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

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

Abstract

Liability under section 10(b) of the Securities Exchange Act is one of the primary mechanisms for enforcing the federal securities laws. Section 10(b), however, prohibits only intentional or reckless deception, and there has never been consensus as to how to determine whether an organization, rather than a natural person, harbors the relevant mens rea. Traditionally, organizational liability under federal law is determined according to agency principles, and most courts pay lip service to the notion that agency principles govern under section 10(b). As this Article demonstrates, they do not.

Many section 10(b) actions involve "open-market"frauds, whereby the allegedly fraudulent statements are issued publicly under the corporate imprimatur. These statements depend on agents operating at all levels of the company, who may intentionally or recklessly pass along inaccurate information through corporate reporting channels. In such circumstances, the actus reus that forms the basis of the section 10(b) violation--the false public statement--has been disaggregated from the actor who harbors mens rea. As this Article shows, courts have used this disaggregation to eschew the agency principles applied in other areas of law. Courts instead seek to impose a form of "direct" organizational liability tied to the actions and omissions of the organization's highest-level authorities. This regime is, in practical effect, strikingly similar to the regime used to determine the liability of local governments under [section] 1983, where vicarious liability has been formally rejected by the Supreme Court.

Though these two statutes would seem to have little in common, this Article argues that vicarious liability has been rejected under both regimes for similar policy reasons. Among other things, as federal corporate disclosure requirements--backed by the threat of section 10(b) liability--expand into a mechanism for substantively regulating the quality of corporate governance (a matter traditionally left to state law), courts have pushed back by limiting vicarious liability in order to distinguish "true "fraud claims from garden-variety mismanagement. Similarly, in the [section] 1983 context, the elimination of vicarious municipal liability functions, as a practical matter, to distinguish matters of federal constitutional concern from ordinary state law torts.

This Article ultimately concludes that, despite the criticisms that have been leveled at the current approaches to organizational liability under [section] 1983, [section] 1983 doctrine may in fact improve jurisprudence under section 10(b). Courts considering section 10(b) claims may borrow from jurisprudence developed under [section] 1983 to formulate objective standards of fault, in order to prevent high-level corporate authorities from insulating themselves from knowledge of wrongdoing at lower levels of the corporate hierarchy.

TABLE OF CONTENTS INTRODUCTION I. ORGANIZATIONAL LIABILITY UNDER FEDERAL LAW II. THE DIFFERENT RULES APPLICABLE TO [section] 10(B) A. Courts Resist Application of Agency Principles in Open Market Section 10(b) Cases B. The Supreme Court Affirms that Section 10(b) Is Different C. Why the Difference? 1. Many Instrumental Justifications for Vicarious Liability Do Not Apply to Section 10(b) Open-Market Claims 2. Section 10(b) Has Taken on a More Expressive Role 3. Distinguishing Poor Corporate Governance from Fraud 4. The Puzzle of Secondary Actors III. SECTION 10(B) AND DIRECT ORGANIZATIONAL LIABILITY A. Organizational Liability Under [section] B. Section 10(b) and [section] 1983: Similar Means to Similar Ends IV. MONELL AS APPLIED TO SECTION 10(B)--IMPLICATIONS AND PROBLEMS A. The Scope of the Final Authority Rule B. The Role of "Deliberate Indifference CONCLUSION INTRODUCTION

Securities fraud liability--and in particular, liability under section 10(b) of the Securities Exchange Act of 1934 (1)--is one of the primary mechanisms for enforcing the disclosure obligations imposed upon publicly traded corporations under the federal securities laws. Nonetheless, despite the long history of securities fraud litigation under section 10(b), courts have yet to announce a uniform standard for determining liability when the defendant is an organization. The sticking point is organizational mens rea: Professor Donald Langevoort recently described corporate scienter as "one of the greatly under-theorized subjects in all of securities litigation" (2)

Yet despite courts' failure to formally endorse a coherent standard for attributing mens rea to an organization, this Article demonstrates that the situation is less indeterminate than has been previously acknowledged. It turns out that when evaluating section 10(b) claims, courts increasingly seek to identify organizational "fault" in a manner that is strikingly similar to the regime that is used to determine the liability of local governments under the Civil Rights Act of 1871, 42 U.S.C. [section] 1983. Though these two statutes would seem to have little in common, and the case law under each has developed independently of the other, this Article shows that similar policy considerations have driven courts to eschew vicarious liability in both contexts, in favor of developing a form of "direct" organizational liability tied to the actions and omissions of the organization's highest-level authorities.

The story begins with the changing nature of the section 10(b) cause of action. The statute prohibits any person from engaging in manipulative or deceptive conduct in connection with securities transactions, (3) and requires proof that the defendant acted with "scienter"--either an "intent to deceive, manipulate, or defraud," (4) or reckless indifference to the "'danger of misleading buyers or sellers'" (5) Because the Exchange Act explicitly provides that organizations, as well as natural persons, can violate section 10(b), (6) courts must create rules for determining the "scienter" of an organizational defendant.

Traditionally, under federal law, mens rea is imputed to organizations via agency principles, such as respondeat superior. Because the earliest claims against organizational defendants under section 10(b) involved face-to-face frauds--corrupt brokers, for example, were common--they presented easy cases. (7) The fraudster, acting in his capacity as an employee, personally violated section 10(b), justifying strict liability for his employer. Over time, however, brokerage claims moved out of public view and into arbitration. (8) Simultaneously, courts began to entertain cases involving "open-market" frauds, whereby a publicly traded corporation is alleged to have issued false statements about the quality of its business. In such circumstances, courts would presume that the false statements affected the market price of the corporation's securities, thereby damaging investors who had traded at that price. (9) This legal theory, known as the fraud-on-the-market doctrine, left the corporation potentially liable to the entire marketplace of traders. It also radically altered the nature of the section 10(b) action with two significant consequences.

First, it allowed for disaggregation between the employee who committed the actus reus--the corporate official who issued the false statement--and the employee harboring the mens rea. This necessarily presented the question of which actors' mental states could be imputed to the corporation. Statements issued under the corporate imprimatur often have multiple anonymous authors, and include information supplied by employees scattered throughout the company. Any of these employees, or combinations of them, or business segments, may intentionally filter false information up through corporate reporting channels without the knowledge of the top officers.

Second, the extension of liability to open-market frauds exponentially expanded the number of potential plaintiffs damaged by a single fraudulent act, and the fraud-on-the-market doctrine facilitated the certification of classes of those plaintiffs, thus dramatically increasing corporations' damages exposure. With this change, the purpose of the section 10(b) was transformed. No longer is "compensation" for defrauded investors a realistic or achievable goal; (10) instead, section 10(b) actions--at least those based on open-market purchases--are now justified as a deterrent mechanism to protect the integrity of corporate communications. (11) But this justification extends section 10(b) far beyond the mere confines of fraud prevention, because corporate communications today serve broader purposes. Disclosure enhances internal corporate governance by, among other things, enforcing a duty of care on corporate managers and facilitating shareholders' ability to monitor managers' conduct. (12) Disclosure also has macroeconomic effects: Regulators make policy based on their understanding of how businesses operate; lenders extend credit based on their perception of the stability of the borrower; competitors change business strategies based on reports of their rivals; symbiotic industries make business plans based on their expectations of future dealings with customers and suppliers; employees choose where to invest their skills based on perceived demand. (13) All of these areas of economic activity depend on the accuracy and reliability of public corporate communications, yet the persons and institutions affected have few, if any, avenues for relief when those communications prove false. Thus, the securities laws--and in particular, the private section 10(b) cause of action--bear the practical responsibility of protecting these varied interests, despite the rather distant relationship between section 10(b) plaintiffs and the wide variety of persons injured by false public statements.

As a result, section 10(b) has shifted from a mechanism for making defrauded investors whole to a mechanism for representing the...