Supporting actors can be just as vital to the success of a corporate fraud as they are to a film. So it’s no surprise that they’re attracting a lot of attention these days.
Earlier this month the Securities and Exchange Commission settled aiding-and-abetting charges against a distributor for videogame maker Take Two Interactive Software for its role in helping Take Two book sham transactions to boost revenue figures. The SEC charged Capitol Distributing and one of its owners, Terry Phillips, for their roles in a scheme earlier this decade where Take Two shipped hundreds of thousands of videogames to Capitol, usually at the end of reporting periods. While Take Two booked the shipments as revenue, Capitol only held the games a short while and then returned them. Phillips admitted to violations of the antifraud, reporting, and recordkeeping provisions of the federal securities laws.
The SEC’s enforcement action, however, also spotlights the stark difference between the government’s ability to go after so-called “secondary actors” in corporate fraud and that of private litigants who want to take secondary actors to court. As Compliance Week has previously reported, courts are currently split on whether secondary actors—suppliers, distributors, accounting firms, investment banks, and others—can face legal liability for a primary actor’s actions. As a result, the Supreme Court has agreed to take up this matter later this year.
Alonso
Under Section 20(e) of the Securities Exchange Act, the SEC has the right to go after aiders and abettors. “They must prove [secondary actors] knowingly provided substantial assistance in violating the law,” says Daniel Alonso, a trial lawyer at the law firm Kaye Scholer.
And from its perch as a regulator, the SEC has clearly laid out its attitude about secondary actors’ liability, as evidenced in past aiding-and-abetting cases. For example, when the SEC brought aiding and abetting charges against seven individuals in November 2005 who were employees of or agents for vendors that supplied U.S. Foodservice, the SEC’s associate director of enforcement said at the time: “These actions demonstrate the Commission’s continued scrutiny of third parties who help companies commit and hide financial fraud. The use of third-party confirmations is an important part of the audit process, and the Commission will hold accountable those who work to subvert it.”
Himmel
“The SEC goes after aiding and abetting for many reasons,” says Michael Himmel, a member of the law firm Lowenstein Sandler. It may want to send a message to a senior officer or seek to ban an individual from the securities business, regardless of whether the person personally benefited, he explains. Or the Commission might want to bring about some sort of governance changes.
Private litigants face a very different landscape. They essentially have been foreclosed from the ability to sue for aiding and abetting since a 1994 Supreme Court ruling, Central Bank of Denver v. First Interstate Bank of Denver. The High Court ruled that Congress did not intend that secondary actors be held responsible in private suits for “aiding and abetting” the securities fraud of a primary violator, under the Securities Exchange Act and its Rule 10b-5.
Moreover, when Congress passed the Private Securities Litigation Reform Act of 1995, it did not prescribe civil causes of action for aiding and abetting under Rule 10b-5. “After Central Bank, there is no provision for a private litigant to pursue someone for aiding and abetting,” says Andrew Kaizer of the law firm McDermott Will & Emery.
Creative Thinking On Aiding And Abetting
ENFORCEMENT EXCERPT
Below is an excerpt of the SEC's settlement against Capitol Distribution and one of its principals, Terry Phillips.
Section 21C(a) of the Exchange Act specifies that a respondent is a cause of another’s violation if the respondent knew or should have known that his act or omission would contribute to such violation.
Section 10(b) of the Exchange Act and Rule 10b-5 thereunder proscribe a variety of fraudulent practices. An issuer or individual may violate these provisions by either intentionally or recklessly making materially false or misleading statements in connection with the purchase or sale of securities. To violate Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, a defendant must act with scienter, which the Supreme Court has defined as “a mental state embracing intent to deceive, manipulate, or defraud.” Scienter of a company’s management is imputed to the company.
Take-Two violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by using the transactions with Capitol to materially inflate its operating results, and by filing and releasing to the public periodic reports, registration statements and press releases that were materially false and misleading, and that misrepresented Take-Two’s
financial condition. Based on his conduct described above, Phillips was a cause of Take Two’s violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
Section 13(a) of the Exchange Act and Exchange Act Rules 13a-1 and 13a-13 thereunder require all issuers with securities registered under Section 12 of the Exchange Act to file annual and quarterly reports on Forms 10-K and 10-Q respectively. Exchange Act Rule 12b-20 requires that, in addition to the information expressly required to be included in such reports, the issuer include such additional material information as may be necessary to make the required statements, in light of the circumstances under which they were made, not misleading. The obligation to file these periodic reports includes the obligation to ensure that they are complete and accurate in all material respects. No showing of scienter is required to establish violations of these provisions. Information regarding the financial condition of a company is presumptively material.
Take-Two violated Section 13(a) of the Exchange Act and Exchange Act Rules 12b-20, 13a-1 and 13a-13 thereunder when, as a result of the parking transactions with Capitol described above, it filed with the Commission materially false and misleading annual reports on Forms 10-K for the fiscal years ending October 31, 2000 and October 31, 2001, and quarterly reports on Forms 10-Q for the quarters ending April 30, 2001 and July 31, 2001, which contained inflated operating results. Based on his conduct described above, Phillips was a cause of Take-Two’s violations of Section 13(a) of the Exchange Act and Exchange Act Rules 12b-20, 13a-1 and 13a-13 thereunder.
Section 13(b)(2)(A) of the Exchange Act requires issuers to “make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer.” Exchange Act Rule 13b2-1 prohibits direct or indirect falsification or causing falsification of books, records, or
accounts subject to Section 13(b)(2)(A). No showing of scienter is required to establish violations of Exchange Act Section 13(b)(2)(A).
Take-Two failed to make and keep accurate books, records and accounts with respect to its transactions with Capitol. It also used those transactions to falsify its books and records. Based on his conduct described above, Phillips was a cause of Take-Two’s violations of Section 13(b)(2)(A) of the Exchange Act and Exchange Act Rule 13b2-1.
In view of the foregoing, the Commission deems it appropriate to impose the sanctions agreed to in Respondent Phillips’ Offer.
Source
Administrative Proceeding In The Matter Of Terry M. Phillips (SEC; May 2, 2007)
As a result, says, Herb Washer, partner at the Shearman & Sterling law firm, plaintiff lawyers “have looked for other ways around it.” Plaintiffs have tried to sue under certain interpretations of Section 10b of the Exchange Act, such as characterizing the conduct in question as qualifying for “primary actor liability” status.
More recently, some plaintiffs have pursued cases asserting a “scheme to defraud” theory, under Rule 10b-5(a) and (c), in going after secondary actors. “They rely upon those two subsections of Rule 10b-5 to make it sound as though the secondary actors are primary actors,” Kaizer says. This strategy, however, has led to split rulings at the appellate level, and ultimately the Supreme Court’s decision to take up one of the cases.
For example, last summer, the Ninth Circuit Court of Appeals determined that plaintiffs can seek damages from a secondary actor in certain circumstances. The plaintiffs in Simpson v. AOL Time Warner were shareholders in a company that in 1996 launched the real-estate Web site Homestore.com (now Move.com); the court ruled that plaintiffs could prevail if they proved that the principal purpose and effect of a defendant’s behavior was to create “a false appearance from illegitimate transactions in furtherance of a scheme” to commit fraud.
In March, however, a three-judge panel for the Fifth Circuit decided in favor of secondary actors. In this case, the court ruled that former Enron shareholders could not combine their litigation against Merrill Lynch, Credit Suisse First Boston, and Barclays Bank into a class action lawsuit. The judges ruled that, yes, Enron may have committed fraud by misstating its 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.”
Shortly afterward, the Supreme Court agreed to take up Stoneridge Investment v. Scientific-Atlanta. The case involves Stoneridge Investment Partners and its stake in cable television provider Charter Communications. Stoneridge alleged that Charter had entered into sham transactions with Motorola and Scientific-Atlanta that inflated Charter’s revenue by $17 million. Stoneridge sued Motorola and Scientific-Atlanta (now part of Cisco Systems) for participating in a “scheme to defraud” investors. A federal district court and the Eighth Circuit Court of Appeals each dismissed Stoneridge’s claim, ruling that Motorola and Scientific-Atlanta aided and abetted Charter’s fraud but did not violate securities laws themselves.
“It’s a classic aiding-and-abetting case, which cannot result in civil liability under Section 10(b),” after the Central Bank ruling, Washer says.
Meanwhile, the SEC recently weighed in with its own recommendation for where to draw the line between primary liability and aiders and abettors. In its amicus brief filed with the Ninth Circuit in the Homestore case, the Commission wrote: “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 of Securities 10(b) and Rule 10b-5(a); 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 or abettor.”
Washer
Of course, the distinction is not critical for the SEC. “They don’t need to fight the label,” Washer says. “They can sue aiders and abettors. Private litigants can’t, which is why they sometimes attempt to relabel the conduct as a primary violation through the allegation of a scheme to defraud.”
The Supreme Court is expected to take up this case in the fall. Says Washer: “What the court does could have an effect on who can be sued by private litigants. Lawyers, accountants, and bankers will all be interested in what the court says.”
Could private litigants simply sue aiders and abettors after they have settled with the SEC based on the contents of those settlement deals? No, say attorneys. The reason: In the settlements with the SEC, the defendants distinctly say they “neither admit nor deny” the charges. “That’s the reason for putting in that representation,” Kaizer says.
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