Secondary Liability and Vendors: In re Charter Communications

We have been tracing the development of primary liability under Rule 10b-5.  After Central Bank in 1994, actors who merely aid and abet securities fraud can no longer be sued under the antifraud provision. 

In the aftermath of Central Bank, it became more important to know who fell within the definition of primary violator.  Having said that, the issue was only of modest importance.  With securities fraud suits alleging false disclosure by the issuer (an unmistakable primary violator), other players did not matter as much so long as the company was solvent and could pay any settlement amount.  To a lesser extent, accountants, as available deep pockets and to some degree involved in the disclosure process, found themselves involved in these suits.  As a result, much of the case law attempting to draw lines between primary and secondary liability involve accounting firms.  For a recent example, take a look at Overton v. Todman, 478 F.3d 479 (2nd Cir. 2007)(concluding that an accountant can be primarily liable under Rule 10b-5 for failing to correct a certified opinion that it later learns was false).   

But with the spectacular corporate failures of the new millennium, including those arising out of the dot com bubble, pressure on the definition increased.  The insolvent companies weren't able to pay any settlement amount.  Plaintiffs, as a result, began to search for additional deep pockets.  In Simpson v. AOL/Time Warner, 452 F.3d 1040 (9th Cir. 2006), the 9th Circuit addressed the meaning of primary liability in the context of vendors.  The court found that vendors could be sued where they engaged in transactions, the purpose and effect was to create a false appearance of fact in furtherance of the scheme to defraud.  While the test was a tough one (largely concluding that vendors could not be sued unless the transactions were a sham designed to facilitate fraud), the court still allowed for vendors to be sued even though they did not make the false disclosure and were not involved in the drafting or editing process.

In In re Charter Communications, 443 F.3d 987 (8th Cir. 2006), the 8th Circuit took another approach.  Charter was not a bankrupt company but it was one in serious distress, with some speculating that it would fail.  Perhaps as a result, plaintiffs opted to sue two equipment vendors, Scientific-Atlanta and Motorola.  Plaintiffs alleged that the vendors engaged in sham transactions designed to facilitate fraud by Charter.  As the court described: 

• "At the time in question, Charter delivered cable services through set-top boxes installed on customers' TV sets. Charter purchased the set-top boxes from third-parties, including the Vendors. In August 2000, although Charter had firm contracts with the Vendors to purchase set-top boxes at a set price sufficient for its present needs, Charter agreed to pay the Vendors an additional $ 20 per set-top box in exchange for the Vendors returning the additional payments to Charter in the form of advertising fees."

Plaintiffs alleged that the $20/box in advertising fees was treated as revenue while the additional $20 paid for the boxes was capitalized.  Plaintiffs asserted that these transactions were a sham, had no economic substance, and were used only to allow Charter to meet Wall Street expectations.   The vendors did not, however, play "any role in preparing or disseminating the fraudulent financial statements and press releases through which Charter published its deception to analysts and investors." 

The 8th Circuit adopted a narrow reading of liability under Rule 10b-5.  "Thus, any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable" under the antifraud provisions.  With respect to the vendors, they did not meet this standard:

• "However, neither Motorola nor Scientific-Atlanta was alleged to have engaged in any such deceptive act. They did not issue any misstatement relied upon by the investing public, nor were they under a duty to Charter investors and analysts to disclose information useful in evaluating Charter's true financial condition. None of the alleged financial misrepresentations by Charter was made by or even with the approval of the Vendors."

The test employed by the 8th Circuit is not all that different from the one used by the 9th Circuit in Simpson.  The 8th Circuit brought within the definition of primary liability not just those who made the statement but anyone who "cause[d]" a fraudulent misstatement to be made.  Presumably actors who deliberately facilitated fraudulent financial statements by, for example, providing false documentation, would "cause" a violation.

The astounding part of the decision is its application.  As the plaintiffs make clear in their briefs (which are available at the DU Corporate Governance web site), they alleged that the transactions with the vendors had no bona fide business purpose.  Instead, the "raison d'etre was to inflate Charter's cash flow and satisfy analysts' expectations."  Add in that the vendors allegedly "falsified documentation to lend the appearance of legitimacy."  

In other words, these were transactions without economic substance and designed to allow Charter to inflate its earnings.  Yet the 8th Circuit concluded that such behavior was not a "cause" of Charter's misstatements.  This suggests that any vendor or other third party not actually engaging in the drafting process would escape liability.  This would be true even where the transaction was a sham and the third party knew that the only purpose was to commit securities fraud.   Moreover, this would be a particularly difficult type of fraud for accountants to uncover since everything would appear, as a matter of paper work, in order.

There is no doubt that extending Rule 10b-5 liability to vendors would create enormous problems, as the comment by Marc Hodak reflects.  (His blog, by the way, is here ).   At the same time, exonerating all persons not directly involved in the actual disclosure process would likewise permit a considerable amount of fraudulent activity to escape the reach of Rule 10b-5.  Understand that even if the vendors and other third parties fit within the definition of primary violator, all other elements of fraud must be proven, including scienter.  Many many vendors will ultimately escape suits because of the difficulty plaintiffs will have showing this element. 

The Supreme Court has accepted certiorari in this case.  Tomorrow we will discuss the 5th Circuit's decision in Enron.