(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

SEC Says Business Partners Can Be Primary Violators in Company's Fraud Scheme

In an amicus brief filed in a private securities fraud action, the SEC urged the Ninth Circuit Court of Appeals to adopt an appropriate and meaningful test for finding a company's business partner to be a primary violator rather than an aider and abettor in a scheme to defraud under 1934 Act Rule 10b-5(a). The SEC said in its brief in the Homestore.Com, Inc. litigation that this is an important question under the federal securities laws because of a 1994 Supreme Court ruling (Central Bank of Denver v. First Interstate Bank, 1993-94 CCH Dec. ¶98,178) that private securities fraud actions can only be brought against persons who are primary violators of Rule 10b-5 and not against those who aid and abet them. 

The SEC's friend-of-the court brief was filed in a private action alleging that a company and several of its business partners engaged in a scheme to defraud investors by entering into deceptive transactions to falsely inflate corporate revenues. The allegations raised the question of whether the business partners' alleged conduct, in engaging in such transactions, can make them primary violators.

The district court ruled that a business partner with no special relationship to a company who is the subject of a securities fraud action could not be liable as a primary violator of Rule 10b-5. The SEC, arguing that the court employed the wrong approach, said that a proper analysis should focus, not on whether there is a special relationship between the business partner and the company, but on the conduct of the party alleged to have played a part in the fraudulent scheme.

The district court, noting that accountants and auditors are the types of secondary actors the Supreme Court envisioned as potential primary violators of the antifraud rule, reasoned that holding liable a business partner with no special relationship to the company would broaden the scope of the securities acts so as to haul into court anyone doing business with a public company.

However, the SEC pointed out that nothing in the language of Section 10(b) or Rule 10b-5 suggests a requirement of any special relationship among alleged co-schemers. Automatically excluding all business partners from primary liability is inconsistent with the Supreme Court's directive that the antifraud provision be construed flexibly to effectuate its remedial purposes, according to the SEC.

While the district court's pronouncement may appear to have the virtue of bright line certainty, the Commission said that it may also have the unfortunate consequence of encouraging fraudulent schemes deliberately designed to evade liability through compliance with mechanical distinctions.

Further, the SEC argued that to require a special relationship with the company would allow a person who is not in such a relationship to accomplish the same fraud, with the same state of mind and with the same effect on investors as a person who has such a relationship, and yet escape liability. Wrongdoers could deliberately avoid having any such relationship arise, the Commission contended, and effectively immunize their fraudulent conduct.

Liability under Section 10(b) should be imposed on any person whose conduct comes within the proscriptions of the statute, the SEC emphasized, regardless of that person's relationship with the company.

The Commission urged the court to adopt a primary violation test requiring that a particular defendant either directly or indirectly engage in a manipulative or deceptive act as part of the fraudulent scheme. Under the test, a person providing assistance to other participants in a scheme, but who does not engage in a manipulative or deceptive act, can only be an aider and abettor.

In the SEC's view, this test would appropriately distinguish between conduct to which primary liability should attach and mere aiding and abetting. For example, if an investment bank provides services to arrange financing for a client, knowing that the client will use the proceeds to commit securities fraud, it is at most an aider and abettor. If, however, the investment bank engages in the creation of a sham entity as part of the services to arrange the financing, it may be a primary violator if it acted with scienter. In that scenario, the Commission said, the investment bank itself engaged in a deceptive act.

In the context of the overstatement of revenues, if a third party enters into a legitimate transaction with a company, knowing that the company will overstate the revenue generated by the transaction, the third party is at most an aider and abettor since there is nothing deceptive about the third party entering into the legitimate transaction. If, however, the third party engages with the company in a transaction whose principal purpose and effect is to create a false appearance of revenues, intending to deceive investors, it may be a primary violator.

The SEC also addressed the reliance requirement in Rule 10b-5, which it called a form of transaction causation, and noted that nothing in the rules of causation suggests that only the final act in a scheme to defraud meets the causation requirement. When the making of the false statements by one participant in the scheme is an objective of the scheme, the making of the statements should not be viewed as breaking the chain of causation.

Another example of subsequent conduct that should not break the causal chain would be an outside auditor's failure to detect another person's deceptive act. A person should not be able to escape liability simply because his or her deceptive act also deceived the outside auditor, according to the SEC.