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Investor advocates prod for expanding which companies can be considered primarily responsible for securities fraud. But opponents say a change in law would raise the cost of doing business.
Sarah Johnson, CFO.com | US
August 11, 2009
Regulators and lawmakers are trying to widen the net of securities-fraud liability. If they're successful, more companies could be ensnared in private litigation because of their business partnerships with fraudulent companies.
In an amicus brief filed in an appeals court last week, the Securities and Exchange Commission disagreed with a lower court judge's decision to drop an investor lawsuit against an outside lawyer convicted of conspiracy and securities fraud related to Refco Inc.'s $2.4 billion scheme. The bankrupt commodities brokerage was involved in hiding the full extent of its bad debt from investors before filing for Chapter 11 protection.
Refco's trustees had asked for more than $2 billion in damages from accounting, financial, and legal advisers — including Mayer Brown LLP partner Stephen Collins, Grant Thornton, Ernst & Young, PricewaterhouseCoopers, Credit Suisse Securities, and Banc of America Securities — but their case was dismissed earlier this year.
More recently, Sen. Arlen Specter (D-Pa.) introduced a bill, co-sponsored by three Democrat senators, that would reverse Supreme Court decisions on which those dismissals were largely based. If passed, the legislation would greatly expand the number of parties that could be found in violation of securities laws and could make business partnering riskier, say observers.
Specter's two-page bill includes among the liable those companies that knowingly helped another business commit fraud, as well as companies that were reckless in not knowing they had a hand in the fraud. The legislation would raise the status of so-called secondary actors — such as suppliers, bankers, and accounting firms — to primary violators of securities fraud.
Moreover, the bill could have a serious financial effect on market prices for professional services, say opponents. A recent Supreme Court decision to drop the plaintiffs' claim against the vendors that had supplied services to a fraudulent cable company noted that expansion of laws designed to limit private litigation in these types of cases "would expose a new class of defendants to risks.... Contracting parties might find it necessary to protect against these threats, raising the costs of doing business."
Indeed, opponents of Specter's legislation, including the U.S. Chamber of Commerce, are using the current economic downturn to blunt interest in changes to existing rules. "Specter's bill would once again throw American business to the trial lawyer wolves, weakening our competitive position, at a time when our economy needs all the help it can get," wrote Stephen Bainbridge, a law professor at the University of California, in a recent blog post. He has said that an expanded interpretation of the law could force companies to extend the monitoring of their internal controls to those of their vendors and other business partners.
Lawmakers and courts have previously rejected taking an approach similar to Specter's bill because "counterparties to a transaction shouldn't be held responsible for the accounting decisions of their counterparty," says Herbert Washer, a partner at Shearman & Sterling, which represented Merrill Lynch in a similar type of case involving Enron shareholders that was dismissed. "It shouldn't be the responsibility of a [business] to look over the shoulder of their counterparties."
Plaintiffs' lawyers disagree. In recent years, the Supreme Court "has taken an excessively narrow and constricted view of liability for secondary actors," according to Ira Schochet, a partner at Labaton Sucharow and president of the National Association of Shareholder and Consumer Attorneys. His nonprofit organization supports the SEC's recent amicus brief and Specter's bill. The most recent Supreme Court decision on the issue, StoneRidge v. Scientific Atlanta, allows corporations' gatekeepers to "effectively be immune from legitimate claims by injured investors," the group asserts.
In StoneRidge, the judges decided earlier this year that business partners of Charter Communications could not be held culpable for the cable company's sham transactions because they had not themselves issued any publicly disseminated statements that could have misled investors. That case made moot the Enron investors' suit against the banks accused of helping the now-collapsed energy giant misrepresent its financial health.
As it is, wrongdoers convicted of fraudulent activities don't necessarily have to pay up in civil court — as long as they can show they merely aided and abetted the fraud, but were not the primary culprit in the wrongdoing. For instance, Collins, the Mayer Brown partner in the Refco case, is awaiting sentencing after being found guilty of conspiracy and securities-fraud charges last month. However, in the civil case, the judge ruled Collins cannot be sued by Refco investors that accuse him of helping the firm hide critical financial data from investors.
Collins was found guilty of drafting misleading information that was published in Refco's financial reports. While he wrote the text, investors did not know he wrote it, and therefore weren't fooled by him, in the eyes of the court. Collins's attorney did not respond to CFO.com's request for comment. In a statement to CFO.com, Mayer Brown noted "that the SEC's brief states explicitly that it is not arguing for either affirmance or reversal of [the judge's] decision." In addition, the SEC is not asking the lower court to reconsider its dismissal of the law firm from the case.
The Private Securities Litigation Reform Act of 1995 is often cited in these cases, as it aims to limit frivolous lawsuits involving securities laws. Essentially, the act allows private litigants to sue only if they can prove the accused company did more than just aid and abet the wrongdoing. On the other hand, the SEC can take up their cause by collecting damages from those aiding and abetting the fraud.
However, the SEC has continually reminded the courts that private litigation cases still have a purpose "because they supplement the civil law enforcement actions the Commission brings," the regulator wrote in its amicus brief last week, siding with the Refco investors.
The SEC noted that the lower court's judge, Gerard Lynch, had too narrowly interpreted the rules. "In the Commission's view, attribution of a false or misleading statement to a person is only one means by which that person can create the statement and thus be a primary violator," the commission's attorneys wrote.
Unlike Lynch, the SEC believes a person who creates a misstatement could be considered a primary violator even if investors did not know who made the misstatement (such as in anonymous online postings or, in the case at hand, a lawyer who drafts the management's discussion and analysis text in a financial filing).
However, Lynch apparently thought his hands were tied. In his opinion on the Refco case earlier this year, the judge noted that the high court and Congress "have declined to provide a private right of action for victims of securities fraud against those who merely — if otherwise substantially and culpably — aid a fraud that is executed by others."
Lynch further suggested that the issue should be raised again. He called it "perhaps dismaying" that people who have participated in a fraudulent scheme could be convicted but do not have to pay damages to their victims. Citing the U.S. Code, he wrote, "In the criminal context when the Godfather orders a hit, he is only an accomplice to murder — one who 'counsels, commands, induces, or procures' — but he is nonetheless liable as a principal for the commission for the crime."