Scheme Liability: The District Courts Speak
Notwithstanding the availability in some jurisdictions of the "substantial participation" test, Central Bank 's bar of aiding and abetting liability, coupled with the difficulty of meeting the prevailing "bright line" test, has led to some creative thinking among plaintiffs' lawyers seeking to pursue secondary actors with big pockets. In response, plaintiffs have begun to make use of Rule 10b-5(a) and (c) - formerly little-used provisions of Rule 10b-5 - to argue that liability under those sections can be established without the making of a false statement or an omission if a secondary actor employs a "device, scheme, or artifice" to defraud or engages in an "act, practice, or course of business conduct" that operates as a fraud or deceit. Using the broad language of 10b-5(a) and (c) as a starting point, securities plaintiffs have increasingly turned their attention to secondary actors beyond the traditional outside professionals who assist or participate in crafting an issuer's allegedly false statements. Increasingly, plaintiffs are pursuing business entities that have had nothing to do with preparing an allegedly false statement, but have engaged in transactions with an issuer that plaintiffs allege were falsely represented on the issuer's financial statements. Recently, these claims have gained traction with courts.
In In re Lernout & Hauspie Securities Litigation , 236 F. Supp. 2d 161 (D. Mass. 2003), plaintiffs brought claims under 10b-5(a) and (c) against Lernout & Hauspie ("L&H") and the owners of certain "strategic partner" entities. For the most part, the "strategic partners" were start-up software companies that entered into software licensing arrangements with L&H. According to plaintiffs, the "strategic partner" transactions were shams, the "strategic partner" entities were owned by undisclosed related parties, and the only purpose behind the "strategic partner" transactions was improperly to inflate L&H's reported earnings. Recognizing that case law on scheme liability was "slender," the district court nevertheless was persuaded that business associates of L&H who were owners of the "strategic partners" could be liable as primary violators under 10b-5 if they "substantially participat[ed] in a manipulative or deceptive scheme by directly or indirectly employing a manipulative or deceptive device (like the creation or financing of a sham entity) intended to mislead investors, even if a material misstatement by another person creates the nexus between the scheme and the securities market." Id. at 173.
The district court also held that, if it turned out that the "strategic partner" entities were not "complete shams" but were "viable, legitimate, ongoing strategic partners," primary liability under Section 10(b) might not be warranted . Id . at 174. The district court went on to evaluate the plaintiffs' claims against the owners of the strategic partners, principally by considering whether the strategic partners were alleged to be mere shell companies formed for the purpose of participating in sham transactions, as opposed to legitimate, viable businesses. Id . at 175. On the issue of reliance, the district court held that a plaintiff could establish reliance on the conduct of a secondary actor in a scheme liability case based upon his reliance on the scheme "as a whole." See id.
The district court in In re Parmalat Securities Litigation , 376 F. Supp. 2d 472 (S.D.N.Y. 2005) considered allegations of scheme liability against Citigroup Inc., Citibank, N.A., Bank of America, and Banca Nazionale del Lavoro. There, plaintiffs alleged that defendants violated Rule 10b-5(a) and (c) by virtue of their participation in two deceptive schemes: one involved loans disguised as equity transactions and the other involved the securitization of phony receivables for the purpose of improperly enhancing Parmalat's reported earnings. Notably, none of the defendants (with the exception of Bank of America) were alleged to have participated in the creation of a false statement or omission by Parmalat. Rather, the allegations focused on transactions that were subsequently misrepresented by Parmalat on its financial statements. Id . at 503.
The district court set forth the elements of a 10b-5(a) and (c) claim as requiring: (i) the commission of a "deceptive or manipulative act," (ii) "with scienter," that (iii) "affected the market for securities or was otherwise in connection with their purchase or sale," and that (iv) "caused the plaintiff's injuries." Id . at 492. Addressing the scope of Rule 10b-5(a) and (c), the court held that these provisions covered not merely manipulative securities trading practices, but other forms of deceptive conduct as well. In particular, the court determined that 10b-5(a) and (c) covered defendants' knowing participation in transactions that were "by nature deceptive." Id. at 502. In the district court's view, liability under 10b-5(a) or (c) for the bank defendants would be appropriate if it was "impossible to separate the deceptive nature of the transactions [between the bank defendants and Parmalat] from the deception actually practiced upon Parmalat's investors." Id. With this distinction in mind, the district court, like the court in Lernout & Hauspie , reviewed plaintiffs' allegations against each defendant to determine whether plaintiffs had sufficiently alleged participation in a sham transaction. Id. at 504-506. As in Lernout & Hauspie , the court did not believe that liability was appropriate if the deceptiveness of the alleged scheme "resulted from the manner in which Parmalat or its auditors described the transactions on Parmalat's balance sheets and elsewhere" rather than from the deceptive nature of the transaction itself. Id. at 505.
Although the district court's opinion is thorough and persuasive, its analysis of two elements of the 10b-5(a) and (c) cause of action falls short. One is the requirement that the alleged manipulative or deceptive conduct have an "effect" on the securities markets. Here, the court simply concluded that, insofar as the alleged schemes "would have created the appearance of revenue or assets where there was none," a fortiori , they "distorted the prices of Parmalat's securities." Id. at 506. This overlooks the fact that the transactions themselves did not create a false appearance of revenue or assets; rather, any false appearance was the result of Parmalat's conduct in improperly recording the transactions on its financial statements. In other words, it was Parmalat's false statements that ultimately affected the market for its stock. At best, the bank defendants gave assistance to Parmalat by engaging in transactions that Parmalat was able to report falsely. Viewed in this light, there is no significant difference between the bank defendants' conduct in Parmalat and a classic aiding and abetting scheme.
Another issue on which the Parmalat and Lernout & Hauspie courts both strayed is reliance. In analyzing this issue, the Parmalat court acknowledged that, in the absence of a false statement by the bank defendants, plaintiffs "cannot be said to have relied on the banks." Id. at 509. However, the court side-stepped the reliance issue by positing that it was essentially inapplicable to a cause of action under 10b-5(a) and (c). Id. In the court's view, the reliance requirement was a proxy for causation - a way "to certify that the conduct of the defendant actually caused the plaintiff's injury." Id. (internal citations omitted). In the absence of a false statement or omission on which a plaintiff could rely, the court held, this requirement could be met by evidence that the defendant's conduct was a "substantial, i.e., a significant contributing cause" of plaintiff's injury. Id. (internal citations omitted). In Parmalat , this evidence was supplied by the fact that the defendant banks' actions "actually and foreseeably" caused losses in the securities markets:
The banks made no relevant misrepresentations to those markets, but they knew that the very purpose of certain of their transactions was to allow Parmalat to make such misrepresentations. In these circumstances, both the banks and Parmalat are alleged causes of the losses in question. So long as both committed acts in violation of statute and rule, both may be liable.
And in Lerner & Hauspie , as we have seen, the district court effectively did away with the requirement that a plaintiff prove detrimental reliance on the defendant's words or conduct, finding it sufficient that the plaintiff was able to allege reliance on the scheme "as a whole." See Lernout & Hauspie , 236 F. Supp. 2d at 174.
When it comes to reliance, both Parmalat and Lernout & Hauspie effectively undermine Central Bank . The inability to establish reliance on the conduct of an aider and abetter was one of the primary reasons the Central Bank Court rejected aiding and abetting liability. According to the district court's holdings in Parmalat and Lernout & Hauspie , however, this infirmity may be overcome simply by recasting one's cause of action as participation in a deceptive scheme pursuant to 10b-5(a) and (c). Moreover, although the district court in Parmalat permitted plaintiffs to maintain claims against secondary actors based on a presumption of reliance, it failed to address how plaintiffs would be able to meet the ultimate burden of proof on the issue, especially in light of the court's view that plaintiffs had not specifically relied on anything the secondary actors said or did.
A more fundamental problem with both the Lernout & Hauspie and Parmalat decisions lies in the nature of the conduct that those courts deemed to be a violation of Rule 10b-5(a) and (c). In both cases, the courts undertook a review of the underlying business transactions in order to assess whether the transactions were a sham, had a legitimate business purpose, or were otherwise justifiable from a business perspective. Although this analysis has practical appeal, if the ultimate goal is, as it should be, to assess whether the plaintiff has adequately pled the commission of a manipulative or deceptive act under Section 10(b), the analysis cuts too broadly. Liability under Rule 10b-5 based merely on one's participation in a business transaction that is subsequently found to have lacked a "legitimate business purpose" goes beyond Section 10(b)'s core purpose - to catch those who actually engage in deceptive or manipulative conduct affecting the securities markets. This is because there is nothing inherently deceptive or manipulative about engaging in a financial transaction, even one that appears to lack a business justification, in the absence of a false statement or omission about that transaction that is communicated to the securities markets. In Lernout & Hauspie and Parmalat , the secondary actors who were found to be potentially liable under Rule 10b-5 had made no such communications.
James C. Dugan is a Partner at Willkie Farr & Gallagher LLP in New York City. He specializes in federal securities litigation, accountant's liability, and corporate internal investigations. The author would like to thank Antonio Yanez, Jr. and Rebeccah Niesen for their contributions to this article.