Slouching towards Monell: the disappearance of vicarious liability under section 10(b).

• Author: Lipton, Ann M.
• Position: II. The Different Rules Applicable to s. 10(b

3. Distinguishing Poor Corporate Governance from Fraud

   Finally, the expansion of section 10(b) has posed a challenge for courts regarding the tension between section 10(b)'s doctrinal and practical roles. Traditionally, section 10(b) lawsuits and federal securities regulation generally have been reserved for regulation of corporate disclosures. Internal governance matters have been considered to be matters of state concern, and various specific laws, both state and federal, govern substantive corporate behavior. (136) But, as mandatory disclosure requirements have increased, the federal securities laws have come to resemble a type of "backdoor federalization of state corporation law." (137) By requiring extensive disclosures regarding a corporation's financial position, its plans, and its trends, the federal securities laws have become a mechanism for policing the quality of corporate governance by ensuring that managers exercise a certain duty of care, (138) facilitating informed voting by shareholders, (139) and enhancing the ability of outside directors to monitor managerial performance. (140) The consequence of this regime is that every corporation is at risk of a securities fraud lawsuit if it conceals that the business was at least partially reliant on unethical or illegal activity. Courts may be limiting the use of vicarious liability principles as a way of distinguishing core "fraud" from other forms of corporate misconduct.

   Section 10(b) claims are frequently premised on the allegation that the organization secretly engaged in some form of illegal or unethical activity unrelated to corporate disclosures, such as anticompetitive conduct; (141) or bribery of foreign officials; (142) or "kickbacks" to steer business to particular companies; (143) or the misuse of analyst reports to attract IPO business; (144) or off-label drug marketing; (145) or fraudulent sales of consumer financial products. (146) For these kinds of cases, the false statement that ostensibly triggers the section 10(b) violation--typically, a generic attribution of the company's profits to a legitimate business strategy--can seem like a fig leaf for a claim that, in truth, is based on corporate managers' failure to properly supervise and direct corporate activities. (147) By truncating the use of vicarious liability, courts set an outer limit on the degree to which antisocial corporate behavior can be reformulated into a section 10(b) violation.

   Courts accomplish this by drawing sometimes rather strained distinctions between the mens rea likely to be harbored by lower level actors and the mens rea required for a section 10(b) violation. For example, in Nordstrom, the Ninth Circuit expressed doubt that lower level agents, such as the personnel director and public relations director, would be "aware of the requirements of SEC regulations and state law and of the 'danger of misleading buyers and sellers.'" (148) Similarly, the Fifth Circuit in Zale held that a mid-level executive who falsified internal financial results had "acted with the intent to maintain the good appearance of her department rather than to defraud investors," and thus did not harbor the kind of scienter required for section 10(b) liability to be imposed on the corporation. (149) In Plichta v. SunPower Corp., (150) the court dismissed a complaint alleging that mid-level executives had falsified accounting entries, because, in the court's view, "[t]he question ... is not whether one or more SunPower accounting department employees intended to mislead someone when preparing journal entries, but whether the corporation and management intended to mislead potential investors when they relied on that information and incorporated it in the various SEC filings...." (151)

   If these decisions are questionable--someone who knowingly manipulates internal accounting entries is likely aware that his actions will mislead investors, or at least is recklessly indifferent to the possibility--in other cases, it may be difficult to distinguish scienter with respect to section 10(b) specifically from scienter with respect to other forms of corporate misconduct. When lower level actors are responsible for antitrust violations or illegal marketing schemes or improper charges to vendors, they no doubt hoped to increase the corporation's bottom line, and almost certainly had at least some perception that "the numbers" would be publicly reported. In such circumstances, by ignoring lower level mens rea, courts avoid the necessity of having to parse the precise nature of the lower level actors' awareness and risk expanding section 10(b) into an all-purpose good-corporate-citizen statute. (152)

   Causation has a role to play here, as well. It is precisely because there is a relatively distant causal nexus between the lower-level actors' behavior and the ultimate false statement that lower-level actors' precise intentions seem impossible to discern. Thus, it is not surprising that when imposing its "supercausation" rule in Stoneridge, the Supreme Court cited, among other things, a fear of employing "the federal power ... to invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees." (153) Courts' curtailment of vicarious liability--that is, their refusal to allow lower-level actors' actions and intentions to be imputed to the corporation--served the same purpose even before Stoneridge was decided.

   Relatedly, vicarious liability is only supposed to be imposed when the agent acts for the principal's benefit. But employees who filter false information up the reporting chain may seem to be doing so to preserve their own salaries or jobs, or to obtain bonus payments and other undeserved rewards from the corporation. Though these motives are not sufficient to defeat the agency relationship as a formal matter, (154) they may still strike courts as suggesting less the intent to mislead investors on the corporation's behalf than the intent to defraud the corporation itself. (155) Once again, the fear that section 10(b) intent cannot be distinguished from other kinds of malicious intent when it comes to lower level actors seems to be driving courts to adopt the rather blunt approach of simply disregarding these actors' intent entirely. (156)

   The problem of identifying whether an agent held the precise mens rea required for the offense is not unique to section 10(b), but may be an issue in any form of "cat's paw" liability.157 But because section 10(b) is (theoretically) confined to fraud in connection with securities laws, and set off from other areas of corporate governance, the problem apparently looms large in courts' concerns.

4. The Puzzle of Secondary Actors

   Viewing courts' approach to organizational scienter through this lens also helps explain another phenomenon--the fact that a different set of rules applies when courts examine the section 10(b) liability of secondary actors, such as underwriters and auditing firms.

   After the Central Bank line of cases, secondary actors may only be liable when they personally issue false statements or engage in deceptive conduct communicated directly to the market, such as when an auditor falsely issues a clean audit opinion. Curiously, however, when organizational secondary actors are defendants, courts almost never search for a single agent whose knowledge may be imputed to the firm, let alone a high-level agent; instead, they are willing to gauge the firm's conduct as a whole (or at least the conduct of the particular team assigned to the issuer's account) to determine whether it evidences scienter. As the Second Circuit put it in the context of an audit firm defendant, "the requisite [organizational] intent exists '[w]hen it is clear that a scheme, viewed broadly, is necessarily going to injure,"' a standard that would be met "where a large entity, firm, institution, or corporation is acting in a manner that easily can be foreseen to result in harm." (158) One court even went so far as to explicitly hold that the scienter of an audit firm can be shown "through a cumulative pattern of decisions and inaction," even if no individual auditor behaves with scienter. (159)

   With this approach, courts are not concerned with the relative rank of any particular employee involved in the fraud. To the contrary, courts locate scienter not in the mind of any single actor, high-or low-level, but in the firm's overall functioning--exactly the type of "direct" organizational liability that theorists have long sought in the criminal context. (160) Critically, however, these standards are almost never applied to primary actors. They appear to be uniquely associated with secondary actors, even in situations where the primary actor also has been "acting in a manner that easily can be foreseen to result in harm." (161)

   There are two related reasons for this disparate treatment. First, when a secondary actor assists with an issuer's fraud--for example, falsely certifying an issuer's financial statements--there is a direct benefit to that actor, in the form of the fees from the issuer and the maintenance of the business relationship. Moreover, the harm caused by a secondary actor is not to its own shareholders or owners, but to the owners of the issuer, so that the secondary actor, much more than the issuer, is externalizing the cost of its business onto innocent parties. Thus, the traditional justifications for vicarious liability have more of a role to play, which, at the very least, likely makes courts less wary of looking to lower level actors when identifying organizational fault. Ironically, courts' disregard of employee rank in this context ultimately results in a more holistic view of the firm, if only because low-level employees rarely act alone; thus, courts' willingness to consider lower ranking employees when determining the scienter of a secondary-actor organizational...