Accounting firms, law firms and other third-party vendors to corporations can breathe a sigh of relief these days, thanks to a recent federal appeals court decision that such vendors can’t be held liable in civil suits as “primary violators” of securities laws if they had only tangential involvement in an alleged fraud.
Federal law states that parties cannot be held responsible in private suits for “aiding and abetting” securities fraud under the Securities Exchange Act and Rule 10b-5. Nevertheless, plaintiffs in a suit involving cable television giant Charter Communications claimed that two of the company’s equipment vendors were still liable because they allegedly entered into kickback agreements with Charter to help it artificially boost financial results.
Hurd
Susan Hurd, a lawyer for one of the two vendors in the case, notes that a handful of lower court decisions have “applied a more liberal standard” to such disputes and given corporations a scare that, under two provisions of 10b-5, the cases might be allowed to proceed after all. Last month, however, the St. Louis-based 8th Circuit Court of Appeals disagreed, finding that the plaintiffs had merely dressed up an aiding-and-abetting claim in different clothing.
In their decision, In re Charter Communications Securities Litigation, the judges wrote that imposing liability on vendors that supply goods to a company, which then uses those goods to mislead investors, “would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings. Decisions of this magnitude should be made by Congress.”
Persons
Oscar Persons, another lawyer representing one of the vendors in the case, tells Compliance Week that the court essentially decided that parties that don’t make any representations to shareholders—so-called “secondary actors”—can’t be held liable in private suits. “What the court is saying is that you do not have a primary liability claim unless you can show that the secondary actor made a misrepresentation, or had a duty to make a representation and didn’t do it, or engaged in market manipulation,” says Persons, a partner with Alston & Bird.
‘Sham Transactions’ Alleged
The shareholders in the Charter case claimed that the company had engaged in a scheme to boost its financial results artificially by deliberately delaying the disconnecting of customers no longer paying their bills, improperly capitalizing labor costs and entering into sham transactions with two equipment vendors—Scientific-Atlanta and Motorola—that improperly inflated Charter’s reported operating revenues and cash flows. Several officers of Charter were indicted on criminal charges in 2003 and the company was the subject of a Securities and Exchange Commission complaint, which was settled.
The lawsuit claimed that Scientific-Atlanta and Motorola had deliberately participated in a scheme to defraud Charter’s investors. But a trial judge dismissed the claims, finding that they fell within the definition of “aiding and abetting” corporate fraud and thus were barred by the landmark 1994 Supreme Court decision Central Bank v. First Interstate Bank.
EXCERPT
Below is an excerpt of the 8th Circuit Appeals Court decision on the case:
In this case, the focus of plaintiffs’ § 10(b) and Rule 10b-5 claims was deception—they alleged a “continuous course of conduct” in which Charter allegedly “made and/or failed to correct public representations which were or had become materially false and misleading regarding Charter’s financial results and operations.”
Indeed, 18 pages of the amended complaint alleged in 50 detailed paragraphs the fraudulent financial reports and press releases published by Charter during the class period. However, neither Motorola nor Scientific-Atlanta was alleged to have engaged in any such deceptive act. They did not issue any misstatement relied upon by the investing public, nor were they under a duty to Charter investors and analysts to disclose information useful in evaluating Charter’s true financial condition. None of the alleged financial misrepresentations by Charter was made by or even with the approval of the Vendors. Accordingly, the district court properly dismissed the claims against the Vendors as nothing more than claims, barred by Central Bank, that the Vendors knowingly aided and abetted the Charter defendants in deceiving the investor plaintiffs.
Like the district court and the court in In re Homestore.com, we are aware of no case imposing § 10(b) or Rule 10b-5 liability on a business that entered into an arm’s length non-securities transaction with an entity that then used the transaction to publish false and misleading statements to its investors and analysts. The point is significant. To impose liability for securities fraud on one party to an arm’s length business transaction in goods or services other than securities because that party knew or should have known that the other party would use the transaction to mislead investors in its stock would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings. Decisions of this magnitude should be made by Congress.
Source
In Re: Charter Communications (April 11, 2006)
In urging the 8th Circuit to reinstate the suit, the plaintiffs argued that a primary violation of Section 10b of the Exchange Act and Rule 10b-5(a) and (c) can be based on a business partner’s fraudulent conduct or a scheme directed at deceiving investors. Section (a) says it is unlawful to “employ any device, scheme or artifice to defraud.” Section (c) says it is a violation to “engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.”
Scientific-Atlanta and Motorola “knew the scheme was fraudulent from the outset, and that its sole purpose was to inflate Charter’s reported operating cash flow,” the plaintiffs said, urging the court to adopt the rationale of other courts that have based liability on the fraudulent acts themselves rather than who foisted them onto unwitting investors. One of the rulings cited by the plaintiffs was a 2002 decision by a federal judge in Texas in the Enron litigation.
The 8th Circuit was not persuaded. “[A]ny defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting” and cannot be held liable under Section 10b or Rule 10b-5, the court said.
Manipulative Conduct ‘Not Enough’
Carney
John Carney, a partner with the law firm Baker Hostetler, says the decision “means it’s going to be harder for plaintiffs to bring a securities fraud suit against people who helped a public company commit a fraud. The court has narrowed type of activity that would pass muster as a primary violation of 10b-5.” Third parties can “gain some comfort that they’re not going to be hailed into court in situations where they’re only tangentially involved,” Carney says.
Dyckman
Matthew Dyckman, of Thacher Proffitt & Wood, notes that Scientific-Atlanta and Motorola had no connection at all with the false statements made to Charter’s shareholders. “So even though their hands may not have been clean,” he says, “they were nothing more than aiders and abetters.” Manipulative conduct, he says, “is not enough. There must be a material misstatement or a failure to disclose a material fact by somebody who has a duty to disclose. And there must be reliance by the harmed party—the shareholders.”
Since the Supreme Court’s Central Bank decision, plaintiff lawyers “have had to get creative,” says Robert Ridge, a partner with Thorp Reed & Armstrong. They have tried to exploit the various sections of Rule 10b-5, “but if you look at (a) and (c), those sections are really [targeting] market manipulation schemes,” he says. “In that case, secondary actors … assume a primary responsibility.”
Ridge
Ridge says the 8th Circuit decision underscores a point he frequently emphasizes to clients that do business with public companies: “Be very careful about statements that are attributed to you,” he says. “If you’re a law firm and there’s a big piece of litigation and it involves a publicly traded company, you may want to go on the defensive and say, at the request of your client, ‘This lawsuit has no merit.’ But such public statements may impact on how the market perceives the value of those shares. So, for professionals, you have to be careful not to have statements attributed to you.”
Thomas Sjoblom, a partner with Chadbourne & Parke, notes that while decisions like the one in the 8th Circuit might lower anxiety about private litigation, the SEC still has the power to go after parties that abet securities fraud.
“It’s problematic when you’re dealing with a party that may have some involvement, but perhaps doesn’t rise to the level of culpability [as a primary actor],” notes Sjoblom, formerly a long-time SEC lawyer. “What do you do with them? It may be that the SEC would look at them even though they can’t be sued” by private plaintiffs.
Related decisions, briefs and coverage can be found in the box above, right.
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