The dividing line between primary and secondary liability in securities fraud actions has been a key subject of debate since 1994 when the Supreme Court handed down its decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). There, the high court held that Exchange Act Section 10(b), the antifraud weapon of choice for the SEC as well as private litigants, did not reach aiding and abetting. In the wake of that decision, the circuits have split on the question of primary and secondary liability. Some have adopted the “bright line” test, initially fashioned by the Tenth Circuit and later developed and amplified by the Second Circuit. The Ninth Circuit, in contrast, used the “substantial participation test.” Both tests are discussed here.

Congress partially addressed the issue by restoring the SEC’s aiding and abetting authority in the PSLRA. Nevertheless, the issue continues to be of importance in its enforcement actions. Congress has declined to extend aiding and abetting authority to private securities fraud plaintiffs.

Many thought that the Supreme Court would resolve the question Central Bank created in deciding Stoneridge Investment Partners, LLC. v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008) two years ago. While the high court’s decision offers some guidance on the question, it left the issue unresolved.

Last week, the Second Circuit in Pacific Investment Management v. Mayer Brown, Case No. 09-1619 (2nd Cir. April 27, 2010) clarified a portion of its jurisprudence on the question and harmonized its decisions with Stoneridge. Pacific Investment arises out of the collapse of Refco, one of the world’s largest providers of brokerage and clearing services in the international derivatives, currency and futures markets as discussed here. Defendants Mayer Brown, and firm partner Joseph Collins, were the primary outside counsel for Refco. Plaintiffs purchased securities from Refco prior to its collapse.

According to the complaint, Refco engaged in a massive fraud. To conceal huge trading losses at the end of each accounting period, the firm engaged in a series of sham loan transactions. Those transactions were designed to transfer the losses to a privately held company controlled by Refco’s CEO. After the accounting period, the transactions were reversed. Mayer Brown attorneys, under the direction of Mr. Collins, documented those transactions. As a result of these transactions, Refco’s financial statements were false.

Mayer Brown and Mr. Collins also are responsible, according to plaintiffs, for false statements which appear in: 1) an Offering Memorandum for an unregistered bond offering; 2) a Registration Statement for a subsequent registered bond offering; and 3) a Registration Statement for Refco’s initial public offering of common stock in August 2005. According to plaintiffs, each of these documents are false because they conceal the true financial condition of the company. Mayer Brown and Mr. Collins helped draft these documents and reviewed them. No statements in any of the documents are specifically attributed to the law firm or any of its attorneys, although both the Offering Memorandum and the IPO registration statement list Mayer Brown as outside counsel.

The district court dismissed the complaint. That court held that the claims against the law firm and Mr. Collins were essentially aiding and abetting, for which there is no private right of action under Exchange Act Section 10(b). The district court also rejected the contention that defendants could be held liable on a theory of “scheme liability.”

The Second Circuit affirmed. The court began its analysis by reviewing its precedents on primary liability. Generally the circuit’s decisions require that there be attribution of the claimed false statement to a defendant who is outside the corporation under its leading case, Wright v. Ernst & Young, LLP, 152 F.3d 169 (2nd Cir. 1998). Where the defendant is a corporate insider however, the circuit has not required attribution. In re Scholastic Corp. Sec. Litig., 252 F.3d 63 (2nd Cir. 2001). In this case involving those outside the company, the court reaffirmed Wright and its bright line test including its attribution requirement. Stated differently, a false statement must be attributed to the particular defendant for that person to be held liable under Section 10(b) at least where the person is outside the company.

In reaching its conclusion, the court rejected a “creator” test urged by the plaintiffs as well as the SEC in an amicus brief. Under this standard, those who “create” a false statement are within the ambit of Section 10(b) even if there is no public attribution of the statement to the person. After noting that the views of the SEC are entitled to little deference in private suits, the court concluded that the “creator” test is even broader than the Ninth Circuit’s “substantial participation” test of primary liability, which it has consistently rejected as inconsistent with Central Bank.

In contrast, the attribution requirement of the bright line test is consistent with Stoneridge. While the Supreme Court did not specifically consider the bright line test, critical to its holding is the element of reliance. In this regard, the Stoneridge Court specifically rejected claims of liability for those alleged to have been involved in the fraud where plaintiffs could not demonstrate that they relied upon the defendant’s own deceptive conduct. The attribution requirement of the bright line test fortifies the reliance requirement by requiring that the plaintiffs actually rely on the false statement of the defendant.

Likewise, the attribution requirement fortifies the overall “bright line” approach to liability the circuit has used – it helps draw a clear line. This contrasts sharply with the “substantial participation” and “creator” tests which are essentially open ended. Indeed, prosecutors and regulators such as the SEC often favor rules which are overbroad which tend to render “’capital markets less rather than more efficient,’” quoting Ralph K. Winter, Paying Lawyers, Empowering Prosecutors, and Protecting Managers: Raising the Cost of Capital in America, 42 Duke L.J. 945, 962 (1993).

Dismissal of plaintiffs’ claims is appropriate here because none of the statements alleged to have been false are specifically attributed to either the law firm or its former partner. The fact that the firm’s name appeared on two of the documents as outside counsel is not sufficient to attribute the specific claimed false statements to the law firm.

Finally, the court agreed with the district court that plaintiffs could not use a “scheme liability” test. That approach was rejected by Stoneridge. Accordingly, Mayer Brown and Mr. Collins could not be held liable under Section 10(b).

In reaching its conclusions, the circuit court specifically noted that its bright line test does not apply to SEC enforcement actions. This follows from the fact that reliance is only an element of a private damage action, not a Commission enforcement case. At the same time the court did not reconcile its holding with In re Scholastic Corp. Sec. Litig. Accordingly whether attribution is required for corporate insiders remains an open question in the Second Circuit.