by T. GormanPosted on Posted in SECActions

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 

by T. GormanPosted on Posted in SECActions

The SEC Enforcement Staff has been back in the archives again.  Last week, they dusted off another accounting fraud from 1999 and charged IBM employee Kevin Collins with assisting Dollar General in cooking the books.  As a result, a settled civil injunctive action containing the usual remedies was filed, as well as a related administrative proceeding.  Perhaps the markets are now safe since the SEC has dug back in history and obtained orders precluding future violations of the federal securities laws by Mr. Collins based on the ancient conduct alleged in the enforcement proceedings.  The SEC’s Litigation Release on this matter can be viewed at http://www.sec.gov/litigation/litreleases/2007/lr20166.htm. 

This is not the first time comments have been made in this space questioning whether the current enforcement staff should be reassigned to the SEC historical society.  A post on March 28, 2007 raised the same question when the SEC filed two settled cases focused in 1999, 2000 and 2001.  That post also recounted the fact that earlier this year, one District Court had refused to enter the statutory injunction the SEC sought viewing it as punitive time barred since the five year statute of limitations had expired, while another Court dismissed a Commission enforcement action seeking an injunctive relief for want of prosecution (the case had been brought after the statute of limitation for penalties had run).  

Despite these court rulings the Collins case filed last week demonstrates the apparent resolve of the SEC and its enforcement staff to continue bringing years old enforcement cases.  For what reason?  The SEC is supposed to police the capital markets and keep them safe for all.  The remedies given to the SEC by Congress reflect this serious mission.  Those remedies are largely equitable and remedial.  Their focus is on halting on-going conduct and preventing future violations.  SEC enforcement actions – save perhaps the current debate over financial penalties which will be the subject of another post – has never been about punishment or being punitive.  It has always been about being remedial and ensuring the integrity of the markets for the future.  

Bringing years-old enforcement actions, however, has little to do with the mission of the SEC or its traditional remedies.  Demanding a statutory injunction against future violations based on events that took place eight years ago has little, if anything, to do with preventing future violations.  It is difficult at best to claim such a demand is remedial.  The market reaction to the filing of this action reflects this fact – it had no discernable impact on the share price of IBM or Dollar General.  The reason – no investor was made to feel more safe from this action.  

Rather, Judge Casey in SEC v. Jones, No. 07 Civ 7044 (S.D.N.Y Feb. 26, 2007) was right when he held that a request for a statutory injunction under circumstances similar to those in the Collins case was not remedial, but punitive, and thus subject to the statute of limitations.  To ensure that the SEC focuses on policing the markets rather that shuffling through the archives, it is time to for Congress to pass a statute of limitations setting a time limit within which the SEC must bring an action or be time barred.  At the same time, perhaps more Courts will follow the lead of Judge Casey and start denying injunctions where no remedial purpose can be served by entering such an order other than to permit the SEC to claim what is surly a hollow victory that does little to implement its important statutory mandate.