In private actions for securities fraud under Section 10(b), can corporate officers, outside lawyers, accountants and other individuals or companies be vicariously liable for fraudulent misrepresentations made by others?
After the Supreme Court threw out liability for aiding and abetting violations of Section 10(b) in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), many thought the answer was no. Outside of actions by the SEC (which can still bring actions for aiding and abetting), the only exception would be vicarious liability for those who "controlled" a primary violator of Section 10(b), and Section 20(a) provides a good faith defense against such "controlling person" claims. But recent cases show that courts differ on the effect of Central Bank.
The disagreements in this area are highlighted by two recent cases raising claims that in the past might have been characterized as aiding and abetting. In one, Converse, Inc. v. Norwood Venture Corp., 1997 WL 742534 (S.D.N.Y. 1997), the court dismissed claims against corporate officers and others alleged to have acted as agents who prepared and disseminated materially false financial information for a primary violator of Section 10(b), holding that claims based on agency as well as all other forms of secondary liability were barred by Central Bank.
In the other case, however, a unanimous panel of the Court of Appeals for the Third Circuit reversed a district court for dismissing claims against a law firm involved in preparing misleading disclosure documents for its client, and then less than a month later a majority of the judges on the full Court of Appeals voted to rehear the case and vacate the panel's opinion. The vacated opinion Klein v. Boyd, 1998 U.S. App. LEXIS 2004 (3d Cir.), vacated, rehearing granted, 1998 U.S. App. LEXIS 4121 (3d Cir. 1998) reviewed the leading cases applying Central Bank and concluded that if "secondary" actors participate in the creation of the misrepresentation to such a degree that they can fairly be characterized as its authors or co-authors, then they may face primary liability under Section 10(b) for those misrepresentations. The decision to rehear the case threw the panel's conclusion into doubt. After the 3rd Circuit granted rehearing, the parties settled the matter, leaving substantial uncertainty as to the issues in the future.
Disagreement in this area is not unique to the Third Circuit. Different courts use different tests to separate primary and secondary liability, and they do not agree on how to handle 10(b) claims based or agency or respondeat superior theories. Here's a landscape of recent vicarious liability decisions under Section 10(b):
Conspiracy Liability is Out, Except That . . .
"[E]very court addressing the viability of a conspiracy cause of action under § 10(b) and Rule 10b-5 in the wake of Central Bank has agreed that Central Bank precludes such a cause of action," said the Second Circuit Court of Appeals in late January, 1998, in Dinsmore v. Squadron, Ellenoff, Plesent, Sheinfeld & Sorkin, 135 F.3d 837 (2d Cir. 1998). The district court had allowed a conspiracy claim despite Central Bank, on the theory that the aiding and abetting conduct at issue in Central Bank was "reckless," while conspiracy claims require "knowing and willful" conduct. The Court of Appeals reversed, preserving the universal bar on conspiracy claims.
At the same time, however, Dinsmore emphasized that "secondary actors who conspire to commit such violations will still be subject to liability so long as they independently satisfy the requirements for primary liability." That a "secondary" actor may face liability for a "primary" violation of Rule 10b-5 was explained in Central Bank, and the Second Circuit's caution in Dinsmore is consistent with similar statements in other courts. This leaves the liability door open.
Klein's Test for Primary Liability by a Secondary Actor is Now in Limbo
The Klein plaintiffs alleged that one of the defendants, a law firm, knew that its client had not disclosed to investors certain material information about a principal's past record of securities violations, regulatory sanctions and customer complaints, and that the law firm helped prepare disclosures that fell short of correcting its client's misleading omissions.
On a motion for summary judgment, the district court concluded that under Central Bank the lawyers could not be liable because they never signed the disclosure documents and the investors were unaware of the lawyers' involvement in the preparation of the disclosure documents.
The Court of Appeals panel reversed, concluding that "secondary actors who significantly participate in the creation of their client's misrepresentations, to such a degree that they may fairly be deemed authors or co-authors of those misrepresentations, should be held accountable as primary violators under section 10(b) and Rule 10b-5," whether or not the misled investors knew of that participation.
That particular way of describing the line between primary and secondary liability has no official force after March 9, 1998, when the full Court vacated the panel's opinion. The panel's three judges thought their opinion was a fair extension of what other decisions had held. However, because the parties settled we will never know what the Third Circuit would have eventually decided. In doubt, that some judges in other circuits are likely to have views similar to those of the Klein panel.
The Sixth Circuit Court of Appeals sitting en banc reversed a grant of summary judgment in favor of a law firm accused of securities fraud in connection with the plaintiffs' purchase of securities sold by the law firm's client. Rubin v. Schottenstein, Zox & Dunn, et al., 1998 U.S. App. LEXIS 9004.
In Rubin, the lawyer had direct contact with the plaintiffs and allegedly made misrepresentations about the company in which the plaintiffs were investing. In remanding the case for trial, however, the court characterized the issue more broadly by focusing on cases decided before Central Bank which held that "[a]n accountant or lawyer, for instance, who prepares a dishonest statement is a primary participant in a violation even though someone else may conduct the personal negotiations with a security purchaser."
The Sixth Circuit did not discuss Central Bank although it did make a passing reference to the vacated Klein decision, characterizing that case as one similar to Rubin where a lawyer "elected to speak to potential investors but did not disclose certain facts material to the investment."
The Range of Judicial Tests for Drawing the Line around Primary Liability
One of the cases relied upon by Klein was the decision by the Ninth Circuit Court of Appeals in In re Software Toolworks Inc. Securities Litigation, 50 F.3d 615 (9th Cir. 1994, amended 1995), cert. denied sub nom. Montgomery Securities v. Dannenberg, 516 U.S. 907 (1995), in which the plaintiffs alleged that accountants had violated Section 10(b) by participating in the drafting of two letters sent by their client to the SEC.
While the first letter specifically referred to the accountants, the Software Toolworks panel concluded that the second letter, which was not attributed to the accountants, could also support liability, and held that primary liability could attach to those who "played a significant role in drafting and editing" the second letter. A similar standard is also found in In re ZZZZ Best Securities Litigation, 864 F. Supp. 960 (C.D. Cal. 1994), which held that if a secondary actor "actively participates" in the creation of a materially misleading statement issued by a "primary actor," then the secondary actor has committed a primary violation of Section 10(b).
Many see the Ninth Circuit's standard for primary liability as more liberal than the test used by the Tenth Circuit in Anixter v. Home-Stake Prod. Co., 77 F.3d 1215 (10th Cir. 1996), which held that the "critical element separating primary from aiding and abetting violations is the existence of a representation, either by statement or omission, made by the defendant, that is relied upon by the plaintiff." Anixter held that although there is "no requirement that the alleged violator directly communicate misrepresentations to plaintiffs for primary liability to attach," secondary actors face primary liability only if they "themselves make a false or misleading statement (or omission) that they know or should know will reach potential investors." Anixter rejected interpretations of the Software Toolworks and ZZZZ Best standard that would hold a secondary actor liable without requiring that that actor actually make a representation.
To complicate matters, some decisions in Second Circuit courts appear to go even further than the vacated Klein decision. In SEC v. First Jersey Securities, 101 F.3d 1450 (2d Cir. 1996), the Court of Appeals for the Second Circuit reiterated that primary liability may be imposed "'not only on persons who made fraudulent misrepresentations but also on those who had knowledge of the fraud and assisted in its perpetration.'" Relying on First Jersey Securities, a district court, in In re Health Management, Inc. Securities Litigation, 970 F. Supp. 192 (S.D.N.Y. 1997), refused to dismiss claims against certain defendants even though the complaint did not allege that those defendants "made any fraudulent statements during the Class Period."
How different is this from what plaintiffs and courts once called "aiding and abetting?" There is a danger that standards for primary liability based on "substantial participation" merely reintroduce the old aiding and abetting test of "substantial assistance," which is what a district court in Michigan decided in Picard Chemical Inc. Profit Sharing Plan v. Perrigo Co., 940 F. Supp. 1101 (W.D. Mich. 1996). Picard questions whether In re Software Toolworks and In re ZZZZ Best are consistent with Central Bank. Picard introduced another wrinkle, however, when the court refused to dismiss claims against certain defendants because the complaint alleged that they "controlled the content" of materially misleading statements made by others and were the "original source" of such statements. The court reasoned that under such circumstances the primary actor is essentially operating as an "agent" or "mere conduit" for the secondary actor's statement.
Agency and Apparent Authority Liability
All that said, Central Bank can still slam the door shut on many claims against secondary actors, as recently shown in the Converse decision mentioned above. Converse alleged that Norwood, either through its agents or as a control person, violated Section 10(b) when Norwood sold to Converse the equity and debt securities of Apex One, Inc. The complaint alleged that Apex and various officers and directors of Apex had acted "on behalf of Norwood" and "as agents for Norwood" when they prepared and disseminated materially false financial information to Converse to induce it to purchase Apex.
The court dismissed the Section 10(b) claim, however, reasoning that "the text of 10(b) does not provide for claims based on agency" and that Central Bank "implied that all forms of secondary liability are no longer viable" (emphasis added). "[T]he weight of authority after Central Bank in this Circuit supports this conclusion," said the court, and "[f]ederal courts outside of New York have also rejected secondary liability claims under § 10(b) after Central Bank."
Converse had argued that the "directly or indirectly" language in Section 10(b) encompasses agency liability, and that the court should not read Central Bank to bar agency liability because such an interpretation "would confer immunity on a corporation, which can act only through its agents." Converse was wrong, said the court, because "it ignores the difference between primary corporate liability, which survives Central Bank, and secondary liability, which does not."
The court said "[i]n primary liability the corporate delegate has spoken as the corporation whereas in the realm of secondary liability, a corporate delegate has simply spoken in the scope of his employment and the corporation is strictly liable by reason of that relationship to the delegate." While none of the individual defendants in Converse was an employee of Norwood, this passage suggests the possibility that a corporate defendant facing liability under Section 10(b) could successfully claim that it is not bound by the acts of its own employees.
In contrast to Converse, however, Pollack v. Laidlaw Holdings, Inc., 27 F. 3d 808 (S.D.N.Y. 1994), held that agency liability survived Central Bank. In Pollock, certain defendants, a group of corporations and their officers and directors, argued that because they themselves were not primary violators the claims against them must be dismissed under Central Bank. Pollack held that Central Bank dealt only with aiding and abetting liability, a concept different from the "liability of a principal based upon apparent authority" granted to an agent. The Pollack court refused to dismiss the defendants, reasoning that any fraud by their agent may be imputed to them based on the agent's apparent authority to act on their behalf.
Pollack relied on American Society of Mechanical Engineers, Inc. v. Hydrolevel Corp., 456 U.S. 556 (1982), which approved the use of common law agency principles in imposing liability under the federal antitrust laws because the "apparent authority theory has long been the settled rule in the federal system" and was consistent with the intent behind the statute. Hydrolevel was raised in the Central Bank dissent but not discussed in the majority opinion. Although Converse did not discuss Hydrolevel, it is likely that Section 10(b) plaintiffs will urge the relevance of Hydrolevel's reasoning when agency is at issue.
Respondeat Superior Liability
Some courts distinguish respondeat superior liability from agency liability based on apparent authority because apparent authority adds an element of affirmative representation that authority is present. Does Central Bank always bar claims based on respondeat superior?
One court has said no. In Seolas v. Bilzerian, 951 F. Supp. 978 (D. Utah 1997), the court, relying in part on the Supreme Court's Hydrolevel decision, held that Central Bank did not abolish respondeat superior as a theory of liability under Section 10(b). At least two other district courts have said yes. In ESI Montgomery County, Inc. v. Montenay Internat'l Corp., 1996 WL 22979 (S.D.N.Y. 1996), the complaint alleged that one defendant, a corporation, was liable because three of its officers made misrepresentations and led the negotiations for the securities transaction at issue. The district court dismissed claims under Section 10(b), holding that under Central Bank the defendant corporation could not be secondarily liable under a respondeat superior theory because of the fraudulent acts of its officers. A New Jersey court held the same in In re Prudential Ins. Co., 975 F. Supp. 584 (D.N.J. 1997). Neither ESI nor In re Prudential discussed Hydrolevel.
The bottom line on "vicarious" liability? Very little is simple; the cases give both plaintiffs and defendants plenty to argue over; and what may look like nuances in the facts can have large consequences.