In two decisions issued last year, the Eighth Circuit and the Ninth Circuit split over the extent to which secondary actors (e.g., accountants, lawyers, or bankers) can be held primarily liable under Rules 10b-5(a) and (c) for deceptive devices, schemes, and acts. The Eighth Circuit limited the scope of potential liability, holding that “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 Sec. 10(b) or any subpart of Rule 10b-5.” In contrast, the Ninth Circuit created a broader test, finding that “to be liable as a primary violator of Sec. 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.” In a decision issued yesterday, the Fifth Circuit has sided squarely with the Eighth Circuit and limited the scope of liability.
In Regents of the Univ. of California., et al. v. Credit Suisse First Boston (USA), Inc., et al., 2007 WL 816518 (5th Cir. March 19, 2007), the issue presented was whether the district court had properly granted class certification for Rule 10b-5 claims brought against three banks that had entered into transactions with Enron. The “common feature of these transactions is that they allowed Enron to misstate its financial condition; there is no allegation that the banks were fiduciaries of the plaintiffs [Enron investors], that they improperly filed financial reports on Enron’s behalf, or that they engaged in wash sales or other manipulative activities directly in the market for Enron securities.” Nevertheless, the district court held that class certification was appropriate because a “deceptive act” included participation in a transaction whose principal purpose and effect was to create a false appearance of revenues. Because the banks had failed in their duty not to engage in a fraudulent scheme, the district court found that plaintiffs were “entitled to rely on the classwide presumption of reliance for omissions and fraud on the market.” On appeal, the Fifth Circuit disagreed.
As an initial matter, the court found that it could address the district court’s definition of “deceptive act” because it was the basis for the district court’s determination that the plaintiffs were entitled to a presumption of reliance. Without that presumption, class certification would fail.
The court then turned to whether plaintiffs could properly rely on a presumption of reliance created by either the existence of actionable omissions or a fraud on the market. First, the court held that the banks had not made any actionable omissions because they “did not owe plaintiffs any duty to disclose the nature of the alleged transactions.” Second, the court found that the district court’s definition of “deceptive act” was “inconsistent with the Supreme Court’s decision that Sec. 10 does not give rise to aiding and abetting liability.” After examining relevant Supreme Court precedent, the court held that the Eighth Circuit’s definition of “deceptive act” (i.e., conduct involving “either a misstatement or a failure to disclose by one who has a duty to disclose”) was correct. In contrast, the banks’ acts “at most aided and abetted Enron’s deceit by making its misrepresentations more plausible.” Finally, the court concluded that the transactions did not constitute market manipulation because the banks “did not act directly in the market for Enron securities.” Because the banks’ transactions with Enron were not deceptive acts and did not constitute market manipulation, there could be no fraud on the market presumption of reliance and class certification failed.
A few additional notes on the panel’s decision:
(1) There is a “concurrence” that, in fact, is a vigorous dissent from the primary legal holdings in the majority opinion. In particular, the concurring judge found that the majority had overreached in deciding the substantive scope of Rule 10b-5 on an appeal from class certification and that its definition of “deceptive act” was too narrow.
(2) There has been a significant amount of commentary on the decision already. For an internet roundup, see this Point of Law post.
(3) One obvious question is whether this ruling will have any effect on the previous bank settlements in the Enron securities litigation totaling over $7 billion. According to a Wall Street Journal article in today’s edition, the answer is “no,” because the settlements are already final.
Quote of note (opinion): “We recognize, however, that our ruling on legal merit may not coincide, particularly in the minds of aggrieved former Enron shareholders who have lost billions of dollars in a fraud they allege was aided and abetted by the defendants at bar, with notions of justice and fair play. We acknowledge that the courts’ interpretation of § 10(b) could have gone in a different direction and might have established liability for the actions the banks are alleged to have undertaken. Indeed, one of our sister circuits – the Ninth – believes that it did. We have applied the Supreme Court’s guidance in ascribing a limited interpretation to the words of § 10, viewing the statute as the result of Congress’s balancing of competing desires to provide for some remedy for securities fraud without opening the floodgates for nearly unlimited and frequently unpredictable liability for secondary actors in the securities markets.”