Supreme Court Agrees To Address Scheme Liability Of Third Party Aiders And Abettors

April 2007

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Last week, the U.S. Supreme Court accepted Stoneridge Investment Partners vs. Scientific-Atlanta (06-43) for review. In Stoneridge Investment, the Eighth Circuit threw out a securities class-action suit against defendants that aided and abetted a securities fraud. The U.S. Supreme Court review announcement comes immediately after a Fifth Circuit decision in re Regents of the University of California, et al. vs. Credit Suisse, et al. in the Enron case. It would appear that the Supreme Court was aware of the Enron decision (which will certainly also be appealed), and took the first opportunity it had to weigh in on these issues. The stage is now set for perhaps the most important securities law case in a decade. The issue before the U.S. Supreme Court in Stoneridge Investment is:

“Whether this court’s decision in Central Bank, N.A. vs. First Interstate Bank, N.A., 511 U.S. 164 (1994), forecloses claims for deceptive conduct … where Respondents engaged in transactions with a public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where Respondents themselves made no public statements concerning those transactions.”

The Stoneridge Investment case will not be argued until the court’s next term beginning in October 2007. In each of the similar cases described in this article, a publicly traded company engaged in clearly fraudulent accounting transactions. The fraudulent transactions generally involved either (i) “round trip” transactions in which the parties manufactured offsetting transactions with each other, or (ii) debt disguised as something else. In all of these transactions, a presumably independent third party was required to disguise the transaction in order to fool the outside auditors, who were not aware of the complete nature of the dealings. In throwing out the $40 billion of claims in the Enron suit, the Fifth Circuit was aware of the direct participation that the defendants played in the Enron deception. For example, here is how the Fifth Circuit described the Enron transactions:

“[Enron] could find no legitimate buyer, so it contacted Merrill Lynch and guaranteed that it would buy the barges back within six months at a premium for Merrill Lynch. Six months later, Enron made good on its guarantee; an Enron-controlled partnership bought the barges from Merrill Lynch at a premium. When Enron reported its results for 1999, instead of booking the transaction as a loan, the characterization that Enron’s outside accountants state would have been appropriate had they known of the side-agreement to buy back the barges, Enron booked the transaction as a sale and accordingly, listed the revenue therefrom in its year-end financial statement.”

“Plaintiffs allege that the banks know exactly why Enron was engaging in seemingly irrational transactions such as this. They cite certain of the banks’ internal communications they characterize as proving the banks were aware of the … illusion.”

Similarly, the Fifth Circuit described Credit Suisse’s involvement as:

“Communications between Credit Suisse employees allegedly reveal similar scienter. (‘Osprey is a vehicle enabling Enron to raise disguised debt which appears as equity on Enron’s balance sheet …’).”

The issue is whether the parties who aided and abetted the fraud can be held accountable for their conduct in a class action securities case, or whether the plaintiffs must pursue the defendants in individual cases. Without the Central Bank precedent, Rule 10b-5 (CFR 240.10b-5) would appear to be sufficiently broad to encompass fraudulent aiding and abetting, as follows:

“It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality … (a) to employ any device, scheme, or artifice to defraud, … (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person …”

However, the Fifth and Eighth Circuits relied on Central Bank vs. First Interstate Bank, supra. In Central Bank, the U.S. Supreme Court held that SEC Rule 10b-5 does not allow claims against those who only aid and abet the securities law violation. As long as the Central Bank prohibition against aiding and abetting stands, plaintiffs need to establish another direct liability cause. This is challenging because the defendants’ (i) conduct was not public, (i) had no disclosure requirements to the plaintiffs, and (iii) owed no fiduciary duty to the plaintiffs. In this circumstance, the Ninth Circuit determined that defendants could be held responsible in a class action if they engaged in a fraudulent scheme. In Simpson vs. AOL Time Warner, 452 F.3d 1040, 1048 (9th Cir. 2006), the Ninth Circuit determined:

“To be liable as a primary violator of Section 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.”

“… a plaintiff may be presumed to have relied on this scheme to defraud if a misrepresentation, which necessarily resulted from the scheme and the defendant’s conduct therein, was disseminated into an efficient market and was reflected in the market price.”

The Fifth Circuit, in determining the Enron-related liability of the investment banks, rejected the Ninth Circuit’s rationale, as follows:

“The Eighth Circuit, unlike the Ninth, has correctly taken these decisions collectively to mean that ‘deceptive conduct involves either a misstatement or a failure to disclose by one who has a duty to disclose.’ (Charter, 443 F.3d at 990.) That court quoted the technical definition of manipulation … [as] ‘any defendant who does not make or affirmatively cause to be made a fraudulent statement 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 Section 10(b) or any subpart of Rule 10b-5.’”

Putting aside the important legal precedents, the Enron case is important because of its sheer size. Attorneys general from thirty states (including California) had sided with the Enron class members in their desire to maintain their status as an appropriate class action case. The Fifth Circuit ruling terminating the Enron class action case comes just a month before trial was scheduled to start. Regardless of how the Supreme Curt rules, the Enron class members (and their lawyers) will keep the more than $7.3 billion in earlier settlements reached with other investment banks. These prior settlements include $2.3 billion from JPMorgan Chase, $2 billion from Citigroup, and $2.4 billion from Canadian Imperial Bank (CIBC).

Fulcrum Inquiry is a forensic accounting firm. We assist with investigations of accounting frauds, and with damages and causation analyses in complex commercial disputes.