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GAO-11-664:
United States Government Accountability Office:
Washington, DC 20548:
B-321063:
July 21, 2011:
The Honorable Tim Johnson:
Chairman:
The Honorable Richard C. Shelby:
Ranking Member:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Spencer Bachus:
Chairman:
The Honorable Barney Frank:
Ranking Member:
Committee on Financial Services:
House of Representatives:
Subject: Securities Fraud Liability of Secondary Actors:
Since the 1930s, publicly traded companies that commit fraud in the
issuance or sale of their securities have been liable to private
investors under the U.S. securities laws, as well as subject to
government enforcement of these laws. Entities commonly referred to as
"secondary actors"--such as banks, brokers, accountants, and lawyers,
who play important but generally lesser roles in securities
transactions[Footnote 1]--may also be liable to investors and to the
government for certain securities law violations, but as of 1994, such
entities are liable only to the government, not to investors, for
substantially assisting--or "aiding and abetting"--securities fraud
under section 10(b) of the Securities Exchange Act of 1934 (1934 Act).
[Footnote 2] Before 1994, courts had interpreted section 10(b), as
implemented by the Securities and Exchange Commission's (the SEC) Rule
10b-5,[Footnote 3] as implicitly authorizing investors to file aiding
and abetting lawsuits even though the 1934 Act did not expressly
authorize it.[Footnote 4] The courts found that Congress had created
an "implied private cause of action" under section 10(b). In the
landmark 1994 decision Central Bank of Denver, N.A. v. First
Interstate Bank of Denver, N.A.,[Footnote 5] however, the U.S. Supreme
Court clarified that section 10(b) and Rule 10b-5 do not create an
implied private cause of action for aiding and abetting, a
determination the Court reaffirmed in its 2008 decision in Stoneridge
Investment Partners, LLC v. Scientific-Atlanta, Inc[Footnote 6] and
its 2011 decision in Janus Capital Group, Inc. v. First Derivative
Traders.[Footnote 7] Congress took action in the wake of Central Bank
as well; in 1995, it enacted the Private Securities Litigation Reform
Act,[Footnote 8] giving the SEC express authority to seek enforcement
against aiders and abettors of securities fraud, but imposing
additional procedural restrictions on the filing of private securities
fraud class action lawsuits--one of the primary vehicles by which
investors seek redress.
Although the Supreme Court's decisions in Central Bank, Stoneridge,
Janus, and other recent cases have established the contours of
liability under section 10(b) as the statute is currently written,
debate continues over what the appropriate scope of liability should
be. As the Supreme Court noted in Central Bank, "[t]he issue ... is
not whether imposing private civil liability on aiders and abettors is
good policy but whether aiding and abetting is covered by the
statute."[Footnote 9] In response, legislation has been introduced to
amend the 1934 Act, most recently in 2010, to establish an express
private right of action for aiding and abetting violations of the
federal securities laws.[Footnote 10] Proponents of the legislation
have argued that creating such private liability could have a number
of potentially positive implications for investors, the U.S. capital
markets, and public companies, while opponents have argued that
creating such liability could have the opposite effect.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act or the Act)[Footnote 11] requires GAO to analyze the impact
of creating a private right of action for aiding and abetting
securities law violations, including describing the factual and legal
background against which creation of such authority would be
considered. This analysis responds to that mandate.[Footnote 12]
We conducted our work from August 2010 through July 2011 in accordance
with GAO's quality assurance framework relevant to our objectives. The
framework requires that we plan and perform the engagement to obtain
sufficient, appropriate evidence and legal support to meet our stated
objectives. We believe that the information we obtained and the
analysis we conducted provide a reasonable basis for any findings and
judgments in this product. A more detailed description of our scope
and methodology is included in Enclosure I.
Summary:
Following the stock market crash of 1929 and the ensuing Great
Depression, Congress enacted two statutes that established the
fundamental securities regulatory framework in place today. The
Securities Act of 1933 (1933 Act) regulates public offerings of
securities, while the Securities Exchange Act of 1934 (1934 Act)
regulates trading in securities after they have been issued.[Footnote
13] These laws require companies that issue securities to disclose
specific information both before the security is first issued and
periodically thereafter, to enable investors to make informed
investment decisions.
The securities laws also include a number of remedies for investors
who are injured by violations of the laws. The most prominent of these
is section 10(b) of the 1934 Act, implemented by SEC Rule 10b-5,
[Footnote 14] which prohibits material misrepresentations or omissions
and fraudulent conduct and provides a general anti-fraud remedy for
purchasers and sellers of securities.[Footnote 15] Starting in the
1940s, federal courts determined that even though section 10(b) did
not expressly authorize private investors and sellers to sue under
section 10(b) and Rule 10b-5, there was an "implied private cause of
action" to do so based on what the courts found to be congressional
intent to ensure maximum enforcement. Using this implied cause of
action, investors sued both the parties who carried out the fraud--
using a theory of primary liability--and those who assisted, or aided
and abetted, the fraud--using a theory of secondary liability. Service
providers that customarily assist companies with securities
transactions were included in this category of secondary liability and
became known as "secondary actors." Secondary actors can include
accountants, attorneys, underwriters, credit rating agencies,
securities analysts, and others. Some of these secondary actors have
been characterized as "gatekeepers" because they allegedly serve as
intermediaries between investors and issuers of securities and verify
or certify the accuracy of corporate disclosure or have the ability to
use their special status to influence the behavior of companies and
thus prevent wrongdoing. At least some of these alleged gatekeepers
vigorously disagree that they serve, or should serve, such a function.
In order to bring a successful case for securities fraud, a private
party must prove six basic elements. These elements have been
developed by the courts over the years, and some aspects have been
affected by the requirements of the Private Securities Litigation
Reform Act of 1995 (PSLRA).[Footnote 16] The elements are: (1) a
material misrepresentation or omission; (2) fraudulent conduct "in
connection with" the purchase or sale of a security; (3) a wrongful
state of mind, known as "scienter," when making the misrepresentation
or omission; (4) reliance upon the fraudulent conduct; (5) measurable
monetary damages; and (6) a causal connection between the
misrepresentation or omission and the economic loss. Each of these
elements has been extensively interpreted by the courts, and because
these elements are not defined by statute, court decisions continue to
shape how they are applied.
The ability of investors to sue for aiding and abetting securities
fraud (as distinct from a direct suit for securities fraud) changed in
1994. In Central Bank, the Supreme Court clarified that section 10(b)
does not establish a private cause of action for aiding and abetting.
Relying on the language of the statute, the Court found that Congress
had not, expressly or even by implication, created a private cause of
action for aiding and abetting. The Court reasoned that the requisite
securities fraud element of investor reliance is not present where a
party aids or abets a fraud, because the aider and abettor's conduct
is not known to, and thus cannot be relied upon by, investors. The
Court emphasized, however, that while there is no private cause of
action for aiding and abetting, secondary actors may still be
primarily liable for securities fraud if they themselves commit all of
the elements listed above.
Lawsuits alleging securities fraud are often brought as class actions.
Class actions are well-suited to securities litigation because they
enable a number of shareholders to combine claims that they could not
afford to litigate individually. In PSLRA, Congress targeted what it
identified as abuses in class action securities fraud litigation by
imposing additional procedural restrictions on the filing of such
lawsuits, designed to help weed out weaker cases at an earlier stage
in the proceedings.[Footnote 17] Two particularly important PSLRA
reforms for Rule 10b-5 actions are a heightened requirement for
alleging the scienter element and the codification of the element of
loss causation. The Supreme Court has decided cases involving both of
these reforms. PSLRA also gave the SEC specific authority to pursue
cases against aiders and abettors of securities fraud.
After the Supreme Court struck down aiding and abetting liability in
Central Bank, courts continued to address the question of primary
liability for secondary actors. In 2008, the Supreme Court reaffirmed
its Central Bank decision in Stoneridge. The Court determined in
Stoneridge that secondary actors--in this case customers and
suppliers--who were part of a "scheme to defraud" were not primarily
liable under Rule 10b-5 because investors had not relied on their
fraudulent conduct. As it had in Central Bank, the Supreme Court again
emphasized the requisite element of investor reliance in ruling that
the secondary actors were not liable to investors. The Court ruled
that it was not sufficient that an entity participate in a scheme to
defraud; rather, the investor must show he actually relied on the
secondary actor's conduct or participation. Since Stoneridge, courts
have addressed whether secondary actors may be held liable for
substantial participation in the preparation of fraudulent statements,
or whether the statements must actually be attributed to the secondary
actor for liability to arise. In June 2011, the Supreme Court ruled in
the Janus case that an investment adviser cannot be held liable for
mere participation in the drafting and dissemination of false and
misleading prospectuses issued by its client; the Court found that the
client, not the adviser, "made" the fraudulent statement, and thus the
adviser was not liable.[Footnote 18] It remains to be seen how the
lower courts will implement this latest Supreme Court decision.
Arguments for and against creating a private right of action for
aiding and abetting relate to concerns frequently expressed about
class action securities litigation: whether it successfully and
efficiently deters securities fraud and whether it adequately and
fairly compensates investors who are the victims of fraud. Proponents
of creating a private right of action argue that it is necessary to
compensate investors and effectively would deter securities fraud.
Opponents maintain that the current system of enforcement by the
government already adequately compensates investors and deters fraud.
Opponents also argue that creating a private right of action would
expand the number of class action securities lawsuits, thus harming
the competitiveness of the U.S. securities markets. In response,
proponents argue that the reforms enacted in PSLRA are sufficient to
guard against non-meritorious litigation.
Analysis:
Part I. Overview Of Section 10(B) And Rule 10b-5 Anti-Fraud Provisions
And Elements Of A Private Cause Of Action For Securities Fraud:
A. History of the Private 10b-5 Cause of Action through the Mid-1990s:
In the wake of the 1929 stock market crash and the ensuing Great
Depression, Congress enacted two statutes that established the
fundamental federal securities regulatory framework in place today.
The 1933 Act regulates public offerings of securities, while the 1934
Act regulates trading in securities after they have been issued.
[Footnote 19] As the Supreme Court has explained, together, these acts
"embrace a fundamental purpose ... to substitute a philosophy of full
disclosure for the philosophy of caveat emptor."[Footnote 20] Both
statutes require disclosure of certain types of information and
prohibit fraudulent or deceptive practices in particular circumstances.
In addition, the 1934 Act contains a broad anti-fraud prohibition,
section 10(b). Under section 10(b), it is:
"unlawful for any person, directly or indirectly, by the use of any
means or instrumentality of interstate commerce ... [to] use or
employ, in connection with the purchase or sale of any security ...
any manipulative or deceptive device or contrivance in contravention
of such rules and regulations as the [SEC] may prescribe as necessary
or appropriate in the public interest or for the protection of
investors."[Footnote 21]
To implement section 10(b), in 1942, the SEC promulgated Rule 10b-5,
which has become a critical component of the overall securities
regulatory scheme. Rule 10b-5 prohibits the direct or indirect use of
any means of interstate commerce to engage in certain wrongful conduct
in connection with the purchase or sale of any security. Specifically,
Rule 10b-5 makes it unlawful, among other things:
"(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to
state a material fact necessary in order to make the statements made,
in the light of the circumstances under which they were made, not
misleading, or:
(c) To engage in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any
person."[Footnote 22]
B. Proving Securities Fraud under Rule 10b-5:
As detailed below, to be successful in a 10b-5 private cause of action
for primary liability for securities fraud, a plaintiff must allege,
and ultimately prove, six elements:[Footnote 23] (1) material
misrepresentation or omission; (2) nexus to the purchase or sale of a
security; (3) scienter; (4) reliance; (5) economic loss; and (6) loss
causation. If any element is not proven, the plaintiff will not
recover damages. These elements also have been influenced by
legislative changes enacted in 1995 in PSLRA but because they are not
specifically defined by statute, court decisions continue to shape
their interpretation.[Footnote 24] Rule 10b-5 cases against secondary
actors usually involve an allegation of a material misrepresentation
where a corporation issues a materially misleading statement to the
public or has failed to disclose information or remained silent about
a matter about which it has a duty to disclose.
Six Elements of a 10b-5 Private Cause of Action:
1. Material misrepresentation or omission. The defendant must have
committed fraud or deceit, generally as a material misrepresentation
or omission.[Footnote 25] A "material" misrepresentation or omission
is one that affects a reasonable investor's purchase decision.
[Footnote 26] Courts have held that Rule 10b-5 does not itself impose
a duty to disclose, meaning that nondisclosure without an independent
duty will not establish a Rule 10b-5 violation.[Footnote 27] However,
if a company makes a statement, there may be a further duty to correct
or update the information that was disseminated.[Footnote 28]
Additionally, a company can be held liable for statements considered
to be half-truths--statements that are literally themselves true, but
omit some other material fact that would be necessary to make the
statement as a whole not misleading.[Footnote 29]
2. Nexus. The defendant's fraudulent conduct must meet the "nexus"
requirement, meaning that the conduct must have been "in connection
with the purchase or sale" of a security in interstate
commerce.[Footnote 30] The Supreme Court in Blue Chip Stamps held that
under the language of section 10(b)--making it "unlawful for any
person" to "use or employ, in connection with the purchase or sale of
any security ..., any manipulative or deceptive device or contrivance
in contravention of such rules and regulations as the [SEC] may
prescribe as necessary or appropriate in the public interest or for
the protection of investors"[Footnote 31]--only those who actually
purchased or sold securities have an implied private right of action
under Rule 10b-5, not those who decided not to purchase or sell a
security based on fraudulent conduct.[Footnote 32] This part of the
nexus element is known as the purchaser/seller requirement.
3. Scienter. The defendant must have "scienter." That is, the
defendant must have performed the conduct at issue with a wrongful
state of mind. The plaintiff must prove that the defendant intended
"to deceive, manipulate, or defraud."[Footnote 33] To meet this
standard of "mental fault," a plaintiff must allege and prove more
than negligence, i.e., more than a failure to exercise the standard of
care that a reasonable person would exercise under the circumstances.
Rather, Rule 10b-5 liability requires the defendant to have acted
knowingly or recklessly. Under the "knowing" standard, the defendant
either knew or consciously disregarded the fact that the results of
his conduct were reasonably certain to occur. Under the "reckless"
standard, the defendant must have made a statement with a deliberate
disregard of a known risk of misleading investors that is either known
to the speaker or so obvious the speaker must have known of it.
[Footnote 34] Although many federal appellate courts have found that
reckless behavior satisfies the scienter requirement in Rule 10b-5
cases, courts have differed on the degree of recklessness required.
[Footnote 35]
4. Reliance. The plaintiff must have relied upon the defendant's
fraudulent conduct when entering into the transaction at issue. In
other words, the defendant's fraudulent misrepresentation or omission
must have affected the plaintiff's decision to purchase or otherwise
enter into the transaction. In certain circumstances, the plaintiff
can qualify for a rebuttable presumption of reliance, which reverses
the burden and requires the defendant to disprove this presumption.
The first circumstance in which a plaintiff is entitled to a
rebuttable presumption of reliance is where the defendant had a duty
to disclose to the plaintiff and made a material omission.[Footnote
36] In a face-to-face transaction between seller and purchaser during
which the defendant seller failed to state material facts, the
plaintiff's reliance can be presumed from the materiality of the
omissions. That is, if the facts omitted would have been important
(i.e., material) to an individual's decision to purchase, reliance by
the plaintiff on the defendant's omission can be presumed. The second
rebuttable presumption circumstance involves the fraud-on-the-market
doctrine, where proof of actual reliance is not necessary in a class
action against public companies.[Footnote 37] The fraud-on-the-market
presumption applies if the information at issue is material, the
market is sufficiently active, and the misinformation was disseminated
publicly.[Footnote 38] Essentially, reliance is presumed when the
statements at issue become public and the public information is
reflected in the market price of the publicly traded security. By
assuming an accurate share price, the shareholders "relied" on the
misstatement, so it is not necessary to prove actual, individual
reliance.
5. Economic loss. The plaintiff must have suffered measurable monetary
damages for which he seeks recovery. As with the common law tort of
fraud, such damages must constitute an actual economic loss, and not
merely nominal or trivial damages. This element also requires the
plaintiff to have already suffered the economic loss; he cannot merely
expect a loss in the future.
6. Loss causation. There must be a causal connection between the
defendant's material misrepresentation or omission and the plaintiff's
economic loss. That is, the plaintiff's loss must not only be related
to the defendant's fraudulent misrepresentation or omission, but
actually caused by it.[Footnote 39]
In the 1940s, lower level federal courts first interpreted section
10(b) and Rule 10b-5 as creating an implied private right of action by
purchasers and sellers of securities injured by securities
fraud.[Footnote 40] Over the decades, federal appellate courts and
eventually the U.S. Supreme Court agreed, interpreting the statute
broadly and flexibly in light of its remedial purpose and well-
developed common law fraud principles.[Footnote 41] While a private
cause of action under Rule 10b-5 still exists today, its breadth has
been narrowed substantially in the last two decades by the Supreme
Court's clarification in the 1994 Central Bank case that Congress did
not intend to create a private cause of action for aiding and abetting
under section 10(b).[Footnote 42] Additionally, while the law
governing the private right of action under section 10(b) was shaped
solely by court decisions for decades, in 1995, Congress recognized
the implied private right of action (for primary violations) but
imposed new procedural requirements for private primary liability
securities fraud class actions.[Footnote 43]
Part II. The Roles Of Secondary Actors In Securities:
Transactions:
A number of "primary" and "secondary" parties are typically involved
in securities transactions both during the issuance process and after
the public offering is complete. First and foremost is the securities
issuer, which must comply with specific statutory and regulatory
requirements to disclose information and inform investors. The issuer
and its executives may commit securities fraud by failing to comply
with those requirements by making deceptive statements or through
participating in fraudulent schemes. Other entities may then assist or
cooperate with the issuer. Commentators have asserted that at least
some of these secondary actors are "gatekeepers"[Footnote 44] who
serve as intermediaries between issuers and investors, but some of the
secondary actors disagree that they serve this role.[Footnote 45] In
some cases, the intermediary is responsible for determining the
accuracy of a company's statements about itself, or about a
transaction, as well as for assessing the merits of an offering or
other transaction. The gatekeeper may assure the accuracy of corporate
disclosures in connection with securities offerings, thus addressing
the problem of information asymmetry between issuers and investors.
[Footnote 46] For example, a credit rating agency assesses a company's
ability to repay long-term debts; an accountant audits a company's
financial statements; and a securities analyst measures a company's
prospects in the marketplace. In some cases the gatekeeper's role is
legally mandated. Some commentators have argued that a gatekeeper may
be able to deter corporate clients from engaging in fraudulent
practices by influencing the behavior of the client.[Footnote 47]
Finally, in some cases, plaintiffs may allege that commercial partners
of issuers are involved in fraudulent transactions.
A. Accountants:
Public accountants perform a broad range of accounting, auditing, tax,
and consulting activities for their clients.[Footnote 48] The practice
of accounting is regulated by the applicable board of accountancy of
each state, the District of Columbia, or U.S. territory in which an
accountant practices, as well as the rules and codes of conduct of
professional associations to which the accountant belongs, such as the
American Institute of Certified Public Accountants (AICPA).[Footnote
49] In that regard, each regulatory jurisdiction defines what
constitutes "public accounting" and who qualifies as a "certified
public accountant" or "CPA" under their regulatory
authorities.[Footnote 50] Subject to applicable requirements of each
licensing jurisdiction, public accountants may provide services as
individuals or firms to clients, including public companies, or to
their employers, if they are employed in-house by a public company.
[Footnote 51] In this regard, public accountants can serve public
companies as part of management (i.e., as employees), as contracted
consultants (i.e., as vendors of professional services), or as
independent certified public accounting service providers.
Certified public accountants can serve as external auditors of public
companies. Federal securities laws require that public companies have
the financial statements that they prepare upon initial registration
and annually thereafter audited by a certified public accountant. To
obtain an audit, the audit committee of the public company's board of
directors engages an external auditor from among the independent
public accountants who are registered with and regulated by the Public
Company Accounting Oversight Board (PCAOB).[Footnote 52] The audit
must be conducted in accordance with the auditing standards
promulgated by PCAOB,[Footnote 53] which require auditors to plan and
perform the audit to obtain reasonable assurance of whether the
financial statements are free of material misstatement (whether caused
by error or fraud) and, for public companies with market
capitalization in excess of $75 million, whether effective internal
control over financial reporting was maintained as of the balance
sheet date in all material respects.[Footnote 54] The objective of the
financial statement audit[Footnote 55] is for the external auditor to
reach an opinion on the fairness in which the financial statements of
the company present, in all material respects, the financial position,
results of operations, and cash flows in conformity with generally
accepted accounting principles. In connection with the financial
statement audit, the PCAOB auditing standards require auditors to
review information reported outside the financial statements and
consider whether such information or the manner in which it is
presented is materially inconsistent with the audited information in
the financial statements. External auditors may also perform work
related to other public company financial reports, such as compiling
financial reports and reviewing quarterly financial statements and
other reports for the public company, subject to the applicable
accounting standards.
B. Attorneys:
Attorneys play important roles in securities transactions. These can
include assisting corporate clients with various types of securities
transactions, such as private placements, public offerings of
securities, and other corporate transactions. Attorneys also are often
involved in preparing disclosure documents, advising on disclosure
issues, and representing clients in formal proceedings. Attorneys also
may represent securities professionals, such as underwriters and
broker-dealers in connection with raising capital for corporate
clients. In addition, attorneys may give advice concerning the
application of the law to specific transactions and on periodic
reports to shareholders and the SEC or public statements made by
corporate executives.
In many cases, attorneys may provide written legal opinions to advise
corporate clients on the best method of carrying out transactions.
They may also provide opinions to issuers in connection with
securities registration or the validity of a securities issuance. In
some cases, attorneys for the issuer or other parties associated with
a public offering may provide opinions to assure the parties that
certain legal conditions necessary to the closing of the offering have
been met.[Footnote 56] Counsel generally reviews the veracity and
completeness of registration materials and attempts to ensure that a
thorough investigation of the issuer is made.[Footnote 57]
C. Investment Banks:
Investment bank activities may include merger and acquisition
services, underwriting, asset management and other securities services
as well as trading and principal investments. They may act as trading
counterparties to other companies or provide financing as commercial
lenders. [Footnote 58] In addition, investment banks may provide
advisory services to other companies in connection with structuring
transactions. As noted below, securities analysts may be employed by
or otherwise affiliated with investment banks. As underwriters,
investment banks assist companies that are registering their
securities offerings under the 1933 Act with sales of their
securities. The underwriter acts as an intermediary between the issuer
and the investor and assists with pricing the offering and structuring
financing. Most commonly, the company will enter into a negotiated
underwriting agreement with an investment banker or group of
investment bankers. The underwriter and the issuer prepare the
registration statement. The underwriters usually are broker-dealers
who are members of the Financial Industry Regulatory Authority
(FINRA), the self-regulatory organization that oversees broker-
dealers, and the underwriting agreements are subject to the rules that
FINRA publishes. FINRA also sets standards for and reviews
underwriters' compensation.[Footnote 59]
The most common underwriting arrangement is the firm-commitment
underwriting in which the issuer sells the allotment of shares
outright to a group of securities firms.[Footnote 60] The securities
firms are represented by managers, managing underwriters or principal
underwriters, who sign the agreement and then contact other broker-
dealers to become members of the underwriting group and act as
wholesalers of the securities. Underwriters undertake a substantial
factual investigation of the issuer to ensure that all disclosures are
accurate.
D. Credit Rating Agencies:
The 1934 Act defines a credit rating as an assessment of the
creditworthiness of an obligor as an entity or with respect to
specific securities or money market instruments.[Footnote 61] In the
past few decades, credit ratings have assumed increasing importance in
the financial markets, in large part due to their use in law and
regulation. In 1975, the SEC first used the term National Recognized
Statistical Rating Organization (NRSRO) to describe those rating
agencies whose ratings could be relied upon to determine capital
charges for different types of debt securities broker-dealers held.
[Footnote 62] Since then, the SEC has used the NRSRO designation in a
number of regulations. Issuers seek credit ratings for a number of
reasons, such as to improve the marketability or pricing of their
financial obligations, or to satisfy investors, lenders, or
counterparties. Institutional investors, such as mutual funds, pension
funds, and insurance companies are among the largest owners of debt
securities in the United States and are substantial users of credit
ratings. Retail participation in the debt markets generally takes
place indirectly through these fiduciaries. Institutional investors
may use credit ratings as one of several inputs to their own internal
credit assessments and investment analysis. Broker-dealers that make
recommendations and sell securities to their clients also use ratings.
[Footnote 63]
Academic literature suggests that credit ratings affect financial
markets both by providing information to investors and other market
participants and by their use in regulations. Studies find that
obtaining a credit rating generally increases a firm's access to
capital markets and that firms with credit ratings have capital
structures different from those of firms without them. Some studies
suggest that firms adjust their capital structure to achieve a
particular credit rating. One explanation of these relationships is
that credit rating agencies have access to private information about
the issuers and issues they rate, and the ratings they assign
incorporate this information. Thus, ratings are a mechanism for
communicating this otherwise unavailable information to market
participants. The appropriate role of credit rating agencies has
become increasingly controversial in the wake of the recent financial
crisis. The performance of the three largest NRSROs in rating subprime
residential mortgage-backed securities and related securities raised
questions about the accuracy of their ratings generally, the integrity
of the ratings process, and investor reliance on NRSRO ratings for
investment decisions.[Footnote 64] The Dodd-Frank Act made a number of
changes affecting rating agencies, as discussed in Part V below.
E. Securities Analysts:
Securities analysts, through their research and stock recommendations,
play an important role in providing investors with information that
may affect investment decisions. Analysts typically research the
current and prospective financial condition of certain publicly traded
companies and make recommendations about investing in those companies'
securities based on their research. This research is likely to include
all publicly available information about the company and its
businesses, including financial statements; research on the company,
industry, product or sector; and public statements by and interviews
with executives of the company and its customers and suppliers. The
analysis and opinions are generally presented on a relative basis and
compare companies' performance with a sector or industry. To develop
judgments about the future prospects of the company and its
securities, analysts may evaluate the company's expected earnings,
revenue, and cash flow; operating and financial strengths and
weaknesses; long-term viability; and dividend potential. They also may
assess the sensitivity of their projections to cyclical factors and
various types of risks, including market and credit risk. Information
in analyst reports has been cited as valuable to the investing public
because an investor might rely on the recommendations and analysis as
helping to foster accurate pricing of securities.[Footnote 65]
Analysts perform their research for different types of investors,
including brokerage firm customers. Sell-side analysts (who perform
research for affiliated investment banks and produce widely-
disseminated reports about companies and advice to buy, sell or hold
securities) are subject to oversight by securities self-regulatory
organizations and the SEC.[Footnote 66]Buy-side analysts (who perform
research for institutional investors, such as mutual funds) produce
private reports for their employers who may purchase securities for
their own account or for client accounts. In contrast, independent
analysts may provide research without any relationship to the firms
that they cover.
Part III. Significant Legislative And Court Developments Affecting
Secondary Actor Liability For Securities Fraud:
A. Central Bank Decision (1994):
Prior to 1994, federal courts held that there was an implied private
right of action under Rule 10b-5 against not only primary actors, but
also aiders and abettors. Lawsuits for aiding and abetting securities
fraud generally could be brought by private parties in federal courts,
as well as by the SEC in civil actions in federal court or in an
administrative proceeding. The elements to be proved in a private
aiding and abetting theory of liability were: (1) the existence of a
primary violation of section 10(b) by another person; (2) some level
of knowledge by the aiding and abetting defendant of the primary
violation (such as recklessness); and (3) substantial assistance by
the aiding and abetting defendant in committing the primary violation.
[Footnote 67]
In 1994, the Supreme Court in Central Bank of Denver held that
although primary actors could be held liable for securities fraud in
private lawsuits, the language of the 1934 Act did not expressly or
implicitly authorize private investors to sue those secondary actors
alleged to have aided and abetted securities fraud.[Footnote 68] In
Central Bank, a municipal authority issued bonds to finance public
improvements at a development, and the bonds were secured by liens on
the property.[Footnote 69] The bond covenants required that the land
be worth at least 160 percent of the bonds' outstanding principal and
interest.[Footnote 70] Central Bank of Denver, the indenture trustee,
had concerns that the property's actual value was less than the
required 160 percent and considered obtaining an independent property
appraisal.[Footnote 71] After discussions with the municipal
authority, however, Central Bank decided to postpone the appraisal;
the authority then became insolvent, and bondholders sued Central
Bank, alleging that the bank recklessly aided and abetted the
authority's fraud.[Footnote 72]
The Supreme Court found Central Bank not liable under section 10(b).
The Bank had not committed any primary violation, and the statute did
not, the Court ruled, expressly or even by implication, include a
private right of action for aiding and abetting. The Court reasoned
that the scope of section 10(b) prohibits only the actual making of a
material misstatement (or omission) and does not reach aiding and
abetting such a violation. The Court noted that because Congress did
not include an express private cause of action for aiding and abetting
anywhere in the federal securities laws, it cannot logically be
inferred that Congress would have implied such a cause of action under
section 10(b). Additionally, the Court concluded that when Congress
wished to provide aiding and abetting liability, it did so expressly,
for example, in connection with the general criminal aiding and
abetting statute.[Footnote 73] According to the Court, Congress's
failure to mention aiding and abetting in section 10(b) indicates that
such liability was not intended.
The Court in Central Bank also placed a heavy emphasis on reliance as
a requirement for a 10b-5 action, a requirement that is by definition
absent in aiding and abetting actions. The Court saw reliance as
essential to any Rule 10b-5 action and could not allow the plaintiff
to recover in a situation where the plaintiff did not directly rely on
any fraudulent statements or omissions by the defendant.[Footnote 74]
The plaintiff therefore could not recover damages because the
defendant's conduct did not satisfy all the elements of primary
liability in a private Rule 10b-5 action and could not recover under
an aiding and abetting theory as such a theory was not provided by
section 10(b).
Finally, the Court acknowledged various policy arguments for and
against recognition of a private cause of action for aiding and
abetting, but rejected the assertion that the cause of action under
Rule 10b-5 should extend to aiders and abettors simply because it
would ensure achievement of the statute's objectives. "The SEC [in a
friend of the court brief] points to various policy arguments in
support of the 10b-5 aiding and abetting cause of action," the Court
noted.[Footnote 75] However, "policy considerations cannot override
our interpretation of the text and structure of the Act ... The point
here ... is that it is far from clear that Congress in 1934 would have
decided that the statutory purposes would be furthered by the
imposition of private aider and abettor liability."[Footnote 76] The
Court also cited policy-based reasons for eliminating a cause of
action for aiding and abetting, including large sums expended by
secondary actors even before trial and the generally vexatious nature
of Rule 10b-5 class action litigation.[Footnote 77]
B. Private Securities Litigation Reform Act (1995):
Following Central Bank, Congress addressed some concerns about class
action securities litigation by enacting the Private Securities
Litigation Reform Act of 1995.[Footnote 78] PSLRA amended the
securities laws by creating new procedural requirements for
instituting private actions, including Rule 10b-5 actions. PSLRA is
intended to address concerns that Congress had about securities class
action litigation by discouraging frivolous litigation.[Footnote 79] A
class action is a litigation procedure that allows a representative of
a group of persons to sue on behalf of that group when the litigated
issues are of common interest to a number of persons. Class actions
enable members of a class, i.e., shareholders, to sue even though they
are geographically dispersed, and class action lawsuits enable members
of the class to combine claims that they could not afford to litigate
individually. Securities fraud actions typically are brought to
benefit all shareholders who purchased stock during a class period in
which misrepresentations about the stock have been made but not
corrected.
With PSLRA, Congress targeted what it identified as abuses in class
action securities fraud litigation.[Footnote 80] In particular,
Congress was concerned that plaintiffs' attorneys pursued cases that
were intended to generate large fees and settlements without regard to
the best interests of shareholders and corporations. The PSLRA
amendments include:
(1) Imposing additional requirements concerning whom a court can
appoint as class representative in claims under both the 1933 and the
1934 Acts, with a presumption in favor of the class member with the
largest financial interest in the relief sought by the class.[Footnote
81] This reform was intended to increase the likelihood that
institutional investors would serve as class representatives and
replace the traditional approach of selecting the first plaintiff to
file as the class representative.[Footnote 82]
(2) Limiting attorney's fees in securities class actions to a
reasonable percentage of any damages paid to the class.[Footnote 83]
(3) Restricting the use of pre-trial discovery by barring discovery
until after a resolution of a motion to dismiss.[Footnote 84]
(4) Instituting a system of proportionate liability, as opposed to
joint and several liability, for defendants in private actions that
did not knowingly violate Rule 10b-5. Defendants who acted knowingly
would be subject to joint and several liability.[Footnote 85]
(5) Providing a so-called safe harbor for forward-looking statements.
If the predicted results do not materialize, liability cannot be based
on a predictive statement if the statement is identified as such and
accompanied by meaningful cautionary language.[Footnote 86]
PSLRA is directed primarily at concerns about class action litigation
and raises the standards for certain elements that must be alleged in
order to maintain an action to recover for securities fraud.[Footnote
87] In filing a complaint in a Rule 10b-5 case, the plaintiff must
allege each of the six required elements, discussed above, and if the
plaintiff fails to adequately allege any one of the elements, the
claim is subject to dismissal by the court. As discussed below, PSLRA
addressed three aspects of the elements of a Rule 10b-5 fraud action:
the standard for describing the statements alleged to have been
misleading, the standard for what must be alleged about the
defendant's mental state, and the standard for proving loss causation.
PSLRA's heightened pleading requirements are designed to enable courts
to screen out cases that lack merit at an early stage in the
proceedings, thus saving defendants the expense of defending these
suits.
1. Heightened Pleading Standards:
All private Rule 10b-5 actions are subject to PSLRA's heightened
pleading standards that require plaintiffs to specifically assert
"each statement alleged to have been misleading [and] the reason or
reasons why the statement is misleading."[Footnote 88] To meet this
standard, the complaint must generally include facts that show exactly
why the statements were misleading, including facts about the "time,
place, and content of the alleged misrepresentations."[Footnote 89]
The court then determines whether the complaint sufficiently states a
cause of action by examining the specific factual content of the
allegations made with respect to each essential element of the action.
If a plaintiff fails to meet the heightened complaint standards for
alleging this element, PSLRA requires the court to dismiss the case
upon the defendant's motion to dismiss.[Footnote 90]
2. Scienter:
PSLRA created a heightened requirement in connection with scienter,
the third element of the Rule 10b-5 cause of action noted previously.
Under PSLRA, the complaint must "state with particularity facts giving
rise to a strong inference" that the defendant acted with scienter.
[Footnote 91] This means that the complaint must support an inference
that the defendants acted with scienter, "a mental state embracing
intent to deceive, manipulate or defraud."[Footnote 92] PSLRA does
not, however, define what constitutes "a strong inference."
In a significant recent decision, the U.S. Supreme Court in Tellabs,
Inc. v. Makor Issues & Rights, Ltd. addressed how to treat competing
inferences in determining whether a complaint establishes a strong
inference of scienter. The Court held that the fraud claims will
survive dismissal and be decided at trial only if a reasonable person
would find that the inference of scienter is "more than merely
plausible or reasonable--it must be cogent and at least as compelling
as any opposing inference of nonfraudulent conduct."[Footnote 93] This
standard requires that the lower courts, when considering a private
complaint in a securities fraud action, must consider the complaint in
its entirety and take into account plausible opposing inferences.
First, the court must consider everything in the complaint, including
documents incorporated by reference, to determine "whether all of the
facts alleged, taken collectively, give rise to a strong inference of
scienter, [and] not whether any individual allegation, scrutinized in
isolation, meets that standard."[Footnote 94] Second, the court must
engage in a comparative analysis, considering not just the inferences
asserted by the plaintiff but all the competing inferences put forth
by the defendant that could be drawn rationally from the alleged
facts.[Footnote 95] At trial, the plaintiff must then prove scienter
by a preponderance of the evidence, i.e., the plaintiff must establish
that it is "more likely than not" that the defendant acted with
scienter. The Court in Tellabs did not determine whether recklessness
was sufficient to prove scienter or whether the plaintiff must show
intent to deceive, manipulate, or defraud.[Footnote 96]
3. Loss Causation:
PSLRA codified the element of loss causation by requiring the
plaintiff to prove that the defendant's act or omission (i.e.,
material misrepresentation or omission) actually caused the economic
loss for which the plaintiff is seeking damages.[Footnote 97] In many
Rule 10b-5 class action lawsuits, the plaintiffs' economic loss
relates to a significant drop in stock price. Therefore, the loss
causation element requires the plaintiffs to allege and prove that,
for example, they bought the stock at a price that was artificially
inflated as a result of the defendant's misstatement or omission.
[Footnote 98] This means that the plaintiffs must allege and prove
that there is a strong relationship between the defendant's conduct
and the plaintiffs' subsequent loss.
The Supreme Court in 2005 in Dura Pharmaceuticals v. Broudo
interpreted the loss causation requirement.[Footnote 99] In that case,
shareholders alleged that Dura Pharmaceuticals (Dura) made fraudulent
statements about its belief of future Food and Drug Administration
approval of a new medical device. The shareholders claimed that they
suffered economic loss, because this misrepresentation caused an
artificial elevation in Dura's share price and after the statement was
disclosed as fraudulent, the share price fell. The plaintiffs argued
that their damages were based on overpayment at the time of purchase.
Looking to the language of PSLRA and principles of common law tort
actions for deceit and misrepresentation, the Supreme Court found that
to satisfy the loss causation requirement, it is not sufficient to
state that the price was inflated by the fraud, but the plaintiff must
go further to show economic loss. The temporary drop in share price
following the disclosure of the fraudulent statement, according to the
Court, was not inevitably caused by the fraud. The fraudulent
statement may have contributed to the price drop, but many other
factors, including changed economic circumstances and new industry-
specific or firm-specific facts, also may have contributed to or
caused the drop in share price. According to the Court, it is not
sufficient for the fraudulent statement to "touch upon" or relate to
the economic loss; instead, the statement actually must cause the
loss.[Footnote 100] The Court determined that the plaintiff's
complaint was legally insufficient and remanded the case to be decided
by the lower court under the Court's interpretation of the loss
causation requirement.
The requirements for successfully alleging loss causation continue to
be litigated. The Supreme Court in Dura did not determine the
appropriate pleading standard for loss causation. Courts of appeal
have differed on whether the heightened pleading standard set forth in
rule 9(b) of the Federal Rules of Civil Procedure or the
"plausibility" standard under rule 8(a)(2) should apply.[Footnote 101]
Additionally, the Supreme Court recently determined in the case of
Erica P. John Fund, Inc. v. Halliburton Co. that securities fraud
plaintiffs need not prove loss causation order to obtain class
certification.[Footnote 102]
C. Securities Litigation Uniform Standards Act (1998) and Class Action
Fairness Act (2005):
After PSLRA was enacted, some plaintiffs tried to avoid its higher
standards for federal court lawsuits by suing in state court. Congress
reacted to this trend by passing the Securities Litigation Uniform
Standards Act of 1998 (SLUSA).[Footnote 103] SLUSA provides that
certain class actions with more than fifty class members involving
state securities laws and class actions based on common law fraud are
preempted and cannot be filed.[Footnote 104] SLUSA generally applies
to class actions involving publicly traded securities.[Footnote 105]
Immediately after the passage of SLUSA in 1998, there was some
disagreement as to how far the law went in displacing class actions
for securities fraud under state law. Some believed that SLUSA only
applied to those initiating a lawsuit who met the purchaser/seller
requirement from Blue Chip Stamps, discussed above. Others read SLUSA
more broadly as not containing that specific limitation. The Supreme
Court addressed the issue in 2006, holding that the more broad reading
was appropriate and that it is not necessary for the purchaser/seller
requirement to be met in order for a securities fraud action to be
preempted by SLUSA.[Footnote 106] The Court found this reading of
SLUSA to be more consistent with Congress's goal of creating uniform
procedural standards in PSLRA for bringing securities fraud lawsuits.
If only a narrow subset of private securities fraud class actions were
preempted by SLUSA, plaintiffs could circumvent the procedural
requirements put in place in PSLRA by filing class actions outside
that narrow subset in state court or in federal court under state law.
In essence, the Court found that the distinction between
purchasers/sellers and holders is irrelevant for the purposes of SLUSA
preemption, and that class actions brought by either type of party
cannot be brought under state law or in state court because they are
preempted.[Footnote 107]
Additionally, Congress enacted the 2005 Class Action Fairness Act
(CAFA).[Footnote 108] CAFA confers original federal jurisdiction over
any class action with at least 100 claimants, minimal diversity,
[Footnote 109] and an aggregate amount in controversy of at least $5
million. Commentators have noted that SLUSA and CAFA result in state
securities class actions being restricted to claims that involve
corporate governance or merger and acquisition transactions that are
based on the law where the defendant was incorporated, smaller class
actions, and perhaps class actions based solely on 1933 Act claims.
[Footnote 110]
D. Primary Liability for Secondary Actors under Rule 10b-5 after
Central Bank:
Recent court cases have addressed the extent to which secondary
actors' actions may make them primarily liable under Rule 10b-5. Prior
to Central Bank, courts had not often distinguished between secondary
actor conduct that was subject to primary liability and conduct that
amounted only to aiding and abetting. After Central Bank, plaintiffs
brought actions based on secondary actors' involvement in fraudulent
transactions or participation in making fraudulent statements. The
Supreme Court has recently decided two cases on the scope of liability
for secondary actors under Rule 10b-5.
1. Stoneridge case addresses scheme liability and reliance:
After Central Bank, instead of alleging that defendants made a
fraudulent statement, plaintiffs in some rule 10b-5 cases alleged that
the secondary actors were part of a "scheme to defraud." The concept
of scheme liability is premised on subsections (a) and (c) of Rule 10b-
5, which respectively make it unlawful to "employ any device, scheme,
or artifice to defraud" and prohibit "any act, practice, or course of
business which operates ... as a fraud or deceit ... in connection
with the purchase or sale of any security."[Footnote 111] Under this
theory, active participation in a scheme to defraud would be
sufficient to create liability in a Rule 10b-5 action for securities
fraud. Appellate courts varied in their support of such a concept of
scheme liability, with some circuits finding scheme liability
sufficient for secondary actors to be liable in a 10b-5 action.
[Footnote 112]
In 2008, the Supreme Court addressed the issue of scheme liability in
Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc.
[Footnote 113] In that case, plaintiffs alleged that Charter
Communications, Inc. (Charter), the company being sued for primary
liability for securities fraud, entered into sham transactions with
two vendors.[Footnote 114] The vendors allegedly were aware of the
fraudulent transactions, which Charter used to inflate its operating
revenues and cash flow in financial statements presented to its
investors.[Footnote 115] Investors sued the two vendors, among others,
alleging that they participated in a "scheme to defraud" with Charter
and should therefore be held liable under 10b-5, regardless of the
fact that they made no public statement of their own.[Footnote 116]
The Court held that it is not sufficient for the defendant to have
merely participated in a scheme to defraud, but that the plaintiff
actually must have relied on the defendant's participation or conduct
for liability to attach. Because the vendors neither had a duty to
Charter's investors nor made a statement on which the investors
relied, the vendors were not liable. The Court reasoned that to allow
scheme liability where no reliance exists would create a way for
plaintiffs to bring suit for conduct that would otherwise be
considered aiding and abetting, because the conduct did not meet the
necessary elements for primary liability. And because Congress chose
not to overturn Central Bank by creating a private aiding and abetting
cause of action for securities fraud when enacting PSLRA, the Court
concluded that there still was no private aiding and abetting action
under Rule 10b-5.[Footnote 117]
2.Janus case addresses scope of Rule 10b-5 prohibition of fraudulent
statements:
Most recently, in Janus Capital Group, Inc. v. First Derivative
Traders,[Footnote 118] the Supreme Court has addressed what must be
shown to establish liability under Rule 10b-5(b), which prohibits
"making any untrue statement of a material fact" in connection with
the purchase or sale of securities.[Footnote 119] Janus involved an
investment adviser that provided advice and administration services to
a group of mutual funds that issued prospectuses containing false
statements. In a 5-4 decision, the Court found that the investment
adviser did not "make" the statement contained in the prospectuses
because it did not have "ultimate authority over the statement,
including its content and whether and how to communicate it."[Footnote
120] The Court noted that without control, one who prepares a
statement cannot "make" a statement in its own right. Although the
Court recognized that there was a close relationship between the
investment adviser and the mutual funds, it found that the investment
adviser was not the maker of statements by its client mutual fund. The
Court observed that "any reapportionment of liability in the
securities industry in light of the close relationship between
investment advisers and mutual funds is properly the responsibility of
Congress and not the courts."[Footnote 121]
The dissent disagreed with the majority's analysis of Rule 10b-5,
concluding that certain secondary actors, such as management companies
and individual company officers, might "make" statements contained in
a firm's prospectus. The dissent pointed out that each of the fund's
officers was an employee of the investment adviser and that those
employees both carried out the fund's daily activities and implemented
its long term strategies.[Footnote 122] The dissent went on to
conclude that the specific close relationships alleged among the
investment adviser, the fund and prospectus statements warranted the
conclusion that the investment adviser "made" the statement.
Part IV. Additional Legal Avenues For Pursuing Secondary Actors And
Compensating Investors:
Since the Supreme Court issued its Central Bank decision in 1994,
there has been no aiding and abetting liability for secondary actors
in private securities fraud cases litigated under Rule 10b-5. However,
in certain circumstances, aiders and abettors of securities fraud may
be subject to liability under other provisions of state or federal
securities laws. The SEC and Department of Justice (DOJ) both have
express statutory authority to impose sanctions on persons who aid and
abet securities fraud. Other provisions of the federal securities laws
also may give investors the right to bring suit against parties who
have defrauded them, including secondary actors. Although SLUSA
generally requires that class actions be brought in federal court, in
certain circumstances, large institutional investors can bring non-
class action suits (or small class action suits below the threshold
triggering SLUSA) against aiders and abettors in state court where the
heightened PSLRA standards do not apply. Finally, the SEC is
authorized to distribute money penalties that it collects to injured
investors under the Fair Funds provision of the Sarbanes-Oxley Act;
this provides an alternative method of compensating investors.
A. Federal Government Enforcement:
In PSLRA, Congress expressly authorized the SEC to pursue persons who
knowingly provide substantial assistance to primary violators of the
securities laws.[Footnote 123] The Dodd-Frank Act amended the pleading
standard in the 1934 Act from "knowingly" to "knowingly or
recklessly." The lower pleading standard may enable the SEC to more
easily bring cases for aiding and abetting securities fraud. The SEC
can bring civil actions against secondary actors in administrative
proceedings or court actions. The possible resolutions in these
actions include, among other remedies, injunctions, disgorgement
orders, civil penalties, and orders barring or suspending individuals
from serving as officers or directors of securities issuers or
participating in the securities industry.[Footnote 124] Even if an
investigation by the SEC does not result in an enforcement action, the
SEC can publicize the results of its investigations.[Footnote 125]
The SEC has used its authority to enforce the securities laws against
aiders and abettors. Before the Stoneridge class action lawsuit was
filed, the SEC had recovered around $45 million in disgorgement and
civil penalties from the two secondary actors that the SEC found to
have aided and abetted the violations by Charter Communications.
[Footnote 126] Similarly, the SEC has pursued secondary actors
involved in other enforcement or civil actions.
DOJ has authority to impose criminal sanctions to enforce the federal
securities laws, including aiding and abetting securities fraud.
[Footnote 127] The SEC may refer violations to DOJ to determine if
criminal sanctions are appropriate, and the U.S. Attorney's Office
decides independently when a violation warrants a criminal
prosecution. Any person convicted of violating the 1934 Act is subject
to a maximum fine of $5 million ($25 million for corporations) and a
maximum of 20 years imprisonment. In many instances, DOJ has conducted
investigations and brought criminal prosecutions in the same cases
pursued by the SEC. In 2010 there were 12 U.S. federal securities
class action law suits that had DOJ involvement. Additionally, DOJ
pursued secondary actors that aided and abetted fraud in the Enron and
AOL Time Warner cases. Furthermore, it obtained fines against
individual officers of Charter Communications, who were accused of
conspiracy and aiding and abetting the alleged fraud at issue in
Stoneridge.[Footnote 128]
The Sarbanes-Oxley Act gives the SEC authority to distribute civil
money penalties for federal securities law violations to investors who
have been harmed by those violations.[Footnote 129] Prior to enactment
of Sarbanes-Oxley, the SEC could seek disgorgement of defendants'
profits both in federal court and in administrative proceedings, and
disgorged funds could be distributed to investors. The SEC describes
disgorgement as forcing defendants "to give up the amount by which
they were unjustly enriched."[Footnote 130] Sarbanes-Oxley provides
the SEC with authority to combine any civil penalty with the
disgorgement amount in a Fair Fund to compensate victims of the
violation. In a recent report, we recently found that from 2002
through February 2010, $9.5 billion in disgorgements had been ordered,
of which $9.1 billion had been collected and $6.9 billion had been
distributed to investors.[Footnote 131] We also found that the SEC was
taking steps to better capture, report, and manage the programmatic
and financial impact of the collections and distribution process, but
it was too early for us to determine the impact and ultimate success
of the SEC's efforts at improving the program. Before the enactment of
the Dodd-Frank Act, penalties were only distributed to investors if
there were a disgorgement order against the defendant. The Dodd-Frank
Act enables the SEC to distribute penalties in cases where there is no
disgorgement, providing the SEC with greater flexibility to compensate
injured investors.[Footnote 132]
B. Other Private Causes of Action:
In some circumstances, secondary actors can be subject to liability
under other provisions of the federal securities laws. Both the 1933
Act and the 1934 Act provide investors with a right to bring a private
suit against market participants who have defrauded them. The 1933 Act
provides private rights of action to investors injured by violations
of the registration and disclosure requirements in the following
circumstances:
* Section 11 of the 1933 Act provides an express private right of
action for damages for material misrepresentations or omissions in a
registration statement for an offering of new securities. Section 11
applies to issuers, signatories, directors of the issuer, and
underwriters. Section 11 also provides for the liability of an expert,
including accountants, engineers, and appraisers, or any person who
consents to be named as having prepared or certified any portion of
the registration statement.[Footnote 133] In general, "materiality"
refers to those facts that a reasonable investor would consider
significant in making an investment decision.[Footnote 134] Defendants
in a section 11 claim can avoid liability by showing that they
conducted a reasonable investigation with regard to the registration
statement.[Footnote 135] However, this defense does not apply to
issuers.
* Section 12 of the 1933 Act provides remedies to investors who
purchase securities that were sold in violation of the Act's
registration requirements or by means of a false or misleading
communication. Section 12(a)(1) provides that anyone who offers or
sells a security in violation of the registration requirements is
liable in a civil action to the person purchasing the security.
[Footnote 136] Damages are limited to the return of the purchase price
of the security with interest upon return of the security.[Footnote
137] Section 12(a)(2) creates an express private remedy for material
oral and written misstatements or omissions in connection with the
sale or offer of a security.[Footnote 138] Under section 12(a)(2), the
seller or offerer of the security is liable to the purchaser of the
security. Like section 11, section 12(a)(2) provides for a "due
diligence" defense that permits a defendant who exercised reasonable
care but did not know of the untruth or omission.
The 1934 Act also provides private remedies for fraud and
manipulation, including remedies for violations of a prohibition on
manipulative practices,[Footnote 139] and a private right of action
for investors who have been injured due to reliance on a material
misstatement or omission of fact in connection with a document
required to be filed with the SEC under the 1934 Act.[Footnote 140]
C. Controlling Person Liability:
The 1933 and the 1934 Acts impose liability not only on the person who
actually commits a securities law violation, but also on the entity or
individual who controls the violator. Section 20(a) of the 1934 Act
provides that "[e]very person who, directly or indirectly, controls
any person liable under any provision of this chapter or of any rule
or regulation thereunder shall also be liable jointly and severally
with and to the same extent as such controlled person."[Footnote 141]
However, no liability exists if "the controlling person acted in good
faith and did not directly or indirectly induce the acts constituting
the violation or cause of action."[Footnote 142] Section 15 of the
1933 Act imposes similar liability, but is limited to violations of
sections 11 or 12 of the Act.[Footnote 143] Although the provisions
are not identical, they have been interpreted and applied similarly.
[Footnote 144]
Although section 20(a) does not define the term "control," the SEC has
promulgated a rule defining "control" as "the possession, direct or
indirect, of the power to direct or cause the direction of the
management and policies of a person, whether through the ownership of
voting securities, by contract, or otherwise."[Footnote 145] However,
the determination of whether control exists depends on the particular
factual circumstances of each case.
Section 929P(c) of the Dodd-Frank Act clarified that the SEC can
maintain an enforcement action for control person liability under
section 20(a); this provision resolved a conflict among the U.S.
Courts of Appeals over this issue.[Footnote 146]
D. State Law Liability:
In addition to the various remedies available against secondary actors
under federal law, many states' "blue sky laws" impose express private
liability for secondary actors.[Footnote 147] Many state statutes
extend liability not only to control persons but also to other actors
who participate or materially aid in the fraudulent securities
transaction.[Footnote 148] The conduct required for secondary
liability varies from state to state, as states' definitions of
"participate" and "materially aid" differ, but many states have some
type of private cause of action for aiding and abetting securities
fraud. However, since enactment of SLUSA, state secondary liability
causes of action generally may only be brought by individuals or
classes of 50 plaintiffs or fewer.[Footnote 149] Plaintiffs that are
members of large class actions are therefore generally unable to
utilize state blue sky laws to hold secondary actors liable for aiding
and abetting securities fraud.
Part V. Current Standards For Secondary Liability In Light Of Recent
Developments:
As discussed above, while secondary actors are not liable to private
plaintiffs for aiding and abetting securities fraud, they may be
liable for primary violations of Rule 10b-5. This scope of this
liability has been shaped by the Supreme Court's decisions in Central
Bank, Stoneridge, and Janus, as well as by PSLRA's procedural and
substantive revisions applicable to securities fraud lawsuits.
Additionally, secondary actors are subject to liability under other
provisions of 1933 and 1934 Acts, including those that prohibit
misrepresentations in registration statements filed for publicly
traded securities or in connection with manipulative practices.
A. Liability of Attorneys:
Liability of attorneys to investors has been based on the attorneys'
formal legal opinions as well as their direct contacts with investors.
For example, when an attorney makes a materially false or misleading
statement as part of an opinion intended to be used by a third-party
investor, the attorney may be held primarily liable under Rule 10b-5.
Additionally, attorneys will be treated as professionals for purposes
of section 11 of the 1933 Act when providing expert opinions.[Footnote
150] Attorneys who write tax opinions have a duty to make inquiry into
all relevant facts, to be satisfied that the material facts are
accurately and completely described in the offering materials, and to
assure that any representations about future activities are clearly
identified, reasonable, and complete.[Footnote 151] One federal
appeals court has ruled that a knowingly or recklessly false tax
opinion letter, which the attorneys expressly consented could be
distributed to investors, could give rise to primary liability under
Rule 10b-5.[Footnote 152] Another federal appeals court has ruled that
recklessly false tax opinion letters could be the basis for primary
Rule 10b-5 liability. Although the opinion letters contained
disclaimers (that they were based only on facts provided by the
client), the court held that the attorney might nonetheless be liable
where the law firm knew or had reason to know that the factual
description of the transaction provided by the client was materially
inaccurate.[Footnote 153] In a recent case, AFFCO Investments 2001
L.L.C. v. Proskauer Rose, L.L.P., the defendant law firm worked behind
the scenes to prepare model opinions supporting the validity of a tax
shelter.[Footnote 154] The plaintiffs participated in the tax shelter
based, in part, on the promises of opinions from unnamed law firms.
After their investment, the plaintiffs received the favorable tax
opinions from the defendant. Citing Stoneridge, the Fifth Circuit
Court of Appeals ruled that without direct attribution to the law firm
of its role in the tax scheme, reliance on its participation could not
be shown.[Footnote 155]
In contrast, when a client makes a misrepresentation to investors,
courts have held that the attorneys drafting the documents for the
client cannot be held liable for the misrepresentations. In Schatz v.
Rosenberg, the attorney preparing closing documents for the client's
sale of a control block of stock could not be held liable under Rule
10b-5 although the attorney knew that representations in the documents
that were relied on by purchasers were false.[Footnote 156] The
federal appeals court in that case found that the attorney could not
be held liable for failing to disclose information about a client to a
third party, absent some fiduciary or confidential relationship to the
third party.[Footnote 157] Another federal appeals court held that in
cases in which a law firm assists in drafting materially false
offering documents, but itself does not make any false statement, the
firm cannot be held primarily liable under Rule 10b-5 for the false
statements made by its clients.[Footnote 158] The court also
determined that the law firm was not primarily liable for any material
omissions, because Rule 10b-5 proscribes failure to state material
facts only when the defendant has a duty to disclose. The court found
that the law firm did not have such a duty. In another federal appeals
case, the PIMCO case, attorneys allegedly reviewed and revised
portions of an issuer's offering documents that they knew contained
false statements.[Footnote 159] The Second Circuit held in PIMCO that
secondary actors can be held liable in a private Rule 10b-5 action
only for those statements attributable to them.[Footnote 160] In the
recent Janus case, the Supreme Court determined that attribution is
normally required for liability.[Footnote 161]
However, when an attorney makes representations directly to
prospective purchasers of securities, the attorney is under an
obligation to tell the truth about those securities and may be held
liable under Rule 10b-5 if those representations are materially
misleading. In Rubin v. Schottenstein, Zox & Dunn, the Sixth Circuit
found that when an attorney elects to speak with prospective
investors, "he assumes a duty to provide complete and non-misleading
information with respect to the subjects on which he undertakes to
speak" and "he assumed a duty to speak fully and truthfully on those
subjects."[Footnote 162]
B. Liability of Investment Banks:
Investment banks may be primarily liable in private Rule 10b-5 actions
for fraud in connection with the purchase or sale of securities if all
the requirements for liability are met. In litigation involving the
now-insolvent Enron Corporation, investors sued investment banks and
law firms that were alleged to have helped Enron report financial
results fraudulently.[Footnote 163] The defendants were alleged to
have engaged in a series of transactions with Enron that enabled it to
temporarily take liabilities off its books and to book revenue from
transactions. Although the Federal District Court for the Southern
District of Texas denied the defendants' motion to dismiss and allowed
the case to proceed,[Footnote 164] the Fifth Circuit reversed[Footnote
165] and found that the investors failed to state a claim for primary
violations against the lender. The Fifth Circuit found that because
the bank's conduct was not conduct on which an efficient market could
be presumed to rely, the fraud-on-the-market presumption did not
apply. The court also ruled that the lack of any duty running from the
banks to investors prevented the investors from relying on the
Affiliated Ute presumption of reliance to allow the class action to go
forward. The Supreme Court declined to review this appellate decision.
[Footnote 166] Other scheme liability cases involved investment banks
that provided services to the company. The district court in In Re
Parmalat Sec. Litigation cited Stoneridge in determining that
investors could not have relied on the deceptive disclosures made by
the defendant.[Footnote 167] As discussed below, investment banks are
often named as defendants in litigation against securities analysts
affiliated with the bank.
Investment banks also serve as underwriters in connection with the
issuance of securities. Section 2(a) of the 1933 Act defines an
underwriter as "any person who has purchased from an issuer with a
view to, or offers or sells for an issuer in connection with, the
distribution of any security, or participates or has a direct or
indirect participation under such undertaking."[Footnote 168]
Underwriters may be held liable under sections 11 and 12(a)(2) of the
1933 Act. Section 11 imposes liability on underwriters "in case any
part of the registration statement, when such part became effective,
contained an untrue statement of material fact or omitted to state a
material fact required to be stated therein or necessary to make the
statements therein not misleading."[Footnote 169] Section 12(a)(2)
imposes liability on "any person who offers or sells a security ... by
means of a prospectus or oral communication, which includes an untrue
statement of material fact or omits to state a material fact necessary
in order to make the statements ... not misleading."
Under both sections 11 and 12, an underwriter may absolve itself of
liability by establishing an affirmative "due diligence" defense. This
defense may be invoked if the underwriter proves it undertook a
"reasonable investigation" to determine that the statements in the
registration statement were true or exercised "reasonable care" in
determining whether statements in registration statement were true.
[Footnote 170] An underwriter is not liable for any part of the
registration statement that is made "on the authority of an expert" if
the underwriter shows that it "had not reasonable ground to believe
and did not believe" that there were material misstatements or
omissions in that part of the registration statement.[Footnote 171]
A recent First Circuit decision, SEC v. Tambone, held that an
underwriter who has a duty to investigate the nature and circumstances
of an offering does not make an implied representation to investors
that statements in the prospectus are truthful for purposes of primary
Rule 10b-5 liability.[Footnote 172] In Tambone, the prospectus was
alleged to contain statements that the underwriter knew to be false.
C. Liability of Accountants:
Independent public accountants can be subject to primary liability if
their audit reports, which are included in public reports of the
public company, or other public statements (or omissions) otherwise
meet the elements of primary liability.[Footnote 173] According to
AICPA officials with whom we spoke, a significant percentage of
private civil actions naming public company auditors are for
allegations of liability under Rule 10b-5 for false or misleading
statements reflected in auditor reports. One important aspect of Rule
10b-5 cases against public accountants is the requirement to plead and
prove that the independent auditor acted with scienter. Many courts
have held that alleged violations of applicable auditing and
accounting standards by the external auditor are not sufficient, by
themselves, to establish scienter. For example, courts have held that
negligent performance of an audit, including failure to design an
audit that would have resulted in reviewing a fraudulent transaction
or failure to review certain transactions to such a degree that
company manipulation of the transaction would have been detected, does
not meet the requirement to prove intent to defraud or recklessness.
[Footnote 174] Also, as discussed above, section 11 of the 1933 Act
expressly subjects external auditors to civil liability for false or
misleading statements they make in connection with their audits of
public company registration statements. To the extent that external
auditors do not engage in conduct that subjects them to primary
liability--in other words, issuing audit opinions or other statements
to investors--they are not subject to a private cause of action for
secondary liability under the federal securities laws. However,
accountants also are subject to the tort or statutory civil liability
laws of the state, District of Columbia, or U.S. territory in which
the conduct giving rise to liability may have occurred. The sources
and standards for liability to investors and others under these laws
vary by jurisdiction.
D. Liability of Credit Rating Agencies:
Several amendments enacted as part of the Dodd-Frank Act increase the
potential liability of credit rating agencies in securities fraud
actions. First, prior to the enactment of the Dodd-Frank Act, SEC Rule
436(g) provided that a security rating assigned to a class of debt
securities or a class of preferred stock by an NRSRO is not a part of
the registration statement prepared by an expert under section 11 of
the 1933 Act. The Dodd-Frank Act supersedes the regulation so that
NRSROs may be exposed to liability as experts under section 11 of the
1933 Act for material misstatements and omissions with respect to the
ratings.[Footnote 175] Second, the Dodd-Frank Act also specifically
provides that the enforcement and penalty provisions of the 1934 Act
"apply to statements made by a credit rating agency in the same manner
and to the same extent as such provisions apply to statements made by
a registered public accounting firm or a securities analyst under the
securities laws."[Footnote 176] Third, the law modifies the requisite
"state of mind" for private securities fraud actions for money damages
against a credit rating agency. An investor or other plaintiff may now
satisfy pleading standards by stating facts giving rise to a strong
inference that the credit rating agency knowingly or recklessly failed
to conduct a reasonable investigation of the rated security or the
credit rating agency failed to obtain reasonable verification of such
factual elements from a competent party independent of the issuer.
[Footnote 177] Fourth, the Dodd-Frank Act clarifies that ratings are
not forward-looking statements for purposes of the PSLRA safe harbor.
[Footnote 178] Fifth, the Dodd-Frank Act also increases the SEC's
enforcement authority in connection with NRSROs.[Footnote 179]
Finally, the Dodd-Frank Act requires every federal agency to review
existing regulations that require the use of an assessment of the
credit-worthiness of a security or money-market instrument and modify
the regulations to remove any reference or the requirement of reliance
on credit ratings and substitute with an appropriate standard of
credit-worthiness.[Footnote 180]
Some federal courts have determined that rating agencies have First
Amendment protection and are liable only for "actual malice" in making
their ratings.[Footnote 181] Under this standard, the rating agencies
would be liable only if they knew their statements were false or the
statements were made with reckless disregard of the truth. In
Compuware Corporation v. Moody's Investors Services,[Footnote 182] the
Sixth Circuit determined that in a breach of contract claim, the
actual malice standard applied to credit ratings published by Moody's.
In Abu Dhabi Commercial Bank v. Morgan Stanley & Co., Inc. the Federal
District Court for the Southern District of New York determined that
First Amendment protections may not apply when ratings information is
made available only to a small group of investors rather than to the
general public.[Footnote 183] The court determined that because the
ratings were distributed to a small number of investors, they were not
"matters of public concern" and thus may not be protected by the First
Amendment.
E. Liability of Securities Analysts:
Securities analysts may be subject to primary liability if publication
of their research reports meets the test for primary liability.
Investors have brought lawsuits against securities analysts and
investment banks alleging that securities analyst reports were false
and misleading and intended to artificially inflate the value of
securities. As indicated above, sell-side analysts may be affiliated
with or employed by investment banks or other financial firms that
have clients for whom they provide services. These clients may be the
same companies that securities analysts are researching and about
which they write reports. The analyst may face a conflict of interest
if the investment bank client will be benefited by positive coverage
in his research report. FINRA and the New York Stock Exchange (NYSE)
have promulgated rules on analyst recommendations, including increased
supervision and restrictions on activities designed to prevent
potential conflicts of interests.[Footnote 184] The FINRA and NYSE
rules are designed to help insure analyst independence. The First
Circuit has found that even though a securities analyst may have a
conflict of interest, the plaintiff in a securities fraud case must
show that particular statements in the recommendation were false and
misleading when made in order to establish liability.[Footnote 185]
Courts have also focused on loss causation and reliance in Rule 10b-5
cases involving securities analysts and investment banks. In a case
where investors in companies that Merrill Lynch's research analysts
covered alleged that the opinions were materially misleading and
violated section 10(b), the Second Circuit determined that the
plaintiffs did not sufficiently plead that the alleged
misrepresentations and omissions caused the claimed losses.[Footnote
186] In Fogarazzo v. Lehman Brothers, Inc. the plaintiffs alleged that
Lehman Brothers, Morgan Stanley and Goldman Sachs issued fraudulently
optimistic research reports that artificially inflated the stock price
of a company. The Federal District Court for the Southern District of
New York determined that for class certification purposes, the
plaintiffs had adequately pled loss causation by showing that the
element of loss causation may be proven class-wide., which can be
shown by proposing a suitable methodology.[Footnote 187] In addition,
some courts have determined that the fraud-on-the-market presumption
of reliance can apply to lawsuits against securities analysts without
a specific finding that the analysts' misrepresentations actually
affected the price of the securities traded in the open
market.[Footnote 188] Commentators have differed over whether a
lawsuit against a securities analyst under section 10(b) is likely to
be successful.[Footnote 189]
Part VI. Proposals And Potential Implications Of Creating A Private
Cause Of Action For Aiding And Abetting Securities Fraud:
Legislation recently has been introduced in the U.S. Senate and House
of Representatives, in 2009 and 2010, respectively, to create a
private right of action to permit investors to pursue claims against
secondary actors for aiding and abetting securities fraud.[Footnote
190] Both bills proposed to amend section 20(e) of the 1934 Act
[Footnote 191] to include an express private right of action for
aiding and abetting a violation of the securities laws. The bills
would make individuals and firms that knowingly or recklessly provide
substantial assistance to primary actors in a securities fraud liable
to investors.
Proponents and opponents have made various policy arguments to support
or oppose creating a private right of action for aiding and abetting
securities fraud. Because enacting a private cause of action for
aiding and abetting could expand the volume of securities class action
lawsuits, many of these arguments reflect policy concerns that have
been expressed about class action securities litigation generally.
These concerns include whether these lawsuits effectively and
efficiently deter securities fraud, whether they appropriately
compensate injured investors and how they impact the capital markets
and the economy.
Proponents of creating such an action have included attorneys that
represent investors; public retirement funds, including the California
State Teachers' Retirement System, New York State Common Retirement
Fund, and Pennsylvania State Employees' Retirement System; the North
American Securities Administrators Association; investor and consumer
advocacy groups, including AARP, the National Association of
Shareholder and Consumer Attorneys, and the Consumer Federation of
America; former SEC commissioners; and law professors.[Footnote 192]
Opponents of creating such an action have included industry and
business associations, such as the American Institute of Certified
Public Accountants, U.S. Chamber of Commerce, Business Roundtable, and
Securities Industry and Financial Markets Association; securities
firms; U.S. securities exchanges, including the New York Stock
Exchange and Nasdaq; former SEC commissioners; and law professors. A
summary of key policy arguments made for and against creating a
private right of action for aiding and abetting securities fraud and
expanding liability in connection with securities fraud class actions
is set forth below.
A. Deterring Fraud:
Deterrence is often cited as a primary goal of enforcement of
securities laws. A number of parties are involved in the enforcement
of Rule 10b-5, including the SEC, the Department of Justice, private
investors in class action litigation, and state officials that bring
enforcement actions. Proponents of creating a private right of action
for aiding and abetting securities fraud argue that such action is a
necessary supplement to SEC enforcement and provides an additional
deterrent to fraud. SEC enforcement actions serve as one of the
primary tools for deterring fraud by secondary actors. In light of the
financial scandals that have occurred over the past decade that were
aided by secondary actors, proponents question whether SEC alone can
adequately deter securities fraud. They note that the SEC and Congress
repeatedly have recognized that SEC enforcement is not sufficient to
deter wrongdoers and compensate investors. In that regard, proponents
contend that private aiding and abetting liability would serve a
critical deterrent function. They also note that private enforcement
is not subject to government budgeting constraints and is
entrepreneurially motivated, enabling private plaintiffs and their
attorneys to vigorously pursue secondary participants. Moreover, they
argue that the prospect of a large recovery and, hence, large
attorney's fees are necessary to attract the attention of the creative
entrepreneurial attorney.
Proponents also argue that allowing injured investors to seek recourse
from secondary actors that may serve as "gatekeepers" would not only
better deter them from aiding and abetting fraud but also better
motivate them to be diligent gatekeepers. Gatekeepers have been cited
as including accountants, securities analysts, credit rating agencies,
and underwriters.[Footnote 193] These secondary actors assist publicly
held companies with their securities transactions and related
disclosures--for example, by verifying or certifying the accuracy of
financial and other information. In some cases, publicly traded
companies cannot complete their securities transactions without the
approval of such secondary actors. As a result, these secondary actors
can provide a check on securities fraud to the benefit of investors.
Proponents contend that the current legal regime that excludes aiding
and abetting liability improperly shields secondary actors from
private liability and, thus, does not sufficiently deter them from
aiding and abetting fraud or encourage them to be more diligent
gatekeepers. According to proponents, deterring secondary actors that
serve as gatekeepers from engaging in fraud can be easier than
deterring the primary violators, because they do not stand to reap the
same gain as the primary violators. One commentator has also advocated
a modified strict liability regime for gatekeepers.[Footnote 194]
Opponents respond that a private right of action for aiding and
abetting is unnecessary for deterrence of securities fraud, because
public enforcement under the current regulatory structure is adequate.
First, the SEC employs a broad range of statutory and administrative
tools to combat fraud involving aiders and abettors and that authority
has been expanded by the Dodd-Frank Act.[Footnote 195] According to
opponents, the SEC has used this authority vigorously, in large part
to pursue individual wrongdoers. They note that SEC enforcement
actions, more so than private lawsuits, have a significant stigma that
can cause reputational damage. Second, DOJ has broad statutory powers
to pursue secondary actors who assist others in committing securities
fraud.[Footnote 196] Opponents note that the threat of a criminal
indictment is a serious deterrent, because even an indictment, and
certainly a conviction, could amount to a professional death sentence.
They further note that the SEC and DOJ have the expert judgment to
decide when to prosecute alleged aiders and abettors of securities
fraud, and these agencies, unlike private attorneys, do not have a
profit motive that can bias their decisions.
Third, opponents cite the authority of the PCAOB to promulgate
auditing standards and bring enforcement actions against accounting
firms and individual auditors. Finally, opponents note that laws in
several states provide penalties that potentially help to deter
secondary actors from aiding and abetting securities fraud. These
include state "blue sky" laws that permit attorneys general and state
regulators to seek fines and obtain restitution from,[Footnote 197]
and impose criminal sanctions against,[Footnote 198] anyone who aids
and abets state securities law violations.
Opponents also question the ability of private securities class
actions to deter fraud, citing research showing that resolution of
class actions does not depend on the merits of the case, but are based
on the settlement value to the defendant and the fact that defendants
view settlement as a cost of doing business. They also cite the fact
that companies and insurers, not individual wrongdoers, pay
settlements. Thus, the cost of settlements is ultimately borne by the
corporation's shareholders, not those that committed the fraud.
Opponents of creating a private right of action for aiding and
abetting securities fraud argue that such a right would lead to an
increase in non-meritorious lawsuits and, in turn, an increase in
litigation risk. Opponents note that creating the right of action
would expand the range of parties and transactions that could give
rise to a private lawsuit to include ordinary commercial transactions
and customers, vendors, and others with no direct connection to the
securities markets:
Although PSLRA heightened the pleading requirements applicable to
securities fraud claims, opponents note that getting non-meritorious
complaints dismissed is still costly and difficult. Opponents maintain
that a lawsuit under an aiding and abetting theory of liability would
often be inherently fact intensive. Thus, according to opponents,
there would be factual disputes in nearly every case, making it
difficult for innocent parties to succeed on a motion to dismiss. Once
a claim survives a motion to dismiss, the case is almost always
settled regardless of the merits of the case. According to opponents,
even if a case lacks merit, defendants may seek to settle for cost-
benefit reasons, such as avoiding the high costs of discovery and
litigation or the risks of massive damages. That is, the settlement
value to defendants can turn more on the expected costs of their
defense and less on the merits of the claim. Opponents maintain that
going to trial is a risk that secondary actors are often unwilling to
take, no matter how non-meritorious the case. This is in part because
of the potential for these actors to be found jointly and severally
liable if they knowingly participate in the fraud, putting them at
risk of paying damages out of proportion to their involvement in the
fraud.[Footnote 199]
B. Compensating Investors:
Proponents of creating a private right of action for aiding and
abetting argue that such action would help to compensate investors who
have been harmed through securities fraud. Proponents disagree with
the criticism that class action lawsuits do not effectively compensate
investors because current shareholders who do not benefit from the
increase in stock price effectively compensate those who bought at
fraud-related prices during the class period.[Footnote 200] They note
that this criticism does not apply to litigation against secondary
actors because recoveries from secondary actors do not come from the
corporation. They note that publicly traded companies that have
committed securities fraud have become distressed or insolvent in some
cases, leaving secondary actors who assisted issuers in the fraud as
the only sources from which injured investors can recover their
losses. According to proponents, such an outcome is more common for
new companies but also has included other companies. Proponents also
note that the argument that higher costs discourage firms from listing
on U.S. securities exchanges does not apply directly where secondary
liability is involved.
Proponents further note that in contrast to securities fraud cases
that result in recoveries from issuers, recoveries from secondary
actors provide unique compensation to investors, because the current
shareholders of the issuers do not bear the cost of the recoveries.
According to proponents, if investors were allowed to bring lawsuits
against only issuers (and their directors and officers), they would
not be able to recover much of their losses and, as a result, public
confidence in the markets would suffer. Proponents maintain that
private securities class actions currently represent the principal
means by which financial penalties are imposed in cases of securities
fraud and manipulation. Specifically, proponents contend that the
SEC's disgorgement and civil money penalty authorities, although
enhanced by Sarbanes-Oxley, are limited and generally can be used to
recover only a fraction of the losses suffered by investors in large-
scale securities frauds. As an example, they note that the SEC
recovered $440 million from aiders and abettors in the Enron fraud,
while investors recovered $7.3 billion in private suits.[Footnote 201]
They further argue that the SEC, with its limited resources, cannot
bring actions in every one or even most of the securities fraud cases
that have proliferated in recent years.
Opponents to creating private aiding and abetting liability argue that
such action would not effectively or efficiently serve the goal of
compensating injured investors. First, they note that damages
resulting from securities fraud lawsuits historically have provided
limited compensation to investors: such lawsuits, on average, have
settled for a small percentage of losses alleged by investors, with a
large proportion of total settlement value going toward attorney
fees.[Footnote 202] Second, opponents maintain that aiding and
abetting liability would not increase the amount of money to which
injured investors would be entitled; rather, it would increase only
the number of actors who would be responsible for paying the judgment.
Thus, according to opponents, investors would benefit only if the
primary actor becomes insolvent or otherwise unable to pay a judgment.
Opponents note that when a securities fraud case involving securities
traded in the secondary market is settled, a company's present
shareholders, in effect, largely pay the company's past shareholders.
According to opponents, investors with a diversified stock portfolio
generally will receive settlement payments in some cases and make
settlement payments in other cases but will be worse off in the end
because of legal fees.[Footnote 203] They argue that this circularity
of payments renders class actions an illogical method of compensation.
Moreover, according to opponents, the cost of settling and defending
securities class action is passed to shareholders through higher
directors and officers' insurance premiums. Finally, opponents contend
that a private right of action for aiding and abetting is unnecessary
for compensation purposes because of the government's ability to
compensate injured investors without the legal costs associated with
private litigation. For example, they note that Sarbanes-Oxley
directed the SEC to create a Fair Fund program to collect and return
money that it recovers through disgorgement and civil penalties to
injured investors. Similarly, DOJ is able to return ill-gotten gains
directly to injured investors through restitution and forfeiture.
C. Effect on Investors and the Economy:
Proponents of creating a private right of action for aiding and
abetting securities fraud argue that such an action would not result
in a significant increase in non-meritorious lawsuits. They note that
PSLRA's reforms provide secondary actors with safeguards from non-
meritorious lawsuits.[Footnote 204] The heightened pleading standard
is seen as a key safeguard as it is designed to make it more difficult
for plaintiffs to allege securities fraud without specific evidence of
misconduct. Even if a private aiding and abetting cause of action were
created, proponents argue that PSLRA's pleading standard would enable
defendants to succeed on a motion to dismiss when one is warranted.
Proponents note that the pre-trial dismissal rate for securities class
actions has nearly doubled since PSLRA, but settlement sizes have
increased--reflecting, in their view, a higher proportion of
meritorious litigation.[Footnote 205]
Proponents further note that such trends have prompted securities
experts to surmise that PSLRA's reforms may be preventing meritorious
claims from being filed.[Footnote 206] They point out that Congress
has limited the use of class action lawsuits for securities fraud to
federal courts instead of state courts. In 1998, Congress enacted
SLUSA to address the concern that securities fraud lawsuits had
shifted from federal to state courts as a means of circumventing
PSLRA. Additionally, proponents note that a private right of action
for aiding and abetting existed for decades before Central Bank and
the passage of PSLRA, and secondary actors at that time did not
experience a high volume of non-meritorious lawsuits. Finally,
proponents say that such a private right of action would protect the
integrity and enhance the competitiveness of U.S. financial markets
because it would promote transparency and good corporate governance.
According to opponents, creating a private right of action for aiding
and abetting would exacerbate the impediment that class action
lawsuits pose to economic growth in the United States. Opponents note
that the risk of securities fraud litigation already has caused some
foreign companies to choose not to do business with U.S. companies to
avoid a higher litigation risk. Alternatively, business partners could
take steps to mitigate such risk, such as by insuring themselves
against the risk or charging companies higher prices for their
services. However, opponents note that any such approach would
increase the cost of doing business with a publicly held company and,
in turn, the cost of being a publicly held company. Opponents also
contend that the higher costs imposed on U.S. publicly traded
companies because of securities fraud litigation risk would discourage
U.S. and foreign firms from listing or remaining listed on U.S.
securities exchanges or raising capital in the United States.
Opponents maintain that the U.S. capital markets are losing their
competitiveness with foreign markets, in part evidenced by their lower
growth rate and creation of fewer new companies relative to foreign
markets.[Footnote 207]
D. Possible Measures That Might Mitigate Potential Negative Effects:
At least one legal expert has suggested that if Congress were to
create private aiding and abetting liability, it could mitigate the
potential adverse effects of such actions by placing a ceiling on
liability for secondary actor defendants. This would be particularly
appropriate for secondary actors such as accountants or other
professionals.[Footnote 208] This expert noted that a liability
ceiling could be beneficial, in part because gatekeepers can be
deterred more easily, given that they stand to make only a small
portion of the gain from fraud that a primary actor expects and the
failure of a gatekeeper could be as disruptive to the capital markets
when gatekeeper services are highly concentrated. The expert further
noted that a ceiling on damages would not only permit gatekeepers that
currently cannot obtain liability insurance to obtain such coverage,
thus averting their potential collapse, but also protect gatekeepers
from feeling pressure to settle by the threat of potential
astronomical damages if found liable at trial.
According to this expert, the goal of the liability ceiling would be
to devise a penalty that is sufficient to deter aiding and abetting by
secondary actors but not so large as to threaten their insolvency.
Because some secondary actors are publicly held companies and some are
not, a variety of measures should be used to set the amount of the
ceiling: for example, market capitalization or net worth for public
companies, and revenues or income for private ones. A ceiling may be
necessary so that companies are not subject to unlimited liability. In
brief, the expert proposed that the ceiling be set at $2 million for a
natural person and $50 million for a public corporation, noting that
the real impact of a ceiling is to induce the parties to settle for an
amount below the ceiling.
Another legal expert opposed to creating private aiding and abetting
liability has suggested limiting the damages available in Rule 10b-5
fraud-on-the-market cases to focus on deterrence rather than
compensation.[Footnote 209] This expert noted that instead of making
defendants liable for all losses resulting from fraud, defendants
should be forced to disgorge their gains (or expected gains, for those
who fail in their scheme) from the fraud. According to this expert, in
most fraud-on-the-market cases, the corporation does not benefit from
the fraud but rather is the victim of the fraud, such as when an
executive is awarded an undeserved bonus by creating the appearance of
meeting the target stock price. This expert noted that under a
disgorgement rule, the proper remedy would be for the executive to
return the bonus earned from the fraud to the corporation. According
to this expert, if Congress were to adopt a disgorgement measure of
damages for Rule 10b-5 class actions, plaintiffs' lawyers would have
to settle with executives instead of corporations or secondary
defendants. Under this approach, secondary actors complicit in a
corporation's fraud would be forced to give up their fees (or some
multiple thereof) earned during the fraud period. Other proposals
suggested by legal experts in connection with aiding and abetting
liability to private investors involve how liability is imposed. Under
current law, proportionate liability (liability based on the
percentage of responsibility) generally applies where the defendant
does not act knowingly. If the person knowingly violates the
securities laws, liability can be joint and several (each defendant
potentially can bear the total damages). These legal experts propose
creating aiding and abetting liability but limiting potential
liability to proportionate liability for secondary actors shown to
have actual knowledge of the wrongdoing or who demonstrate intent to
defraud.
Conclusion:
Legislation and court decisions over the past two decades have
dramatically altered the scope of private securities fraud liability
for secondary actors, as well as the requirements for litigating all
types of private securities fraud class actions. Debate continues over
whether a private cause of action for aiding and abetting securities
fraud should be created, centering on whether this would enhance
deterrence of securities fraud, promote equitable compensation of
injured investors, and affect the U.S. economy and corporate
governance.
We are sending copies of this analysis to interested congressional
committees and to the Chairman of the Securities and Exchange
Commission and the Attorney General. In addition, this analysis will
be available at no charge on GAO's website at [hyperlink,
http://www.gao.gov].
If you or your staff have questions about this analysis, please
contact Susan D. Sawtelle at (202) 512-6417 or SawtelleS@gao.gov.
Contact points for our Offices of Congressional Relations and Public
Affairs are: Ralph Dawn, Managing Director, Congressional Relations,
(202) 512-4400 or DawnR@gao.gov; and Chuck Young, Managing Director,
Public Affairs, at (202) 512-4800 or YoungC1@gao.gov. The following
persons made key contributions to this analysis: Orice Williams Brown,
Managing Director, Financial Institutions and Markets; Assistant
General Counsel Rachel M. DeMarcus; Assistant Directors Richard S.
Tsuhara and Francis L. Dymond; Patrick S. Dynes; Lauren S. Fassler;
Nina Horowitz; Daniel S. Kaneshiro; Marc W. Molino; and Patricia A.
Moye.
Signed by:
Susan D. Sawtelle:
Managing Associate General Counsel:
[End of section]
Enclosure I:
Scope and Methodology of this Analysis:
To conduct this analysis, we reviewed the securities laws and
regulations that provide for a right of action for private plaintiffs
for violations of the securities laws. We focused on the evolution of
the implied private right of action under section 10(b) of the 1934
Act and SEC Rule 10b-5 against persons who commit fraud in connection
with the purchase or sale of securities. We also reviewed sources that
discuss the roles of various financial market participants such as
public companies, investment banks, accountants, lawyers, and vendors.
We reviewed relevant federal legislation including the Private
Securities Litigation Reform Act of 1995 (PSLRA), the Securities
Litigation Uniform Standards Act of 1998 (SLUSA), the Sarbanes-Oxley
Act of 2002, and the Dodd-Frank Wall Street Reform and Consumer
Protection Act. We reviewed key Supreme Court decisions, including the
Central Bank decision in 1994, the Stoneridge decision in 2008, and
the Janus decision in 2011, concerning the types of claims that can be
brought against secondary actors under section 10(b) of the 1934 Act,
as well as other relevant federal court decisions. We reviewed the
briefs filed with the Supreme Court by the parties and other
interested entities in the Central Bank and Stoneridge cases and
interviewed a number of these entities. We also reviewed relevant law
review articles and court decisions on the scope of the implied
private right of action under section 10(b). Further, we reviewed key
court decisions and articles interpreting PSLRA and SLUSA since their
enactment in the mid-1990s. Finally, we interviewed representatives
from a broad range of organizations to obtain their input and
perspectives on the potential implications of authorizing a private
right of action for aiding and abetting, including the Securities and
Exchange Commission; the Department of Justice; consumer, corporate,
accounting, and securities associations; and companies and individuals
that participated in the Central Bank and Stoneridge litigation. We
provided a copy of the draft report to the Department of Justice and
the Securities and Exchange Commission for review and comment. The
Securities and Exchange Commission provided technical comments that we
incorporated as appropriate; the Department of Justice did not provide
comments.
[End of section]
Footnotes:
[1] In general, "secondary actors" are persons charged with "secondary
liability" because they do not directly commit violations of the anti-
fraud provisions but instead are alleged to provide substantial
assistance to fraudulent conduct. Because transactions subject to the
federal securities laws are often complex and involve multiple
entities, it can be difficult to determine, at the time a violation
occurs, who should be subject to primary versus secondary liability.
In this report, we use the term "secondary actor" to refer to parties
providing services to, or involved in transactions with, corporate
issuers.
[2] 15 U.S.C. § 78j(b).
[3] 17 C.F.R. § 240.10b-5.
[4] See, e.g., Brennan v. Midwestern United Life Ins. Co., 259 F.
Supp. 673 (N.D. Ind. 1966).
[5] 511 U.S. 164 (1994).
[6] 552 U.S. 148 (2008).
[7] 131 S. Ct. 2296 (2011).
[8] Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified as amended in
scattered sections of titles 15 & 18 of the U.S. Code).
[9] 511 U.S. at 177.
[10] See, e.g., H.R. 5042, 111th Cong. (2010).
[11] Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified in scattered
sections of titles 12 & 15 of the U.S. Code).
[12] Specifically, section 929Z of the Act directs GAO to study the
impact of authorizing a private right of action against any person who
aids or abets another in violation of the securities laws, and
identifies areas to be included in the study if practicable. This
analysis addresses all of those areas. Part I of the analysis provides
an overview of the general anti-fraud prohibitions of section 10(b)
and Rule 10b-5 and identifies the elements that private investors must
show to prove a case for securities fraud. Part II discusses the roles
that secondary actors, including accountants, attorneys, and
underwriters, play in securities transactions. Part III reviews
significant legislative and case law developments over the past two
decades affecting secondary actors' liability for securities fraud.
Part IV discusses other legal avenues for pursuing secondary actors
and compensating investors. Part V sets out current standards for
secondary actor liability in light of these developments. Finally,
Part VI identifies recent proposals to create a private cause of
action for aiding and abetting securities fraud, describes arguments
that have been advanced in favor of and against such proposals, and
discusses steps that have been identified, if such a right were
created, to mitigate potential concerns that have been raised with
creating such liability.
[13] Securities Act of 1933, 48 Stat. 74 (1933) (codified as amended
at 15 U.S.C. §§ 77a et seq.); Securities Exchange Act of 1934, 48
Stat. 881 (1934) (codified as amended at 15 U.S.C. §§ 78a et seq.).
[14] 17 C.F.R. § 240.10b-5.
[15] Section 10(b) of the 1934 Act makes it unlawful "to use or employ
[by the use of any means or instrumentality of interstate commerce],
in connection with the purchase or sale of any security ... any
manipulative or deceptive device or contrivance in contravention of
such rules and regulations as the Commission may prescribe as
necessary or appropriate in the public interest or for the protection
of investors." 15 U.S.C. § 78j(b).
[16] Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified as amended in
scattered sections of titles 15 & 18 of the U.S. Code).
[17] H.R. Rep. No. 104-369, at 31-32, 37-41 (1995) (Conf. Rep.).
[18] 131 S. Ct. 2296 (2011).
[19] Securities Act of 1933, 48 Stat. 74 (1933) (codified as amended
at 15 U.S.C. §§ 77a et seq.); Securities Exchange Act of 1934, 48
Stat. 881 (1934) (codified as amended at 15 U.S.C. §§ 78a et seq.).
[20] Central Bank of Denver, 511 U.S. at 171 (quoting Affiliated Ute
Citizens of Utah v. United States, 406 U.S. 128, 151 (1972)).
[21] 15 U.S.C. § 78j(b).
[22] 17 C.F.R. § 240.10b-5.
[23] In private civil litigation filed in federal court, the person
bringing the lawsuit (the plaintiff) generally must plead (lay out in
the initial complaint) just "enough facts to state a claim to relief
that is plausible on its face." Bell Atlantic v. Twombly, 550 U.S.
544, 570 (2007). The Federal Rules of Civil Procedure provide special
standards for fraud cases. The plaintiff's complaint must allege "with
particularity" specific facts showing each of the elements of fraud.
Fed. R. Civ. P. 9(b). Additionally, the PSLRA enhanced pleading
requirements for private securities cases; if the plaintiff's
complaint fails to allege the necessary facts with particularity, the
court can dismiss the case. If the complaint is sufficient, then, as
in all civil suits, the plaintiff must prove each of the elements of
his claim by a preponderance of the evidence at trial, or, if the
facts are not in dispute, in motions filed with the court.
[24] See, e.g., Janus Capital Group, Inc. v. First Derivative Traders,
131 S. Ct. 2296 (2011); Stoneridge Investment Partners, LLC v.
Scientific-Atlanta, Inc., 552 U.S. 148 (2008).
[25] 17 C.F.R. § 240.10b-5.
[26] Basic Inc. v. Levinson, 485 U.S. 224, 240 (1988). In a recent
case, Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011),
the Supreme Court addressed how a plaintiff would plead the
materiality of adverse events associated with a pharmaceutical
company's products.
[27] Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1321-22
(citing Basic Inc. v. Levinson, 485 U.S. 224, 239 n.17 (1988)).
[28] Thomas Lee Hazen, Treatise on the Law of Securities Regulation, §
12.17 (West Group 2005).
[29] See, e.g., Donald C. Langevoort, Half-truths: Protecting Mistaken
Inferences by Investors and Others, 52 Stan. L. Rev. 87, 88 (1999).
[30] Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 768 (1975)
(citing 17 C.F.R. § 240.10b-5).
[31] 15 U.S.C. § 78j(b).
[32] Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 746-47
(1975).
[33] Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976).
[34] Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th
Cir. 1977). The Seventh Circuit states that "reckless conduct may be
defined as a highly unreasonable omission, involving not merely
simple, or even inexcusable negligence, but an extreme departure from
the standards of ordinary care, and which presents a danger of
misleading buyers or sellers that is either known to the defendant or
is so obvious that the actor must have been aware of it." Id. (citing
Franke v. Midwestern Okla. Dev. Auth., 428 F.Supp. 719 (W.D. Okla.
1987)).
[35] See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308,
319 n.3 (2007). The Supreme Court has not yet determined whether
reckless conduct is sufficient to satisfy the scienter requirement.
[36] Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128,
152-53 (1972).
[37] Basic, Inc. v. Levinson, 485 U.S. 224, 246-47 (1988). In 1968,
the Second Circuit Court of Appeals laid the groundwork for the fraud-
on-the-market doctrine by determining that privity was not a
requirement for Rule 10b-5 liability. Thus, parties other than the
issuer could be held liable. SEC v. Texas Gulf Sulphur, 401 F.2d 833
(2d Cir. 1968) (en banc), cert. denied, 404 U.S. 1005(1971).
[38] Id.
[39] See 15 U.S.C. § 78u-4(b)(4); see also Dura Pharmaceuticals, Inc.
v. Broudo, 544 U.S. 336, 338 (2005).
[40] See, e.g., Kardon v. National Gypsum Co., 69 F. Supp. 512, 514
(E.D. Pa. 1946). An implied private cause of action exists where
Congress did not include an explicit private right of action in a law,
but courts read a provision to mean that Congress intended there to be
a remedy in order to ensure the provision is enforced.
[41] Superintendent of Ins. of N.Y. v. Bankers Life & Casualty Co.,
404 U.S. 6, 13, n.9 (1971).
[42] 511 U.S. 164 (1994).
[43] Private Securities Litigation Reform Act, Pub. L. No. 104-67, 109
Stat. 737 (1995) (codified as amended in scattered sections of titles
15 & 18 of the U.S. Code).
[44] See, e.g., John C. Coffee, Jr., Gatekeepers: The Professions and
Corporate Governance (Oxford Univ. Press 2006).
[45] See Report of the New York City Bar Association Task Force on the
Lawyer's Role in Corporate Governance--November 2006, 62 Bus. Law. 427
(2007).
[46] See John C. Coffee, Jr., Gatekeeper Failure and Reform: The
Challenge of Fashioning Relevant Reforms, 84 B.U. L. Rev. 301, 308-09
(2004).
[47] Reiner H. Kraakman, Corporate Liability Strategies and the Costs
of Legal Controls, 93 Yale L. J. 857, 888-96 (1984).
[48] Bureau of Labor Statistics, Occupational Outlook Handbook, 2010-
11 Edition: Accountants and Auditors (2010), available at [hyperlink,
http://www.bls.gov/oco/ocos001.htm]; see also AICPA, FAQs--Become a
CPA, [hyperlink, http://www.aicpa.org/BecomeACPA/FAQs/Pages/FAQs.aspx]
(last visited July 19, 2011).
[49] AICPA, Code of Professional Conduct (2010), available at
[hyperlink,
http://www.aicpa.org/Research/Standards/CodeofConduct/Pages/default.aspx
].
[50] For example, the Code of Virginia defines "the practice of public
accounting" as "the giving of an assurance" other than under certain
circumstances, Va. Code Ann. § 54.1-4400, and it generally prohibits
the practice of public accounting or the use of the title "Certified
Public Accountant" unless licensed by the Virginia Board of
Accountancy, Va. Code Ann. § 54.1-4414.
[51] According to AICPA, all 55 public accounting licensing
jurisdictions require prospective public accountants to pass the
Uniform CPA Examination as a condition of licensure. The AICPA is
responsible for content development and scoring of the CPA Exam. See
AICPA, Examination Overview, [hyperlink,
http://www.aicpa.org/BECOMEACPA/CPAEXAM/EXAMOVERVIEW/Pages/default.aspx]
(last visited July 19, 2011).
[52] PCAOB was established by the Sarbanes-Oxley Act of 2002 to
oversee the audit of public companies subject to the securities laws,
and related matters, in order to protect the interests of investors
and further the public interest in the preparation of informative,
accurate, and independent audit reports for companies whose securities
are sold to, and held by and for, public investors. 15 U.S.C. § 7211.
PCAOB Rule 2100 requires each domestic or foreign firm to register
with PCAOB if it prepares or issues any audit report with respect to
an issuer or plays a substantial role in the preparation or issuance
of such audit reports. Registered public accountants are subject to
periodic inspection by PCAOB and investigation and disciplinary action
by PCAOB for noncompliance with the Sarbanes-Oxley Act, the rules of
PCAOB and the SEC, and other laws, rules, and professional auditing
standards governing the audits of public companies, brokers, and
dealers. PCAOB Rules 4000, 5000.
[53] PCAOB, Standards, available at [hyperlink,
http://pcaobus.org/Standards/Pages/default.aspx].
[54] See also SEC Regulation S-X, Art. 2, 17 C.F.R. § 210.2-02.
[55] See PCAOB, Statement on Auditing Standards No. 1, AU § 110.01.
[56] Ass'n of the Bar of the City of N.Y., Report of the Special
Committee on Lawyers' Role in Securities Transactions, 32 Bus. Law.
1879, 1884-86 (1977).
[57] The rules and ethical considerations of the Model Rules of
Professional Conduct and the Model Code of Professional Responsibility
of the American Bar Association address the duties of attorneys in a
range of contexts. The Model Rules and/or Model Codes are adopted in
some form by most individual states, and depending on the details of a
particular state's rules, would apply to attorney conduct in the
context of securities-related transactions. For example, attorneys
have an obligation to be properly prepared, accept only those matters
they are competent to handle, and, in rendering opinions and
disclosure advice, diligently represent their clients. On the other
hand, if a client's conduct is criminal in nature, counsel must not
assist or advise the client in furthering such conduct.
[58] See Robert J. Rhee, The Decline of Investment Banking:
Preliminary Thoughts on the Evolution of the Industry 1996-2008, 5 J.
Bus. & Tech. L. 75 (2010).
[59] See FINRA Rule 5100, Securities Offerings, Underwriting and
Compensation. The purpose of the review is to assure that the
compensation is fair and reasonable.
[60] Other types of negotiated underwriting agreements include strict
underwriting and best efforts underwriting. The strict underwriter
guarantees to purchase the unsold portion of the allotment. Best
efforts underwriting does not put the underwriter at risk if investors
do not purchase the shares being offered to the public.
[61] 15 U.S.C. § 78c(a)(60).
[62] See 17 C.F.R. § 240.15c3-1.
[63] See GAO, Securities and Exchange Commission: Action Needed to
Improve Rating Agency Registration Program and Performance-Related
Disclosures, [hyperlink, http://www.gao.gov/products/GAO-10-782]
(2010).
[64] See SEC Office of Compliance Inspections and Examinations,
Division of Trading and Markets and Office of Economic Analysis,
Summary Report of Issues Identified in the Commission Staff's
Examinations of Select Credit Rating Agencies (2008).
[65] See, e.g., Mark A. Chen & Robert Marquez, Regulating Securities
Analysts 23 (Working Paper, 2003), available at [hyperlink,
http://ssrn.com/abstract=485942].
[66] See, e.g., SEC Regulation Analyst Certification; NASD Rule 2711;
NYSE Rule 472. Sell-side analysts are subject to rules requiring them
to disclose conflicts of interest and prohibiting certain conduct that
would result in a conflict of interest.
[67] First Interstate Bank of Denver, N.A. v. Pring, 969 F.2d 891, 898
(10th Cir. 1992), rev'd sub nom. Central Bank of Denver, N.A. v. First
Interstate Bank of Denver, N.A., 511 U.S. 164 (1994).
[68] 511 U.S. 164, 191 (1994).
[69] Id. at 167.
[70] Id.
[71] Id. at 167-68.
[72] Id. at 168.
[73] See 18 U.S.C. § 2.
[74] 511 U.S. at 180.
[75] Id. at 188.
[76] Id. at 188-90.
[77] Id. at 189.
[78] Pub. L. No. 104-67, 109 Stat. 737 (1995).
[79] H.R. Rep. No. 104-369, at 31, 32-36, 42-47 (1995) (Conf. Rep.).
[80] Id.
[81] 15 U.S.C. §§ 77z-1(a)(3)(B), 78u-4(a)(3)(B).
[82] H.R. Rep. No. 104-369, at 32-35 (1995) (Conf. Rep.).
[83] 15 U.S.C. § 78u-4(a)(6).
[84] Id. § 78u-4(b)(3)(B).
[85] Id. § 78u-4(f). If defendants are found jointly and severally
liable under Rule 10b-5, the entire damage award generally can be
collected from one or more of the defendants. Where proportionate
liability applies, defendants are liable for only their proportionate
share of the damages.
[86] Id. § 78u-5(c).
[87] H.R. Rep. No. 104-369, at 41 (1995) (Conf. Rep.).
[88] 15 U.S.C. § 78u-4(b)(1).
[89] See In re Credit Suisse First Boston Corp., 431 F.3d 36, 46 (1st
Cir. 2005) (quoting Greebel v. FTP Software, Inc., 194 F.3d 185, 193
(1st Cir. 1999)).
[90] 15 U.S.C. § 78u-4(b)(3)(A).
[91] Id. § 78u-4(b)(2).
[92] Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 319
(quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193-94, n.12
(1976)).
[93] Id. at 314.
[94] Id. at 310.
[95] Id. at 314.
[96] In Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309
(2011), the Court applied the Tellabs standard to find that the
defendant acted with the required level of scienter.
[97] 15 U.S.C. § 78u-4(b)(4).
[98] See H.R. Rep. No. 104-369, at 41 (1995) (Conf. Rep.).
[99] 544 U.S. 336 (2005).
[100] Id. at 343 (emphasis in original).
[101] Fed. R. Civ. P. 8(a)(2) requires that a plaintiff submit "a
short and plain statement of the claim showing that the pleader is
entitled to relief"; Fed. R. Civ. P. 9(b) requires that a plaintiff
"state with particularity the circumstances constituting fraud." See
Gregory A. Markel & Martin L. Seidel, Lower Courts Divided on Standard
For Pleading Loss Causation Post-'Dura', 245 N.Y. L.J. 61 (2011).
[102] 131 S. Ct. 2179 (2011). In order for a class action to proceed,
the court must find that "the questions of law and fact common to
class members predominate over any questions affecting only individual
members, and that a class action is superior to other available
methods for fairly and efficiently adjudicating the controversy." Fed.
R. Civ. P. 23(b)(3). The Fifth Circuit U.S. Court of Appeals had found
that the plaintiff had to prove the separate element of loss causation
in order to trigger Basic's presumption of reliance. The Supreme Court
determined that this requirement was not justified by the Basic case.
[103] Pub. L. No. 105-353, 112 Stat. 3227 (1998).
[104] 15 U.S.C. § 78bb(f)(5)(B).
[105] Id. § 78bb(f)(5)(E).
[106] Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S.
71, 88-89 (2006).
[107] Id.
[108] Pub. L. No. 109-2, 119 Stat. 4 (2005) (codified in scattered
sections of title 28 of the U.S. Code).
[109] The diversity requirement is satisfied if "any member of a class
of plaintiffs is a citizen of a State different from any defendant."
28 U.S.C. § 1332(d)(2).
[110] See, e.g., Jennifer J. Johnson, Securities Class Actions in
State Court, U. Cin. L. Rev. (forthcoming), available at [hyperlink,
http://ssrn.com/abstract=1856695].
[111] 17 C.F.R. § 240.10b-5.
[112] See, e.g., Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th
Cir. 2006).
[113] 552 U.S. 148 (2008).
[114] Id. at 153.
[115] Id. at 155.
[116] Id.
[117] Id. at 167. As noted below, however, the SEC successfully
enforced against the vendors.
[118] 131 S. Ct. 2296 (2011).
[119] 17 C.F.R. § 240.10b-5(b) (emphasis added).
[120] 131 S. Ct. at 2302.
[121] Id. at 2304.
[122] Id. at 2306.
[123] Pub. L. No. 104-67, §929O, 109 Stat. 737 (1995).
[124] 15 U.S.C. § 78u (Investigations and Actions by SEC); 15 U.S.C. §
78u-1 (Civil Penalties for Insider Trading); 15 U.S.C. § 78u-2 (Civil
Remedies in Administrative Proceedings); 15 U.S.C. § 78u-3 (Cease-and-
Desist Proceedings); 15 U.S.C. § 78 (Penalties for Willful
Violations); 15 U.S.C. §78u(d)(1) (Injunctions); 15 U.S.C. § 78u(d)(2)
(Barring service as officer or director).
[125] 15 U.S.C. § 78u(a).
[126] See SEC v. Scientific-Atlanta, Inc., SEC Litig. Release No.
19,735 (June 22, 2006); In re Motorola, Inc., Exchange Act Release No.
55,737 (May 8, 2007).
[127] The principal tool for criminal enforcement of the securities
laws is 18 U.S.C. § 2(a), which states that "whoever commits an
offense against the United States or aids, abets, counsels, commands,
induces or procures the commission, is punishable as a principal."
Offenses include violations of the criminal provisions of the
securities laws. 15 U.S.C. § 78ff(a).
[128] See Judgment, United States v. Barford, No. 4:03CR00434 (E.D.
Mo. Apr. 22, 2005); Judgment, United States v. Smith, No. 4:03CR434
(E.D. Mo. Apr. 22, 2005); Judgment, United States v. Kalkwarf, No.
4:03CR434 (E.D. Mo. Apr. 22, 2005); Judgment, United States v. McCall,
No. 4:03CR00434 (E.D. Mo. Apr. 22, 2005).
[129] Pub. L. No. 107-204, 116 Stat. 745 (2002); 15 U.S.C. § 7246.
[130] SEC, Report Pursuant to Section 308(c) of the Sarbanes-Oxley Act
of 2002 at 3 (2003).
[131] GAO, Securities and Exchange Commission: Information on Fair
Fund Collections and Distributions, [hyperlink,
http://www.gao.gov/products/GAO-10-448R] (2010).
[132] 15 U.S.C. § 7246(a).
[133] Id. § 77k(a)(4).
[134] 17 C.F.R. § 230.405.
[135] 15 U.S.C. § 77k(b)(3)(B).
[136] Id. § 77l(a)(1).
[137] Id. § 77l (a).
[138] The Supreme Court has held that section 12(a)(2) applies only to
public offerings. Gustafson v. Alloyd Co., 513 U.S. 561 (1995).
[139] 15 U.S.C. § 78i.
[140] Id. § 78r(a).
[141] Id. § 78t(a).
[142] Id.
[143] Id. § 77o.
[144] The two standards may differ concerning whether knowledge of the
misstatements is required. Hazen, supra note 28, § 7.12, at 344.
[145] 17 C.F.R. § 230.405.
[146] 15 U.S.C. § 78t(a).
[147] Securities Litigation Uniform Standards Act of 1997: Hearing on
S. 1260 Before the Subcomm. on Securities, S. Comm. on Banking,
Housing, and Urban Affairs, 105th Cong. 47 (1997) (prepared statement
of Arthur Levitt, Jr., Chairman & Isaac C. Hunt, Jr., Commissioner,
U.S. Securities and Exchange Commission) (stating that according to
the SEC, 49 of 50 states authorize private rights of action for aiding
and abetting violations of state securities laws).
[148] Jennifer J. Johnson, Secondary Liability for Securities Fraud:
Gatekeepers in State Court, Del. J. Corp. L. (forthcoming) (citing
Unif. Sec. Act § 410(b) (1956) (amended 1958); Unif. Sec. Act § 509(b)
(2002)), available at [hyperlink, http://ssrn.com/abstract=1803762].
[149] 15 U.S.C. § 78bb(f)(5)(B)(ii).
[150] In re Am. Cont'l Corp./Lincoln Sav. & Loan Sec. Litig., 794
F.Supp. 1424, 1453 (D. Ariz. 1992).
[151] ABA Comm. on Ethics & Prof'l Responsibility, Formal Op. 346
(1982) (discussing tax law opinions in tax shelter investment
offerings). Formal Opinions supplement the Model Rules and Code by
providing guidelines in certain areas.
[152] Ackerman v. Schwartz, 947 F.2d 841, 848-49 (7th Cir. 1991).
[153] Kline v. First W. Gov't Sec., Inc., 24 F.3d 480, 485-86 (3d Cir.
1994).
[154] 625 F.3d 185 (5th Cir. 2010).
[155] Id. at 192-195.
[156] 943 F.2d 485, 492-93 (4th Cir. 1991).
[157] Id.
[158] Ziemba v. Cascade Int'l, Inc. 256 F. 3d 1194, 1205-07 (11th Cir.
2001).
[159] Pacific Inv. Mgmt. Co. v. Mayer Brown LLP, 603 F.3d 144, 149-50
(2d Cir. 2010).
[160] Id. at 157-58.
[161] 131 S. Ct. 2296 (2011).
[162] 143 F.3d 263, 268 (6th Cir. 1998). See also Thompson v. Paul,
547 F.3d 1055, 1062 (9th Cir. 2008).
[163] Donald C. Langevoort, Reading Stoneridge Carefully: A Duty-Based
Approach to Reliance and Third-Party Liability Under Rule 10b-5, 158
U. Pa. L. Rev. 2125 (2010).
[164] In re Enron Corp. Sec., Derivative & ERISA Litig., 529 F. Supp.
2d 644 (S.D. Tex. 2006).
[165] Regents of the Univ. of Cal. v. Credit Suisse First Boston
(USA), Inc., 482 F.3d 372 (5th Cir. 2007).
[166] Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA)
Inc., 482 F.3d 372 (5th Cir. 2007), cert. denied, Regents of the Univ.
of Cal. v. Merrill Lynch, Pierce Fenner & Smith, Inc, 552 U.S. 1170
(2008).
[167] In re Parmalat Secs Litig., 570 F. Supp. 2d 521, 524 (S.D.N.Y.
2008).
[168] 15 U.S.C. § 77b(a)(11).
[169] Id. § 77k(a)(5).
[170] The SEC has promulgated Rule 176 to identify certain
circumstances bearing on the reasonableness of the investigation and
the determination of what constitutes reasonable ground for belief. 17
C.F.R. § 230.176.
[171] 15 U.S.C. § 77k(b)(3)(C).
[172] SEC v. Tambone, 597 F.3d 436, 447-448 (1st Cir. 2010).
[173] See McGann v. Ernst & Young, 102 F.3d 390 (9th Cir. 1996), and
cases cited therein. Compare with Wright v. Ernst & Young, 152 F.3d
169 (2d Cir. 1998), cert. denied, 525 U.S. 1104 (1999) (auditor's
alleged review and tacit approval of company press release does not
result in primary liability where auditor did not make a public
statement about it). See Central Bank, 511 U.S. at 191 ("Any person or
entity, including a lawyer, accountant, or bank, who employs a
manipulative device or makes a material misstatement (or omission) on
which a purchaser or seller of securities relies may be liable as a
primary violator under 10b-5, assuming all of the requirements for
primary liability under Rule 10b-5 are met.") (emphasis in original).
[174] See, e.g., In re Worlds of Wonder Sec. Litig., 35 F.3d 1407 (9th
Cir. 1994), cert. denied, 516 U.S. 868 (1995); In re Software
Toolworks Inc. Sec. Litig., 50 F.3d 615 (9th Cir. 1994).
[175] 15 U.S.C. § 78m note.
[176] Id. § 78o-7(m)(1).
[177] Id. § 78u-4(b)(2).
[178] Id. § 78o-7(m)(1).
[179] Id. §§ 78o-7(d)(1), 78o-7(d)(2).
[180] 15 U.S.C. § 78o-7 note.
[181] This standard originated in New York Times v. Sullivan, 376 U.S.
254, 279-80 (1964), where the Supreme Court held that the First
Amendment protects a public official for a defamatory falsehood
relating to his official conduct unless he proves the statement is
made with knowledge that it is false or with reckless disregard of the
whether it was false.
[182] 499 F.3d 520, 530 (6th Cir. 2007).
[183] 651 F. Supp. 2d 155, 175-176 (S.D.N.Y. 2009).
[184] FINRA Rule 2711; NYSE Rule 472. In addition, SEC Regulation AC
requires that a research report disseminated by a broker or dealer
include certifications by the research analyst that the views
expressed in the report accurately reflect the analyst's personal
views. 17 C.F.R. § 242.500.
[185] See In re Credit Suisse First Boston Corp., 431 F.3d 36, 53-54
(1st Cir. 2005) ("[T]he fact that an organization is ethically
challenged does not impugn every action that it takes. In a securities
fraud case, the plaintiffs still must carry the burden, imposed by the
PSLRA, of pleading facts sufficient to show that the particular
statements sued upon were false and misleading when made.").
[186] Lentell v. Merrill Lynch & Co., Inc, 396 F.3d 161, 172-174 cert.
denied, 126 S. Ct. 421. The plaintiffs did not allege facts that would
establish that the analyst's misstatements and omissions concealed the
risk that materialized and played some part in diminishing the market
value of the securities.
[187] 263 F.R.D. 90, 106-107 (S.D.N.Y. 2009).
[188] See In re Salomon Analyst Metromedia Litig., 544 F. 3d 474, 480-
483 (2d Cir. 2008); In re Healthsouth Securites Litigation, 257 F.R.D.
260 (N.D. Alabama 2009)
[189] See John C. Coffee, Jr., Security Analyst Litigation, N.Y. L.J.
at 5 (2001); Elizabeth A. Nowicki, A Response to Professor Coffee:
Analyst Liability Under Section 10(b) of the Securities Exchange Act
of 1934, 72 U. Cin. L. Rev. 1305 (2004).
[190] See H.R. 5042, 111th Cong. (2010); S. 1551, 111th Cong. (2009).
[191] 15 U.S.C. § 78t.
[192] Some of these entities have not expressly supported creating a
private right of action for aiding and abetting.
[193] See, e.g., John C. Coffee, Jr., Gatekeeper Failure and Reform:
The Challenge of Fashioning Relevant Reforms, 84 B.U. L. Rev. 301
(2004).
[194] Frank Partnoy, Barbarians at the Gatekeepers? A Proposal for a
Modified Strict Liability Regime, 79 Wash. U. L. Q. 491 (2001).
[195] Dodd-Frank lowered the scienter standard that the SEC must show
to prove aiding and abetting violations from knowledge to recklessness
and made civil penalties available in enforcement actions.
[196] The U.S. Code criminalizes aiding and abetting violations of the
securities laws and mail and wire fraud and conspiracy to violate
those laws. 18 U.S.C. §§ 2, 371.
[197] See, e.g., Del. Code Ann. tit. 6, § 7325; Cal. Corp. Code §§
25403(b), 25530-25536; State v. McLeod, 12 Misc. 3d 1157(A), 2006 WL
1374014, at *11 (N.Y.S. 2006) (citing N.Y. Gen. Bus. Law Art. 23-A §§
352(1), 352-c(2) (the Martin Act)).
[198] See, e.g., Del. Code Ann. tit. 6, § 7325; Cal. Corp. Code §§
25540-25542; 815 Ill. Comp. Stat. § 5/14.
[199] As noted above, under the PSLRA, joint and several liability
applies only when the conduct of the defendant is knowing. 15 U.S.C. §
78u-4(f).
[200] See, e.g., Jill E. Fisch, The Continuing Evolution of Securities
Class Actions Symposium: Confronting the Circularity Problem in
Private Securities Litigation, 2009 Wis. L. Rev. 333 (2009).
[201] The class action claim was based on a scheme theory of liability
that was subsequently overturned, and other secondary actors who had
not settled escaped liability when the class action was decertified.
Opponents also note that damages were estimated at $40 billion.
[22] For the federal securities class action cases that settled during
1996-2010, NERA Economic Consulting found that attorneys' fees
declined as a percentage of settlement value as the settlement values
rose. For settlements less than $100 million, the median attorneys'
fees as a percent of settlement value ranged from around 28 percent to
33 percent. For settlements between $100 and $500 million, the median
attorneys' fees fell to around 23 percent. For settlements above $500
million, the median declined to around 9 percent.
[203] See John C. Coffee, Jr., Reforming the Securities Class Action:
An Essay on Deterrence and Its Implementation, 106 Colum. L. Rev. 1534
(2006).
[204] For a summary of PSLRA's reforms and analyses of their
effectiveness, see Stephen J. Choi & Robert B. Thompson, Securities
Litigation and Its Lawyers: Changes during the First Decade after the
PSLRA, 106 Colum. L. Rev. 1489 (2006).
[205] See, e.g., Todd Foster, Ronald I. Miller, & Stephanie Plancich,
Recent Trends in Shareholder Class Action Litigation: Filings Plummet,
Settlements Soar (2007).
[206] See, e.g., Stephen J. Choi, Karen K. Nelson, & A.C. Pritchard,
The Screening Effect of the Private Securities Litigation Reform Act,
35-68 (U. of Mich. L. & Econ., Olin Working Paper No. 07-008, 2007).
[207] See, e.g., McKinsey & Company, Sustaining New York's and the
U.S.'s Global Financial Services Leadership (2006) (report
commissioned by Mayor Michael R. Bloomberg & Senator Charles E.
Schumer); Committee on Capital Markets Regulation, Interim Report
(2006).
[208] John C. Coffee, Jr., Testimony Before the Subcommittee on Crime
and Drugs of the Committee on the Judiciary of the U.S. Senate, Sep.
17, 2009.
[209] Adam C. Pritchard, Testimony before the Subcommittee on Crime
and Drugs of the Committee on the Judiciary of the U.S. Senate, Sep.
17, 2009.
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