Thursday, October 1, 2009

Aiding and Abetting under Rule 10b-5: Time for a Change?

Should lawyers and others continue to get a free pass on aiding and abetting the commission of securities fraud under Section 10(b) of the Securities Exchange Act of 1934 and the SEC's Rule 10b-5? Two of our esteemed law academy colleagues testified on this issue a few weeks ago before the U.S. Senate Subcommittee on Crime and Drugs of the United States Senate Committee on the Judiciary. The bill at issue was the "The Liability for Aiding and Abetting Securities Violations Act of 2009," Senate Bill 1551, introduced by Senator Arlen Specter. In essence, the bill would permit private actions to be brought against those providing substantial assistance to a securities fraud or other violation of the securities laws. Professor Jack Coffee (Columbia) supports the bill, but believes there should be a cap on liability. He states that:
the time has come for legislative re-examination of the immunity given secondary participants; a balance needs to be struck. As I suggest below, this balance is best struck by restoring private aiding and abetting liability, but with a ceiling on damages.
In his testimony, Professor Coffee contends that pleading requirements for scienter would make it difficult for plaintiffs to bring frivolous litigation against aiders and abettors that survives a motion to dismiss.

Professor Adam Pritchard (Michigan) opposes the bill as a significant threat to free enterprise. He notes the pressure on issuers to settle out securities fraud cases and argues that "[g]iving the plaintiffs’ bar aiding‐and‐abetting authority would offer class action lawyers one more weapon with which to shake down settlements." He also indicates that the bill has the capacity to transform lawyers and other professionals into "quasi‐fraud police."

Who is right? One? Both? Neither?

On the one hand, it does not seem right (at some level) to let fraud facilitators "walk." On the other hand, because the securities class action process and the elements of a Rule 10b-5 claim most often propel securities fraud actions toward settlement (even if the case is weak), plaintiffs have incentives to seek new deep pockets (aiders and abettors drawn from the ranks of lawyers, accountants, and investment bankers, among others) from which to extract settlement payments. Professor Pritchard suggests an alternative to the bill that he has posited elsewhere: force wrongdoers to disgorge any ill-gotten gains.
Accountants, lawyers, and investment bankers who are complicit in the corporation’s fraud should be forced to give up their fees (or some multiple thereof) earned during the fraud period. Canada uses a version of this remedy in its recently adopted securities class action legislation. Under that legislation, the liability cap for experts is $1 million or the revenue that the expert and its affiliates have earned from the issuer and its affiliates during the 12‐month period immediately preceding the day on which the misrepresentation or the failure to make timely disclosure occurred. Those limits are inapplicable if the fraud is done knowingly.
I find this an interesting proposition worth further thought.

I respect the scholarship of Professors Coffee and Pritchard. The testimony of each on this matter does not disappoint; I commend it to your reading.


  1. I do not understand the basis for protecting putative fraudfeasors or those substantially assisting in fraud. For decades during a period of expanding securities fraud liability we had a system of corporate governance that seemed to worked. Since the mid-1990s when the Court and Congress joined forces to emasculate private securities litigation we have seen scandal after scandal.

    Moreover, for what its worth, the very concept of extortionate settlements is baseless. Large corporations, law firms and accounting firms have huge resources to defend themselves with. The federal courts are largely populated with conservative judges that usually hail from the corporate firms. Most settlements occurred on the eve of trial. All of this means that securities defendants had every advantage in litigation and would only pay as a last resort.

    I used to litigate securities cases for plaintiffs and defendants. I always felt the playing field was systematically tilted in favor of defendants. After the 1990s, private securities litigation lost its effectiveness and the parade of scandals started.

  2. Interesting thoughts, SR. I never was a litigator, and I find your perspectives informative. No doubt that expanding fraud liability chills transactions--but I would argue it chills both the good and the bad under our current system, based on my transactional experience.

    I therefore also have argued for reform in securities fraud litigation, but from a different vantage point. I am a big proponent of fixing the substantive ambiguities in the law so that everyone knows what's legal and illegal with more certainty.

    And I do think that the large number of settlements is an indication that something is wrong in the system.

    Again, thanks for the thoughts--and for having me blog here.

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  4. I wonder the basis for the assertion that fraud liability chills "good" transactions. Fraud liability was most expansive in the securities markets from 1934 through 1995, a period of scandal free, stable growth. Moreover, fraud requires a showing of scienter, meaning a jury must find an intent to defraud. Typically, these defendants have the benefit of the finest attorneys money can buy. A rational plaintiffs' attorney knows this and will only take the strongest cases. The rational plaintiffs' attorney also factors in the very costly prospect of litigating against a large law firm with incentives for leaving no stone unturned. The firm also has a professional duty to only recommend settlement upon a solid basis of facts--meaning full discovery. This professional duty is amplified by monetary incentives (fees) and social pressures to appear to be a hard nosed litigator. Every defense firm will move to dismiss and for summary judgment. If you survive all that, the chances of it being anything like a "good" transaction are slim to none.

    The problem I see today is that we have narrowed fraud liability too much and that chills investment because investor confidence is shot.

  5. You may be right. But I can say from my 15 years of practice experience in advising corporations and their executives that the vagueness of the elements of a Rule 10b-5 claim--including the amorphous nature of the materiality and scienter requirements--often scare folks from, e.g., stock repurchases that may be beneficial to shareholders. It's the careful, good corporations that generally are deterred. This is why I push for reform in the substance (rather than procedure) of fraud claims.

    My experience with plaintiffs' bar attorneys is significantly different from yours, it seems. Or maybe my difference here can be explained by the word "rational" in your comment (in which case, we may agree). The plaintiffs' bar counsel that typically brought claims against my firm's clients in practice brought claims more for their nuisance and settlement value--claims that were hard to dismiss because of issues involving materiality or scienter. Some of those cases were, in fact, dismissed--a lot of them being "cookie cutter" complaints brought in the wake of a successful action against a similarly situated firm. These suits cost corporations huge amounts of dollars.

    Where I disagree with what's going on in fraud liability (and you and I may agree here) is that the PSLRA procedural machinations that have been in place for the past (almost) 15 years are likely misdirected and seemingly have resulted in the dismissal of suits that may have merit. I would like to see some good empirical research on that aspect of the issue, and if you can point me that way, I would appreciate it.

    Having said all of this, however, I should note that the complete lack of aiding and abetting liability under Rule 10b-5 is quite troubling to me. Although I am not confident that instituting full liability (even with a cap on monetary exposure) is the right answer, I don't have a good answer here. Perhaps "substantial assistance" is the right standard, but I am wary about its clarity in light of the materiality and scienter issues that I have seen in my practice and research. I also invite further reactions to that aspect of this issue.