Friday, May 21, 2010

Second Circuit Addresses Attribution Requirement under Rule 10b-5

On April 27, 2010, the Second Circuit Court of Appeals issued a decision in Pacific Investment Management Company LLC v. Mayer Brown LLP regarding whether a corporation’s outside counsel can be liable for false statements that attorneys allegedly create, but which are not attributed to the law firm or its attorneys at the time the statements are disseminated.

The court held that a secondary actor can be held liable in a private damages action brought pursuant to Rule 10b-5(b) only for false statements attributed to the secondary-actor defendant at the time of dissemination. Absent attribution, a plaintiff cannot show that he or she relied on the secondary actor’s own false statements, and participation in the creation of those statements amounts, at most, to aiding and abetting securities fraud.

The underlying case arose from the 2005 collapse of Refco, Inc., which was once one of the world’s largest providers of brokerage and clearing services in the international derivatives, currency, and futures markets. According to plaintiffs, Mayer Brown LLP served as Refco’s primary outside counsel from 1994 until the company’s collapse. Joseph Collins, a partner at Mayer Brown, was the firm’s primary contact with Refco and the billing partner in charge of the Refco account.

The plaintiffs alleged that Refco transferred its uncollectible debts to Refco Group Holdings, Inc. (“RGHI”)—an entity controlled by Refco’s Chief Executive Officer—in exchange for a receivable purportedly owed from RGHI to Refco. Recognizing that a large debt owed to it by a related entity would arouse suspicion with investors and regulators, Refco, allegedly with the help of outside counsel, engaged in a series of sham loan transactions at the end of each quarter and each fiscal year to pay off the RGHI receivable.

Plaintiffs alleged that Mayer Brown and Collins (collectively “Defendants”) participated in seventeen of these sham loan transactions between 2000 and 2005, representing both Refco and RGHI. Plaintiffs also alleged that Defendants were responsible for false statements appearing in three Refco documents: (1) an Offering Memorandum for an unregistered bond offering in July 2004 (“Offering Memorandum”), (2) a Registration Statement for a subsequent registered bond offering (“Registration Statement”), and (3) a Registration Statement for Refco’s initial public offering of common stock in August 2005 (“IPO Registration Statement”).

Plaintiffs alleged that each of these documents contained false or misleading statements because they failed to disclose the true nature of Refco’s financial condition, which had been concealed, in part, through the loan transactions described above. Plaintiffs alleged that Collins and other Mayer Brown attorneys reviewed and revised portions of the Offering Memorandum and attended drafting sessions. Plaintiffs alleged that Collins and another Mayer Brown attorney also personally drafted the Management Discussion & Analysis (“MD&A”) portion of the Offering Memorandum, which, according to plaintiffs, discussed Refco’s business and financial condition in a way that Defendants knew to be false. The Offering Memorandum was used as the foundation for the Registration Statement, which was substantially similar in content. According to plaintiffs, Defendants further assisted in the preparation of the Registration Statement by reviewing comment letters from the SEC and participating in drafting sessions. Finally, plaintiffs alleged that Defendants were directly involved in reviewing and drafting the IPO Registration Statement because they received, and presumably reviewed, the SEC’s comments on that filing. However, none of the documents specifically attributed any of the information contained therein to Mayer Brown or Collins.

Plaintiffs, who purchased securities from Refco during the period that Defendants were allegedly engaging in fraud, commenced the lawsuit after Refco declared bankruptcy in 2005. They asserted claims for violation of § 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, along with claims for “control person” liability under § 20(a) of the Exchange Act, 15 U.S.C. § 78t(a). The District Court dismissed plaintiffs’ claims against Mayer Brown and Collins pursuant to Fed. R. Civ. P. 12(b)(6).

On appeal, there were two primary issues regarding the scope of Rule 10b-5 liability in private actions: (1) whether defendants could be liable under Rule 10b-5(b) for false statements that they allegedly drafted, but which were not attributable to them at the time the statements were disseminated; and (2) whether the allegations in the complaint were sufficient to state a claim for “scheme liability” under Rule 10b-5(a) and (c).

Plaintiffs asserted that the district court erred in holding that attorneys who participate in the drafting of false statements could not be liable in a private damages action if the statements are not attributed to those attorneys at the time of dissemination. They (along with the SEC as amicus curiae) urged the court to adopt a “creator standard” and hold that a defendant can be liable for creating a false statement that investors rely on, regardless of whether that statement is attributed to the defendant at the time of dissemination. Defendants responded that, under Second Circuit precedents, attorneys who participate in the drafting of false statements cannot be liable absent explicit attribution at the time of dissemination.

The court of appeals noted that the Supreme Court in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) had acknowledged that “secondary actors” could, in some circumstances, still be liable for fraudulent conduct. Specifically, the Court explained that “[a]ny person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5, assuming all of the requirements for primary liability under Rule 10b-5 are met. In any complex securities fraud, moreover, there are likely to be multiple violators . . . .” Id. at 191 (citation omitted).

Moreover, in Wright v. Ernst & Young LLP, 152 F.3d 169, 171 (2nd Cir. 1998), the court noted that claims were made against the accounting firm Ernst & Young for orally approving a corporation’s false and misleading financial statements, which were subsequently disseminated to the public. In that case, the Second Circuit explained that, after Central Bank, courts had generally adopted either a “bright line” test or a “substantial participation” test to distinguish between primary violations of Rule 10b-5 and aiding and abetting. Because the misrepresentations on which plaintiffs’ claims were based in Wright were not attributed to Ernst & Young, the court held that the complaint failed to state a claim under Rule 10b-5. Id. at 175.

The court acknowledged that subsequent decisions in the Second Circuit may have created uncertainty with respect to when attribution is required. Notwithstanding this uncertainty, the court noted that it had recently confirmed the importance of attribution for claims against secondary actors. In 2007, in Lattanzio v. Deloitte & Touche, 476 F.3d 147, 151-52 (2nd Cir. 2007), the court considered claims that the accounting firm Deloitte & Touche had, inter alia, reviewed and approved false or misleading quarterly statements issued by a public company. There the court held that “to state a § 10b claim against an issuer’s accountant, a plaintiff must allege a misstatement that is attributed to the accountant ‘at the time of its dissemination,’ and cannot rely on the accountant’s alleged assistance in the drafting or compilation of a filing.” Id. at 153.

The court found that, based on precedent, secondary actors can be liable in a private action under Rule 10b-5 for only those statements that are explicitly attributed to them. The mere identification of a secondary actor as being involved in a transaction, or the public’s understanding that a secondary actor “is at work behind the scenes” are alone insufficient. The court found that an attribution requirement makes clear—to secondary actors and investors alike—that those who sign or otherwise allow a statement to be attributed to them expose themselves to liability. Those who do not are beyond the reach of Rule 10b-5’s private right of action. A creator standard (urged by the plaintiffs and the SEC) establishes no clear boundary between primary violators and aiders and abettors, and it is uncertain what level of involvement might expose an individual to liability.

Applying the attribution standard to the alleged false and misleading statements in the case before it, the court concluded that the district court properly dismissed plaintiffs’ Rule 10b-5(b) claims against Mayer Brown and Collins. No statements in the Offering Memorandum, the Registration Statement, or the IPO Registration Statement were attributed to Collins, and he was not even mentioned by name in any of those documents. Accordingly, plaintiffs could not show reliance on any of Collins’ statements.

The district court also dismissed plaintiffs’ Rule 10b-5(a) and (c) claims on the ground that the Supreme Court’s decision in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148 (2008) foreclosed plaintiffs’ theory of “scheme liability.” In Stoneridge, plaintiffs sought to hold two companies liable for their participation in sham transactions that allowed an issuer of securities to overstate its revenue. 552 U.S. at 153-55. Although the defendants’ conduct was deceptive and enabled the issuer to conceal the misrepresentations in its financial statements, the Supreme Court found that the essential element of reliance was absent. Id. at 159. Mayer Brown and Collins were alleged to have facilitated sham transactions that enabled Refco to conceal the true state of its financial condition from investors. However, as in Stoneridge, the plaintiffs were not aware of those transactions and, in fact, plaintiffs explicitly disclaimed any knowledge of defendants’ involvement.

The court found that it was clear from the Supreme Court’s holding in Stoneridge that although the ultimate result of the deceptive conduct of secondary actors such as the Defendants may be misleading communication to the public through a company’s financial statements, this alone is insufficient to show reliance on the secondary actor’s own deceptive conduct. Therefore, the court agreed with the district court that plaintiffs’ Rule 10b-5(a) and (c) claims for “scheme liability” were foreclosed by the Supreme Court’s decision in Stoneridge.

A full copy of the Second Circuit Court of Appeals’ decision can be found here.

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