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In the wake of high-profile corporate meltdowns like Enron Corp. and Refco Inc., attorneys and other professionals who advise public companies are concerned over what they see as their widening exposure when shareholders sue the companies they counsel.
Many in the securities defense bar say this concern stems in part from plaintiffs finding creative ways to implicate outside lawyers and secondary participants as primary violators in schemes to defraud investors.
To do so, plaintiffs must get around a key 1994 U.S. Supreme Court ruling, Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164. Central Bank ruled out claims of aiding and abetting fraud under Rule 10b-5 of the Securities Exchange Act of 1934, which typically had been used against lawyers and accountants involved in the alleged wrongdoing. But now plaintiffs are claiming that a fraud could not have taken place without lawyers' and accountants' advice to their clients, which in turn misled investors.
The casualties are mounting.
Last month, Refco's longtime counsel, Mayer, Brown, Rowe & Maw of Chicago, and Mayer partner Joseph P. Collins, were named co-defendants in a shareholder action for allegedly conspiring with the bankrupt company's former CEO Phillip R. Bennett to further a massive fraud. The firm denies wrongdoing and has retained Williams & Connolly lawyer John K. Villa to represent it. Teachers' Retirement System of Illinois v. Lee, No. 1:05-cv-10403 (S.D.N.Y.). [See sidebar.]
Houston law firm Vinson & Elkins, Enron's principal counsel, is a defendant in the Enron multidistrict litigation. In re Enron Corp. Sec., Deriv. & ERISA Litig., MDL No. 1446 (S.D. Texas 2002).
Buchanan Ingersoll of Pittsburgh, longtime counsel to Adelphia Communications Corp., is a defendant in the Adelphia multidistrict litigation in federal court in New York. In re Adelphia Communications Corp. Securities & Deriv. Lit., No. 03md1529 (S.D.N.Y.).
Scott J. Rein and Rein Evans & Sestanovich of Los Angeles settled out of a shareholder class action in which investors alleged that they knowingly represented a company that was a Ponzi scheme in February 2004. Forslund v. Rein, No. 8:01cv1085 (C.D. Calif.).
'SCHEME THEORY'
Stanley Keller, a corporate transactional attorney at Boston's Edwards Angell Palmer & Dodge, worries about the increasing exposure of lawyers to liability.
"The biggest concern is that where once there might have been a reluctance on the part of third parties to sue lawyers, now there's not," Keller said, particularly among plaintiffs who are "more willing to maximize their return by seeking to recover whatever they can."
The new atmosphere of uncertainty arises in part from the Sarbanes-Oxley Act of 2002, which brought an increased focus on legal responsibility and personal accountability, Keller said.
William M. Wycoff of Thorp Reed & Armstrong in Pittsburgh, a lawyer for Buchanan Ingersoll in the Adelphia multidistrict litigation, said that plaintiffs are trying to do an end run around Central Bank.
In the Adelphia litigation, Buchanan Ingersoll is alleged to have made misrepresentations to the market under Rule 10b-5(b), and as such were primary actors with Adelphia in a scheme to defraud investors under subsections (a) and (c) of the rule.
While subsection (b) prohibits untrue statements of fact, (a) forbids employing a "device, scheme or artifice to defraud," and (c) "any act or practice" to defraud someone in connection with buying or selling securities.
Wycoff and others in the defense bar say that the difficulty of proving a primary violation of the misrepresentation subsection (b) of Rule 10b-5 has inspired the improvisation of so-called "scheme liability" of secondary actors under subsections (a) and (c).
Buchanan Ingersoll objected in a pleading that the plaintiff's "novel theories" threaten to "expand existing securities law in a manner such that has no support in law or logic," Wycoff said.
"What the plaintiffs are trying to say is, if you can't attribute a statement to [the firm], you can say [it's] involved in a scheme," and in that way "shoehorn a misrepresentation case into fraudulent scheme law."
Herbert S. Washer, a partner at Shearman & Sterling in New York who represents Merrill Lynch in the Enron class action securities litigation and other Enron-related cases, agreed with Keller, Wycoff and other securities lawyers who noted "a tendency in the big cases to apply scheme theory to capture law firms and their insurance companies because plaintiffs are always looking for a deep pocket."
But William S. Lerach of Lerach Coughlin Stoia Geller Rudman & Robbins in San Diego, chief plaintiffs counsel in Enron, WorldCom and other large, high-profile securities and corporate derivative actions, said that "with issue of insolvency of course you have to go beyond the [distressed entity] in order to get the recovery."
'MEGAMELTDOWNS'
Not all securities defense lawyers are seeing these phenomena across the board.
Tracy A. Nichols, who heads Holland & Knight's national securities litigation practice group in the firm's Miami office, said that apart from "the megameltdown cases with their spectacular failures and losses," she is not aware of law firms being defendants in "the middle-market types of cases" on which her Florida practice is centered.
In Nichols' view, "it used to be pretty routine for law firms and accountants to get sued along with companies in securities class action lawsuits, until Central Bank came down with a resounding thud."
Then "plaintiffs got wise and figured out ways to bring law firms back into securities class actions," prompting Congress to tighten the standards with the Private Securities Litigation Reform Act of 1995, "back in the day when Milberg Weiss still was seen as wearing black hats," she said.
"In 1998, Congress passed the Securities Litigation Uniform Standards Act when it was still pro-corporations, to close up loopholes plaintiffs tried to drive trucks through," Nichols said.
Then came Enron and WorldCom, and the pendulum swung back with Sarbanes-Oxley and Congress thinking "maybe class actions aren't all frivolous," she said.
The defense bar's apprehension has been fueled by U.S. District Judge Melinda Harmon's denial of a motion to dismiss the Houston law firm Vinson & Elkins, Enron's principal counsel, from the Enron multidistrict litigation on grounds that shareholders can hold liable law firms that make public statements about their clients' financial condition or are participants in a company's fraudulent acts. In re Enron Corp. Sec., Deriv. & ERISA Litig., 235 F. Supp. 2d 549 (S.D. Texas 2002).
Although many lawyers, bankers, accountants and underwriters had welcomed Central Bank as settling the law, the Supreme Court made it clear the decision was not intended to foreclose the liability of secondary actors participants, Lerach said.
"Post-Enron, most courts have found that there is liability for law firms or others who participated in securities fraud," he said. "What you have to focus on is: is there liability for participation? If there is, the question becomes, what do you have to do to be liable?" Lerach said.
He added that this is precisely what Harmon did in considering Vinson & Elkins' motion to be dismissed from the Enron multidistrict litigation.
In denying that motion, Harmon noted in her memorandum that "in light of its alleged voluntary, essential, material, and deep involvement as a primary violator in the ongoing Ponzi scheme, Vinson & Elkins was not merely a drafter, but essentially a co-author of the documents it created for public consumption concealing its own and other participants' actions."
"As long as you can show some direct participation, you're going to survive," Lerach said, pointing out that Harmon also dismissed Milbank, Tweed, Hadley & McCloy of New York and Chicago's Kirkland & Ellis from the Enron litigation.
Washer of Shearman & Sterling also said that he is concerned about lawyers as the principle architects of the highly complex structured finance deals to create special-purpose entities.
"Lawyers do these all the time, and there's nothing necessarily wrong with them. However, the potential does exist for companies to abuse those structures. The question is: Does the company that abuses those structures implicate those who created them?" Washer asked.
Lawyers who participate in those kinds of transactions are not the ones who decide how to report them, he said. "It is up to the company and its auditors to report them in a fair and accurate way."
A split has developed among the federal circuits over what makes so-called secondary participants liable as primary violators in cases involving misleading statements. The 2d, 10th and 11th U.S. Circuit Courts of Appeals apply a "bright line" test that rules out misrepresentations that cannot be attributed directly to a secondary actor.
But the 9th Circuit and at least one federal district court in the 1st Circuit have used a less rigorous "substantial participation" test that allows primary violator liability if the secondary actor can be shown to have had a significant hand in preparing the misrepresentation.
| WIDENING EXPOSURE Law firms included in suits filed by shareholders against companies the firms advised include: |
