A federal judge in New York recently became the first to squarely rule that the Securities and Exchange Commission cannot hold a corporate officer or director liable for assisting in securities fraud if the person didn’t have “actual knowledge” of the wrongdoing.
Griesa
The SEC has taken the position that individual officers and directors face liability for aiding and abetting fraud if they are “reckless”—even if they did not actually know about the fraud, but were negligent in their fiduciary oversight. But Judge Thomas Griesa of the Southern District of New York said the agency’s interpretation of its powers under the Private Securities Litigation Reform Act was overaggressive.
“[K]nowing misconduct must … be shown,” said Griesa in SEC v. Cedric Kushner Promotion Inc., et al., granting summary judgment to a director of a small public company that promotes boxers and boxing matches.
Susan Muck, a partner with Fenwick & West in San Francisco, bluntly says “the court got it right.” The practical implications of the ruling “are particularly important for individual defendants of an SEC claim, particularly outside directors and officers who don’t have any significant role in the transactions that are being challenged,” Muck says, noting that the SEC in recent years “has made considerable headway” in going after individuals.
Muck
The decision might give individuals “who are not the primary focus of the SEC’s proceeding a lot more leverage in getting a better settlement or deciding to take their chances and actually litigate,” Muck says. “It’s very hard to prove actual knowledge of wrongdoing. That’s a much higher standard than recklessness, particularly when it’s a third party or a smaller player within a corporation.”
Paul Edwards, a lawyer with McDonald Hopkins in Cleveland, notes that the director in Kushner was “pretty marginal” to the wrongdoing. “This issue gets litigated a lot,” Edwards says. “Trying to show someone had actual knowledge can be pretty tough. It’s a difficult burden for the SEC to carry.”
Edwards says the distinction between recklessness and knowledge can be a grey one. “At some point it really looks like the guy probably did know—but [the SEC] can’t prove that the person intended the fraud,” says Edwards. “If there’s evidence to suggest he probably knew, if there were warning flags that caused a reasonable person to inquire further, that’s a person who the SEC should be punishing.”
An SEC spokesman says the agency has not yet decided whether to appeal the ruling.
Misrepresentations And Omissions
The case involved alleged securities law violations made by Cedric Kushner Promotions in a Form 10-KSB filing made on May 20, 2003. According to Judge Griesa, the form contained misrepresentations and omissions, including incorrect statements of the company’s cash flows and operating expenditures. In addition, the form contained audit reports that had been included by the company without the consent of its auditors, and had computer signatures of the auditors which were, in effect, forged. Three days later, on May 23, 2003, the company filed a Form-10-KSB/A, amending its original Form 10-KSB. The Form 10-KSB/A also contained various misrepresentations and omissions, the judge noted.
On March 25, 2004, the SEC announced that it had filed a complaint against the company and three of its officers: CEO Cedric Kushner, CFO James DiLorenzo and Steven Angel, one of the company’s three directors (see box above, right for related complaints, settlements and opinions).
AMICUS
The SEC’s Position
An amicus curiae, Latin for "friend of the court," is a legal brief that is submitted to a court to present a particular point of view in a case. Such briefs are typically submitted by entities that are not party to the case in question. The Securities and Exchange Commission has a history of submitting such briefs when a particular case might have a "substantial precedential impact" on the SEC's jurisdiction or enforcement of securities laws.
Back in October 2004, the Commission filed an amicus curiae arguing those who aid and abet fraud should be liable as a "primary violator" who perpetrated the fraud. The brief was related to an entirely difference case involving Homestore.com; however, it outlined the SEC's position on the matter, and was in line with charges that had been filed against AIG, Peregrine, and other companies. An excerpt from the amicus is below, and complete coverage—as well as the actual brief—can be found in our October 2004 article, "SEC: Those Who Aid Fraud Should Be Liable As Those Who Conducted It":
For the foregoing reasons, the Court should hold that any person who has
the requisite scienter can be liable as a primary violator of Section 10(b) of the
Securities Exchange Act of 1934 and Rule 10b-5(a) thereunder when he, directly
or indirectly, engages in a manipulative or deceptive act as part of a scheme to
defraud; that engaging in a transaction whose principal purpose and effect is to
create a false appearance of revenues constitutes such a deceptive act; and that the
reliance requirement in private actions is satisfied where a plaintiff relies on a
material deception flowing from a deceptive act, even though the conduct of other
participants in the scheme may have been a subsequent link in the causal chain
leading to the plaintiff’s securities transaction.
Source
SEC: Those Who Aid Fraud Should Be Liable As Those Who Conducted It (26 Oct. 2004)
According to the complaint, Kushner and DiLorenzo had each personally certified that the filing fairly and accurately presented the company’s financial condition, in violation Section 302 of the Sarbanes-Oxley Act. Kushner and DiLorenzo were charged with being primary violators of the Securities Exchange Act. Angel was charged with being a primary violator and with aiding and abetting Kushner and DiLorenzo.
In November 2005, the company and Kushner settled with the SEC. The claims went forward against DiLorenzo and Angel, who moved for summary judgment on the both the primary violator and aiding and abetting claim.
‘Very Background Role’
In dismissing the claims against Angel, Griesa first found that no basis to hold him liable as a primary violator existed.
“Angel had literally no involvement in the falsifications,” the judge said. “He did not prepare the financial figures, did not assist in the preparation of these figures, did not review these figures, and had no responsibility or authority to take any such steps or actions. As to the false signatures of the auditors, Angel had nothing to do with such falsification.”
On whether Angel could be held liable for assisting in the wrongdoing of others, the judge noted that aiding and abetting liability requires a “showing of knowledge of the violation.” Here, the SEC claimed that knowledge could be established by recklessness since Angel was a fiduciary of the corporation. But the judge disagreed, finding that recklessness is not enough to impose aiding and abetting liability. “[I]t is obvious … that Angel committed no such knowing misconduct,” Griesa wrote.
The SEC had not made “the slightest showing that Angel was involved with any of the subjects … which turned out to be falsely presented,” the judge said. “Since he was not involved in any way with the preparation or review of the figures, it follows necessarily that he had no consciousness of any danger or risk that these figures might end up being falsified.”
Crossing The Line
Bielema
John Bielema, a partner with Powell Goldstein in Atlanta, notes that the controversy over the standard applicable to aiding and abetting claims began with a Supreme Court decision in the early 1990s called Central Bank v. Denver. That decision held that no private cause of action existed under Section 10(b) of the Exchange Act and Rule 10b-5 for aiding and abetting a securities violation. Congress, to ensure that the SEC’s ability to go after aiders and abetters wasn’t impaired by the court ruling, enacted a provision, as part of the PSLRA, that included the word “knowingly” in its language.
Bielema notes that a few decisions have come out contrary to Kushner, but he says those courts relied on pre-PSLRA precedents and “rather breezily assumed that the PSLRA was just intended to resurrect the law of aiding and abetting as it existed pre-Central Bank.”
McGuinness
William McGuinness, a partner with Fried, Frank, Harris, Shriver & Jacobson in New York, says the judge in Kushner is telling the SEC, “There’s a line here, guys, and you crossed it.” The SEC’s approach, according to McGuinness, is often that “if you’re at the scene of an accident, you’re liable, but the judge here just doesn’t buy that.”
McGuinness notes that Congress deliberately used the word “knowing” when it enacted the PSLRA. “If you want to say ‘reckless’ there’s a way to say reckless. It begins with the letter ‘R’ and ends with the letter ‘S.’ If you want to say ‘knowingly or recklessly,’ those are two words that lawyers know how to use and [Congress] didn’t.”
Related documents and coverage can be found in the box above, right.
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