Corporate law - primary-violator liability under 10(b) applies to outside business partners in suits brought by shareholders - Simpson v. AOL Time Warner, Inc.

• Author: Gentile, Donald

Corporate Law--Primary-Violator Liability Under 10(b) Applies to Outside Business Partners in Suits Brought by Shareholders--Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th Cir. 2006)

Section 10(b) of the Securities Exchange Act of 1934 makes it illegal for a person "to use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device...." (1) In 1994, the Supreme Court held that a secondary party is only civilly liable under section 10(b) if the party is a primary violator and not merely an aider and abettor. (2) In Simpson v. AOL Time Warner, Inc., (3) the Ninth Circuit Court of Appeals considered whether an outside business associate can be liable as a primary violator under section 10(b) as interpreted in Central Bank. (4) The Ninth Circuit concluded that an outside business associate can be liable as a primary violator if all the elements of section 10(b) are fulfilled. (5)

Plaintiff shareholders of Homestore.com (Homestore), through lead plaintiff California State Teachers' Retirement System (Teachers), brought a putative class action lawsuit against the company and twenty-seven other defendants alleging securities fraud under section 10(b). (6) Teachers claimed, among other things, that defendants AOL Time Warner, Inc., Cendant Corporation, Richard Smith, L90, David Colburn, and Eric Keller (Outside Actors) engaged in fraudulent business transactions with Homestore by enabling the company to illegally inflate revenues. (7) As a result of the scheme, Teachers claimed financial loss due to a decrease in stock value. (8)

Relying on Central Bank, the district court granted the Outside Actors' motions to dismiss, concluding that outside business partners could never be primary violators under section 10(b). (9) Teachers appealed to the Ninth Circuit Court of Appeals seeking to reverse the district court's dismissal of the Outside Actors' motions. (10) By reasoning that any person or entity is able to fulfill all of the section 10(b) elements, the Ninth Circuit held that outside business partners can be primary violators. (11) The Ninth Circuit thus affirmed the district court's decision and granted Teachers the chance to seek leave in order to take advantage of the appellate ruling. (12)

Prior to Central Bank, a private party could bring a cause of action against an actor who aided and abetted securities fraud under section 10(b). (13) In Central Bank, the Supreme Court held that a private party could not bring a civil action for aiding and abetting because such an action does not comport with the reliance element of section 10(b). (14) The Supreme Court, however, ruled that secondary actors can still be liable as primary violators, although it did not offer an adequate primary-liability test for lower courts to apply. (15) After Central Bank, lower courts initially developed two distinct tests for secondary-actor primary liability: the bright-line test and the substantial participation test. (16) The bright-line test, which the Eleventh and Second Circuits used, imposed primary liability when a secondary actor made a misstatement that was disseminated to the public. (17) The Ninth Circuit's more liberal substantial participation test required that a secondary actor be closely involved in the creation of a misstatement. (18) Recently, in response to Enron and other corporate scandals, the scheme test has emerged as the most liberal test. (19) The scheme test comes closest to imposing primary liability for what the Central Bank Court defined as "aiding and abetting." (20)

Under the scheme test, courts differ on who or what constitutes a primary violator. (21) The United States District Court for the District of Massachusetts has twice denied dismissal to secondary actors who financed sham businesses and formed false agreements to effectuate securities fraud. (22) The District Court for the Southern District of New York (S.D. New York) found banks that "substantially assisted fraud with culpable knowledge" were not liable, while ruling that auditors who designed a fraudulent accounting scheme were primary violators. (23) The Eighth Circuit did not find primary-violator liability when a corporation transacted with a business that used the deal to make misstatements to its shareholders. (24) The Eighth Circuit instead requires that secondary actors must make a misstatement or be closely tied to the accounting fraud in order to assume primary liability. (25)

In Simpson v. AOL Time Warner, Inc., the Ninth Circuit Court of Appeals considered whether primary-violator liability under section 10(b) extends to outside business partners. (26) Restating its prior rationale, and that of the Massachusetts District Court, the Ninth Circuit split with the Eighth Circuit and flatly rejected the notion that Central Bank prohibits liability for indirect acts of fraud. (27) Consequently, the court applied the scheme test. (28) In defining primary liability under section 10(b), the court stated that the pertinent question is "what conduct constitutes a manipulative or deceptive act in the furtherance of a scheme to defraud ...?" (29) Relying on precedent from S.D. New York, the Massachusetts District Court, and the United States District Court for the Southern District of Texas (S.D. Texas), the Ninth Circuit reasoned that primary liability does not extend to outside business partners conducting "legitimate" business deals. (30) The Ninth Circuit defined routine business transactions as legitimate even where an outside partner knows or intends that another will use the deal to commit fraud. (31)

The Ninth Circuit did, however, categorically overrule the California district court's decision that outside business partners are immune from primary-violator liability under section 10(b). (32) Citing Central Bank, the Ninth Circuit reasoned that outside business associates, including inside actors such as lawyers, accountants, and bankers, are capable of satisfying all the elements of section 10(b). (33) The court, however, reasoned that the defendants in Simpson were not primary violators under section 10(b) because they only engaged in legitimate...