LIABILITY IN SECURITIES FRAUD DAMAGE ACTIONS AND THE SUPREME COURT: Part III – Congress Re-affirms Central Bank as the Circuits Struggle to Define Who Is A “Primary Violator”

The year after Central Bank of Denver N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) was decided, Congress essentially reaffirmed the Supreme Court’s decision the next year as part of a package of amendments to the securities laws which limited the ability of plaintiffs to initiate securities class actions.  In the Private Securities Litigation Reform Act of 1995 (“PLSRA”), Congress imposed a series of limitations on securities class actions.  This law was passed after a series of hearings in which the testimony repeatedly emphasized the pernicious impact securities suits on business.  The new PLSRA imposed, for example, heightened pleading standards in fraud cases, including Section 21D(b)(2) requiring that plaintiffs “state with particularity facts giving rise to a strong inference that the defendant acted with the requisite sate of mind.”  (The meaning of this phrase is at issue in Tellabs, Inc. v. Makor Issues & Rights, Ltd., No. 06-484 which is currently pending decision by the Supreme Court and which will be discussed later in this series).  As part of those amendments, Congress added Section 20(e) to the Exchange Act, restoring the ability of the SEC to bring Section 10(b) fraud suits based on aiding and abetting.  However, lawmakers did not adopt an SEC suggestion to expand such liability to private damage actions however.

Following Central Bank, the Courts struggled to draw the line between primary and secondary violators in private actions.  Over time, three separate tests evolved, although one of those three may be a refinement of one of the other two.  First, the Ninth Circuit created the “substantial participation” test.  Second, the Tenth Circuit adopted what later became known as the “bright line” test.  The Second, Fifth, Eighth and Eleventh Circuits subsequently adopted variations of this test.  Finally, the Ninth Circuit appears to have evolved its “substantial participation” test into a “scheme liability” theory, based on a variation of a test proposed by the SEC in an amicus brief.  While each of these tests differ significantly in theory, in various District Court decisions the lines between them are often less than clear.

The first “primary violator” test to evolve after Central Bank was the “substantial participation” test of the Ninth Circuit in In Re Software Toolworks, 50 F.3d 615 (9th Cir. 1994).  That case involved in part a clam against an outside auditor who had approved a company letter sent to the SEC in advance of a secondary offering.  According to the plaintiffs, the auditors reviewed the letter, had access to materials or information demonstrating it contained misrepresentations and authorized the inclusion of the names of firm partners in it so the SEC staff could call them with questions.  The District Court granted summary judgment in favor of the auditors.

The Ninth Circuit reversed.  In a remarkably brief opinion, the Court held that “as members of the drafting group … [auditors] had access to all information that was available and deliberately chose to conceal the truth …,”  Substantial participation in the drafting process was sufficient for liability under Section 10(b) – that is, to be a primary violator. 

In adopting the “substantial participation” test the Court did not explain how “substantial “participation” differs from the aiding and abetting requirement of “substantial assistance.”  Likewise, the Court did not discuss the requirement of reliance which had been a key focus of Central Bank

Six years later, the Court reaffirmed this holding in Howard v. Everex Systems, Inc., 228 F.3d 1057 (9th Cir. 2000).  There, the court concluded that primary liability can be established by signing and attesting to a statement and essentially adopting it as your own.  Again, reliance was not discussed.

Next:  The “Bright Line” Test