Risk & Compliance

Fall Lineup Includes Secondary Actors

The outcome of lawsuits against Enron's business partners could be determined later this year when the Supreme Court hears an unrelated case.
Sarah JohnsonJune 1, 2007

The outcome of shareholder lawsuits that placed some of the blame for Enron’s fraud on the energy giant’s business partners could hinge on an unrelated case that will be heard by the Supreme Court later this year. The case, which involves Charter Communications and its vendors, could answer the tricky question of whether business partners of fraudulent businesses are similarly liable for violating securities laws.

The lower courts have been divided on the issue, which has been played out in shareholder cases against the banks that did business with Enron. But those cases could be held up until the Supreme Court opines on StoneRidge Investment v. Scientific Atlanta, which the justices could hear as early as October. Agreeing to take the case in March, the high court is tasked with deciding whether vendors of Charter Communications that were involved in an alleged sham transaction involving behind-the-scenes dealings could be considered primary violators of securities rules.

By including an Enron-associated bank case with the StoneRidge case, the Supreme Court could answer larger issues about liability and secondary actors. However, the court has yet to decide whether it will agree to combine the cases, or even hear the Enron case at all. The lead plaintiff’s attorney in the Enron case, William Lerach, has requested that the Supreme Court hear his client’s appeal for its suit against Merrill Lynch, Barclays, and Credit Suisse along with StoneRidge. If that happens, Lerach hopes the decision will answer the question of whether so-called secondary actors — such as banks, audit firms, or vendors — can be considered directly liable for securities fraud. As in most legal cases, the wording is key: under the Private Securities Litigation Reform Act of 1995, private litigants have no case unless they can prove the accused company did more than just aided and abetted the wrongdoing.

Along with the possibility that it could be considered in tandem with the Enron case, legal experts consider the StoneRidge hearing important because it gives the Securities and Exchange Commission a public forum for siding with either business or investors in these types of cases. The SEC has until June 11 to file an amicus brief on behalf of the plaintiffs and address the issue of scheme liability. The commission last addressed the question nearly three years ago when it filed a “friend of the court” opinion on the side of Homestore shareholders in Simpson v. AOL with the Ninth Circuit Court of Appeals.

At the time, the commission argued against a lower court ruling that said aiding and abetting manipulative or deceptive behavior is not in itself enough to classify a company as a primary violator of Rule 10(b) of the Securities and Exchange Act of 1935. The SEC asserted that a third party can be considered a primary violator if it “engages with the corporation in a transaction whose principal purpose and effect is to create a false appearance of revenues, intending to deceive investors in the corporation’s stock.”

The Ninth Circuit’s decision to dismiss the case went against the plaintiffs and added to the confusion about when secondary actors could be held liable. “There is clearly a split in the circuit courts on when you can draw the line between primary liability and aiding and abetting,” says Herbert Washer, a partner at Shearman & Sterling, which represents Merrill Lynch in the Enron case. The Ninth Circuit’s opinion went beyond the scope of how the Supreme Court and other courts have defined what is considered a manipulative and deceptive act, he adds.

Companies that had a hand in creating the fraud, rather than just knowing about the violation, should be held liable, says Donald Langevoort, a professor at Georgetown University Law Center, who is considering submitting an amicus brief with other law professors in the StoneRidge case. Langevoort and other securities-law experts are hoping for a bright-line rule to come out of the StoneRidge case, which could happen if it is linked with the Enron case. Otherwise the question before the court would be too narrow and “we will have more years of uncertainty in litigation,” he says.

In StoneRidge, shareholders of Charter Communications accuse the cable company’s vendors — including Motorola and Scientific-Atlanta (now owned by Cisco) — of partaking in a “scheme to defraud” investors. A federal district court and the Eighth U.S. Circuit Court of Appeals have dismissed StoneRidge’s claim, ruling that Motorola and Scientific-Atlanta aided and abetted Charter’s actions to misrepresent its revenue, but did not violate securities laws themselves.

At a Senate hearing about the SEC budget earlier this month, SEC chairman Christopher Cox said the commissioners had not decided what point of view they would take in StoneRidge, if any. He answered “no” when asked whether anything had changed in the past three years to warrant a shift in the SEC’s opinion on the Homestore case, which was issued a year before Cox became chairman. On Thursday an SEC spokesman told CFO.com the commission has not yet decided whether to address the case, but said that if it were to submit a brief, it would likely do so closer to the June 11 deadline.

The bank defendants in the Enron case have until Friday to submit their response to Lerach’s request for a Supreme Court hearing. The banks had been scheduled for an April trial when a Fifth Circuit three-judge panel decided to reverse a lower court’s decision for class certification. According to various press reports, Lerach has said his clients filed a class-action suit because they could not afford to try three separate cases. Lerach did not respond to CFO.com’s request for comment.

The Fifth Circuit’s majority opinion said the banks did not have direct responsibility for Enron’s investors. “Presuming plaintiffs’ allegations to be true, Enron committed fraud by misstating accounts, but the banks only aided and abetted that fraud by engaging in transactions to make it more plausible; they owed no duty to Enron’s shareholders.”

To be sure, the banks that shareholders have accused of helping Enron to misrepresent its financial health — through the creation of fraudulent special-purpose entities, among other schemes — have paid for their relationship with the collapsed company. As of February, the SEC has collected $440 million from settlements and enforcement actions against individuals and business partners (including some banks) that it accused of participating in Enron’s fraudulent activities. The SEC has not yet announced a distribution plan for the funds.

As for the shareholder lawsuits, three banks have settled, bringing the total dollar figure of settlements for Enron investors so far to $7.3 billion, according to Lerach, who believes his clients are owed more than $40 billion in damages. (Citigroup settled for $2 billion, J.P. Morgan Chase for $2.2 billion, and Canadian Imperial Bank of Commerce for $2.4 billion.) The shareholders’ case against Deutsche Bank was dismissed on appeal, and a separate case against Royal Bank of Canada, Royal Bank of Scotland, and Toronto Dominion has yet to progress to the same stage as the other banks. That case could similarly be affected by StoneRidge, say securities-law attorneys.

Recent Milestones in Determining Scheme Liability for Securities Fraud

1994: In Central Bank of Denver v. First Interstate Bank of Denver, the Supreme Court rules that parties that aided and abetted securities fraud are not directly liable for violating Rule 10(b). Only primary violators can be considered liable.

1995: Congress overrides President Clinton’s veto to pass the Private Securities Litigation Act to limit frivolous lawsuits involving securities laws.

2004: In an amicus brief, the SEC gives the following test for Simpson v. AOL, a lawsuit presented by Homestore shareholders: “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 … 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.”

2005: Citigroup, Canadian Imperial Bank of Commerce, and J.P. Morgan Chase settle class-action lawsuits related to Enron fraud.

April 11, 2006: Eighth U.S. Circuit Court of Appeals dismisses Charter Communications shareholders’ claims against Motorola and Scientific-Atlanta. If the courts impose liability for securities fraud on secondary actors that knew, or should have known, about their business partners’ fraudulent activities (but were not involved in related securities matters themselves), they would “introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings.”

June 30, 2006: In Simpson v. AOL, Ninth U.S. Circuit Court of Appeals defines the scope of primary liability under “scheme to defraud” 10(b), saying “the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of a scheme.”

March 19, 2007: Fifth U.S. Circuit Court of Appeals reverses the class certification for three lawsuits against Merrill Lynch, Barclays, and Credit Suisse for their involvement in Enron’s fraud.

June 11, 2007: The deadline for the U.S. solicitor general to submit the government’s (such as the SEC’s) view on scheme liability in the Charter case.

October 2007: The earliest the Supreme Court will hear arguments in the Charter case. — S.J.

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