Unlike Vegas, what happens in bankruptcy court does not necessarily stay in bankruptcy court. The ripples born of Enron’s and its affiliates’ chapter 11 filings are still reverberating in nonbankruptcy courts. The recent decision in Regents of the Univ. of Calif. v. Credit Suisse First Boston (USA) Inc., 482 F.3d 372 (5th Cir. 2007) (“Regents”), adds a new perspective on secondary liability in securities fraud cases.
The court of appeals, on an interlocutory appeal, addressed whether the U.S. District Court for the Southern District of Texas improperly granted class certification to a putative class action against banks that engaged in a series of transactions with Enron Corp. The transactions allowed[1] Enron to take liabilities off of its books temporarily and to book revenue from the transactions when Enron was actually incurring debt.[2] These transactions allowed Enron to misstate its financial condition, which inflated its stock price. There was no allegation that the banks were fiduciaries to the plaintiffs, that they improperly filed financial reports for Enron or engaged in manipulative activities directly in the market for Enron securities.
An example of such transactions was provided. It was alleged that Enron wanted to “sell” its interest in certain electricity-generating barges by the end of 1999 so it could book revenue and meet stock analysts’ estimates for the calendar quarter. Finding no legitimate buyer, Enron contacted Merrill Lynch and guaranteed that it would buy the barges back within six months at a premium for Merrill Lynch.
Enron honored its guarantee. An Enron-controlled partnership bought the barges from Merrill Lynch at a premium. Enron’s reported 1999 results booked the transaction as a sale with revenues. Enron’s outside accountants stated that had they known of the side-agreement to buy back the barges, booking the transaction as a loan would have been appropriate.[3]
The plaintiffs alleged that although each bank may not have been aware of exactly how the other banks helped Enron misrepresent its financial condition, they knew, generally, that other banks were doing so and that Enron was engaged in a long-term scheme to defraud investors and maximize executive compensation by inflating revenue and disguising risk and liabilities through its transactions with the banks.[4]
“According to plaintiffs, defendants could have pulled the plug on the Enron fraud; instead they profited from it while large numbers of people eventually lost an aggregate sum in the tens of billions of dollars.”[5]
The court reversed the order granting certification to a single class of plaintiffs. Reversal was based on the court’s determination that “class-wide reliance” could not apply to the certified class.[6] The court was concerned that the district court misapplied aiding-and-abetting liability under the guise of primary liability through an overly broad definition of “deceptive acts,” thus giving rise to an erroneous class-wide presumption of fraud on the market.[7]
No Deception
Accordingly, the court examined the definition of “deceptive act” under 15 U.S.C. §78j-10(b) and 17 C.F.R. §240.10b-5. Following the Eighth Circuit in In re Charter Commc’ns Inc. Sec. Litig.,[8] the court found that “‘deceptive’ conduct involves either a misstatement or a failure to disclose by one who has a duty to disclose.”
The court also found that the plaintiffs failed to allege that the banks “made public and material misrepresentations - i.e., the type of fraud on which an efficient market may be presumed to rely.”[9] Likewise:
assuming arguendo that plaintiffs’ case primarily concerns improper omissions, the banks were not fiduciaries and were not otherwise obligated to the plaintiffs. They did not owe plaintiffs any duty to disclose the nature of the alleged transactions.[10]
It determined that:
…an act cannot be deceptive within the meaning of §10(b) where the actor has no duty to disclose. Presuming plaintiffs’ allegations to be true, Enron committed fraud by misstating its accounts, but the banks only aided and abetted that fraud by engaging in transactions to make it more plausible; they owed no duty to Enron’s shareholders.[11]
However, 10(b) does not include “aiding and abetting” liability.[12]
No Manipulation
Having found no deception, the court considered whether the banks manipulated the market. The court accepted Hundahl v. United Benefit Life Ins. Co.’s[13] definition for “manipulation,” which the Eighth Circuit adopted in Charter Commc’ns, Inc. Sec. Litig:
…practices in the marketplace which have the effect of either creating the false impression that certain market activity is occurring when in fact such activity is unrelated to actual supply and demand or tampering with the price itself…[14]
The court also agreed with the Eighth Circuit that manipulation “could not take place outside the market for the relevant security and retain the title of manipulation; conduct that affects the marketplace indirectly can violate §10(b) only if it constitutes deception.”[15] It concluded that the “banks’ actions were not alleged to be the type of manipulative devices on which an efficient market may be legally presumed to rely because the banks did not act directly in the market for Enron securities.”[16]
The court opined that the banks “escape[d] liability for alleged conduct that was hardly praiseworthy.”[17]
Regents thus insulates parties from §10(b) liability where they only facilitated the fraud. Absent a misrepresentation, a duty to disclose or direct manipulation of the market, a facilitator is an “aider and abetter” and thus escapes liability under §10(b).
Out of the Frying Pan into the Fire?
Regents has been criticized as an unwarranted advance for securities fraud class action defendants facing claims of secondary liability.[18] However, Regents-type defendants may have traded one form of liability for another having a potentially easier burden of proof.
“Aider and abetter” conduct is not actionable under §10(b).[19] However, aiding and abetting a fraud is actionable under Common Law.[20]
The elements of securities fraud are: (1) a material misrepresentation or omission by the defendant, (2) scienter on the part of the defendant, (3) reliance and (4) due diligence by the plaintiff to pursue his or her own interest with care and good faith.”[21] Regents shows the difficulty in pleading facts for §10(b) claims asserting secondary liability.
In contrast, the elements of aiding and abetting a fraud are that (1) a fraud existed, (2) the defendant had actual knowledge of the fraud and (3) the defendant provided substantial assistance to advance the fraud’s commission. Federal Nat. Mortg. Ass’n v. Olympia Mortg. Corp., 2006 WL 2802092, *10, citing Lerner v. Fleet Bank N.A., 459 F.3d 273, ----, 2006 WL 2260822, *15.
There must be “actual knowledge” of the fraud. Constructive knowledge is insufficient.[22] However, an aiding-and-abetting fraud claim was permitted to proceed where specific facts were alleged that gave rise to a strong inference of a defendant’s actual knowledge of a fraud.[23]
The alleged “general knowledge” of the banks in Regents[24] may have been sufficient to state a claim for common law aiding and abetting a fraud. This could produce a drastically different result.
Bankruptcy practitioners are well aware that “aider and abetter” claims are trustees’ new darling claim for enhancing estates.[25] Regents’ holding created a defense for defendants similarly situated to the banks in Regents. However, its dicta may have opened a far more perilous door for them. It may only be a matter of time before Regents’ own ripple resounds in bankruptcy courts.
[1] The court used the term “allowed.” Considering the nature of the transactions, the better word may have been “enabled.”
[2] Regents at 377.
[3] Id.
[4] Id.
[5] Id. at 392.
[6] Id. at 393.
[7] Id. at 383.
[8] 443 F.3d 987, 990 (8th Cir.2006)
[9] Regents at 385.
[10] Id. at 284.
[11] Id. at 386.
[12] Id., citing in fn. Central Bank N.A. v. First Interstate Bank N.A., 511 U.S. 164, 177, 114 S.Ct. 1439, 128 L.Ed.2d 119 (1994) 511 U.S. at 177, 114 S.Ct. 1439 (§10(b) “prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act. The proscription does not include giving aid to a person who commits a manipulative or deceptive act.”).
[13] 465 F.Supp. 1349, 1360 (N.D. Tex. 1979)
[14] Regents at 390.
[15] Id. at 391.
[16] Id. at 392.
[17] Id. at 392.
[18] “Holding Accomplices Accountable,” New York Times, May 13, 2007, Editorial.
[19] Regents at 386; Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. at 177.
[20] Federal Nat. Mortg. Ass’n v. Olympia Mortg. Corp., Slip Copy, 2006 WL 2802092, (E.D.N.Y. 2006); Lerner v. Fleet Bank, N.A., 459 F.3d 273, ----, 2006 WL 2260822 (2d Cir. 2006).
[21] Regents at 382, citing Unger v. Amedisys Inc., 401 F.3d 316, 322 at fn. 322 (5th Cir. 2005).
[22] In re Worldcom Inc. Securities Litigation, 382 F.Supp.2d 549, 560 (S.D.N.Y. 2005).
[23] Federal Nat. Mortg. Ass’n v. Olympia Mortg. Corp., 2006 WL 2802092.
[24] Regents at 37s7.
[25] Brighton, J.J., “Secured Creditors Beware: The Latest Tool in the Creditors’ Committee Toolbox Aiding and Abetting in the Breach of a Fiduciary Duty”, ABI Journal, Oct. 2006.