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May 2003
Volume 6 / Number 12

The Extent of Primary Liability in the Age of Enron
by Ignacio E. Salceda*

When Judge Melinda Harmon of the United States District Court for the Southern District of Texas issued her initial ruling on the motions to dismiss filed by the investment banks and law firms sued in the Enron securities litigation, 1 press reports implied the decision was a landmark in holding peripheral defendants potentially liable.2 The suggestion was that, despite a seemingly contrary Supreme Court decision a decade earlier, the court had ruled that investment banks and others not directly responsible for a company’s statements could be held liable for securities fraud.

Sensational press reports aside, the decision represents both less and more than most commentary would suggest. Although the magnitude of the case and the attention it has generated is unprecedented, the Enron decision picked up a thread of interpretation that has been around for a number of years in several cases. The more significant implication is that the split in the caselaw is laid bare and may soon have to be reconciled as Enron and other cases wind their way through the courts.

The Supreme Court’s Central Bank Decision

In Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.,3 the plaintiff sued several parties involved in the issuance and sale of public bonds. The plaintiff alleged primary liability for the bond authority, the underwriters, and the other defendants, and argued that Central Bank—the bond trustee—aided and abetted the fraud committed by the other parties. Although at the time all of the circuit courts had found that an aider and abettor could be held liable, the Supreme Court took the Central Bank case in order to determine whether a plaintiff could maintain such a claim.

The Supreme Court held that Section 10(b) and SEC Rule 10b-5, the “catch-all” securities fraud provisions, do not prohibit aiding and abetting. In a vigorously debated 5-4 decision, the Court held that Rule 10b-5 prohibits only “the making of a material misstatement (or omission) or the commission of a manipulative act.” After noting that the language of the Securities Exchange Act of 1934 made no reference to aiding and abetting, the court analyzed whether the cause of action could exist under the rubric of Section 10(b)’s prohibition against “directly or indirectly” violating its provisions. Finding that no federal court had relied on this language as support for aiding and abetting, the Court also declined to do so because aiding and abetting “reaches persons who do not engage in the proscribed activities at all.” Accordingly, the Supreme Court expressly held that a private plaintiff may not maintain an aiding and abetting suit under Section 10(b) and Rule 10b-5.

The Central Bank Fallout

Following Central Bank, the lower courts had to decide what constituted primary liability. Previously, given that defendants could be held jointly and severally liable whether they were primary violators or aiders and abettors, there had been little need to set out the exact border between primary and secondary liability, although courts did focus extensively on what minimal level of involvement was sufficient to establish aiding and abetting.

The Ninth Circuit adopted one approach in In re Software Toolworks, Inc. Securities Litigation. 4 In that case, plaintiffs sued a company’s auditors and underwriters for, among other things, assisting an issuer in sending two allegedly misleading letters to the SEC. After the district court found for the auditor and underwriter defendants on summary judgment (before the Supreme Court’s decision in Central Bank), the appeals court had to consider whether the involvement of the non-company defendants was sufficient to establish primary liability. The Ninth Circuit held that the company’s auditors could be held liable for the two letters because the auditors had been intimately involved with preparing them. One of the letters was drafted and edited significantly by the auditors, while the other stated on its face that it “was prepared after extensive review and discussions” with the auditors. In light of the extensive involvement and identification of the auditors as a drafter of the challenged statements, the Ninth Circuit held that primary liability attached.5

[T]he Supreme Court expressly held that a private plaintiff may not maintain an aiding and abetting suit under Section 10(b) and Rule 10b-5.

The Ninth Circuit’s standard soon came to be called the “substantial participation” test. Ironically, before Central Bank, the threshold for aiding and abetting was whether the defendant provided “substantial assistance” to the primary violator. 6 It appeared that the court would simply adopt the old test for aiding and abetting as the standard for primary liability, effectively ignoring the holding of Central Bank.

Other circuits had a much more restrictive application of Central Bank, holding that for primary liability the defendant must be the maker of the statement and be publicly identified as such. For example, in Anixter v. Home-Stake Production Co., the Tenth Circuit disagreed with Software Toolworks and two similar district court opinions because “[t]o the extent these cases allow liability to attach without requiring a representation to be made by defendant, and reformulate the ‘substantial assistance’ element of aiding and abetting liability, they do not comport with Central Bank of Denver.”7

Similarly, the Second Circuit held in several cases that in order to hold a defendant liable as a primary violator, it was necessary for the defendant to have made a false or misleading statement. In Wright v. Ernst & Young, LLP,8 plaintiffs sued the auditor of a public company, alleging that it had reviewed and approved of preliminary unaudited financial results that the company included in a press release. The auditor did not issue an audit opinion and was not mentioned in the press release. In affirming dismissal, the court concluded that, at most, plaintiffs were alleging that the auditor aided and abetted, and thus the auditor could not be held liable. 9

As the Second Circuit summarized its view in another decision, “[i]f Central Bank is to have any real meaning, a defendant must actually make a false or misleading statement in order to be held liable under Section 10(b). Anything short of such conduct is merely aiding and abetting, and no matter how substantial that aid may be, it is not enough to trigger liability under Section 10(b).” 10 In addition, the Second Circuit, later followed by the Eleventh Circuit, made clear that “a secondary actor cannot incur primary liability under the [Securities Exchange] Act for a statement not attributed to that actor at the time of its dissemination.”11

In the face of this split in the caselaw, the lead plaintiff ’s complaint in Enron named Arthur Andersen, nine investment banks, and two law firms as defendants. The complaint charged that these defendants were liable as primary violators for either making false statements, insider trading, or “participating in a scheme to defraud and/or a course of business that operated as a fraud or deceit on purchasers of Enron securities.” 12

In a lengthy decision, the court largely denied the motions to dismiss brought by the defendants, adopting a variant of the substantial participation test urged by the SEC.13 With respect to Arthur Andersen, which had issued a number of audit opinions, there was little question that it had directly made public statements. Regarding the law firms, the court denied the motion to dismiss filed by Enron’s main outside firm, Vinson & Elkins, on the grounds that the firm negotiated, structured, and documented “the illicit partnerships and off-the-books [special purpose entities]” and was “not merely a drafter, but essentially a co-author of the documents it created for public consumption concealing its own and other participants’ actions.”14 As to the other firm, Kirkland & Ellis, which had represented some of the partnerships and outside entities, the court dismissed the claim, finding that the firm did not make any public statements to Enron shareholders and did not serve as Enron’s counsel for SEC filings.15

[T]he Enron court seemed to treat the transactions themselves as the violations of the securities laws rather than Enron’s failure to account for the transactions properly.

Regarding the investment bank defendants, with a couple of exceptions, the court found that their participation in setting up or financing a number of Enron’s off-balance sheet entities was sufficient to establish primary liability. For example, one defendant, Barclays, was alleged to have financed two large special purpose entities that were intended to keep substantial debt off of Enron’s balance sheet, all while it allegedly knew that these entities lacked the requisite independence to qualify for off-balance sheet treatment. 16 The court found that this involvement was sufficient for primary liability under Rule 10b-5.

In finding that some of the investment banks could be primarily liable for their involvement in these transactions, the Enron court seemed to treat the transactions themselves as the violations of the securities laws rather than Enron’s failure to account for the transactions properly. Although the Enron court only impliedly dealt with this question as it referred to “illicit partnerships,” another court addressed it explicitly—and reached a decision that is directly opposite.

A Different Result in the Homestore.com Case

In In re Homestore.com, Inc. Securities Litigation,17 the court dealt with allegations involving another serious instance of financial fraud. In that case, plaintiff sued the company, a number of its executives (four of whom had pled guilty to securities fraud), and the company’s auditors after a substantial restatement. Plaintiff also named as defendants several dozen of Homestore.com’s business partners, alleging they had entered into fraudulent “barter” and “roundtrip” transactions with Homestore.com as part of a scheme to defraud.18 Even though the business partners did not make any statements, plaintiff sought to hold them liable because these transactions were recognized improperly by Homestore.com and were included in financial results that were ultimately restated.

In finding that the business partners could not be liable for primary liability, the court noted that the transactions themselves were not fraudulent. Rather, the fraud was the way the transactions were recorded as revenue, and the fact that the “revenue” was reported to the public:

  In the present case, plaintiff suffered damage through its reliance on false or misleading statements, not from the ‘scheme’ itself. Thus, the scheme is one step removed from the injured party. The scheme was not complete until the statement was made. Essentially what plaintiff alleges is a scheme to make a deceptive statement or material omission. Yet the principal ‘wrong’ alleged under the rule is the statement, not the scheme.19  

Since there was no allegation that the business partners actually drafted or assisted in drafting any of Homestore’s financial statements, the court granted these defendants’ motions to dismiss.20 In doing so, the court acknowledged that while “it feels compelled to arrive at this result, it does so with reservation” because “[i]n particular, the detailed factual allegations describing the role of AOL and its agents in helping Homestore please Wall Street and in boosting its own revenues through bogus commissions give this Court great pause. Nevertheless, the role of AOL and the other business partner and third party vendor defendants appears to be exactly the role of aiders and abettors prior to Central Bank, and is exactly the role that Central Bank exempted from liability.”21

The court noted that the SEC had the authority to bring enforcement actions for aiding and abetting. In fact, within days, there were press reports that AOL was under Justice Department investigation over these transactions.22

Still Another Result in Lernout & Hauspie

Another recent decision also dealt with the question of whether the violation consisted of the misleading financial statement or the underlying financial arrangement. This time the court reached a conclusion different than the court in Homestore.com.

In In re Lernout & Hauspie Securities Litigation,23 the court considered allegations against several peripheral defendants arising out of the collapse of Lernout & Hauspie (“L&H”). L&H set up thirty “strategic partners” that would license L&H technology. L&H would then book the license fees as revenues. Plaintiffs alleged that the partners were in fact shell companies. The partners were created by two entities, FLV, which was founded by L&H’s founders, and Mercator, an insurance company with an equity interest in L&H.

[C]ourts will sometimes strain to reach beyond the apparent limits of Central Bank in order to reach secondary actors who assisted or participated in a notorious fraud.

After examining Central Bank and the cases interpreting it, the court considered whether FLV and Mercator could be primarily liable even though they did not make any statements or control L&H’s financial reporting. Noting that the line between primary and secondary liability in such a case “can be murky and fact sensitive” the court concluded that the defendants could be primarily liable because “the complaints here have alleged that most of the strategic partner entities were complete shams.”24 Nevertheless, the court held that the defendants could later argue for a lack of primary liability “[i]f it turns out that the entities were viable, legitimate, ongoing strategic partners, and the only fraud was misrepresenting the relationship between L&H and the strategic partners.”25 The court did dismiss the Rule 10b-5 claim against the chairman of Mercator (who was also a partner at L&H’s chief law firm), because there were no specific allegations as to his participation in the scheme.

Reconciling the Cases

The decisions in Enron and Lernout & Hauspie show that courts will sometimes strain to reach beyond the apparent limits of Central Bank in order to reach secondary actors who assisted or participated in a notorious fraud. Nevertheless, as Homestore.com demonstrates, courts are able to make the tough—and potentially unpopular—decision to dismiss secondary actors because their conduct is truly just aiding and abetting.

The larger lesson of these cases is that the amorphous “substantial participation” test for primary liability adopted by some courts allows excessive latitude and creates significant uncertainty. Ironically, in deciding Central Bank, the Supreme Court stressed that among the policy considerations against aiding and abetting liability was that “the rules for determining aiding and abetting liability are unclear in an area that demands certainty and predictability. That leads to the undesirable result of decisions made on an ad hoc basis, offering little predictive value to those who provide services to participants in the securities business.”26 Now, with different courts applying dramatically different standards and some courts applying a highly subjective one, we are back to the uncertainty Central Bank was intended to eliminate. It is time for the courts to clear up this uncertainty and follow those decisions (like those of the Second, Tenth, and Eleventh Circuits) that have set out a bright-line test in conformity with Central Bank.

Notes

1.. In re Enron Corp. Sec., Derivative and ERISA Litig., 235 F. Supp. 2d 549 (S.D. Tex. 2002).
2. See, e.g., Kurt Eichenwald, “Ruling Leaves Most Players Exposed to Suits on Enron,” NEW YORK TIMES, Dec. 21, 2002; Carrie Johnson, “Judge Lets Suit Against Banks Move Ahead; Loans to Enron Subject of Claims,” WASHINGTON POST, Dec. 20, 2002.
3. 511 U.S. 164 (1994).
4. 50 F.3d 615 (9th Cir. 1994). Disclosure note: The author and his firm represented the underwriter defendants in this litigation.
5. Id. at 628-29 n.3.
6. See, e.g., Jett v. Sunderman, 840 F.2d 1487, 1495 (9th Cir. 1988) (elements of aider and abettor liability are (1) an independent primary wrong, (2) actual knowledge by the aider and abettor of the wrong and role in furthering it, and (3) “substantial assistance in the wrong”) (quotation omitted).
7. 77 F.3d 1215, 1226 n.10 (10th Cir. 1996).
8. 152 F.3d 169, 175 (2d Cir. 1998).
9. See also In re Kendall Square Research Corp. Sec. Litig., 868 F. Supp. 26 (D. Mass. 1994); Vosgerichian v. Commodore Int’l, 862 F. Supp. 1371, 1378 (E.D. Pa. 1994).
10. Shapiro v. Cantor, 123 F.3d 717, 720 (2d Cir. 1997) (quotation omitted).
11. Wright, supra note 8, at 175. See Ziemba v. Cascade Int’l, Inc., 256 F.3d 1194, 1205 (11th Cir. 2001) (“[I]n order for [a defendant] to be primarily liable under 10(b) and Rule 10b-5, the alleged misstatement or omission upon which a plaintiff relied must have been publicly attributable to the defendant at the time that the plaintiff ’s investment decision was made.”).
12. In re Enron, supra note 1, at 565.
13. Id. at 586-94.
14. Id. at 704-05. Vinson & Elkins subsequently filed a petition with the Fifth Circuit Court of Appeals asking that court to consider the question of primary liability. The petition was denied.
15. Id. at 705-06.
16. Id. at 614-615, 703.
17. Case No. C-01-11115 MJP (CWx), 2003 WL 1227643 (C.D. Cal. Mar. 7, 2003). Disclosure note: The author and his firm represented one of the business partner defendants in this litigation.
18. Barter transactions are “two party reciprocal transactions” where “two companies agree to buy each other’s services for an extremely exaggerated rate.” “Round trip” transactions involved three parties where, a third party would be brought in and money would go in a circle from one company to the next. Id. at *4.
19. Id. at *24.
20. Id. See In re Harmonic Inc. Sec. Litig., 163 F. Supp. 2d 1079, 1099 (N.D. Cal. 2001) (dismissing claims against corporation where no participation in preparation of another company’s statements alleged).
21. In re Homestore.com, supra note 17, at *24. Plaintiff has filed a motion asking that the court certify the question of primary liability as to AOL and several other defendants to the Ninth Circuit. That motion is pending.
22. David A. Vise, “AOL Probe Widened to ‘Abetting’ Other Firms,” WASHINGTON POST, Mar. 12, 2003. See also David D. Kirkpatrick, “AOL Says S.E.C. is Questioning Its Accounting of $400 Million,” NEW YORK TIMES, Mar. 29, 2003.
23. 236 F. Supp. 2d 161 (D. Mass. 2003).
24. Id. at 173-74.
25. Id. at 174. In a prior decision, the court held that several affiliates of L&H’s outside auditor could be primarily liable even if those affiliates did not sign audit opinions where they were alleged to have worked extensively on the audits. In re Lernout & Hauspie Sec. Litig., 230 F. Supp. 2d 152, 166-69 (D. Mass. 2002).
26. 511 U.S. at 188 (quotation omitted).

Mr. Salceda (ISalceda@wsgr.com)is a member of Wilson Sonsini Goodrich & Rosati in Palo Alto, California. The views expressed herein are solely those of the author and not necessarily those of his firm or its clients.