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Fraud Charges Against Enron Secondary Actors Survive

In a far-reaching and lengthy opinion, a federal court (SD Tex) has found that primary securities fraud allegations were sufficiently stated against a number of secondary actors in the Enron Corp. securities litigation, including the company's outside law firm, its auditor and commercial and investment banks. In so ruling, the court adopted the SEC's test for primary liability of secondary actors under Exchange Act Rule 10b-5. This means that persons who create a misrepresentation on which investors rely, whether or not they initiate the misrepresentation, can be liable as primary violators if they act with scienter. Further, secondary actors who write misrepresentations for inclusion in a document to be given to investors can be primary violators even if the ideas for those misrepresentations came from someone else.

Thus, as a general matter, secondary actors such as law firms, accounting firms and banks can be liable for primary violations under an alleged scheme to defraud if all of Rule 10b-5's requirements have been satisfied as to each one. Under the test, however, persons who prepare a truthful and complete portion of a document would not be liable as primary violators for misrepresentations in other portions of the document even if they knew of them since they would not have created the misrepresentations.

In the Enron litigation, the lead plaintiff alleged that Enron's lawyers, accountants and underwriters participated with the company in a "Ponzi" scheme to enrich themselves which, in an essential part of the plan, defrauded third-party investors in company securities in an effort to keep funds flowing into the company. More specifically, the complaint alleged that the secondary actors caused Enron to violate Generally Accepted Accounting Principles and SEC rules in order to overstate corporate assets, shareholder equity and net income, while understating debt.

Instructively, the court noted that the 1995 Private Securities Litigation Reform Act's significance as a protective shield for business must be viewed within the context of the decades-old private right of action granted to defrauded investors injured by corporate management, auditors, outside counsel and investment bankers when their conduct allegedly violates the federal securities laws. Since the passage of the PSLRA, with its procedural hurdles and stringent pleading standards, reasoned the court, overwhelming corporate scandals have placed Congress' goal in enacting the PSLRA in a much wider perspective.

As a factor common to all, the court initially found that the scienter pleading requirement was partially satisfied by allegations of a regular pattern of related conduct involving the creation of unlawful, Enron-controlled special purpose entities, and the sale of unwanted corporate assets to those entities in non-arms length transactions in order to shift debt off the company's balance sheet and sham profits onto its books at critical times when SEC filings were due. These transactions were alleged to be part of a common scheme through which all defendants profited. Their very pattern, said the court, undermines claims of negligence and supports allegations of intent to fraud.

The court also emphasized that securities professionals, including lawyers and accountants, when they take affirmative steps of speaking out, whether individually or as an author or co-author of a statement, whether identified or not, about their client's financial condition, have a duty to third parties not to issue misleading statements on which they intend or have reason to expect those third parties will rely. Fearing the danger of opening the professional liability floodgates to any potential investor who might obtain and rely on the statement, the court favored a restrictive approach with regard to the group to which the attorney and accountant owes the duty. In the Enron litigation, the court found that the investors who alleged the specific scheme of wrongdoing were part of the limited group that the secondary actors allegedly intended, or might reasonably have expected, to rely on their misrepresentations and who allegedly did rely and suffer loss.

¨ In re Enron Corp. Securities, Derivative and ERISA Litigation (SD Tex) will be published in a forthcoming REPORT.