Stoneridge: The Supreme Court’s Ruling and Its Impact – Part 3: The Circuits Struggle to Define Primary Liability
Following Central Bank and the passage of the PSLRA, the Circuit Courts struggled to draw the line between primary and secondary liability. At the same time, the District Courts struggled to apply the tests crafted by the circuits. While Central Bank cautioned that anyone could be held liable under Section 10(b) and Rule 10b-5 where each of the elements of a private damage is satisfied, much of the debate focused on defining what type of conduct and thus who would be held liable.
The Circuit Courts evolved two basic approaches to defining primary liability, the “substantial participation” test and the “bright line” test. Each of these became a precursor to “scheme liability” and the Supreme Court’s decision in Stoneridge.
The Ninth Circuit created the “substantial participation” test immediately following the decision in Central Bank. In re Software Toolworks, Inc., 50 F.3d 615 (9th Cir. 1995). There, the question was whether auditors who had helped prepare offering documents that were fraudulent and who had made false representations to the SEC during the review process could be held liable in a private Section 10(b) action. The court concluded that the auditors could be held liable as primary violators in view of their substantial participation. There was virtually no discussion of reliance or whether the investors knew or should have known about the actions of the auditors.
Five years later, the Ninth Circuit reaffirmed the “substantial participation” test in Howard v. Everex Systems, Inc., 228 F.3d 1057 (9th Circ. 2000). Again, there was virtually no discussion of the reliance element.
Other circuits, such as the Tenth and the Second, rejected the “substantial participation” test as inconsistent with Central Bank. Those circuits adopted what became known as the “bright line” test. The Second Circuit’s decision Shapiro v. Cantor, 123 F.3d 717 (2nd Cir. 1997) is one of the early and leading cases utilizing this theory of primary liability. There, the court held that a claim against an auditor was insufficient based on allegations that the defendant had assisted in the development of business plans and had participated in internal communications despite allegations that the company had defrauded its shareholders. To hold the auditor liable the court held, there had to be facts demonstrating that the auditors not only participated in a misrepresentation, but also that they knew or should have known that it would reach the investors.
The Second Circuit’s ruling echoed and built on a Tenth Circuit decision handed down the year before Shapiro. Anixter v. Home-State Production Co., 77 F.3d 1215 (10th Cir. 1996). There, in considering the sufficiency of a claim against an auditor in a case based on a ponzi swindle, the court concluded that a key element of primary liability is a misrepresentation that the auditor knew or should have known would be relied on by the investors.
Subsequently, the Eleventh Circuit adopted an even more restrictive version of the bright line test in Ziemba v. Cascade Int., Inc., 256 F.3d 1194 (11th Cir. 2001). The Ziemba court added to the bright line test by requiring that the statement alleged to be false be publicly attributed to the defendant.
Other courts adopted variations of the bright line test which were less restrictive than the version employed by the Eleventh Circuit. For example, in In re Lemout & Hauspise Sec. Litig., 230 F. Supp. 2d 152, 166-67 (D. Mass. 2002), the court held that it was sufficient to establish liability if it could be inferred from available facts that the statement claimed to be false had been made by the auditor defendant.
As the courts debated over how to define primary liability under Section 10(b) and whether the bright line or substantial participation test was the appropriate standard, the SEC crafted a theory of Section 10(b) primary liability it called “scheme liability.” That test was later rolled out in amicus briefs in huge fraud cases such as Enron and Homestore. Ultimately, a version of the test was adopted by the Ninth Circuit and argued by the Stoneridge plaintiff. The debate over that theory and its potential ultimately set the stage for what many commentators thought would be the “securities law decision of the century.”
Next: The SEC’s scheme liability theory.