Central Bank: the End of Secondary Liability Under Section 10(b) of the Securities Exchange Act of 1934 - Stephen H. Brown

• Publication year: 1995

CASENOTES

Central Bank: The End of Secondary Liability Under Section 10(b) of the Securities Exchange Act of 1934

In Central Bank of Denver v. First Interstate Bank of Denver,¹ petitioner served as an indentured trustee for bonds issued in 1986 and 1988 to finance public improvements at a planned residential and commercial development.² Landowner assessment lien's secured the bonds, and the covenant required the land subject to the lien be worth at least 160 percent of the bond's outstanding principal and interest.³ The land's developer was to provide petitioner an annual report indicating fulfillment of the 160 percent test.⁴ In January 1988, the developer reported to petitioner that land values remained unchanged from the 1986 appraisal.® Shortly thereafter, the senior underwriter for the 1986 bonds sent a letter to petitioner asserting that property values were declining and that petitioner was functioning on an appraisal outdated by sixteen months.⁶ In-house appraisers advised petitioner that an independent review was needed on the 1988 appraisal.⁷ At the urging of the developer, petitioner agreed to delay the reappraisal until six months after the closing of the 1988 bond issue.⁸ The Authority defaulted on the 1988 bonds prior to the completion of the reappraisal.⁹ Respondent, as purchasers of $2.1 million of the 1988 bonds, sued petitioner, among others, for violation of section 10(b) of the Securities Exchange Act of 1934.¹⁰ The complaint alleged petitioner was "secondarily liable under Sec. 10(b) for its conduct in aiding and abetting the fraud."¹¹ The district court granted summary judgment to petitioner, and the Court of Appeals for the Tenth Circuit reversed and remand-ed.¹² On appeal, the Supreme Court held that section 10(b) of the Securities Exchange Act of 1934 does not permit a private plaintiff to extend civil liability to those who only aid and abet the violation without themselves engaging in manipulative or deceptive practices.¹³

Congress passed the Securities Exchange Act of 1934 in the aftermath of the roaring 1920s and the 1929 stockmarket crash where fortunes were accumulated and lost at astounding levels.¹⁴ Much of the gain during this period was attributable to fraud, manipulation, and other highly questionable practices.¹⁵ To curb such practices, Congress passed vital legislation—the Securities Act of 1933¹⁶ ("1933 Act") and the Securities Exchange Act of 1934 ("1934 Act").¹⁷ The 1933 Act's intent was to regulate initial distributions of securities, and the purpose of the 1934 Act, ostensively, was to regulate post-distribution trading.¹⁸ The 1934 Act did not expressly provide a private section 10(b) cause of action; a section lOb-5 private liability scheme has been inferred through several important Supreme Court decisions.¹⁹ In 1966, in Brennan v. Midwestern Life Insurance Co²⁰ a federal court first adopted the concept of imposing section 10(b) liability on aiders and abettors.²¹ In

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Brennan, the principal violator of section 10(b) expended the stock purchase money and failed to deliver defendant corporation's stock valued at $2.9 million before going bankrupt.²² Plaintiff alleged defendant was aware of the violation, and defendant's failure to report aided and abetted the principal violator. As a result of the omission, defendant "knowingly and purposely encouraged an artificial build-up in the market for its stock."²³ The court stated "[a] basic philosophy of the Securities Exchange Act of 1934 is disclosure and is directed toward the creation and maintenance of a post-issuance securities market that is free from fraudulent practices."²⁴ The court's rationale was the Act, being remedial in nature, should be expanded to include aiding and abetting liability because it is "within the scope of the evils intended to be eliminated."²⁵ In the mid-1970's the Supreme Court began to confront section 10(b) and Rule lOb-5's expanding liability.²⁶ In challenging this expansion, the Court considered two main issues: the scope of conduct prohibited by section 10(b) and the elements of the 10b-5 private liability scheme once a defendant has committed a violation.²⁷ In Ernst & Ernst v. Hochfelder,²⁸ the Court attempted to define the scope of conduct under section 10(b) for which defendants could be held liable.²⁹ Respondents were customers of a brokerage firm for which petitioner's accounting firm audited the books and records.³⁰ Respondents filed suit against petitioner for failing to discover the president of the brokerage had committed securities fraud. The complaint, based on a theory of negligent nonfeasance, alleged petitioner had aided and abetted in violation of section 10(b) and Commission Rule 10b-5 by failing to conduct proper audits.³¹ The Court initially looked to the text of section 10(b) and stated "the words 'manipulative or deceptive' used in conjunction with 'device or contrivance' strongly suggest that s 10(b) was intended to proscribe knowing or intentional misconduct."³² The Commission in an amicus brief asserted "since the 'effect' upon investors of given conduct is the same regardless of whether the conduct is negligent or intentional, Congress intended to bar all such practices and not just those done knowingly or intentionally."³³ The word "manipulative" was significant to the Court's reasoning because "it is . . . virtually a term of art when used in connection with securities markets" and denotes intentional conduct.³⁴ The Court further noted the Commissioner and respondents' arguments were not supported by the legislative history or structure of the Act.³⁵ This holding, that a violation required proof of more than negligence, was a significant development in section 10(b) liability.³⁶ In Santa Fe Industries, Inc. v. Green,³⁷ the Court again narrowed the scope of section 10(b).³⁸ In Santa Fe, the issue was whether majority stockholders' breach of fiduciary duty to minority stockholders violated section 10(b) or Rule l0b-5 without a charge of lack of disclosure or misrepresentation.³⁹ Petitioner controlled ninety-five percent of the stock in a subsidiary and desired complete ownership.⁴⁰ Under Delaware Corporation Law,⁴¹ the "short-form merger" statute, petitioner was permitted, as the parent corporation owning at least ninety percent of the stock in the subsidiary, to merge with the subsidiary.⁴² The statute required approval of the merger by the parent's board of directors and cash payments for the minority stockholder's shares.⁴³ Neither consent nor advance notice to the minority stockholders was required, but the minority stockholders had to be given notice of the merger within ten days after its effective date. The statute also provided a dissatisfied stockholder the opportunity to petition the trial court for a decree ordering the surviving corporation to pay the share's fair market value as determined by a court appointed appraiser.⁴⁴ Respondent was dissatisfied with the offer of $150 per share, asserting the fair market value was at least $772 per share. This figure was based on the physical assets of the corporation shown in the statement sent to the minority shareholders by the appraiser.⁴⁵ Respondent bypassed the Court of Chancery, filing a complaint in district court alleging a Rule lOb-5 violation.⁴⁶ According to the Supreme Court, a claim of fraud and fiduciary breach violates Rule 10b-5 "only if the conduct alleged can be fairly viewed as 'manipulative or deceptive' within the meaning of the statute."⁴⁷ The conduct was characterized as "corporate mismanagement", and the Court found that Congress would not have used the words manipulative or deceptive in section 10(b) to include the petitioner's acts⁴⁸ Thus, in further defining the scope of conduct prohibited under section 10(b), the Court held that a breach of fiduciary duty by a majority stockholder does not violate section 10(b) without deception, misrepresentation, or nondisclosure.⁴⁹ A third prominent case in which the Court narrowed the coverage of section 10(b) was Chiarella v. United States.⁵⁰ The issue in Chiarella was whether section 10(b) is violated when a person trades securities without disclosing nonpublic information.⁵¹ Petitioner was a financial printer hired to print corporate takeover bids.⁵² Having deciphered the names of the target companies, petitioner purchased stock in those companies, selling them after the takeover bids were public.⁵³ Petitioner was convicted of violating section 10(b) for not disclosing the information obtained as a result of his position. The question on appeal became whether petitioner had a duty to disclose his information or refrain from trading the securities.⁵⁴ The Court looked to Cady, Roberts & Co.,⁵⁵ where the Commission decided that corporate insiders could not trade shares in their own corporation unless disclosing all material inside information known.⁵⁶ The Court's reasoning was "one who fails to disclose material information prior to the consummation of a transaction commits fraud only when he is under a duty to do so."⁵⁷ In order for a duty to arise, there must be some special relationship between the two parties.⁵⁸ As a low level employee of another entity, petitioner was not a corporate insider and received no confidential information from the target company.⁵⁹ In reversing the conviction, the Court held section 10(b) was not violated by petitioner's silence

[ because there was no duty to disclose.⁶⁰ Clearly, based on these earlier decisions, the Court was poised to take on the issue of section 10(b) aiding and abetting liability, further limiting the scope of this "catchall" section.

In the instant case, the Court granted certiorari to resolve confusion over the scope of section 10(b) aiding and abetting liability.⁶¹ The Court embarked on the interpretation of section 10(b) by prominently noting the text of the statute would control the decision⁶² Respondent argued that even though not expressly mentioned, the phrase "'directly or...