The First Circuit Defines The Scope of Aiding And Abetting

The First Circuit Court of Appeals gave definition to aiding and abetting liability in an SEC enforcement action, requiring that the agency prove what specific acts each defendant performed which rendered substantial assistance to the primary fraud. In making its ruling, the Court rejected the SEC’s claim that aiding and abetting liability could be predicated on conduct that happened after the fraud was completed, even though that conduct arguably constituted a subsequent breach of fiduciary duty. SEC v. Papa, Case No 08-1172 (1st Cir. Decided Feb. 6, 2009).

The Commission’s complaint names as defendants six former employees of Putnam Fiduciary Trust Company. According to the SEC, the six executives engaged in a scheme to defraud Putnam client Cardinal Health, Inc. The misconduct centered on the cover-up of a one-day delay in investing certain assets of Cardinal in a defined benefit plan in 2001. The delay caused Cardinal to miss out on about $4 million of market gains. Following the error, the defendants chose not to inform Cardinal. Rather, they took steps to conceal the error by improperly shifting about $3 million of the costs to the shareholders of other Putnam mutual funds through backdated accounting entries and various accounting mechanisms. Cardinal bore about $1 million in losses.

The district court, in a decision discussed here, dismissed the complaint as to Virginia Papa, then Director of Defined Contribution Plan Servicing, Kevin Crain, former head of the plan administration unit and Sandra Childs, previously responsible for overall compliance. The court concluded that the SEC failed to plead facts demonstrating that these three defendants were either primary violators or engaged in aiding and abetting because they did little more than attend meetings where the scheme was discussed. At the same time, the court declined to dismiss the claims as to defendants Karnig Durgarian, then Chief of Operations, Donald McCracken, former Head of Global Operations, and Ronald Hogan, then vice president in the new business implementation unit. The court found that the SEC alleged facts which, if established, demonstrated that these three defendants implemented the scheme.

In its appeal, the SEC abandoned its claim that Ms. Papa, Mr. Crain and Ms. Childs were primary violators. Rather, the SEC argued that each aided and abetted the scheme by executing internal audit letters in 2002 and 2003 which they knew were incorrect because of the backdated trades and accounting adjustments used to conceal the error. According to the SEC, the three defendants agreed to the overall scheme and, by executing these letters, breached their fiduciary duty to disclose it.

The Court rejected the SEC’s arguments. The test of aiding and abetting is whether the defendants rendered substantial assistance to the wrong committed. First, the court concluded that the execution of the audit letters did not render substantial assistance to the fraud. Rather, the letters were executed long after the fraud was committed. This is not aiding and abetting because “one can not aid and abet a fraudulent scheme that is already complete … .” If subsequent events such as the ones here were deemed part of the scheme it would never end – the scheme would be a continuing offense. The court rejected this theory.

The court also rejected the SEC’s breach of fiduciary duty argument. Under this theory, the SEC claimed that Putnam had an on-going duty to disclose accurate answers to the audit letters which would have revealed the fraud and that the failure to do so constituted a breach of duty and Section 10(b) fraud. This, the court concluded “would extend the supposed wrong indefinitely and until its disclosure – not just as a common law breach of duty, but as a federal securities violation. Then, through the aiding and abetting device, the SEC’s approach would create new liability under Section 10(b), long after the original transactions … . And it would do so based solely on general denials of knowledge of wrongdoing.” While the denials of knowledge by the defendants a year or more later may be wrongful, that conduct is not aiding and abetting an ongoing securities fraud “merely by dint of some other fiduciary to disclose its errors or wrongs,” the Court concluded.

The Beginning Of A Long Process: A Partial Settlement In One Madoff Case

The first in what promises to be a long series of steps to resolve the Madoff scandal took place yesterday. The SEC has entered into a partial settlement of its enforcement action against Bernard Madoff. Under the terms of the proposed agreement, Mr. Madoff consented to the entry of a permanent injunction prohibiting future violations of the federal securities laws. Mr. Madoff also agreed to continue the temporary relief imposed by the court’s order of December 18, 2008, which includes, among other things, the asset freeze order prosecutors in the criminal case used in their unsuccessful attempt to have Mr. Madoff remanded to jail.

The judgment submitted to the court for approval leaves open the questions of disgorgement, prejudgment interest and/or a civil penalty. For purpose of determining those issues in the future Mr. Madoff, the facts in the SEC’s complaint will be deemed established — Mr. Madoff will not be able to contest those facts.

That complaint is based largely on the admissions of Mr. Madoff to senior employees of his firm that he was running a Ponzi scheme. It paints a picture which suggests that Mr. Madoff operated the scheme alone, which has been his position. SEC v. Madoff, Civil Action No. 08 CV 10791 (S.D.N.Y. Filed Dec. 11, 2008).

The U.S. Attorney’s office has filed a criminal complaint against Mr. Madoff, who has been released on bail, but is confined to his New York apartment. U.S. v. Madoff, No. 08 Mag. 2735 (S.D.N.Y.) An indictment is expected in the near future. Key questions under investigation involve the scope of the fraud as well as whether others were involved. In addition, there are an ever growing number of private suits.

The partial settlement with the SEC yesterday is the first small step in resolving this scandal. Clearly, the open issues in the SEC’s judgment will not be resolved for a considerable period of time. In the more immediate future will likely be the return of the criminal indictment. The key issue there of course is whether anyone in addition to Mr. Madoff is named as a defendant.