Ninth Circuit Court of Appeals Addresses Scope of Primary Violation Liability Under Rule 10b-5(a) and (c) New York July 11, 2006 On June 30, 2006, the Ninth Circuit issued the first appellate decision defining the scope of primary liability under the scheme prongs of Section 10(b). Simpson v. AOL Time Warner Inc., --- F.3d ---, No. 04-55665, 2006 WL 1791042 (9th Cir. June 30, 2006). Employing a test proposed by the SEC, the Court held that to be liable as a primary violator of 10(b) for participation in a scheme to defraud, the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of a scheme. Key to the Court s decision is its holding that each defendant s own conduct must fully satisfy the test. Short of that, allegations of fraud amount to mere aiding and abetting, at most, which since Central Bank 1 has been insufficient to state a claim under Section 10(b). The Court s analysis strongly suggests that only illegitimate or sham transactions -- transactions that would have no purpose other than to deceive -- would satisfy the scheme test. Significantly, the Court explicitly made clear that the primary purpose test it was adopting is related to but different than scienter. In other words, adequately pleading scienter is not enough to plead scheme liability; there must also be adequately pleaded allegations of primary purpose in order to state a claim under Rule 10b-5(a) or (c). Homestore.com, an Internet company that provided links to a variety of home ownership related services, including real estate listings, announced in late 2001 that it would restate its financials to reflect lower revenues. (It eventually restated financials for seven quarters, lowering revenues by more than $170 million.) Multiple class action suits immediately followed, alleging that Homestore, with the active participation of outside businesses, engaged in illicit revenue-boosting transactions. On September 25, 2002, Homestore s former COO, CFO and VP of Finance pled guilty to securities fraud charges, thereby eliminating, as the District Court noted, the question of whether the fraud actually happened. I. 1 Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). Cleary Gottlieb Steen & Hamilton LLP, 2006. All rights reserved. This memorandum was prepared as a service to clients and other friends of Cleary Gottlieb to report on recent developments that may be of interest to them. The information in it is therefore general, and should not be considered or relied on as legal advice.
Plaintiffs alleged that Homestore engaged in three types of phony revenue creating transactions involving outside business entities: barter transactions, revenue purchasing, and triangular transactions. The complaint implicated three categories of non-insider defendants: PWC, third party vendors, and the Business Partner defendants -- AOL, Cendant, L90, and certain of their employees. Of primary interest here are the Business Partner defendants and the allegations concerning triangular transactions. In 1998 Homestore purchased from AOL the exclusive right to place real estate listing products on AOL. Shortly thereafter, Homestore and AOL entered into an advertising reseller, or revenue sharing, agreement pursuant to which AOL would sell advertising on Homestore s website, retain a commission from the sale, and give the balance of the advertising revenue to Homestore. In 2001 Homestore entered into a series of triangular transactions with third party vendors, by which Homestore bought shares at inflated prices or products and services it did not need from thinly capitalized companies (who wished to go public ) on condition that they would in turn purchase advertising on Homestore.com through AOL for approximately the same amount Homestore was paying them. Pursuant to its revenue sharing agreement with Homestore, AOL received a commission for the advertising purchased by the third party vendors and forwarded the rest of the money to Homestore. These triangular, or round trip, transactions created revenue for Homestore with its own money. According to the District Court, plaintiffs alleged that AOL was a major player in arranging many of the illicit revenue boosting transactions, and certain AOL employees were the architects of those transactions. Plaintiffs also alleged that AOL s commissions from the revenue sharing agreement were far above market value, and that AOL agreed not to document the triangular nature of the transactions. L90 allegedly participated in similar triangular transactions. In addition, an L90 officer allegedly signed a false statement to the effect that the transactions were not contingent on any related transactions. However, the information in that false confirmation letter never made it into the market place because the following day Homestore s CEO refused to sign the related Form 10-Q. Cendant sold Move.com to Homestore in 2001 for $750 million in Homestore stock. Plaintiffs alleged that Homestore vastly overpaid for the website and that Cendant agreed in exchange to funnel some of the money back to Homestore, which it accomplished by creating a separate corporate entity funded with $95 million that was subsequently paid to Homestore for various products and services. Significantly, the District Court noted that there was no allegation that Cendant attempted to conceal the contingent nature of the transaction. 2
II. The Business Partner defendants moved to dismiss the claims against them in District Court, arguing that Central Bank precludes claims against simple business partners. They argued that most attempts to hold secondary actors liable under the scheme prongs of Rule 10b-5 have been rejected as aiding and abetting claims barred by Central Bank. Moreover, they argued, Rule 10b-5 liability requires significant participation in the making or dissemination of a false or misleading statement. 2 Although the District Court disagreed with defendants assertion that Rule 10b-5 liability requires the making of a statement, the Court did agree that Central Bank precluded the claims made against the Business Partners on the facts alleged, and it dismissed them with prejudice. 3 The Court gave three reasons for its decision. First, the Business Partners did not have a special relationship with Homestore. According to the District Court, no other post-central Bank decision has ever held that a simple business partner to a corporation is liable to the shareholders of that corporation for securities fraud. The Court reviewed the cases plaintiffs cited, and found that in each instance where an outsider has been held liable as a primary violator, that outsider had some type of special relationship with the corporation, i.e. accountant, auditor, etc. 4 Second, the Business Partners did not employ the scheme to defraud investors, as required by the text of Rule 10b-5. The District Court reasoned that those who actually employ the scheme to defraud investors are primary violators, while those who merely participate in or facilitate the scheme are secondary violators and thus aiders and abettors within the meaning of Central Bank. In the District Court s analysis, the distinction lay in identifying the primary architects of the scheme -- in this case, the officers of Homestore who designed and carried out the schemes to defraud. The Business Partners, who actively participated in the triangular transaction scheme, did not employ the scheme to defraud investors, and are therefore secondary actors. 2 The substantial participation test is a uniquely Ninth Circuit test. Other Circuit Court s addressing the scope of primary liability under the misstatement or omission prong of Rule 10b-5 have applied the bright line rule, requiring the actual making of a statement to investors (or the failure to do so when duty-bound to speak). 3 In re Homestore.com, Inc. Sec. Litig., 252 F. Supp. 2d 1018 (C.D. Cal. 2003). 4 The cited cases included In re Software Toolworks, 50 F.3d 615, 628-29 (9th Cir. 1994), in which the court declined to dismiss Section 10(b) claims against an underwriter who had played a significant role in reviewing, drafting and editing letters sent to the SEC. 3
Third, the Homestore shareholders were damaged by their reliance on statements and material omissions made by Homestore, not the scheme itself. Although a statement is not required for a claim under Rule 10b-5, such as in the case of a manipulative act, in this case it actually was plaintiffs reliance on false or misleading statements that caused their damages. Because plaintiffs could not allege that the Business Partners substantially contributed to those statements, there was no reliance and thus no basis for a claim against them. Unfortunately, the District Court s decision did little to provide a useful test for distinguishing between primary liability under the scheme prongs of Rule 10b-5 and mere non-actionable aiding and abetting. Among other things, although the special relationship rule appeared to provide a convenient bright line test, it offered only a superficial litmus. Likewise, focusing on role descriptors such as primary architect gave a quantitative measure where a qualitative test was needed, and it required an answer to, but left unanswered, the basic question of what constitutes a scheme. Moreover, because of their bright line characteristics, both tests were vulnerable to gamesmanship. Plaintiffs appealed to the Ninth Circuit. The SEC filed amicus briefs, arguing that the District Court s holding was based on unwarranted distinctions (as discussed above), and that using those distinctions as the test for primary liability would undermine the purpose of the antifraud provisions. The SEC proposed its own test for identifying primary liability, and it offered several very helpful illustrative hypotheticals. As discussed below, the Ninth Circuit has now essentially adopted that test. 5 III. Rather than focusing on the categorical distinctions that defined the District Court s analysis, the Ninth Circuit employed a test that examines the purpose and effect of each defendant s own conduct: We hold that to be liable as a primary violator of 10(b) for participation in a scheme to defraud, the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme. It is not enough that a transaction in which a defendant was involved had a deceptive purpose and effect; 5 As a result, the SEC s amicus briefs, and in particular the hypotheticals they discuss, may become a helpful guide to applying the Ninth Circuit s decision. 4
the defendant s own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect. Moreover, the Court emphasized that the principal purpose test is related to -- but different than -- scienter, pointedly noting that a defendant would have no Section 10(b) scheme liability if it intended to deceive the public by substantially assisting another s misconduct as part of a scheme to defraud, but fail[ed] to perform personally any action that created a false appearance as part of th[e] scheme. Applying these tests to the Homestore plaintiffs allegations against the Business Partner defendants, the Court easily determined that they had failed to state a Section 10(b) claim. For example, as summarized by the Ninth Circuit, plaintiffs alleged that AOL and its officers played a role in the scheme to overstate revenues and had helped Homestore organize and create the triangular transactions, and in this way assisted Homestore in misrepresenting the revenues from these transactions. Those allegations were insufficient. The Circuit Court held that more is required than assertions of helping or assisting another s deception. To allege a primary violation, the complaint must allege that AOL or its officers actually engaged in a deceptive act. The Ninth Circuit s analysis helpfully goes a step further, pointing out specifically what plaintiffs did not allege, and in so doing it provides guidance as to the kinds of specific allegations that might satisfy the test. The Court observes, for example, that [i]t is not alleged that AOL or its officers created sham business entities or engaged in deceptive conduct as part of illegitimate transactions.... There is no indication from the [complaint] that the transactions engaged in by AOL were completely illegitimate or in themselves created a false appearance. (emphasis added). Plaintiff only alleges that the first leg of the [triangular] transaction was truly a sham.... The complaint does not allege that AOL itself entered into a transaction that had no legitimate economic value or created a false appearance. (emphasis added). And [w]hile the advertising transactions between the Third Party Vendors and AOL are alleged to contain suspect qualities, such as exaggerated commissions by AOL, there is no suggestion that actual advertisements were not purchased and sold by these companies. Hence, although the Ninth Circuit did not explicitly require inherently illegitimate conduct or a sham transaction in order for primary liability to attach, as a practical matter scheme liability would seem to depend on whether the conduct in question had any legitimate purpose. The Ninth Circuit explained: Conduct by the defendant that does not have a principal legitimate business purpose, such as the invention of sham corporate entities to misrepresent the flow of income, may 5
have a principal purpose of creating a false appearance. Conduct that is consistent with the defendants normal course of business would not typically be considered to have the purpose and effect of creating a misrepresentation. Participation in a legitimate transaction which does not have a deceptive purpose or effect would not allow for a primary violation even if the defendant knew or intended that another party would manipulate the transaction to effectuate a fraud. IV. This decision comes at an important time. Plaintiffs have increasingly looked to the scheme element of Rule 10b-5 in an attempt to avoid Central Bank s restrictions on claims against non-speaking secondary actors who, previously, at most would have been considered aiders and abettors. District Court decisions in a number of these cases, including In re Enron Corp. Sec. Derivative & ERISA Litig, 235 F. Supp. 2d 549 (S.D. Tex. 2002), In re Lernout & Hauspie Sec. Litig., 236 F. Supp. 2d 161 (D. Mass. 2003), and In re Parmalat Sec. Litig., 376 F. Supp. 2d 472 (S.D.N.Y. 2005), have declined to dismiss scheme claims against non-speaking secondary actors, even where the conduct in question did not come within the traditionally understood scope of a manipulative scheme -- such as matched orders or wash trades in which sham transactions were orchestrated for the purpose of deceiving the market. This has given rise to concern among the defense bar over the possibility that new law in this largely undeveloped area of primary scheme liability could lead to an end-run around Central Bank s prohibition against aiding and abetting claims. In Cleary Gottlieb s September 2005 Litigation & Arbitration Report, we noted: One can question whether, if Section 10(b) can be so stretched, the conduct at issue really justifies the imposition of primary liability exposure. Indeed, in light of Central Bank, at a minimum that conduct must -- as in standard manipulation cases -- be the equivalent of false speech (and conduct must also include scienter by the actor). If not, primary liability conduct will be hard to differentiate from the substantial assistance component of aiding and abetting that the pre- Central Bank cases tried to define. The Ninth Circuit s test goes a long way toward addressing these concerns. It returns the focus of the inquiry to the nature of each defendant s own conduct, asking whether that conduct itself was misleading -- i.e., the equivalent of false speech. The Court appropriately narrows the scope of primary scheme liability so that it reaches only conduct that has no legitimate business purpose. And the test requires that a plaintiff plead and 6
prove both scienter and that the defendant engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme. Mitchell A. Lowenthal Stuart N. Mast * * * For further information about any of the issues raised above, please contact Mitchell Lowenthal or Stuart Mast in the Firm s New York office (212-225-2000). CLEARY GOTTLIEB STEEN & HAMILTON LLP 7
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