Puja Vadodaria, for Never Was There a Story of More Woe, Than This of the Defrauded Plaintiff and Her Insolvent Primary Actor: Why Scheme Liability Should Run to Gatekeepers After Stoneridge

• Jurisdiction: United States,Federal
• Publication year: 2009
• Citation: Vol. 58 No. 6

COMMENTS

FOR NEVER WAS THERE A STORY OF MORE WOE, THAN THIS OF THE DEFRAUDED PLAINTIFF AND HER INSOLVENT PRIMARY ACTOR: WHY SCHEME LIABILITY SHOULD RUN TO GATEKEEPERS AFTER STONERIDGE¹

INTRODUCTION

After Enron Corporation's financial scandals,²institutional investors, the U.S. Securities and Exchange Commission (SEC), and Congress scrutinized federal securities laws designed to protect against the abusive acts of public companies.³Those laws attempt to deter fraudulent transactions to boost the market participation of investors.⁴Although the Supreme Court has found an implied private cause of action against perpetrators of corporate fraud,⁵federal statutes have not defined precisely the scope of remedies available to aggrieved investors.⁶

State common law and federal law both hold issuing companies liable to their investors for intentionally misleading investors regarding material information.⁷But, for many investors, litigation is futile against the company, which is the primary actor,⁸because the allegedly fraudulent company is bankrupt.⁹For example, "Enron's bankruptcy, the collapse of its accountants, limited insurance, and government seizure of key insiders' assets" limited investors to nominal recoveries under federal securities legislation.¹⁰

Because gatekeepers-including accounting firms, investment banks, and law firms-assist the stock issuer in verifying financials and distributing disclosures,¹¹their participation is often necessary to execute the fraud.¹²

Therefore, in the past, when the primary actor is bankrupt, investors have looked to these secondary actors, who engaged in the fraudulent transactions, to recoup losses.¹³After Enron's demise, its investors pursued private action claims to recover damages against the large banks involved in the fraud.¹⁴

Unfortunately for the plaintiffs, the difficulty in raising such claims is that they can only allege a securities fraud violation if the secondary actor's conduct amounts to more than just "aiding and abetting" the primary actor's fraudulent acts.¹⁵

A primary actor can be primarily liable for its material fraudulent actions. For example, when company X knowingly releases a fraudulent material statement to the market, X can be primarily liable to its investors. For secondary actors, however, the federal circuit courts have split¹⁶over different theories to determine when its conduct amounts to primary liability for violations of federal securities law.¹⁷The Tenth Circuit and Eighth Circuit adopted a "bright-line" test,¹⁸requiring the plaintiff to prove he or she relied on the defendant's deceptive statement.¹⁹The Ninth Circuit, on the other hand, focused on the text of Rules 10b-5(a) and (c) for its "scheme liability" test.²⁰

This test requires plaintiffs to show that the defendant, or secondary actor, was intricately involved in a fraudulent scheme and undertook "conduct that had the principal purpose and effect" of furthering a fraudulent scheme.²¹

The Supreme Court attempted to resolve these divergent theories in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc.²²Its opinion established that implied private cause of action does not extend to secondary actors for knowingly participating in the execution of a fraudulent scheme.²³

The Court held that the implied private right does not exist against supplier companies of the primary actor unless the plaintiffs can prove that they relied on the secondary actor's material fraudulent actions, statements, or omissions.²⁴

By denying plaintiffs a private cause of action in this case, the Supreme Court continued its tendency to limit the expansion of securities fraud liability.²⁵After a trend of liberally interpreting the reach of Sec. 10(b) of the Securities Exchange Act of 1934²⁶(1934 Act) to protect investors,²⁷the Supreme Court, began to curb the scope of private action to control "vexatious litigation."²⁸The Supreme Court limited investors' class action suits against secondary actors when it disallowed private action against "aiders and abettors" of securities fraud.²⁹Now, based on the holding in Stoneridge, the Court has also prevented investors from applying scheme liability against certain secondary actors.³⁰

Denying plaintiffs the ability to recover from secondary actors decreases investors' confidence about the integrity of the market.³¹This Comment argues that federal courts should limit the holding of Stoneridge to apply only to secondary actors not traditionally regarded as gatekeepers or corporate advisors in order to preserve a private right of action for investors against these culpable actors.³²

In Stoneridge, which considered whether primary liability exists against business partners, the Court expressed concerns about the remoteness of the secondary actor's actions to the proscribed fraud.³³The Court even alluded to a different outcome had the actor been in the "investment sphere" instead of the "realm of ordinary business operations."³⁴Therefore, courts should limit the application of this precedent and allow investors to raise private claims against gatekeepers, a specified category of secondary actors existing within the financial markets.

Part I of this Comment briefly discusses the origins and elements of the SEC's Rule 10b-5 to provide a contextual framework for approaching the Supreme Court's decision in Stoneridge and related cases. Part II analyzes the case law relating to the implied right of private action under Sec. 10(b) of the

1934 Act. This Part contends that the judiciary has leaned toward narrowing the scope of liability afforded to investors to collect damages.

Part III postulates that the best solution is for courts not to apply the Stoneridge decision to select gatekeepers. This contention is supported by the majority's decision in Stoneridge and evidence that the courts have already imposed a duty on select entities within the financial markets to disclose material misstatements and culpable acts to investors. Finally, Part IV evaluates the policy considerations of extending liability to gatekeepers under a theory of "scheme liability." This Part concludes that by limiting the application of the Stoneridge decision, the judiciary can better balance the congressional goals of deterring fraud and "frivolous lawsuits."³⁵By reducing both fraud and litigation, investors benefit.

I. THE ELEMENTS AND ORIGINS OF Sec. 10(B) AND RULE 10B-5

Section 10(b) and Rule 10b-5 have been essential in protecting the integrity of the securities market in the United States for more than fifty years.³⁶In

1942, the SEC, under the auspices of Sec. 10(b) of the 1934 Act, adopted Rule

10b-5.³⁷Congress authorized the SEC to adopt regulations specifying and enforcing the provisions of Sec. 10(b) to reduce corporate fraud and increase participation in the capital markets.³⁸By giving authority to the SEC,

Congress delegated not only its role in reforming securities laws, but also any blame arising from the reforms.³⁹

Although Sec. 10(b) does not restrict a company from any particular act, it does authorize the SEC to define illegal activities.⁴⁰Rule 10b-5 identifies the duties and obligations of participants in a securities transaction.⁴¹The SEC intends Rule 10b-5 to prevent companies from misleading investors.⁴²

In their interpretation of this rule, courts have instituted several procedural and substantive barriers that plaintiffs must satisfy to establish a prima facie case.⁴³To proceed to trial under a Rule 10b-5 claim, a plaintiff must show (1) scienter or a wrongful state of mind,⁴⁴(2) that reliance on the violator's actions caused the damages,⁴⁵(3) material misstatements or omissions (where a duty to disclose exists),⁴⁶(4) economic loss,⁴⁷(5) loss causation,⁴⁸and (6) a connection with the purchase or sale of any security.⁴⁹These elements of proof attempt to restrict the allegations of fraud that get heard in court. As commentators have noted, because the plaintiff's substantial burden of proof is coupled with conservative, corporate-friendly judges presiding over cases, securities lawsuits are overwhelmingly decided against shareholders before they even reach trial.⁵⁰

II. IDENTIFYING THE BOUNDARIES OF THE IMPLIED RIGHT OF PRIVATE ACTION

UNDER SECTION 10(B)

Under Sec. 10(b) and Rule 10b-5, no explicit private right of action exists for aggrieved parties.⁵¹During a period of liberal interpretation of Sec. 10(b), the Supreme Court, based on the 1946 federal district court decision Kardon v. National Gypsum Co.,⁵²held that general principles of law implied that a private right of action exists for claims raised under Sec. 10(b) of the 1934 Act.⁵³

The Court acknowledged a duty to create private remedies to protect investors against fraud.⁵⁴However, the Court eventually recognized that its attempt to protect investors against fraud had plagued businesses with "strike suits"- suits without merit-that attempt to draw out settlement payments from corporations.⁵⁵Thus, the Court recognized the need to define the boundaries of this private cause of action.⁵⁶

A. Broadening the Scope of Private Action: Facilitating the Path to Class

Action

In the 1960s, the Supreme Court defined the scope of private remedies available under securities law to protect investors against the abuses of corporate fraud.⁵⁷Congress created securities law to protect investors,⁵⁸but the government's limited resources could not adequately pursue all wrongdoers.⁵⁹Therefore, the Court, in J.I. Case v. Borak, broadly afforded investors a private right of action for suits "brought to enforce any liability or duty created" by the 1934 Act.⁶⁰The Court rationalized that because it had a duty to offer any remedies necessary to effectuate that purpose of the 1934

Act, it logically followed under general principles of law that Congress intended for the courts to establish a private cause of action to facilitate the legislative campaign against fraud.⁶¹

But, without the ability to raise a class action lawsuit, plaintiffs had...