by T. GormanPosted on Posted in SECActions

The year after Central Bank of Denver N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) was decided, Congress essentially reaffirmed the Supreme Court’s decision the next year as part of a package of amendments to the securities laws which limited the ability of plaintiffs to initiate securities class actions.  In the Private Securities Litigation Reform Act of 1995 (“PLSRA”), Congress imposed a series of limitations on securities class actions.  This law was passed after a series of hearings in which the testimony repeatedly emphasized the pernicious impact securities suits on business.  The new PLSRA imposed, for example, heightened pleading standards in fraud cases, including Section 21D(b)(2) requiring that plaintiffs “state with particularity facts giving rise to a strong inference that the defendant acted with the requisite sate of mind.”  (The meaning of this phrase is at issue in Tellabs, Inc. v. Makor Issues & Rights, Ltd., No. 06-484 which is currently pending decision by the Supreme Court and which will be discussed later in this series).  As part of those amendments, Congress added Section 20(e) to the Exchange Act, restoring the ability of the SEC to bring Section 10(b) fraud suits based on aiding and abetting.  However, lawmakers did not adopt an SEC suggestion to expand such liability to private damage actions however.

Following Central Bank, the Courts struggled to draw the line between primary and secondary violators in private actions.  Over time, three separate tests evolved, although one of those three may be a refinement of one of the other two.  First, the Ninth Circuit created the “substantial participation” test.  Second, the Tenth Circuit adopted what later became known as the “bright line” test.  The Second, Fifth, Eighth and Eleventh Circuits subsequently adopted variations of this test.  Finally, the Ninth Circuit appears to have evolved its “substantial participation” test into a “scheme liability” theory, based on a variation of a test proposed by the SEC in an amicus brief.  While each of these tests differ significantly in theory, in various District Court decisions the lines between them are often less than clear.

The first “primary violator” test to evolve after Central Bank was the “substantial participation” test of the Ninth Circuit in In Re Software Toolworks, 50 F.3d 615 (9th Cir. 1994).  That case involved in part a clam against an outside auditor who had approved a company letter sent to the SEC in advance of a secondary offering.  According to the plaintiffs, the auditors reviewed the letter, had access to materials or information demonstrating it contained misrepresentations and authorized the inclusion of the names of firm partners in it so the SEC staff could call them with questions.  The District Court granted summary judgment in favor of the auditors.

The Ninth Circuit reversed.  In a remarkably brief opinion, the Court held that “as members of the drafting group … [auditors] had access to all information that was available and deliberately chose to conceal the truth …,”  Substantial participation in the drafting process was sufficient for liability under Section 10(b) – that is, to be a primary violator. 

In adopting the “substantial participation” test the Court did not explain how “substantial “participation” differs from the aiding and abetting requirement of “substantial assistance.”  Likewise, the Court did not discuss the requirement of reliance which had been a key focus of Central Bank. 

Six years later, the Court reaffirmed this holding in Howard v. Everex Systems, Inc., 228 F.3d 1057 (9th Cir. 2000).  There, the court concluded that primary liability can be established by signing and attesting to a statement and essentially adopting it as your own.  Again, reliance was not discussed.

Next:  The “Bright Line” Test

by T. GormanPosted on Posted in SECActions

The issue the Supreme Court will decide in Stoneridge traces its roots back to at least 1994, when the Supreme Court decided Central Bank of Denver v. First Interstate, 511 U.S. 164 (1994).  In that case, the Court concluded that there was no aiding and abetting liability under Section 10(b).  Stated differently, the Court held that only “primary” violators could be held liable under the Section.  

The question of who is a primary violator was left for resolution on another day.  Nevertheless, Central Bank suggests much about how Stoneridge will be decided. The holding in Central Bank was a surprise to many.  While the Court suggested that its decision was made to resolve a split in the Circuits, this was hardly the case.  Prior to Central Bank, aiding and abetting liability under Section 10(b) was well established in both SEC enforcement actions and private damage cases.  Every Circuit had acknowledged that there was liability for aiding and abetting.  Interestingly, when previously faced with the universal conclusion of the Circuit Courts that there was an implied cause of action under Section 10(b), the Court had acquiesced, despite its own jurisprudence which, beginning at least with Cort v. Ash, 422 U.S. 66 (1975), had consistently constricted implied causes of action.  The Central Bank majority, however, ignored this point, as Justice Stevens noted in dissent.  The real predicate for the Court’s decision in Central Bank was its efforts to reign in what had been called the “judicial oak” of a court-created implied cause of action, coupled with its concern over the pernicious effects of private securities litigation on business.  In a series of decisions such as Santa Fe v. Green, 430 U.S. 462 (1977), Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), and others, the Court had consistently narrowed the scope of Section 10(b), interpreting the literal language of the statute in a constrictive manner.  This trend was driven in part by the Court’s oft-stated view that litigation under Section 10(b) is disruptive and extremely vexatious.  Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975) (“litigation under Rule 10b-5 presents a danger of vexatiosness different in degree and in kind from that which accompanies litigation in general”). 

After citing its prior decisions and reiterating the negative impact of Section 10(b) litigation, the Court concluded that “[w]e reach the uncontroversial conclusion, accepted even by those courts recognizing a Section 10(b) aiding and abetting cause of action, that the text of the 1934 Act does not itself reach those who aid and abet …”  In reaching this decision, the Court relied almost exclusively on the statutory text, emphasizing the fact that the Section only imposes civil liability on those who “commit a manipulative or deceptive act …”  In addition, aiding and abetting liability, the Court noted, is a broad concept and does not provide the “certainty and predictability” necessary for business to know precisely what is precluded by the statute.

While delimiting the scope of the Section, the Court suggested that concept of “primary violators” may be a broader concept than first appears noting: “Any person … including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement … on which a purchaser or seller relies may be liable as a primary violator … assuming all … ” the elements of a cause of action are established (emphasis original). 

This statement, along with the focus on deception, reliance and the necessity for certainty as to where the primary/secondary violator line falls, are the keys to the subsequent struggle in the circuit courts to define primary liability and perhaps ultimately to the decision next term by the Supreme Court in Stoneridge.  Next:  Congress amends the Exchange Act and the Circuit Courts struggle to draw the line between primary and secondary liability.