Scheme Liability Under Rule 10b-5: An Emerging Cause Of Action - Part III

Thursday, February 1, 2007 - 01:00

Parts I and II of this article appeared in the December and January issues, respectively, of The Metropolitan Corporate Counsel.

A Difference of Opinion: The Appellate Courts Weigh In

Within the last few months, appellate courts have begun to weigh in on the viability of scheme liability under Section 10(b). The two appellate decisions that have squarely addressed the issue have reached somewhat different results.

In In re Charter Communications, Inc. Securities Litigation v. Scientific-Atlanta, Inc. , 443 F.3d 987 (8th Cir. 2006), the Eighth Circuit considered claims pursuant to 10b-5(a) and (c) against Scientific-Atlanta, Inc. and Motorola, Inc., two vendors that sold telecommunications equipment to Charter Communications. According to the plaintiffs, these were sham transactions in which Charter agreed to purchase equipment at a premium price with the understanding that the vendors would remit part of this premium back to Charter in the form of advertising fees, thereby enabling Charter to report falsely enhanced revenues. Plaintiffs further alleged that the vendors knew that Charter intended to account for these transactions improperly.

The district court rejected plaintiffs' 10b-5 claim against the vendors based on Central Bank of Denver . In essence, the district court found that the allegations against the vendors amounted to little more than the assertion that they had engaged in business transactions that Charter had recorded improperly and that such claims were tantamount, at best, to aiding and abetting.

The Eighth Circuit affirmed. In doing so, the appellate court found that Central Bank , and the earlier Supreme Court decisions on which it had relied, stood for three "governing principles:" (i) claims under 10b-5 may not be brought "against a defendant for acts not prohibited by the text of Section 10(b)," (ii) a "device or contrivance is not 'deceptive' within the meaning of Section 10(b), absent some misstatement or a failure to disclose by one who has a duty to disclose," and (iii) the term "manipulative" as used in Section 10(b) "has the limited contractual meaning ascribed in [the Supreme Court's decision in Santa Fe Industries, Inc. v. Green , 430 U.S. 462 (1977)]." 443 F.3d at 992. Distilling these three principles, the appellate court held 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 Section 10(b) or any subpart of Rule 10b-5." Id.

Applying this test, the Eighth Circuit found that neither Motorola nor Scientific-Atlanta could be liable because neither was alleged to have engaged in a deceptive act. Id. They had issued no misstatements that were relied upon by the investing public nor were they under a duty to disclose information about Charter's true financial condition. Id . The appellate court found that, in such circumstances:

to impose liability for securities fraud on one party to an arm's length business transaction in goods or services other than securities because that party knew or should have known that the other party would use the transaction to mislead investors would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings.

Id . at 992-93.

In Simpson v. AOL Time Warner Inc ., 452 F.3d 1040 (9th Cir. 2006), the Ninth Circuit reached a different conclusion. There, plaintiffs alleged that a number of Homestore.com's vendors had violated 10b-5(a) and (c) by engaging in "round-trip" or barter transactions whereby Homestore recorded revenue from the receipt of monies that ultimately came from Homestore's own cash reserves. The district court had dismissed plaintiff's claims against the vendors based on reasoning much like that of the Eighth Circuit, finding that Central Bank effectively precluded the plaintiffs' 10b-5(a) and (c) claims because, even accepting the allegations at face value, the vendors had only participated in or facilitated Homestore's fraudulent scheme and were thus mere aiders and abettors. The district court also found that plaintiffs could not establish reliance as to the vendor defendants.

Although the Ninth Circuit affirmed the district court's dismissal of the complaint, it disagreed with the lower court's analysis. On the issue of scheme liability in particular, the Ninth Circuit held that "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." Id. at 1048. In other words, "the defendant's own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect." Id. As to reliance, the appellate court was untroubled by the inability of a plaintiff to establish reliance on secondary actors, holding simply that "absent persuasive conflicting evidence" it could be presumed that "purchasers relied on misstatements produced by a defendant as part of a scheme to defraud, even if the defendant did not publish or release the misrepresentations directly to the securities market." Id. at 1052.

Having concluded that scheme liability could be a valid cause of action under Rule 10b-5, the appellate court proceeded to review the allegations against each secondary actor. Again, as with the Lernout & Hauspie and Parmalat decisions, the Ninth Circuit's analysis focused on whether plaintiffs had alleged that defendants had created or employed "sham business entities," had engaged in a transaction that had no "legitimate economic value," or otherwise had created a "false appearance" in their dealings with Homestore. See Id. at 1052-1053.

As between the Eighth and Ninth Circuits, the Eighth Circuit's decision in In re Charter Communications adheres more faithfully to the spirit of the Supreme Court's decisions in Ernst & Ernst, Santa Fe Industries , and Central Bank of Denver . In each of those decisions, the Supreme Court has applied a consistent methodology of sticking closely to the language of Section 10(b). And, in doing so, the Court has uniformly limited the reach of Rule 10b-5 to the confines of Section 10(b) and its proscription of the "use or employ-[ment]" of "manipulative or deceptive device[s] or contrivance[s]." 15 U.S.C. 78j(b). Thus, devices and contrivances that are not "deceptive" - in the sense of misleading another into doing something to his or her detriment on false pretences - or "manipulative" - in the sense of artificially affecting securities prices - are not prohibited by the statute.

Conclusion

The "schemes" at issue in each of the scheme liability cases reviewed in this article involved, for the most part, allegedly false and misleading statements by issuers about business transactions in which secondary actors were mere participants. In almost every case, the secondary actors themselves uttered no statements to the investing public, nor did they engage in any public conduct on which the securities markets could rely. In fact, they did not communicate with the securities markets at all. In the absence of any such communications, the conduct of these secondary actors in participating in transactions with the issuer was not "deceptive" other than by virtue of the statements subsequently made about those transactions by the issuer. To be sure, insofar as these secondary actors engaged in transactions with an issuer that lacked any business justification, they may have facilitated - perhaps even knowingly - the issuer's fraud. But such conduct - knowing facilitation of another's fraud - is the essence of aiding and abetting liability, not primary liability under Section 10(b). As the Eighth Circuit noted, to hold secondary actors liable as primary violators under Section 10(b) in such circumstances "would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings." 443 F.3d at 993. There is no doubt that Congress intended no such thing in enacting Section 10(b).

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.

Please email the author at jdugan@willkie.com with questions about this article.