In tracing the road which will eventually lead to the Supreme Court’s decision in Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc. next term and will define the scope of liability under Section 10(b), we have reviewed the three tests used by the Circuit Courts to differentiate between primary and secondary actors in securities fraud suits.  In theory, there are clear dividing lines between the “substantial participation” test, the “bright line” test and “scheme” liability.  District Courts have struggled to apply these theories to complex business transactions however, revealing that the lines between these tests are not always so clear. 

In jurisdictions following the “bright line” test, for example, the courts have not always required that the defendant actually make the statement.  Consider the result in In re Vivendi Universal, S.A. Sec. Litig., No. 02 CIV 5571, 2003 U.S. Dist LEXIS 19431 (S.D.N.Y. Nov. 3, 2003).  There, the court declined to dismiss claims against a CFO where statements were made by the company.  Similarly, in In re Lernout & Hauspie, 230 F. Supp. 2d 166 (D. Mass. 2002), the Court permitted a claim to go forward against the outside auditors on the theory that it could be inferred that the auditor made the statements.  These holdings seem somewhat at odds with the focus of the “bright line” test.  Indeed, in some senses the rulings begin to resemble something one might expect under the substantial participation test.  

At the same time, the Ninth Circuit is not the only court to adopt scheme liability.  Consider for example, two cases from the Southern District of New York where the bright line test is the rule of choice from the Second Circuit.  In In re Global Crossing, 313 F. Supp. 2d 189 (S.D.N.Y. 2003), the Court permitted a securities fraud claim to proceed against an outside auditor based on a scheme liability theory.  There, the Court ruled that the auditors could be held liable based on allegations that they masterminded the scheme. However, the Court noted that the auditors could not be held liable for specific misrepresentations of others involved in the scheme.  

Another decision based on scheme liability is In re Parmalat Sec. Lit., 376 F. Supp. 2d 472 (S.D.N.Y. 2005).  That case involved claims against a group of banks who were alleged to have participated in a scheme under which the company cooked the books using various transactions engaged in by the banks.  Judge Kaplan permitted claims against one group of banks to go forward based on allegations that the transactions in which they were involved were sham transactions with no substance.  Other claims based on business transactions which were booked incorrectly by the company to facilitate a fraud were dismissed, however.  Those claims, the court ruled did not involve deception by the banks.  As we will discuss in subsequent parts of this series, Plaintiffs seeking review of the Fifth Circuit’s decision in Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. 2007); Pet. For Cert. filed, 75 U.S.L.W. 3557 (March 5, 2007) (No. 06-13) (Enron), which could be combined with Stoneridge if certiorari is granted, are arguing a sham transaction theory similar to the one Judge Kaplan permitted to proceed in In re Parmalat Sec. Litig. 

Next:  The Supreme Court grants certiorari in Stoneridge   

In earlier parts of this series, we discussed two approaches used by the Circuit Courts to address the question of primary vs. secondary liability under Section 10(b) and Rule 10b-5.  This is part of the struggle the circuit courts have had with this issue that is the prelude to the Supreme Court’s decision in Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc.,  next term.  Some have termed that decision the most important in years.  See, e.g., John Engler, Washington’s Biggest Decision, Washington Post at D 3 ( July 2, 2007).  

Another approached to this issue advocated by the SEC and some plaintiffs and adopted by the Ninth Circuit and a few District Courts is “scheme liability.”  This theory is based on the language of Rule 10b-5(a) which makes it unlawful to “employ any device, scheme or artifice to defraud …” and (c) which prohibits “any act, practice, or course of business which operates or would operate as a fraud.”  While these terms are not in the statute – the rule cannot be construed in a manner which is broader than its enabling section – the Supreme Court defined the Section 10(b) term “device” to include “scheme” in Ernst & Ernst v. Hochfelder, 425 U.S 185, 199 n. 20 (1976).  In addition, the Supreme Court has repeatedly used the word “scheme” in discussing the statute.  See, e.g., SEC v. Zandford, 535 U.S. 813, 821-22 (2002). 

Last year in Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th Cir. 2006), the Ninth Circuit appeared to have transmuted its “substantial participation” test into scheme liability.  The securities class action in Simpson arose out of the financial fraud at Homestore.com.  There, the company engaged in “round trip” barter transactions with certain third-party vendors to inflate its financial statements, according to plaintiffs.  A key question in the case was whether the third-party vendors could be held liable under Section 10(b).  

In an amicus brief, the SEC argued that a person can be held liable under the section “for engaging in scheme to defraud … [if he] directly or indirectly, engages in a manipulative or deceptive act as part of a scheme.”  The Commission defined “deceptive act” as engaging “in a transaction whose principle purpose and effect is to create a false appearance of corporate revenue ….”  The Ninth Circuit did not adopt the SEC’s test. 

The Simpson court did, however, adopt scheme liability and a variation of the SEC’s proposed test.  In doing so the court held that a person is liable for “participation in a ‘scheme to defraud,’ [if he] engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme.”  Substantial participation is enough, “even though that participation might not lead to … [making] actual statements.”  The key, according to the Court, is that the defendants’ “own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect.”  (emphasis original).  This purpose and effect test differentiates conduct and scienter, the Court noted.  Reliance can be established through the fraud on the market theory.  The case was remanded for reconsideration in view of the ruling. 

The ruling in Simpson clearly differs significantly from both the bright line and the substantial participation test and potentially broadens the reach of Section 10(b).  The SEC’s version of scheme liability was adopted in the Credit Suisse case by the District Court, but was rejected at the Circuit Court level.  Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. 2007); Pet. For Cert. filed, 75 U.S.L.W. 3557 (March 5, 2007) (No. 06-13).  See Part IV of this series – https://www.secactions.com/?p=204.  In seeking certiorari in that case, Petitioners have, however, relied on scheme liability.  The Supreme Court has not ruled on that petition.  Granting that petition could have a significant impact on the decision in Stoneridge, as will be discussed in later parts of this series.  

Next: Tests of primary liability used by various District Courts