This Week In Securities Litigation (January 25 to 31, 2008): Commissioner Atkins on Cooperation Credit and Two SEC Litigation Losses

This week, the SEC released the text of a speech given by Commissioner Paul Atkins at the Federalist Society Lawyers’ Chapter of Dallas, Texas on January 18, 2008. In the speech, Commissioner Atkins discussed the Supreme Court’s recent decision in Stoneridge, previously discussed here, and cooperation credit for privilege waivers.

Commissioner Atkins began by reiterating the well-reported split among the SEC Commissioners over whether to file an amicus brief supporting the Stoneridge plaintiffs. While the SEC ultimately requested permission to file such a brief based on a split vote, the Solicitor General not only refused the request, but, later argued that the Commission’s views on scheme liability were wrong. Ultimately, the Supreme Court essentially adopted the Solicitor’s views. Commissioner Atkins noted his agreement with the Court’s position, arguing that the plaintiff’s theory of scheme liability was far too expansive – a position advanced by Justice Kennedy in his opinion for the Court.

The Commissioner then returned to a topic he has addressed before – privilege waivers by corporations in exchange for cooperation credit (discussed here). As in his earlier comments, Commissioner Atkins argued that credit should not be given in exchange for cooperation because it undercuts and erodes the attorney client privilege of the corporation. The Commissioner went on to note that bargaining waivers for cooperation credit is creating a “culture of waiver.”

While Commissioner Atkins focused primarily on the loss of rights by corporations, what is perhaps more important is the impact of bartered waivers on directors, officers and employees of companies. When corporations trade their privileges and other rights for cooperation credit, it is frequently part of a strategy to do anything and everything possible to avoid or mitigate liability. While this effort is clearly understandable in view of the pressure generated by a possible charging decision – particularly in a criminal case – the gambit often has a pernicious impact on employees. As part of the barter process, corporations may decide – albeit “voluntarily,” i.e., without a specific prosecutorial request – to limit indemnification rights. This can have the impact of stripping employees of their right to counsel, since few can afford the huge cost of defending an SEC or DOJ investigation or enforcement action.

The corporate barter process may also include a decision to avoid entering into cooperation or joint defense agreements with current and former employees to avoid the appearance of “stonewalling” the SEC or DOJ inquiry. This can translate into not making corporate documents and information available to the employee for his or her defense or only providing a limit set of materials. Yet, absent access to key corporate documents the employee may not be able to adequately prepare for testimony or raise defenses. Indeed, in view of the fact that most securities cases are heavily dependent on documents, the employee may be left with no effective way to prepare for testimony or a litigation.

Finally, as Commissioner Atkins pointed out, a corporate decision to barter for cooperation credit can include pressuring employees to testify in their internal investigation. When the notes of that meeting are turned over to the SEC and DOJ, this effectively undercuts the employee’s Fifth Amendment rights. In addition, if the employee’s access to corporate materials has been curtailed, the person may not be properly prepared to testify, thus increasing the risk that any statements may be incomplete or wrong. That, in turn, increases the risk that the government will later view the statements as false and decide to charge the employee with making false statements or obstruction – a growing trend called “deputization” (i.e. the government, in effect deputizes the private lawyers conducting the internal investigation as government agents). Despite all of this (which will be detailed in an upcoming paper and series) and Commissioner Atkin’s repeated efforts to end cooperation credit, the SEC Enforcement Division and DOJ barter with corporations for cooperation credit.

Last week, the SEC also lost its third Section 5 charge in a PIPE case involving a hedge fund. SEC v. Berlacher, Case No. 073800 (E.D.Pa. Filed September 13, 2007). As in other cases, the Commission’s complaint alleged that defendant sold an issuer’s securities short in connection with a PIPE offering and later covered with the shares obtained from the resale registration statement. As in two prior cases discussed here, the court rejected the SEC’s claim regarding the Section 5 sale of unregistered securities, but not the insider trading claim. The SEC has taken a consistent position in these cases: the short sales with intent to cover with the shares obtained later form the PIPE violates Section 5. The courts have also taken a consistent position: the SEC is wrong. This issue will be discussed in detail next week.

Finally, in SEC v. Dorozhko, Case No. 1:07-cv-09606-NRB (S.D.N.Y. Filed October 29, 2007), the court rejected a request by the Commission for a preliminary injunction in the so-called “hacking and trading” case. In its complaint, the SEC the charged Mr. Dorozhko, a Ukrainian citizen, with insider trading. Specifically, the SEC claimed that the defendant used non-public information about IMS Health he obtained by hacking into Thomson’s network to purchase put options prior to an announcement of negative information about the company. Although the court initially granted the SEC’s request for a TRO and a freeze order, it denied the request for a preliminary injunction holding that Mr. Dorozhko had not breached any duty to anyone. In making its ruling, the court held that the theft of the non-public information and its subsequent use in trading is, without more, is insufficient to sustain an insider trading claim. The SEC has appealed the ruling to the Second Circuit.

In addition to discussing the Berlacher case next week, the series on Stoneridge will also continue.

Stoneridge: The Supreme Court’s Ruling and Its Impact – Part 2: The Roots of Scheme Liability

The origins of scheme liability and Stoneridge Investment Partners, LLC v. Scientific Atlanta, Inc., No. 06-43, slip op. (Jan. 15, 2008) trace to 1994, when the Supreme Court decided Central Bank of Denver v. First Interstate, 511 U.S. 164 (1994). There, the Court held that liability under Section 10(b) cannot be premised on a theory of aiding and abetting. The decision was based largely on a literal reading of the text of the statute and a record where the it was agreed there was no deception and the plaintiff based the claim solely on a theory of aiding and abetting. The Central Bank Court emphasized the fact that anyone can be liable under Section 10(b) if each element of a private cause of action is established:

The absence of Section 10(b) aiding and abetting liability does not mean that secondary actors in the securities markets are always free from liability under the Securities Acts. Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5, assuming all of the requirements for primary liability under Rule 10b-5 are met … in any complex securities fraud, moreover, there are likely to be multiple violators. …

Id. at 191 (emphasis original).

The decision touched off a debate about who could be held liable under Section 10(b) as primary violator and a debate over how to draw the line between primary and secondary liability. This was a critical issue following Central Bank, not only in private damage cases, but also in SEC enforcement actions. Since the Court based its decision on the text of the statute and not one of the court crafted elements of the implied Section 10(b) private right of action, the ruling applied to both private damage cases and SEC enforcement actions.

The year after the Court’s Central Bank decision, Congress took up the issue in the context of considering what became the Private Securities Reform Act of 1995 (“PSLRA”). That Act placed procedural and substantive limitation on private securities damage actions based on repeated testimony about abusive actions, frivolous suits and huge settlements all out of proportion to the merits of the case. The SEC urged Congress to restore aiding and abetting liability for its actions, as well as in private damage cases. In passing the PSLRA, however, Congress chose only to add Section 20(e) to the Exchange Act, which gave the SEC the right to bring actions based on aiding and abetting. Congress did not extend the same right to private damage actions.

The decision by Congress when enacting the PSLRA set the stage for a years long struggle in the courts over the dividing line between primary and secondary liability. That debate spawned the theory of “scheme liability” to define who might be held liable in a Section 10(b) private damage action. Although this issue did not impact SEC enforcement actions in the wake of Section 20(e), the Commission crafted the theory of scheme liability in amicus briefs filed in some of the largest securities class actions which arose out of corporate debacles such as Enron (Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. 2007) and Homestore (Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th Cir. 2006)) (both discussed here). This is consistent with the SEC’s long-held view that private securities damage actions are necessary adjunct to its enforcement program.

Next: The evolution of primary and secondary liability and the rise of scheme liability.