Beyond Misrepresentations: Defining Primary and Secondary Liability Under Subsections (a) and (c) of Rule 10b-5
Author | Kimberly Brame |
Pages | 935-957 |
The author would like to acknowledge Wendell Holmes for his review of this comment.
Some curs'd fraud / Of enemy hath beguil'd thee, yet unknown, / And me with thee hath ruin'd. 1
Both primary actors, like corporations, and secondary actors, such as accountants, attorneys, and bankers that service businesses, can be primarily liable for fraud under Rule 10b-5. The key determination is whether these actors are primarily or secondarily liable. Primary liability and aiding and abetting liability are not unmistakably partitioned concepts, but courts have recently blurred these grades of liability with respect to claims for employing a device, scheme, or artifice to defraud and for engaging in acts, practices, or courses of business that operate as fraud.
Since the U.S. Supreme Court's unexpected foreclosure of a defrauded investor's civil action against secondary actors in Central Bank of Denver v. First Interstate Bank of Denver,2 circuit courts have grappled with distinguishing primary liability from secondary, or aiding and abetting, liability. Until recently, plaintiffs brought the bulk of securities fraud actions under Rule 10b-5(b), which prohibits the material misrepresentation of facts relied upon by buyers and sellers of securities.3 Subsections (a) and (c), which prohibit fraudulent schemes and actions Page 936 respectively, were of little significance.4 Now, defrauded plaintiffs are making creative arguments via subsections (a) and (c) to distinguish primary from secondary liability and potentially circumvent Central Bank's prohibition of private civil actions against secondary actors.
The Supreme Court rarely grants certiorari for securities cases.
Section 10(b) and Rule 10b-5 provide no insight in defining primary and secondary liability. The provisions make it unlawful for any person to directly or indirectly: (1) "employ any device, scheme, or artifice to defraud"; (2) "make any untrue statement of a material fact or to omit to state a material fact"; or (3) "engage in any act, practice, or course of business" that operates as fraud or deceit on any person.8 The text of the provisions does not suggest a distinction in liability.
The legal background of primary and secondary liability under Section 10(b) and Rule 10b-5 begins with Central Bank. Before this Supreme Court decision, lower courts allowed private actions for aiding and abetting securities fraud.9 There was no need to distinguish between primary and secondary liability because both resulted in private, civil liability. Central Bank complicated fraud claims because it pronounced that a plain reading of Section 10(b) yielded no private cause of action for aiding and abetting fraud.10
Before Central Bank, the Supreme Court had also implicitly allowed aiding and abetting claims. For example, although the Court in Dirks v. SEC reversed the D.C. Circuit's finding that the petitioner had aided and abetted an insurance company's fraud, it did not reverse the circuit court's decision on the basis that a secondary fraud claim did not exist. Instead, Justice Powell, writing for the majority, found that Dirks "had no duty to abstain from use of the inside information that he obtained."11 The Court did not question the existence of an aiding and abetting action under Section 10(b) and Rule 10b-5 until Central Bank.
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The facts of Central Bank were mostly uncontested. After a public building authority defaulted on secured bonds, the bond purchasers sued several defendants in connection with the bonds' sale. Most importantly, the buyers sued the bank that was trustee of the bond issues and alleged that the bank was secondarily liable under Section 10(b) for aiding and abetting the other defendants' fraud.12 Using strict statutory interpretation, the Court reversed the Tenth Circuit's judgment for the buyer and held that no private action for aiding and abetting another's primary fraud existed under the statute.13 In taking its surprisingly limited view of secondary liability, the Court stated: "If, as respondents seem to say, Congress intended to impose aiding and abetting liability, we presume it would have used the words 'aid' and 'abet' in the statutory text. But it did not."14 Section 10(b) and Rule 10b-5 did not imply a right of action against secondary violators, but neither the fraud provisions themselves nor the Court defined secondary liability for misrepresentation claims.
Central Bank's proscription of secondary liability claims radically increased the importance of distinguishing primary violators from secondary violators. In eliminating private secondary actions, the Court complicated securities law and made no mention of what the divide should be between actionable primary claims and non-actionable secondary claims.15
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The circuit courts have issued divergent opinions on the meanings of primary and secondary liability. The Second and Ninth Circuits hear the most securities litigation in the federal court system but these circuits are on opposite sides of the Section 10(b) liability split. Whereas the Second Circuit adopted the bright-line test in Shapiro v. Cantor,16 the Ninth Circuit applied the substantial participation test.17 The SEC proposed an intermediate test, called the creator test, in Klein v. Boyd.18
The majority of circuits adhere to the bright-line test for secondary liability.19 This test narrows primary liability for secondary actors. Secondary actors are primarily liable under Section 10(b) if they make a misstatement, know or should know that the misstatement will be communicated to investors, and are credited with making the misstatement that is publicly disseminated before investment decisions occur.20 The Tenth Circuit has found: "The critical element separating primary from aiding and abetting violations is the existence of a representation, either by statement or omission, made by the defendant, that is relied upon by the plaintiff."21 Anything shy of directly or Page 940 indirectly making a false or misleading statement is aiding and abetting and, as such, is not actionable by private claim.22
Under the substantial participation test, primary violators do not have to make a misstatement; rather, a significant or substantial role in the misstatement is sufficient to constitute primary liability.23 For a defendant to be secondarily liable in a circuit utilizing the substantial participation test, the plaintiff must prove:
(1) the existence of an independent primary wrong, (2) actual knowledge or reckless disregard by the alleged aider and abettor of the wrong and of his or her role in furthering it, and (3) substantial assistance in the wrong. There is no requirement in the Ninth Circuit's test that the aider and abettor commit a manipulative or deceptive act or that the injured parties even rely on the substantial assistance given by the aider and abettor.24
The SEC proposed the creator test for primary liability, a test subsequently adopted by the Enron court.25 Under the creator test, an actor is a primary violator if he creates a misrepresentation and acts with the necessary intent.26 As the Enron court noted, "it would not be necessary for a person to be the initiator of a misrepresentation in order to be a primary violator."27 The SEC provided a few hypotheticals for clarity. For example, provided "a plaintiff can plead and prove scienter, a person can be a primary violator if he . . . writes misrepresentations for inclusion in a document to be given to investors, even if the idea for those misrepresentations came from someone else."28 Further, an actor: Page 941 who prepares a truthful and complete portion of a document would not be liable as a primary violator for misrepresentations in other portions of the document. Even assuming such a person knew of misrepresentations elsewhere...
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