The 10b-5 Daily

In Central Bank, the U.S. Supreme Court held that private action under Rule 10b-5 can only be brought against persons who are primary violators and not against those who aid and abet a primary violator. How to tell the difference between a primary violator and an aider and abettor, however, has been the subject of much debate.

The SEC has filed an amicus brief in the Homestore securities litigation currently pending before the U.S. Court of Appeals for the Ninth Circuit that urges the court to adopt a broad test for determining who is a “primary violator.” The lower court dismissed the claims against three companies – AOL Time Warner, Cendant, and L90 (as well as a few of their executives) – that were Homestore’s business partners in transactions whose alleged purpose was to inflate Homestore’s revenues. The lower court reasoned that these business partners could not be primary violators because they did not have a special relationship with Homestore (e.g., accountant or attorney).

The plaintiffs appealed these dismissals. In support of the plaintiffs, the SEC argues that Central Bank did not create a “special relationship” test for a primary violator and that engaging in a transaction whose purpose was to create a false appearance of revenues constitutes a deceptive act that can support primary liability.

Quote of note: “The Commission urges the following test for determining when a person’s conduct as part of a scheme to defraud constitutes a primary violation: Any person who directly or indirectly engages in a manipulative or deceptive act as part of a scheme to defraud can be a primary violator of Section 10(b) and Rule 10b-5; any person who provides assistance to other participants in a scheme but does not himself engage in a manipulative or deceptive act can only be an aider and abettor.”

The “collective scienter” theory is beginning to gain a foothold in securities litigation caselaw, even if courts are not expressly acknowledging the nature of their holdings. As a general matter, whether a defendant corporation has acted with scienter (i.e., fraudulent intent) is determined by looking “to the state of mind of the individual corporate official or officials who make or issue the statement . . . rather than generally to the collective knowledge of all the corporation’s officers and employees acquired in the course of their employment.” Southland Sec. Corp. v. INSpire Ins. Solutions, Inc., 365 F.3d 353 (5th Cir. 2004). Another way of putting this is that courts recognize corporations only act through their officers and directors, and, therefore, can only be held liable for fraud if one or more of those individuals can be held liable for fraud. A steady trickle of decisions, however, appears to be rejecting this principle in favor of a collective scienter theory.

The U.S. Court of Appeals for the Sixth Circuit recently affirmed the dismissal of a securities class action against Ford based on statements relating to faulty tires, but the manufacturer of those tires has not been as fortunate. In City of Monroe Employees Retirement System v. Bridgestone Corp., No. 03-5505 (6th Cir. 2004), the court found that some of the statements made by Bridgestone and its wholly-owned subsidiary, Firestone, were actionable. On the issue of scienter, the court examined the state of mind of the corporate entities separately from the state of mind of the sole individual defendant (Firestone’s CEO). The court concluded that scienter was adequately plead against Bridgestone and Firestone, even though it failed to identify any individual officers or directors who acted with scienter. Moreover, the court rejected the scienter allegations against Firestone’s CEO and affirmed the dismissal of the claims against him. Leading to the inevitable question: if an officer makes the statement and a janitor knows the statement is false, has the corporation acted with fraudulent intent?

Holding: Affirmed in part and reversed in part.