Monday, December 19, 2005

SECURITIES LITIGATION

REGULATION

SECURITIES LITIGATION

REGULATION&

This fact pattern has arisen in

many of the recent accounting

scandals such as Enron, Parmalat and

Homestore, and the courts have

taken divergent approaches to

defining what constitutes a primary

violation. Two recent district court

decisions—in the Homestore and

Lernout & Hauspie cases—are now

pending before the Ninth and First

Circuit Courts of Appeals, respectively,

and their ultimate disposition may

have far-reaching implications for

secondary actor liability.

A Watershed Decision

In 1994, in Central Bank of Denver

v. First Interstate Bank of

Denver1 the Supreme Court

ruled that there is no private

cause of action for aiding

and abetting securities fraud

under Section 10(b) of the

Exchange Act and Rule

10b-5.2 The decision is of

great significance to

“secondary actor” defendants that,

prior to Central

Bank, often were

sued as aiders and

abettors. Signifi-

cantly, however,

the Supreme

Court in Central Bank left open the

possibility that secondary actors

could be held liable under §10(b)

as primary violators where “all of the

requirements for primary liabili-

ty under Rule 10b-5 are met.”3

In the wake of Central

Bank, securities fraud

plaintiffs began alleging

that secondary actors

themselves were pri-

mary violators, rather

than aiders and abettors.

The courts’ treatment of such

allegations has resulted

in a split among federal

circuits, at least in cases

BY HERBERT S. WASHER AND ADAM S. HAKKI

AFTER THE U.S.Supreme Court ruled in1994 that the securitieslaws do not permit civil

claims for aiding and abetting, litigantshave vigorously debated the questionof when a secondary actor—such as abanker, lawyer or accountant—may beconsidered a primary violator of thesecurities laws. This article focuses onthe recent evolution of that debate incases where secondary actors did notthemselves make misstatements uponwhich investors relied but, instead, participated in transactions that impact-ed an issuer’s financial statements.

Herbert S. Washer and Adam S. Hakkiare partners of Shearman & Sterling and specialize in securities litigation.Monique A. Gaylor, a litigation associate with the firm, assisted in the preparation of this article.The authors represent MerrillLynch in the Enron classaction securities litigationand various other Enron-related cases.

‘Scheme’ TheoryEvolves Under Rule 10b-5

Alleged pursuant to subsections (a) and (c), its application—and the results in two pending

appeals—have potentially far-reaching implications for secondary actor securities fraud liability.

where plaintiffs

rely on Rule 10b-5(b), which creates

liability for untrue statements or

omissions of material fact.4

A majority of the circuit courts that

have addressed the question, including

the Second Circuit, have applied a

bright line test, holding that the

secondary actor must itself directly

or indirectly make the false statement

or omission.5 Thus, for example, reviewing,

editing, or approving a statement

attributed to others is insufficient to create

primary liability in those circuits.6

In contrast, the Ninth Circuit has held

that a secondary actor whose conduct

amounts to substantial participation in

making the false statement (such as

playing a significant role in its drafting)

can be liable as a primary violator.7

‘Scheme’ Theory Evolves

Apparently due to the difficulty

of pleading and proving a primary

violation by a secondary actor under

Rule 10b-5(b), plaintiffs increasingly

have turned to allegations of so-called

“scheme” liability under subsections (a)

and (c) of Rule 10b-5 as an alternative

to claims under subsection (b).

Until recently, subsections (a) and (c)

rarely were invoked in cases involving

false statements in or omissions from

a company’s financial statements and

disclosures. Subsection (a) makes it

unlawful to “employ any device, scheme,

or artifice to defraud,” and subsection

(c) makes it unlawful to “engage in

any act, practice or course of business

which operates or would operate as

a fraud or deceit upon any person, in

connection with the purchase or sale

of any security.”8

Recently, plaintiffs have aggressively

pursued scheme theories of liability

against secondary actors under subsection

(a) and/or (c) in cases involving major

accounting scandals such as Homestore,

Lernout & Hauspie, Parmalat, and Enron.

In those cases, plaintiffs allege that

secondary actor defendants—who did

not make the misleading financial

statements and disclosures—are liable

under subsections (a) and/or (c) for

knowingly or recklessly participating

in “schemes” with insiders that

allowed the companies to misstate their

financial condition.

A threshold question presented in

these cases is whether a secondary actor

who participates in a scheme intended to

generate false financial results, but does

not itself participate in generating the

company’s financial statements, can be

held liable under Rule 10b-5.

In In re Homestore.com Inc. Securities

Litigation,9 the U.S. District Court for the

Central District of California held,

among other things, that where a plaintiff

had suffered injury through its reliance

on false and misleading financial

statements, it was the statements—and

not the underlying scheme to generate

false revenues—that were actionable.10

The court’s decision is now on appeal

to the Ninth Circuit. Notably, the

Securities and Exchange Commission

has submitted an amicus brief on the

appeal, arguing for a more expansive

view of secondary actor liability under

subsections (a) and (c) of Rule 10b-5.

In direct contrast to the district court’s

decision in Homestore, the U.S. District

Court for the District of Massachusetts

ruled, in In re Lernout & Hauspie

Securities Litigation11 that, even where

a defendant is not alleged to have

made or participated in the false and

misleading statement, that defendant

can still be liable as a scheme participant

where it has knowingly or recklessly

engaged in a sham transaction that

allowed an issuer to record false revenue

in its financial statements.12

The court found sufficient allegations

of reliance on the secondary actors’

conduct by viewing the alleged

scheme “as a whole” rather than by

viewing the alleged sham transactions

and subsequent financial statement

disclosures separately from each other.13

Recognizing the importance of the

issue, the district court has certified the

matter for interlocutory appeal to the

First Circuit.14

The U.S. District Court for the

Southern District of Texas reached a

similar result (albeit through somewhat

different reasoning) in the Enron

securities litigation in denying motions to

dismiss by secondary actor defendants

who were alleged to have participated in

transactions designed to manipulate

Enron’s financial results, but who were

not alleged to have helped prepare the

financial statements themselves.15

More recently, Judge Lewis Kaplan of

the U.S. District Court for the Southern

District of New York, ruling in the

Parmalat litigation, essentially followed

the court’s decision in the Lernout &

Hauspie case in denying motions to

dismiss claims under subsections (a) and

(c) of Rule 10b-5.16 In so doing, Judge

Kaplan noted that his scheme “analysis

is not a back door into liability for those

who help others make a false statement

or omission in violation of subsection

(b) of the Rule 10b-5,” which, in

Judge Kaplan’s view, is different from

“whether a defendant’s challenged

conduct in relation to a fraudulent

scheme constitutes the use of a deceptive

device or contrivance.”17

The use of scheme liability under

subsections (a) and (c) of Rule 10b-5

against secondary actors in such cases

where (i) plaintiffs allegedly relied on

false and misleading financial statements,

and (ii) the secondary actors did not

prepare or substantially participate in

preparing the financial statements has

broad implications for the continuing

application of Central Bank, pleading the

NEW YORK LAW JOURNAL MONDAY, DECEMBER 19, 2005

elements of reliance and loss causation,

and the scope of joint and several liability

for knowing violations of Rule 10b-5.

Reliance and Loss Causation

The rise of scheme allegations raises

a fundamental question: How direct

a relationship must there be between

a “primary” violator’s conduct and a

plaintiff ’s losses?

As discussed above, the Supreme

Court in Central Bank held that

secondary actors could be primary

violators under §10(b) only if plaintiff

were able to plead and prove “all of the

requirements for primary liability

under Rule 10b-5.”18 The Court empha-

sized that this requirement is essential

because to hold otherwise would subject

defendants to liability “without any

showing that the plaintiff relied upon

the aider and abettor’s statements or

actions.”19 The Court concluded that

“[a]llowing plaintiffs to circumvent the

reliance requirement would disregard

the careful limits on 10b-5 recovery

mandated by our earlier cases.”20

Since Central Bank, however, a

number of courts that have found

secondary actors potentially liable as

primary participants in a scheme

(including in the Lernout, Enron and

Parmalat cases discussed above) have

done so by requiring only a loose

connection between the secondary actor

defendants’ conduct and plaintiffs.

In these cases, the element of

reliance often is satisfied by showing

that plaintiffs relied on other defendants’

conduct; the element of loss causation

occasionally is not addressed at all.

In short, it is not clear that all courts

are adhering rigorously to the Supreme

Court’s requirement that plaintiffs

prove “all of the requirements for

primary liability.”

For example, the divergent results in

the Homestore and Lernout cases may be

attributed, at least in part, to the courts’

treatment of the element of reliance.

The district court’s opinion in

Homestore—finding that plaintiffs

directly relied only on the financial

statement misrepresentations, rather

than the underlying alleged scheme—

embodied a rigorous and defendant-

specific requirement of reliance. In

contrast, the Lernout decision found a

less direct connection to be sufficient,

holding that primary liability could

apply to “any person who substantially

participates in a manipulative or

deceptive scheme…even if a material

misstatement by another person creates

the nexus between the scheme and the

securities market.”21

Courts’ views also diverge on the loss

causation requirement in the context of

a scheme case. In a broadly defined

scheme case, the question will arise as to

whether plaintiffs must show that each

defendant committed a securities law

violation that directly caused a portion

of plaintiffs’ losses or whether, instead,

plaintiffs merely need to show that the

scheme, considered in the aggregate,

caused those losses.

Although few courts have addressed

the issue squarely, plaintiffs contend

that some decisions have focused on the

loss causation impact of the overall

scheme, rather than on the impact of

each defendant’s individual conduct,

thereby tacitly adopting plaintiffs’ view

that a showing of “scheme-wide” loss

causation is sufficient.22

Defendants interpret such cases

differently and contend that such an

approach would effectively eliminate

the element of loss causation and

undermine the Central Bank decision.

Defendants’ argument begins with

the language of the Private Securities

Litigation Reform Act, which places

upon plaintiffs the burden of proving

that the “act or omission of the

defendant alleged to violate this chapter

caused the loss for which plaintiff seeks

to recover damages.”23

Defendants also cite to both pre- and

post-PSLRA cases holding that loss

causation must be traced to each

defendant’s conduct, even in the

context of a multiple-defendant,

broad-based scheme.24

Joint and Several Liability

Many expect that the Ninth Circuit

in Homestore, and the First Circuit

in Lernout, will provide guidance

concerning the degree to which a

primary violator and a plaintiff must be

connected for purposes of reliance and

loss causation. Until then, however, it

seems likely that plaintiffs will continue

to push for broadly defined schemes

under Rule 10b-5(a) and (c), raising a

final and perhaps most controversial

issue: the application of the joint and

several liability provisions of the PSLRA

in the context of a scheme case.

Courts have only recently begun to

grapple with this issue. The PSLRA

provides that “[a]ny covered person

against whom a final judgment is

entered in a private action shall be

liable for damages jointly and severally

only if the trier of fact specifically

determines that such covered person

knowingly committed a violation of

the securities laws.” In the context of a

scheme in which many defendants

were aware of and participated in only

limited aspects of the overall scheme,

the question becomes “joint and several

liability for what?”

Clearly, the PSLRA is intended to

provide for joint and several liability

against a knowing violator for losses

caused by the transaction in which it

was a primary participant. But is such a

defendant also responsible for losses

caused by other transactions that,

although part of the alleged overall

NEW YORK LAW JOURNAL MONDAY, DECEMBER 19, 2005

scheme, it did not even know about,

much less participate in?

Plaintiffs have argued in a number

of cases that any defendant who

knowingly commits a primary violation

in furtherance of a larger scheme should

be jointly and severally liable for the

entire scheme. The rather straightforward

argument is that under the PSLRA,

defendants who are found to be primary

participants in a scheme under Rule

10b-5(a) are jointly and severally liable if

they “knowingly committed a violation of

the securities laws.”25

Plaintiffs reject any notion of unfairness

in applying joint and several liability,

noting that Congress specifically considered

the potential plight of a defendant who

contributes in an insignificant way to

the overall violation by providing for

contribution26 and verdict or judgment

reduction27 within the PSLRA.

Defendants argue that the notion of

joint and several liability for conduct

known and unknown to the defendant is

plainly inconsistent with the “knowing”

language of the PSLRA, as well as the

loss causation requirement.

In the context of a more traditional

and narrowly defined “scheme,” no issue

arises because the conduct in which the

defendant knowingly participates is the

same conduct that “causes” plaintiffs’

losses. But where a knowing violation of

the securities law is used to propel a

defendant into a larger scheme, that

connection may not exist.

Indeed, in such a circumstance, the

vast majority of plaintiffs’ losses may have

been caused by aspects of the scheme

about which a particular defendant

knew nothing. In that circumstance,

defendants argue, there was no “knowing”

conduct that would justify joint and

several liability.

Although few cases have directly

addressed this issue, differences in

approach already are evident.

In Parmalat, for example, plaintiffs

alleged a multi-year scheme to

falsify Parmalat’s financial statements.

Plaintiffs’ complaint sought damages

“against all Defendants, jointly and

severally, for all damages sustained as a

result of the Defendants’ wrongdoing.”28

In ruling on defendants’ motions to

dismiss, however, Judge Kaplan declined

to treat the defendants as participants

in a single overarching scheme, for

which joint and several liability could

apply. Instead, Judge Kaplan analyzed

each defendant’s individual role in each

relevant transaction to determine

whether that defendant was a primary

violator with respect to each transaction

or act only.29

Confronted with similar allegations

in Enron, Judge Melinda Harmon did

not necessarily reject the notion of an

overarching scheme, but she did not

accept plaintiffs’ argument that one

who commits a knowing violation in

furtherance of that overarching scheme

can be jointly and severally liable for

all losses caused. Rather, she observed

that the PSLRA’s “knowing” requirement

for joint and several liability “seems

incompatible with Lead Plaintiff ’s

argument that a participant is liable for

damages caused by all participants,

known or unknown in the scheme.”30

Ultimately, courts’ willingness to

predicate §10(b) liability on broad-

based, multi-year schemes, and to

impose joint and several liability for such

schemes, will have a significant impact

on the continued meaningfulness of the

Supreme Court’s Central Bank decision

and the balance of power among the

parties in settlement negotiations.

Should the guidance provided by the

Ninth and First Circuits differ materially,

it is conceivable that the Supreme

Court would accept an opportunity to

further clarify the distinction between

actionable primary violations and

nonactionable aiding and abetting.

•••••••••••••••••••••••••••••••

1. 511 U.S. 164 (1994).2. Id. at 177.3. Id. at 191.4. 17 C.F.R. §240.10b-5.5. See Ziemba v. Cascade Int’l, Inc., 256 F.3d 1194, 1205

(11th Cir. 2001); Shapiro v. Cantor, 123 F.3d 717, 720 (2d Cir.1997); Anixter v. Home-State Prod. Co., 77 F.3d 1215, 1225(10th Cir. 1996).

6. See, e.g., Wright v. Ernst & Young LLP, 152 F.3d 169, 175(2d Cir. 1998). But see In re Global Crossing, Ltd. Sec. Litig., 322F.Supp.2d 319, 334 (S.D.N.Y. 2004) (finding allegations thatauditor “reviewed every public filing, earnings release, and quar-terly report” and “materially assisted in preparation of all pub-lic disclosures” sufficient to state a claim even though nomisrepresentations in these documents were attributed to theauditor).

7. See In re Software Toolworks Sec. Litig., 50 F.3d 615, 628n.3 (9th Cir. 1994).

8. Section 240.10b-5.9. 252 F.Supp.2d 1018 (C.D. Cal. 2003).10. Id. at 1041 (finding that “the plaintiff suffered damage

through its reliance on false or misleading statements, not fromthe ‘scheme’ itself [which was] one step removed from theinjured party”).

11. 236 F.Supp.2d 161 (D. Mass. 2003).12. Id. at 173.13. Id. at 174.14. See Order and Memorandum, Quaak v. Dexia, D. Mass.

No. 03 Civ. 11566, Doc. No. 79, at 3, 6-9.15. In re Enron Corp. Sec., Deriv. & ERISA Litig., 235

F.Supp.2d 549, 577-82 (S.D. Tex. 2002). 16. In re Parmalat Sec. Litig., 376 F.Supp.2d 472, 502-03

(S.D.N.Y. 2005).17. Id. at 503.18. Cent. Bank of Denver v. First Interstate Bank of Denver,

511 U.S. 164, 191 (1994). 19. Id. at 180. 20. Id.21. In re Lernout & Hauspie Sec. Litig., 236 F. Supp. 2d 161,

173 (D. Mass. 2003).22. See, e.g., In re Blech Sec. Litig., 961 F. Supp. 569, 576

(S.D.N.Y. 1997) (“With respect to loss causation, the princi-pal question is whether the loss is a reasonably foreseeable con-sequence of the fraudulent actions. Here, the economic harmto the Plaintiffs from the ultimate collapse of the price of theBlech securities that were inflated by the actions of Bear Stearns(and Blech and his confederates) was a foreseeable consequenceof Bear Stearns’ alleged conduct. Accordingly, loss causationis also adequately pleaded.”).

23. 15 U.S.C. §78u-4(b)(4) (emphasis added).24. See, e.g., Bloor v. Carro, Spanbock, Londin, Rodman &

Fass, 754 F.2d 57, 61 (2d Cir. 1985) (affirming dismissal ofclaims against a law firm defendant for participation in broad-based scheme to defraud where plaintiffs failed to allege the“loss causation” connection between defendant’s actions andplaintiffs’ losses); Baxter v. A.R. Baron & Co., No. 94 Civ. 3913,1995 U.S. Dist. LEXIS 14882, at *19 (S.D.N.Y. Oct. 6, 1995)(stating that “[e]ven where a 10(b) claim is based not on spe-cific misrepresentations or omissions, but rather on a ‘com-prehensive scheme to defraud,’ the plaintiff must stilldemonstrate causation in fact by showing that defendant’sallegedly fraudulent activities were actually responsible forplaintiff’s injuries”).

25. Section 78u-4(f)(2)(A).26. See §78u-4(f)(8).27. See §78u-4(f)(7)(B).28. Second Amended Consolidated Class Action Com-

plaint, In re Parmalat Sec. Litig., D. Mass. No. 04 M.D. 01653,Doc. No. 213, at 387.

29. See In re Parmalat Sec. Litig., 376 F.Supp.2d 472, 505(S.D.N.Y. 2005). Judge Kaplan also looked at the schemes indi-vidually when discussing loss causation. See id. at 510.

30. In re Enron Corp. Sec., Deriv. & ERISA Litig., 235 F.Supp. 2d 549, 593 (S.D. Tex. 2002).

This article is reprinted with permission from the December 19, 2005 edition of the NEW YORKLAW JOURNAL. © 2005 ALM Properties, Inc.All rights reserved. Further duplication withoutpermission is prohibited. For information, contactALM Reprint Department at 800-888-8300 x6111.#070-12-05-0050

NEW YORK LAW JOURNAL MONDAY, DECEMBER 19, 2005