Evolving theories of scheme liability: does your D&O policy cover guilt by association?

Risk Management, Sept, 2005 by John C. Tanner, Rebecca M. Lamberth, John H. Goselin

Secondary actor liability--frequently labeled as "aiding and abetting" liability--is a hot topic in the securities litigation world. Although the Supreme Court abolished "aiding and abetting" liability in civil litigation brought under Rule 10b-5(b) in its landmark 1994 opinion in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., courts have struggled mightily in recent days over how to define the scope of primary Rule 10b-5(b) liability for secondary actors--such as underwriters, accountants, attorneys and others.

The unprecedented collapses of WorldCom, Global Crossing, Enron and others have provided new stimuli for plaintiffs' lawyers to seek to hold secondary actors liable for alleged securities fraud or other forms of civil liability. Banks, corporate strategic partners (or even ordinary business partners), accountants and legal counsel for publicly traded companies (or those seeking to go public) would be well-served to take a step back, review the current state of the law and analyze appropriate best practices to address an increasing secondary liability exposure. Indeed, the list of those within the crosshairs of secondary liability may now extend beyond traditional "secondary actor" accounting, investment banking and law firm defendants.

Those who bear responsibility for securing appropriate corporate insurance coverage in today's market should also take account of this trend in order to ensure that their business is appropriately considering the exposure to potential secondary liability.

The Securities Exchange Act of 1934

Before this discussion goes any further, we should acquaint ourselves with the laws at hand.

Section 10(b) of the Securities Exchange Act of 1934 provides as follows:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange

(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act), 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.

Pursuant to its authority granted by Congress in the Exchange Act, the SEC promulgated Rule 10b-5 as follows:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange,

(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, in connection with the purchase or sale of any security.

The Post-Central Bank of Denver Calm

In its 1994 landmark decision, the United States Supreme Court held that no private right of action exists under the federal securities laws against secondary actors--including lawyers, accountants, banks and underwriters--for "aiding and abetting" a primary actor's violation of the federal securities laws. Specifically, the Court concluded in that opinion that Congress never intended to impose secondary liability under Section 10(b) of the 1934 Exchange Act. The 5-4 decision, however, left open the door for these professionals to be held liable as primary violators of the securities laws. Since then, plaintiffs' lawyers, as well as defense lawyers and secondary actors, have sought to identify the line of demarcation between actions that give rise to primary liability versus non-actionable secondary activities.

Recent debate over the degree of conduct and participation required for a secondary actor to take on primary 10b-5(b) liability has increased. Some federal appellate courts continue to require that, in order for a secondary actor to incur liability, an alleged misrepresentation by or on behalf of a public company must be publicly attributable to the secondary actor. Other appellate courts, however, require only that the secondary actor be a substantial participant with others in making a material misrepresentation in violation of the securities laws in order to incur potential liability. Yet, some observers believe there may be a growing trend in the courts allowing the expansion of 10b-5 theories of liability, permitting claims under Rule 10b-5(a) and (c) against so-called secondary actor participants for their roles in alleged fraudulent schemes, notwithstanding the absence of any misrepresentation attributable to the secondary actor. It appears that the plaintiffs' bar is more aggressively pursuing such claims.