Aiding And Abetting Liability For Securities Fraud

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1 Portfolio Media, Inc. 648 Broadway, Suite 200 New York, NY Phone: Fax: Aiding And Abetting Liability For Securities Fraud Law360, New York (September 28, 2009) -- On the heels of a proposed bill that seeks to undo the Iqbal and Twombly heightened pleading standard, Sen. Arlen Specter, D- Pa., along with other Senate Democrats, has introduced Senate Bill 1551, The Liability for Aiding And Abetting Securities Violations Act of 2009, which would permit plaintiffs to pursue claims against secondary parties, such as lawyers and accountants, for aiding and abetting securities fraud. The United States Supreme Court has repeatedly denied this type of claim. The bill seeks to amend 15 U.S.C. 78t(e) to include a new subsection (2), which would provide: Private Civil Actions For purposes of any private civil action implied under this title, any person that knowingly or recklessly provides substantial assistance to another person in violation of this title, or of any rule or regulation issued under this title, shall be deemed to be in violation of this title to the same extent as the person to whom such assistance is provided. As recently as 2008, the Supreme Court held, in Stoneridge v. Scientific Atlanta, that companies cannot be held liable for securities fraud merely for doing business with another firm that commits fraud. This followed the 1994 Central Bank of Denver v. First Interstate Bank of Denver decision, in which the Court expressly limited liability claims against alleged aiders and abettors. This bill would upend these rulings, making individuals and firms that provide substantial assistance to the primary actor(s) subject to investor lawsuits. Among those potentially facing liability are a public company s lawyers, auditors, bankers and even business affiliates.

2 In a floor statement made on July 31, 2009, when he introduced the bill, Sen. Specter argued that The massive frauds involving Enron, Refco, Tyco, Worldcom and countless other lesser-known companies during the last decade have taught us that a stock issuer s auditors, bankers, business affiliates and lawyers... all too often actively participate and enable the issuer s fraud. Other unstated but obviously influential cases include the recent Madoff and Agape World scandals. The recurring theme is that the perpetrators in these fraudulent schemes could not have been successful without the help of their lawyers, accountants, investment bankers and even counterparties. It is important to note, however, that the SEC has the power to pursue and hold accountable secondary parties who participated in securities fraud, including under aiding and abetting theories. The effect of Stoneridge and its predecessors is only to preclude private litigation proceeding on those theories. Nevertheless, Senator Specter argues that the SEC s litigating resources are too limited for the SEC to bring suit except in a small number of cases. While the Senator s attempt to address these fraudulent schemes is laudable, the practical effect of widening the net of securities fraud liability is that it will likely ensnare more companies in private litigation merely because of their business partnerships with or provision of professional services to fraudulent companies. Not only would this legislation reverse long-standing Supreme Court precedent, it would greatly expand the number of parties that may be held liable for violation of securities laws and could make business partnering more risky. As the Stoneridge Court found, "The practical consequences of an expansion [of liability under Rule 10b-5], which the court has considered appropriate to examine in circumstances like these, provide a further reason to reject petitioner s approach. "In Blue Chip, the court noted that extensive discovery and the potential for uncertainty and disruption in a lawsuit allow plaintiffs with weak claims to extort settlements from innocent companies. Adoption of petitioner s approach would expose a new class of defendants to these risks. "As noted in Central Bank, contracting parties might find it necessary to protect against these threats, raising the costs of doing business. Overseas firms with no other exposure to our securities laws could be deterred from doing business here. "This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets."

3 Opponents of the bill, including the United States Chamber of Finance, similarly argue that this legislation will only hurt our already-suffering economy. As University of California law professor Stephen Bainbridge blogged, Specter s bill would once again throw American business to the trial lawyer wolves, weakening our competitive position, at a time when our economy needs all the help it can get. Bainbridge argued that such legislation could force companies to extend the monitoring of their internal controls to those of their vendors and other business partners. The bill effectively imposes an affirmative obligation on companies to look over the shoulder of their counterparties, concerned with the threat of liability for that counterparty s accounting decisions. In a recent Wall Street Journal editorial criticizing the bill, the author warned that it would create a new lawsuit bonanza, opining that [p]rivate lawsuits are about trying to use expansive liability claims that distort justice and harm the shareholders of innocent but deep-pocketed companies. The Specter of Unlimited Liability, Aug. 9, As another commentator colorfully noted, there are two real policies underlying the Stoneridge decision: "The first is that plaintiffs (or their attorneys) bring in peripheral parties in a sort of piggish grasping around for deep pockets. The second is a concern which also underlies the heightened pleading requirements adopted by Congress in the Private Securities Litigation Reform Act of 1995 about innocent parties being sued and forced to settle Rule 10b-5 action. Coupled with this concern is the notion that the more defendants brought into securities fraud lawsuits, the more chance there is of suits against parties who actually did nothing wrong." Gevurtz, Franklin A., Law Upside Down: A Critical Essay on Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc., Northwestern Univ. L. Rev. Colloquy, 103: (2009). Indeed, Stoneridge, Central Bank and the passage of the PSLRA were clearly predicated in part on rising fears of strike suits or what many characterize as abusive or frivolous litigation. The bill was up for hearing before the Committee on the Judiciary, Subcommittee on Crime and Drugs on Sept. 17, At that hearing, Professor Adam Pritchard of University of Michigan, gave testimony opposing the bill, arguing that it would tear down the safeguards the court adopted in Stoneridge and Central Bank and noting, [a]s Justice Kennedy recognized in Stoneridge, expanding liability to secondary actors would undermine the United States

4 international competitiveness and raise the cost of capital because companies would be reluctant to business with American issuers. On the other hand, proponents of the bill claim that the current law unjustifiably immunizes culpable parties from legitimate claims by injured investors and allows many bad actors to go unpunished simply by virtue of the SEC s limited resources. The SEC appears to agree, at least in principle. In an amicus brief submitted by the SEC in the recent Refco case, the SEC reminded the court that private securities lawsuits still have a purpose because they supplement the civil law enforcement actions the commission brings. SEC Amicus Brief, cv (2d Cir.) at 3. The SEC further argued that [i]n the commission s view... a person who, acting with the requisite scienter, creates a misstatement is a primary violator regardless of whether the victim knows of the person s identity. As background, the CEO in Refco hid losses by transferring them to a separate company. The plaintiffs alleged that an outside lawyer may have knowingly drafted the legal papers that allowed the fraud to occur. Judge Gerald Lynch of the Southern District of New York dismissed the suit against the lawyer, relying on Central Bank and Stoneridge and holding that Congress and the court had not provided a private right of action against those who aid and abet fraud. Judge Lynch commented that it is perhaps dismaying that participants in a fraudulent scheme who may even have committed criminal acts are not answerable to the victims of the fraud, noting that the issue may be ripe for legislative re-examination. Interestingly, Judge Lynch s nomination to the Second Circuit was confirmed by the Senate on Sept. 17, In his testimony before the Senate Subcommittee regarding S. 1551, Professor John Coffee of Columbia University Law School, similarly noted that it is anomalous that one could be criminally liable of aiding and abetting by not civilly liable for the same conduct in a private suit. Professor Coffee further argued that private lawsuits against aiders and abettors would be the most realistic means to prevent misconduct, because it would most effectively deter fraudulent misconduct. Professor Coffee refuted the common argument that an expansion of potential liability will open the floodgates of litigation against secondary actors, citing the Private Securities Litigation Act and the safeguards provided therein.

5 This discussion is not purely academic. Given the current political and economic environment, the chances of the bill becoming law are significant. And in the wake of the recent scandals, the impetus for the bill is certainly understandable. Indeed, the reality is that plaintiffs injured as a result of securities fraud are often left with little recourse or hope for meaningful recovery. So, it is not surprising that legislation that expands the ability to recover to other, deeper pockets would be an appealing solution. But, legislators need to consider whether going after these secondary actors is really the right solution. Perhaps the most troubling aspect of the bill is the use of the undefined term, substantial assistance. Read broadly, substantial assistance could encompass acts like drafting public disclosures for company filings, opining on audited financials, and entering into routine business contracts. Each of these acts, and the many other potential hooks for liability under the bill, is performed by professionals that are expressly limited in the scope of their tasks and responsibilities. For example, securities attorneys work with their clients to ensure that the company s disclosures comply with the securities regulations. However, it would be irrational to expect these attorneys to independently verify all of the information contained in these disclosures and provide assurances that all of the statements made therein are true. Similarly, accountants duties are defined by things like GAAP. This bill seeks to impose obligations on accountants far beyond what is required in the profession. In addition, this bill seeks to impose a duty on companies to police the conduct of their counterparties to business transactions. While good intentioned, there are likely to be dramatic unintended consequences if the bill passes. For example, if attorneys become potentially liable for the statements made in their clients public disclosures, malpractice insurance will skyrocket and attorneys will resist performing that kind of work or will be forced to charge more in order to cover the attendant risk. Similarly, accountants will face higher insurance premiums and will pass those costs on to their clients. And, given the current economic crisis, perhaps the most unfortunate consequence would be the effect on business and companies willingness to enter into contracts and conduct business with each other.

6 Moreover, the argument that the scienter requirement will protect those who do not knowingly assist in securities fraud misses the point. Facts required to prove scienter particularly at the pleading stage are not limited to the smoking gun, but rather include circumstantial evidence such as the secondary actor s profit motive. Thus, the inevitable result will be securities fraud plaintiffs naming every possible secondary actor the company s lawyers, accountants, underwriters, counterparties as defendants. Consequently, those defendants will be required to expend substantial legal fees moving to dismiss or will be forced to settle to avoid those fees. Yes, that will result in greater recoveries for securities fraud plaintiffs, but is it truly fair and just to exact that result from innocent professionals and companies? While there is no question that something needs to be done to address the apparent rise in securities fraud, this bill, as drafted, is not the answer. --By Monica M. Riederer, Michael Best & Friedrich LLP Monica Riederer is a partner with Michael Best & Friedrich in the firm's Milwaukee office. The opinions expressed are those of the author and do not necessarily reflect the views of Portfolio Media, publisher of Law360.