PLEADING PRIMARY LIABILITY: IS THE THIRD TIME THE CHARM FOR THE SEC?
Pleading primary liability continues to present difficulties for the SEC. In cases such as SEC v. Lucent Technologies, No. 04-2315, 2009 U.S. Dist. LEXIS 35593 (D.N.J. Apr. 27, 2009) (applying bright line test), SEC v.Wolfson, 539 F.3d 1249 (10th Cir. 2008) (same) and SEC v. Tambone, 550 F.3d 106 (1st Cir. 2008), rehearing en banc granted, SEC v. Tambone, __ F. 3d __, 2009 WL 2170692 (1st Cir. July 22, 2009), the question of primary liability has been key. Now, the issue is of such concern that the agency had Treasury include a provision in its proposals for financial reform requesting Congress to set a uniform standard.
In SEC v. Fraser, CV-09-00443 (D. Ariz. Filed March 6, 2009), the SEC again confronted the question. There, the court granted a motion to dismiss by defendants Martin Fraser and Don Watson on the question of primarily liability while giving the Commission permission to replead its complaint again. The court’s ruling however, suggests that the SEC is having more significant difficulties bringing fraud actions than differing standards of primary liability.
Fraser, discussed here, is an action against four senior officers of CSK Auto Corporation. The complaint alleges that from 2002 through 2004 the defendants improperly inflated the company’s financial results. The scheme centered on allegations that the defendants obtained allowances from vendors which were used to decrease the cost of goods sold and thus increased pre-tax income. When millions of dollars worth of these allowances became uncollectible, defendants improperly failed to write them off, according to the SEC.
Overall, the financial statements overstated pre-tax income in 2002 by about $11 million or 47% in 2002, by about $34 million in 2003 and by about $21 million or 65% in 2004. Defendants also lied to the auditors, failed to write off all of these receivables in a restatement and published false statements regarding the restatement, the complaint claims.
In considering the question of primary liability, the court applied the “substantial participation” test used by the Ninth Circuit. The circuit court evolved the test in two key cases, Howard v. Everex Sys. Inc., 228 F.3d 1057 (9th Cir. 2000) and In re Software Toolworks, Inc., 50 F.3d 615 (9th Cir. 1994). Under this test, the defendant may be primarily liable under Sections 10(b) and 17(a) where he or she substantially participates in, or is intricately involved in, the preparation of financial statements. The participation need not result in the person actually making a false statement or the actor’s identity becoming known to the market place. This contrasts with the “bright line” test followed by the second, third and tenth circuits, discussed here, and applied in decisions like Lucent.
Here, the complaint alleges that Mr. Fraser was a member of CSK’s disclosure team, attend meetings of that group, and that reviewed the company’s 10-K filings for the three years on which the complaint is based. These allegations, without more, are not sufficient, the court held. Vague assertions that Mr. Fraser was somehow involved are not enough. The court went on to state that “[t]he Complaint’s assertions also fall short of alleging fraud consistent with the heightened pleading standards of Rule 9(b) . . . The absence of specific facts regarding the nature of Fraser’s involvement in these meetings, beyond the mere assertion that he was present and somehow involved, is not sufficient to properly state a claim in these circumstances.” Order dated Aug. 11, 2009, at 12.
The SEC attempted to circumvent this difficulty by claiming that under a theory of scheme liability its complaint was adequate. The court agreed with the SEC that this theory can be used to establish primary liability in a Commission enforcement action, noting that the Supreme Court’s decision in Stoneridge Investment Partners LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (2008) rejected the theory in private damage actions based on concerns about expanding implied rights of actions and the question of reliance, neither of which apply here.
As with the Software Toolworks test however, the SEC failed to plead facts sufficient to establish primary liability under a scheme liability theory. Under this theory the pleader must allege more than a transaction which has a deceptive purpose and effect. Rather, the defendant’s own conduct contributing to the transaction and the overall scheme must have a deceptive purpose and effect. While the transactions alleged by the SEC do in fact have a deceptive purpose and effect, the allegations as to Messrs. Fraser and Watson are simply too vague, they lack particularity. The court went on to conclude that allegations claiming the two defendants had violated Section 13(a) and had lied to the auditors also suffered from the same defects.
At the conclusion of its opinion, the court stated that the SEC had engaged in “shotgun” and “puzzle” pleading. The former is a technique which incorporates every preceding allegation by reference into the subsequent claims for relief or affirmative defenses. The latter requires the court and defendant to work through the complaint and match up statements with the reasons they are false and misleading.
While the SEC’s complaint here did “not embody the worst-case-scenario of shotgun or puzzle pleading . . . the Complaint nonetheless makes use of those practices, resulting in an improper pleading format for a complex securities actions such as this one. The Complaint incorporates every factual paragraph into each claim section, and it makes no attempt to lay out which conduct constitutes the violations alleged. Rather, the claims sections simply paraphrase or quote the language of the statutes and rules, leaving the Defendants (and the Court) with the task of combing the Complaint . . .” and figuring out what is what. Id. at 23.
The court is giving the SEC a third attempt to get its complaint right. This seems generous, given the SEC’s extensive investigative powers which, in a case such as this, should have permitted the Commission to sort through the details of these transactions and determine what happened. While it is clear that the circuits have differing standards for pleading primary liability, many of those differences key to the element of reliance in private actions. The SEC of course does not have to plead reliance. At the same time, the common thread to the Ninth Circuit “substantial participation” test and the Second Circuit bright line test is that the claimed primary violator must have performed actions which are critical to the fraud. The differences in the tests, for the SEC, are largely a matter of degree.
The ruling in Fraser is not a situation where the SEC was caught in conflicting pleading standards. Rather, it is one where the agency simply failed to properly plead its complaint not once but twice. If it does not have the facts after years of investigation it should not bring the action. If it does, it should stop playing pleading games and put the facts in the complaint. Here, it remains to be seen if on the third try the SEC can get it right.