Unsettled Law Of Secondary Actor Liability Under Rule 10b-5 Raises Concerns For Attorneys - Part II

Wednesday, November 1, 2006 - 01:00

In re Homestore.com

In In re Homestore.com, Inc., plaintiffs alleged that Homestore entered into a series of sham transactions with various third-party vendors for products or services that Homestore did not need.1 The third-party vendors would then contract with AOL Time Warner for advertising on Homestore's Web site and AOL would give this money back to Homestore under their advertising reseller agreement. Both the third-party vendors and AOL would keep a portion of the money as a commission. Plaintiffs sued, among others, several of Homestore's business partners, alleging they had entered into fraudulent transactions with Homestore as part of a scheme to defraud. Although the third-party business partners did not make any statements, plaintiff sought to hold them liable because the transactions were improperly recognized by Homestore and were included in financial results that Homestore ultimately had to substantially restate.

The district court dismissed the claims against the defendants, declining to expand the scope of liability under Section 10(b) to include the company's business partners where their roles were more as an aider and abettor, rather than a primary violator.2 The court held that these business partners who participated in the scheme did not 'employ' the scheme to defraud investors, and therefore were only secondary violators. Further, the court held that the plaintiff suffered damage through its reliance on false and misleading statements based on how the revenue from the transactions was reported, not from the 'scheme' itself. Because the plaintiff did not sufficiently allege that the business partner defendants substantially contributed to the statements, the court determined that the plaintiff could not state a claim against the defendants for damages resulting from reliance on misstatements or material omissions. Also, the district court ruled that a business partner with no special relationship to the issuer involved in the securities fraud action cannot be liable as a primary violator.3

The SEC submitted an amicus curiae brief in this case to address the question of what test is appropriate for finding a defendant to be a primary violator rather than an aider and abettor in a scheme to defraud under Rule 10b-5(a).4 The SEC urged the court to use 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(a); 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.5

In addition, the SEC addressed the special relationship requirement referred to by the court. The SEC argued that requiring a special relationship with the issuer would allow a party who is not in such a relationship to accomplish the same fraud and yet escape liability. The SEC believes that 'liability under Section 10(b) should be imposed on any person whose conduct comes within the proscriptions of the statute, regardless of the person's relationship with the corporation.'6

Despite the SEC's arguments, the 9th Circuit recently affirmed the district court's decision. The 9th Circuit concluded that the element of using or employing a deceptive device was not adequately alleged, as it could not find that the transactions engaged in were completely illegitimate or in themselves created a false appearance.7

It is difficult to reconcile the cases discussed above and draw a line as to what conduct courts will deem to be primary violations rather than merely aiding and abetting under Section 10(b) and Rule 10b-5(a) or (c). However, in reviewing the facts of the cases, courts seem more likely to find secondary actors to be primary violators when the underlying transaction or disclosure is obviously fraudulent and the parties were aware of such fraud. In Parmalat and Enron , the courts found the transactions that the secondary actors were involved in to be fraudulent, with no true business purpose other than to skew the issuer's financial statements. In Dynegy, Charter and Homestore , the courts appeared to find some legitimacy to the transactions and found that the fraud resulted from the way the issuer reported the transaction, rather than the actual transaction itself, thereby extending some relief to the secondary actors in these cases.

SEC Enforcement Actions

Although the Dynegy, Charter and Homestore decisions might provide secondary actors some comfort that they are protected from third-party fraud liability under Section 10(b), the lack of uniformity in the decisions of the courts is cause for concern. Attorneys and other corporate advisors should proceed with caution in advising their corporate clients in transactions and related public disclosure. Further, even if a secondary actor has relief from private actions for liability under Section 10(b), the SEC is not prohibited from bringing an action against such actors for aiding and abetting liability under Section 10(b). In fact, the SEC recently charged Scientific-Atlanta, Inc. with aiding and abetting Adelphia Communications Corporation in Adelphia's violations relating to reporting, books and records, and internal controls provisions of the federal securities laws.8 In this instance, Scientific-Atlanta entered into a marketing support agreement with Adelphia that Adelphia used to inflate its earnings by approximately $43 million. The structure of the transaction between Scientific-Atlanta and Adelphia was similar to the structure used by the parties in the Charter case discussed above. The complaint alleged that Scientific-Atlanta was aware of a number of facts which demonstrated that Adelphia was misusing the marketing support agreement. Scientific-Atlanta agreed to pay $20 million in settlement of these charges.9 Therefore, although a court may dismiss a private party's claim under Section 10(b) against a secondary actor, the secondary actor may still be on the hook for its actions if the SEC brings an enforcement action.

In addition to bringing enforcement actions against secondary actors for aiding and abetting violations of Section 10(b), the SEC is bringing an increasing number of enforcement actions against attorneys for their 'gatekeeper' role and related responsibilities.10 The basis for many of the recent SEC enforcement actions includes false and misleading SEC filings, books and records violations, lying to auditors, insider trading and reckless advice, with claims often brought under Sections 10(b) and 13(a) of the Securities Exchange Act of 1934 and Rules 10b-5, 12b-20, 13a-1 and 13a-13 promulgated thereunder. Many of the SEC actions brought against attorneys involve blatant and obvious fraud and deception by the attorney. Other SEC actions, however, are more troubling to attorneys, because although the actions involved counsel who knew or should have known that their conduct was a violation of federal securities laws, the facts are much less egregious. These cases are discussed below.

In the Matter of Google, Inc.

In an SEC enforcement action brought against Google, Inc. and David Drummond, its general counsel, the SEC found that Google violated the registration provisions of the Securities Act of 1933 and that Mr. Drummond caused Google to violate those provisions.11 Accordingly, the SEC ordered both parties to cease and desist from future violations of the registration provisions. Before Google went public, it compensated its employees and consultants with stock options, relying on the Rule 701 exemption from registration. Pursuant to this exemption, if the issuer sells securities during any 12-month period in which the amount exceeds $5 million, the issuer must deliver detailed financial statements to investors. Because Google did not want to deliver the required financial statements, and because the issuance of additional options would exceed the $5 million limit, Mr. Drummond consulted with counsel, reviewed the securities laws and subsequently determined that Google could rely on other exemptions. Mr. Drummond advised Google's board to approve the issuance of additional options, but did not disclose his legal analysis on the registration exemptions or the risks involved with the option grants. Google ultimately issued millions of dollars worth of stock options without a proper exemption or proper registration under the Securities Act. In reviewing the facts, the SEC held Mr. Drummond accountable for his business decision and related analysis and his failure to inform the board of the legal analysis and associated risks.

In the Matter of John E. Isselman Jr.

Another SEC enforcement action of interest was brought against John Isselman Jr., the general counsel for Electro Scientific Industries, Inc.12 In this case, the chief financial officer eliminated certain employee benefits for certain employees of the company, which allowed Electro Scientific to record a profit for the quarter, rather than a loss. The CFO did not consult with Mr. Isselman regarding his decision to eliminate these benefits, nor was Mr. Isselman involved in any aspect of the decision. Mr. Isselman learned of the decision when the CFO presented the quarterly results to the audit committee, in which the CFO stated that the decision regarding benefits had been approved by legal. Although Mr. Isselman was unaware of any legal opinions relating to the subject, he did not question the CFO. Mr. Isselman later sought legal counsel on the elimination of benefits and was informed that the company did not take the legal steps necessary to eliminate the employee benefits. Upon learning this information, he did not immediately report it to the company's audit committee or accountants. He attempted to address his concerns at a disclosure committee meeting prior to filing the quarterly report, but the CFO cut off the discussion and the quarterly report was filed with the improper accounting transaction. Mr. Isselman later discovered that the CFO eliminated the benefits to balance out an accounting error that had a negative impact on earnings. Upon learning of this, Mr. Isselman contacted outside counsel and an investigation was conducted, causing the company to restate its earnings for the quarter. The SEC found that Mr. Isselman failed to provide important information to the company's board, audit committee and auditors regarding the accounting transaction, which caused Electro Scientific to ultimately file false financial statements with the SEC, thereby violating Section 13(a) and Rules 13a-13 and 12b-20 promulgated thereunder. Mr. Isselman's failure to speak, when he had a duty to speak, and his ultimate review and filing of the Form 10-Q, which addressed the improper accounting transaction, subjected him to securities law liability.


As discussed above, the state of law regarding secondary actors being held primarily liable under Section 10(b) and Rule 10b-5 is unclear. Although certain courts have dismissed such actions, holding that private actions for aiding and abetting liability under Section 10(b) are prohibited, plaintiffs are being more creative in persuading courts that secondary actors are primary violators of Section 10(b). The implications of secondary actors, particularly attorneys, being deemed primary violators of Section 10(b) and Rule 10b-5 are a concern for any attorney who represents a public company client. Although it is difficult to determine exactly how a court will react to certain actions, attorneys should be particularly cautious in certain circumstances to avoid primary liability, particularly when -

  • making affirmative statements about an issuer client when such statements could be deemed material misstatements;

  • providing legal opinions or other written documentation for which a court will directly attribute statements to the law firm, or

  • advising a client on, and drafting documents related to, a structure that has questionable business or accounting purposes.
  • In addition to potential liability under Section 10(b), attorneys need to be aware of the potential liability they may have for their actions under other provisions of the securities laws when representing and counseling corporate clients. Such liability seems to be growing, especially in today's business world, where companies are under increased pressure to perform in the marketplace, and attorneys are called on more and more not only to address legal issues but to serve as key advisors, counseling on non-legal issues and business decisions.

    1 252 F. In re Homestore.com, Inc. Sec. Litig., Supp. 1018 (C.D. Cal. 2003).
    2 Id . at 1040.
    3 Id. The court stated that in every post-Central Bank case cited to the court where an 'outsider' has been held liable as a primary violator, that outsider had some type of special relationship with the corporation, such as an accountant or auditor .
    4 Brief of the SEC , Amicus Curiae in Simpson v. Homestore.com, Inc ., 9th Cir., No. 04-55665 (October 22, 2004).
    5 Id.
    6 Id.
    7 Simpson v. AOL Time Warner Inc ., 9th Cir., No. 04-55665 (June 30, 2006).
    8 SEC Litigation Release No. 19735, June 22, 2006. Accounting and Auditing Enforcement Release No. 2443, June 22, 2006. SEC v. Scientific-Atlanta, Inc., Civil Action No. 06 CIV. 4823 (PKC) (S.D.N.Y.).
    9 Id.
    10 In general, gatekeepers are recognized as persons, including attorneys, accountants and financial advisors, who control a company's access to the capital markets. As gatekeepers, attorneys have a duty not only to their client, but also to the public markets. An attorney's 'gatekeeper' role includes advising on and policing company disclosures, corporate practices and business transactions to prevent fraud and other securities law violations and to ensure compliance with laws, rules and regulations. If attorneys are successful in this role, the public markets will be stronger and investors will be better for it. As the SEC has made clear, if attorneys fail in this role, such attorneys may be exposed to liability under securities laws .
    11 In the Matter of Google, Inc. and David C. Drummond, Rel. No. 33-8523 (Jan. 13, 2005).
    12 In the Matter of John E. Isselman Jr . , Rel. No. 34-50428 (Sept. 23, 2004)

    Tracy Crum is Senior Counsel in the Corporate Department of Akin Gump Strauss Hauer & Feld LLP in Dallas, Texas.

    Part I of this article appeared in our October issue. Discussed below are several other recent cases in which the 'scheme' theory of liability under Rule 10b-5 has been advanced against secondary actors, signaling the direction courts may go in determining the extent to which attorneys who assist clients in structuring transactions lacking a valid business purpose may become liable under Rules 10b-5(a) or (c).