Fear can be a great motivator. While US regulators increase their vigilance in a bid to prevent future scandals on the Enron model, an even greater fear of the courts is leading banks and securities lawyers to change the way they work.
After a decade of court decisions that seemed to limit the liability of outside advisers in securities fraud lawsuits brought by private plaintiffs, recent decisions have raised the spectre of class action lawsuits once again. More than new regulations and the attorney reporting rules discussed by the US Congress in February, fear of litigation is driving better diligence.
“Everybody is watching their backs very carefully,” says Thomas Morgan of George Washington University Law School in Washington. At a conference last month, Richard Walker, general counsel for Deutsche Bank Securities, said that there has been “quite a raising of the bar” in terms of liability.
Both in-house counsel at investment banks and private practice lawyers insist that they can increase scrutiny of the deals they work on and are doing so – particularly in structured finance. “What we’re being asked to do is very do-able,” says Steven Berkenfeld, a Lehman Brothers managing director.
Primary responsibility
Private litigation has traditionally been an important means of punishing lawyers implicated in corporate malpractice. Until relatively recently, the courts agreed that outside advisers to a party that committed securities fraud could also be held liable for the fraud, if those advisers were shown to have aided and abetted the party committing it. Litigation arising from the savings and loans scandals of the 1980s, for example, put several law firms on the wrong end of multi-million dollar lawsuits.
This changed in 1994 with the Supreme Court’s ruling in Central Bank of Denver v First Interstate Bank of Denver. The court argued that, while the SEC could bring an action for aiding and abetting a securities fraud, neither the Securities Act of 1933 nor the Securities Exchange Act of 1934 gave grounds for private plaintiffs to do so. Private plaintiffs, the court held, could bring suits only against parties that were found to be directly and primarily responsible for fraud.
Supporters of the Central Bank decision say it rightly means that outside advisers can rarely be held liable in a private securities fraud action. Lawyers and bankers, they say, only have access to limited information about issuers, and can be excluded from the corporate decision-making process.
Supporters also argue that Central Bank deters frivolous class actions.
In the past three years, however, there has been a storm of financial scandals and judicial actions that have thrown liability standards into doubt. Most dramatically, a ruling in the Enron litigation in December 2002 challenged Central Bank by allowing the plaintiff to sue some of Enron’s auditing, legal and investment banking advisers, as well as the company.
At the same time, while Central Bank allows for suits against parties with primary responsibility for a securities fraud, it did not set out any clear test for determining when this was the case.
The Ninth Circuit of the federal appeal court has adopted a substantial participation test, under which primary liability exists where a secondary actor is substantially involved in misrepresentations made by others. This test, set in Software Toolworks, circumvents Central Bank by essentially using the traditional standard for aiding and abetting.
In contrast, the Second and Tenth Circuits have used a tougher so-called bright line test that more closely follows Central Bank. This holds that primary liability can be imposed only where a secondary actor itself makes a material misrepresentation, such as in a securities offering prospectus.
In the Enron case, judge Melinda Harmon seems to have created a third test. This holds that a secondary party should be considered a primary violator if it knowingly creates a misrepresentation on which investors relied, even if the idea for those misrepresentations came from someone else.
Uncertainty
Corporate defence lawyers say the Enron ruling puts an unfair burden on investment banks and lawyers. They argue that advising on deals gives them only a restricted view of a company’s activities. The deal itself may be legitimate, they say, even if it helps the company commit fraud on a wider level.
Lawyers say that they should not be held liable where they are just one of several firms advising on a deal. Each firm, they argue, sees just a small part of the picture and is not equipped to judge accounting issues.
George Cohen, a law professor at the University of Virginia, disagrees. Acknowledging that counsel are sometimes legitimately unaware of wrongdoing by their clients, he says that lawyers “should not forget that a lot of these deals cannot be done without active lawyer involvement”. This is particularly true in structured finance, he points out.
The long-term effects of the Enron ruling remain to be seen. It could be appealed, and the circuits disagree on whether to follow its example. In Homestore.com, for example, the court supported Central Bank, ruling that secondary parties could not be held responsible for advising on transactions that were not in themselves fraudulent, but which were misrepresented in the company’s financial disclosures.
Uncertainty is never welcome, but with no legislation on the agenda, questions over liability will continue. This confusion will help maintain pressure on banks and lawyers to ensure that their clients stay inside the law.
Ben Maiden is the US editor of International Financial Law Review. bmaiden@iinvestor.net
