fraud, the deal had economic substance:  The payment of additional $20 with the expectation that the sum would be returned in the form of additional services.  See 443 F3d at 993 (describing transaction by vendors as "arm's length non-securities transaction"). 

Even the infamous Nigerian barge transaction at issue in Credit Suisse might not meet the test in Simpson for primary liability.  While it is true that Merrill Lynch bought the barge subject to an undisclosed guarantee by Enron to repurchase it, the securities firm still held title, had to operate the barge, and presumably assumed the risk of loss.  It was a real purchase, not a sham, albeit one with a guaranteed return if the barge were still in existence. 

In other words, even if the Supreme Court rejects the tests in Charter and Credit Suisse and adopts the one in Simpson, it will be the rare case that a vendor will be primarily liable under Rule 10b-5.  

Comments

[Securities Lawyer]

I respectfully disagree with this analysis, as the facts of Simpson itself shows that it would not be such a rare occurence. Look at what happened following the 9th Circuit's remand. The district court applied the "substantial participation" standard of Simpson and denied the motion to dismiss by one of the vendors (the one which had the least detail pled against them of all the "business partners"). The result had both sides scratching their heads, and highlights the unworkability of the Simpson test.

[J. Robert Brown]

I have not seen the district court opinion (can you send a copy) but it seems to me that the district court incorrectly applied Simpson. The principal and effect test in that case is a long way from substantial participation. Simpson arguably requires the presence of a sham transaction. To the extent this is the case, do that many vendors really have much to worry about?