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Establishing A New Basis For Aider & Abettor Liability?  A Review of SEC Rule 10b-5 in light of Central Bank of Denver v. First Interstate Bank

by George D. Pappas, LL.B (Hon), LL.M

 Editor, The Malet Street Gazette 

 

The majority opinion in Central Bank of Denver v. First Interstate Bank1 established a literal reading of S. 10(b) of the Securities Exchange Act 19342 and Securities and Exchange Commission Rule 10b-53 that no liability could extend to aiders or abettors who participate in material misstatements or omissions in connection with the sale of securities. It was held that "private civil liability under Rule 10b-5 does not extend to those who do not engage in a manipulative or deceptive practice but who aid and abet such a violation of 10(b)."4 The majority in Central Bank based its opinion on a lack of express mention in S.10 (b) and Rule 10b-5 relating to aiding and abetting. The Court rather relied on a strict interpretation of the statute; thus, attempting to draw a bright line between primary liability for violations of Rule 10b-5 and non-primary defendants who did not directly or actively communicate a deception upon the investing public.

The Court's ruling in Central Bank was in contrast to a long history of judicial and administrative interpretations, and in particular, the Securities and Exchange Commission's ("SEC") enforcement actions where aiders and abettors were liable under Rule 10b-5. In the dissenting opinion, Justice Stevens stated "[a]ll 11 Courts of Appeals to have considered the question have recognized a private cause of action against aiders and abettors under S.10 (b) and Rule 10b-5." The crux of Central Bank's attempt to draw a line between primary violators on the one hand, and aiders and abettors on the other turns on whether defendants make direct misstatements or omissions (where a duty to disclose is present5) that are relied upon by purchasers or sellers of securities. According to the Central Bank Court:

A plaintiff must show reliance on the defendant's misstatement or omission to recover under 10b-5. Basic Inc. v. Levinson, supra, at 243. Were we to allow the aiding and abetting action proposed in this case, the defendant could be liable without any showing that the plaintiff relied upon the aider and abettor's statement or actions. . . ."6

Where reliance is present, the Court will extend primary liability under 10b-5 to secondary participants such as lawyers, accounts, and underwriters. Focusing on this point, the Court stated "any 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. . .."7

The Court’s ruling in Central Bank focused on the scienter elements that would permit private actions under Rule 10b-5. Following Ernst & Ernst v.Hochfelder8, the Court held that intent rather the negligence was the scienter to plead a Rule 10b-5 violation against a defendant. "[T]he words 'manipulative or contrivance' used in conjunction with 'device or contrivance' strongly suggest that s. 10b was intended to proscribe knowing or intentional misconduct."9 To be primarily liable under Rule 10b-5, one has to engage in manipulative or deceptive acts in connection with the purchase or sale of securities.10 This interpretation is consistent with Rule 10b-5(3), which prohibits engaging "in any act, practice, or course of business, which operates or would operate as a fraud or deceit upon any person . . . in connection with the purchase or sale of any security."11 As such, plaintiffs must successfully plead scienter by proving either actual knowledge or recklessness.12 Central Bank reinforced the Court's prior ruling in Ernst & Ernst v. Hochfelder13 where it held that private actions under Rule 10b-5 must plead that the culpable party acted with scienter.14 The Ernst Court reasoned that

. . . the words ‘manipulative,’ ‘device,’ and ‘contrivance’—terms that make unmistakable a congressional intent to proscribe a type of conduct quite different from negligence. Use of the word ‘manipulative’ is especially significant. It is and was virtually a term of art when used in connection with securities markets. It connotes intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities.15

There appears to be little disagreement between the ruling in Central Bank and lower court rulings on the state of mind elements necessary to attach primary violation liability with respect to actual knowledge and recklessness. Mere negligence is not sufficient to establish primary liability under S. 10(b).

The Central Bank ruling breaks with prior judicial and administrative interpretations of Rule 10b-5 with respect to aiders and abettors. It will be useful to isolate which elements establish primary liability per se, and what elements prevent private actions against aiders and abettors. An assessment of Central Bank's ruling bears upon "whether private civil liability under S. 10b extends as well to those who do not engage in the manipulative or deceptive practice, but who aid and abet the violation."16 Since Congress did not expressly prohibit fraudulent or deceptive acts by aiders or abettors, the Court in Central Bank confined its interpretation to the express language only. "Our consideration of statutory duties, especially in cases interpreting S. 10(b), establishes that the statutory text controls the definition of conduct covered by S. 10(b)."17 However, the Court in Hochfelder, in rejecting negligence as a basis for primary liability, not only carved out the contours of primary liability in terms of scienter—that is a state of mind requirement—but also implied that had scienter been present, Ernst & Ernst may have been primarily liable. Given the grounds established in Hochfelder, namely, the lack of the requisite scienter on the part of Ernst & Ernst, what was left silent by the Court was whether given the requisite scienter, Ernst &Ernst could have been liable even though they did not directly deceive investors, but participated in the primarily violators’ deception.

The Court in Hochfelder narrowly confined its ruling on whether the aider and abettor (Ernst & Ernst) was liable under Rule 10b-5 only in light of the scienter element. Viewed in this light, it appears that Central Bank's ruling addressed this implication or silence in Hochfelder. Namely, that in rejecting any culpability by Ernst &Ernst on the basis of negligence, the Court's rejection was developed within the context of extending potential liability to an aider and abettor had there been scienter. Central Bank filled any silence in Hochfelder with the proposition that unless the statute or Rule 10b-5 expressly mentions aiding and abetting, then the latter cannot be held primarily liable.

What makes the Court’s strict reading of 10b-5 perplexing is that it allows for instances where an aider and abettor who manifests the requisite scienter still escapes liability under Rule 10b-5. Despite Central Bank's knowledge that the appraisal was inadequate, it knew investors were relying in part on an outdated appraisal to purchase bonds, yet it chose to acquiesce to AM's deception to withhold this information. Failure to disclose the revised appraisal to investors proved fatal as the developer defaulted on the bond before Central Bank could issue a revised appraisal of the land serving as collateral securing the bonds. The Court’s ruling absolved Central Bank of any liability strictly on the grounds that Rule 10b-5 was silent about aiders and abettors, and because Central Bank was not making any direct misstatements or deceptions to the purchasers of the bonds. As the Court concluded, "[r]espondents concede that Central Bank did not commit a manipulative or deceptive act within the meaning of s. 10(b). . . ." 18

At what point in the process does the Court's ruling draw a line to primary liability? Is the text of Rule 10b-5 the line? What makes the Central Bank ruling difficult to apply is that while a reading of the opinion seems to indicate that the line is within the text of Rule 10b-5 itself, it is also quite plausible to reach a different standard of primary liability through a literal interpretation of Rule 10b-5. For example, Rule 10b-5 expressly states "[I]t shall be unlawful for any person, directly or indirectly. . . ."19 The majority opinion in Central Bank chose not to interpret "directly or indirectly" as extending to aiders or abettors since the Court did not infer that the 73rd Congress intended the express language to attach to secondary liability under Rule 10b-5. According to the Court "[f]ederal courts have not relied on the 'directly or indirectly' language when imposing aiding and abetting liability under S. 10(b). . . ." In contrast, Justice Ginsburg challenged the Court’s literal approach in her dissenting opinion:

The language of both S. 10(b) and 10(b)-5 encompasses ‘any person’ who violates the Commission's antifraud rules, whether ‘directly or indirectly’; we have read this ‘broad’ language not technically and restrictively, but flexibly to effectuate its remedial purposes.20

While the federal courts have construed Rule 10b-5 liberally to incorporate aiders and abettors where such defendants are still subject to the same scienter threshold requirements as primary violators of 10b-5, the Supreme Court—prior to Central Bank— did not question an implied private right of action.21 In fact, the Court has developed a judicial history that outlines the elements of primary violations within the context of an implied right of action. The courts have developed the following elements for primary liability under S. 10(b), namely: (1) a material misstatement or omission made in connection with the sale or purchase of a security;22 (2) a misstatement or omission made with scienter or recklessness by the defendant;23 (3) a plaintiff’s reliance upon the misstatement or omission;24 (4) such reliance on the misstatement or omission causing proximate harm to the plaintiff;25 and (5) the plaintiff suffering damages.26

In a post Central Bank case, Anixter v. Home-Stake Production Co.27, the 10th Circuit Court drew a distinction between primary violations and aiding and abetting by focusing on the reliance of investors on information directly supplied by the secondary individual, not the information provided by others. "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. Reliance only on representations made by others cannot itself form the basis of liability."28

Since Central Bank, however, the federal courts, in particular the 10th Circuit, have developed interpretations that have clarified Central Bank's attempt to restrict the scope of implied private actions against aiders and abettors. In Anixter, the court outlined guidelines that clarified the traditional scienter used to attach primary liability upon defendants. Anixter stands for the proposition that if individuals know that their representations will reach investors, then that would establish the necessary scienter that Central Bank deemed vital to primary violation. "[W]e conclude that in order for accountants to ‘use or employ’ a ‘deception’ actionable under the antifraud law, they must themselves make a false or misleading statement (or omission) that they know or should know will reach potential investors."29

In other words, by knowing that your misrepresentation will reach investors, you establish both reliance and active deception within the framework of Central Bank. As such, secondary actors can be held liable, not on the grounds of aiding and abetting, but rather on grounds of a primary violation of Rule 10b-5.

Conclusion

The Court in Central Bank attempted to restrict the scope of Rule 10b-5 by applying a technical or strict reading of the statute. Reading the text literally, the Court interpreted the statute under s. 10b and Rule 10b-5 as not extending to aiders and abettors. What the Court in Central Bank did not do is disturb the acknowledged judicial and administrative precedent on primary liability, that is, the scienter requirement necessary to plead a primary violation of Rule 10b-5. Consistent with its prior ruling in Hochfelder, Central Bank kept in tact the state of mind elements necessary to distinguish liability from pure negligence grounds.

Despite the Court’s belief that it was developing a bright line standard restricting the scope of Rule 10b-5, what it could not foresee was how plaintiffs could extend liability to secondary defendants, not on the grounds of aiding and abetting, but on the primary violation grounds of reliance and deceptive acts that were somehow directed to investors. In Re Software Toolworks30, a case the ninth circuit was reviewing just after Central Bank, liability was extended to Deloitte Touch (the auditors) on the primary violation grounds that Deloitte played a substantial role in preparing the misleading or deceptive statement to investors. "[T]he plaintiffs presented evidence that Deloitte played a significant role in drafting and editing the July 4 SEC letter. This evidence is sufficient to sustain a primary cause of action under section 10(b) and, as a result, Central Bank does not absolve Deloitte on these issues."31

Unlike Central Bank’s attempt to distinguish primary liability from aiding and abetting through reliance standards, the ninth circuit instead extended liability to Deloitte on grounds of significant participation. This ruling did not send a clear and consistent message given the Supreme Court’s decision in Central Bank. In Central Bank, the Court drew a bright line between primary and secondary liability on the grounds of reliance whereas in Software Toolworks, the bright line turned on the degree of participation by a secondary player. The more significant the degree, the greater the likelihood that primary liability would extend to secondary defendants. While not expressly seeking to extend liability under S.10b under aiding and abetting along the lines developed by Central Bank, the Court in Software Toolworks departed from Central Bank's premise that primary liability is based on reliance grounds coupled with the requisite scienter. Software Toolworks appears inconsistent with Central Bank since its ruling to extend primary liability to Deloitte was extrinsic to the reliance requirement set up by Central Bank.

The 10th circuit, however, has ruled along lines more consistent with Central Bank. Despite the fact that since the Supreme Court's decision in Central Bank , Congress has restored to the SEC the right to hold individuals liable for aiding and abetting, no private right was enacted32; therefore, the 10th Circuit's ruling in Anixter presents a second best option for framing private rights of action. Similar to Central Bank, the 10th circuit in Anixter based its ruling on a reliance theory that is transmitted not necessarily through direct acts or deceptions to investors from secondary defendants, but rather depends upon whether the secondary defendant is cognizant that their misstatement or deception will reach the sellers or purchasers of securities. As such, the court in Anixter continues to maintain a state of mind requirement that incorporates the Court’s ruling in Central Bank (i.e., to limit the scope of Rule 10b-5 by maintaining a reliance element) so long as the secondary party has knowledge that their misstatement will reach the investment community.

In essence, aiding and abetting is excluded per se from Rule 10b-5 liability given Central Bank. However, the same actors who were once prosecuted as aiders and abettors can now be held liable on primary liability grounds with similar scienter elements under the modified rule adopted by the 10th circuit; namely, that any deceptive act or misstatement will reach purchases or sellers of securities. Failure to establish that secondary defendants knew that investors would be reached by their misstatements precludes any Rule 10b-5 liability.

___________________________________

Footnotes

1.Central Bank of Denver v. First Interstate Bank, 511 U.S. 164 (1994).

2. 15 U.S.C. [*188] § 78j(b).

3. 17 CFR § 240.10b-5.

4. Central, supra note 1, at 178.

5. Chiarella v. United States, 445 U.S. 222, 228 (1980), the Court stated "the duty to disclose arises when one party has information 'that the other [party] is entitled to know because of a fiduciary or other similar relationship of trust and confidence between them.'

6. Central, supra note 4, at 180.

7. Id. at 191.

8. Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).

9. Central, supra note 1, at 173.

10. Id. at page 2.

11. 17 CFR 240.10b-5(3).

12. In re Software Toolworks, 50 F. 3d 615, 626 (1994).

13. Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).

14. James D Cox, ET AL., Securities Regulation: Cases and Materials, at 697 ( 2d. Ed. 1997).

15. Ernst, supra note 12, at 198.

16. Central, supra note 4, at 167.

17. Id. at 175.

18. Id. at 191.

19. 17 CFR 240.10b.

20. Central, supra note 1, at 18.

21. Ernst, supra note 12, at 196, where the Court confirmed "the existence of a private [right] of action for violations of the statute and the Rule is now well established."

22. Basic, Inc. v. Levinson, 485 U.S. 224, 231 (1988).

23. Ernst, Supra note 12, at 193.

24. supra note 14, at 243.

25. Gray v. First Winthrop Corp., 82 F.3d 877, 884 (9th Cir.).

26. Anixter v. Home-Stake Prod. Co., 77 F. 3d 1215, 1225 (10th Cir. 1996).

27. Id. at 1215.

28. Id. at 1225.

29. Id. at 1226.

30. In re Software Toolworks Inc., 50 F 3d. 615 (1994).

31. Id. at 628 n3 (1994).

32. . Ameena Y. Majid, Diminishing the Expected Impact of Central Bank of Denver v. First Interstate Bank of Denver: Secondary Liability Masquerading as Primary Liability Under Section 10(b), 28 Loy. U. Chi. L.J. 551 (Spring 1997).

 

 

 

 

 

 

 

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