By James Hamilton, J.D., LL.M.
The Senate draft legislation, Restoring American Financial Stability Act, would enable investors to sue persons who aid and abet securities fraud. The draft amends Section 21D of the Exchange Act to provide that, in implied private civil securities fraud actions, any person that knowingly or recklessly provides substantial assistance to another person in violation of the securities antifraud rule or any other SEC rule or regulation must be deemed to be in violation to the same extent as the person to whom such assistance is provided.
This draft provision appears to overrule legislatively the US Supreme Court’s 1994 opinion in Central Bank of Denver v. First Interstate Bank that there is no implied private right of action against secondary actors who aid and abet securities fraud. Derivatively, it apparently also overrules the Court’s 2008 ruling in Stoneridge Investment Partners, Inc. v. Scientific-Atlanta, Inc., where the Court held that secondary non-speaking actors said to have participated with a company in a securities fraud scheme were not liable in a private action under Rule 10b-5
Until the Central Bank ruling, every circuit of the Federal Court of Appeals had concluded that a private right of action for securities fraud allowed recovery not only against the person who directly undertook a fraudulent act, the primary violator, but also anyone who aided and abetted the actor. A five-justice majority in Central Bank narrowed the scope of the antifraud rule by holding that its private right of action extended only to primary violators.
The Stoneridge court relied on the earlier Central Bank ruling. These aiding and abetting issues arise when secondary actors engage in conduct with the purpose and effect of creating a false appearance of material fact to further a scheme to misrepresent the company’s revenue. The argument is that the financial statement the company released to the public was a natural and expected consequence of the non-speaking actor’s deceptive acts. Had the actors not assisted the company, the theory goes, the company’s auditor would not have been fooled, and the financial statement would have been a more accurate reflection of the company’s financial condition. That causal link is sufficient to apply a presumption of reliance to the secondary actors.
Citing the Central Bank ruling, the Stoneridge court observed that, since Rule 10b-5 implied private right of action does not extend to aiders and abettors, the conduct of a secondary actor must satisfy each of the elements or preconditions for liability.
On one level, the Stoneridge opinion represented an affirmation of the ruling in Central Bank. The Stoneridge court noted that, in Central Bank, the court said that allowing the aiding and abetting action would mean that defendants could be liable without any showing that investors relied upon the aider and abettor’s statements or actions. Allowing investors to circumvent the reliance requirement would disregard the careful limits on 10b–5 recovery mandated by earlier cases.
The court also noted that the decision in Central Bank led to calls for Congress to create an express cause of action for aiding and abetting within the Exchange Act. Congress did not follow this course. Instead, in section 104 of the Private Securities Litigation Reform Act of 1995 (PSLRA), Congress directed prosecution of aiders and abettors by the SEC. The court construed this to be a conscious decision by a Congress aware of the Central Bank ruling not to legislatively expand the scope of Rule 10b-5 to private rights of action by investors. With the Restoring American Financial Stability Act, the Senate Banking Committee would change the legislative framework and allow private rights of action for aiding and abetting securities fraud.
If the provision is in the final legislation it would have broad implications for investment banks and accountants and other secondary actors. For example, relying on the Central Bank opinion, a Fifth Circuit panel said in an Enron-related case that secondary actors, such as investment banks and accountants, who act in concert with public companies in schemes to defraud investors cannot be held liable as primary violators of Rule 10b-5 unless they directly make public misrepresentations; owe the shareholders a duty to disclose; or directly manipulate the market for the company’s securities through practices such as wash sales or matched orders. This was the ruling the panel in an action alleging that investment banks engaged in transactions that allowed Enron to misstate its financial condition. (Regents of the University of California v. Credit Suisse First Boston, 06-20856, March 19, 2007).
At most, said the appeals court, the banks could have aided and abetted Enron’s deceit by making its misrepresentations more plausible but their conduct did not rise to primary liability under Rule 10b-5. And, under the Supreme Court’s Central Bank ruling, there is no private action for secondary aiding and abetting liability under Rule 10b-5. The investment banks owed no duty to Enron’s shareholders, emphasized the panel.