Full Disclosure

By Thomas Brom
     
      Bank Holiday?
      As plaintiffs attorney William S. Lerach's career fades to black, much of his legacy may hang on the outcome of a case to be argued before the U.S. Supreme Court next term. Lerach has no involvement in the matter, Stoneridge Investment Partners v. Scientific-Atlanta, Inc. (No. 06?43). But it raises an issue?scheme liability against secondary actors incorporate fraud?that he and others have pursued for the past decade in securities class actions.
      The arguments involved address the liability of fraud's enablers: vendors, bankers, accountants, auditors, and lawyers. More than a decade ago the U.S. Supreme Court held that section 10(b) of the Securities Exchange Act does not extend to those who aid and abet others who commit manipulative or deceptive acts in connection with buying or selling securities. (Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994).) Though third parties may be subject to other enforcement action, the decision substantially reduced the cost of enabling bad behavior.
      But the imagination of plaintiffs lawyers proved as boundless as fraud itself. In the intervening years they divined arguments that caused the federal courts to split over competing tests for determining whether secondary actors are covered by section 10(b) of the Securities Exchange Act rule 10b-5. Now, just as consensus over scheme liability appears near in the Second and Ninth circuits, the U.S. Supreme Court may kill the baby in its cradle.
      Not, however, without some last-minute drama. In March, Lerach's client in the consolidated Enron litigation was brought up short by an interlocutory ruling reversing the lower court's grant of class certification. (Board of Regents of Univ. of Cal. v. Credit Suisse First Boston, Inc., 482 F.3d 372 (2007).) Lerach petitioned for certiorari, and also petitioned the Court to hear his case along with Stoneridge. "The banks should be held accountable," Lerach stated. "Beyond shielding them from redress in the Enron case, the Fifth Circuit's decision gives other corporations the green light to commit fraud without consequence in the future."
      The Court has not yet responded to the petitions. But it has been peppered with amicus briefs in support of scheme liability filed by dozens of state attorneys general, many of the nation's largest pension funds, the Council of Institutional Investors, assorted law school professors, the AARP, and the Consumer Federation of America.
      The SEC's five commissioners also weighed in, voting 3?2 to recommend that the solicitor general file an amicus brief endorsing a reading of section 10(b) that supports third-party liability in fraud cases. But with reported opposition from within the Bush administration, the solicitor general took no action.
      In response to that nonaction, former SEC chairmen Arthur Levitt Jr. and William H. Donaldson, as well as former commissioner Harvey J. Goldschmid, filed a motion for leave to file a late amicus brief in support of scheme liability. "We believe the continued viability of private actions based on such liability is essential for the protection of the nation's investors and the integrity of our financial markets," their motion stated. In late July, Representatives John Conyers Jr. (D-Mich.) and Barney Frank (D-Mass.) also moved for leave to file a late amicus brief supporting Stoneridge.
      These procedural ripples hide serious conflict below the surface?both in realpolitik and in the courts. "The tensions that you see in the law go back to Central Bank," says Boris Feldman, a partner in the Palo Alto office of Wilson Sonsini Goodrich & Rosati. "One of the plaintiffs bar's highest priorities was reinstating third-party liability for aiding and abetting. When Congress failed to act, plaintiffs lawyers filed claims against secondary actors in state courts. But passage of the Private Securities Litigation Reform Act of 1995 (15 U.S.C. § 78u-4) shut those cases down. Next came allegations of conspiracy, which largely lost. They, in turn, were replaced by claims of scheme liability brought under sections (a) and (c) of rule 10b-5."
      Feldman endorses the Court's ruling in Central Bank, which found no language in section 10(b) imposing liability on aiders and abettors. But he concedes that "judges don't like their discretion challenged" in cases of egregious fraud, such as occurred at Enron. "If it's a really stinky case and the judge really wants to impose liability, then plaintiffs will get a ruling," he says.
      In Stoneridge, the secondary actors were vendors who agreed to boost the buyer's reported revenue by overpaying $17 million for set-top boxes in exchange for sham advertising contracts. But in many of the scheme liability cases, the alleged enablers are the money boys?the investment banks that don't themselves make false statements to the market.
      "Outside of the Ninth Circuit, the district courts use a bright-line test that excludes aiding and abetting by secondary actors," says Herbert S. Washer, a partner in the New York office of Shearman & Sterling who represents Merrill Lynch in the Regents case. "Under Central Bank, the alleged fraudulent activity must include a misrepresentation to the market. So plaintiffs attorneys defined the activity as a scheme rather than a misrepresentation, and through that alchemy changed the nature of the cases."
      Stanley M. Grossman, a partner in the New York firm of Pomerantz Haudek Block Grossman & Gross who represents petitioners in Stoneridge, has no problem with that. "Fraud is covered by section 10(b), and it's not even addressed by Central Bank," he asserts. "The key, in our analysis, is whether the bank?or anyone else?committed a fraudulent act."
      So, is the focus for third-party liability in securities cases a fraud on the market, or the underlying fraud itself? The answer to that question means billions of dollars to the deep pockets?the investment banks, accounting firms, and lawyers who either enable fraud or let it happen.
      The Court's vote in Stoneridge promises to be close. Chief Justice John Roberts and Justice Stephen Breyer did not participate in the certiorari vote, but both still could come onto the panel. Grossman likes his chances, but Feldman handicaps the case differently.
      "Sometimes the Court will say, 'You can't use creative ways to get around what we told you,'" Feldman says. "They will be preemptory about it. I predict a ringing reaffirmation of Central Bank that will make the matter clear. Congress can always change the law."
     

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