Regents of the University of California et al. v. Credit Suisse First Boston (USA) Inc., et al.

Click here for the full text of this decision FACTS:Plaintiffs, former shareholders of Enron Corp., alleged that defendants Credit Suisse First Boston, Merrill Lynch & Company Inc. and Barclays Bank PLC (the banks) entered into partnerships and transactions that allowed Enron to take liabilities off of its books temporarily and to book revenue from the transactions when it was actually incurring debt. The common feature of these transactions was that they allowed Enron to misstate its financial condition. There was no allegation that the banks were fiduciaries of the plaintiffs, that they improperly filed financial reports on Enron’s behalf, or that they engaged in wash sales or other manipulative activities directly in the market for Enron securities. For example, plaintiffs alleged that Merrill Lynch engaged in what they dub the Nigerian barges transaction. According to plaintiffs, Enron wanted to sell its interest in electricity-generating barges off the coast of Nigeria by the end of 1999 so that it could book revenue and meet stock analysts’ estimates for the calendar quarter. It could find no legitimate buyer, so it contacted Merrill Lynch and guaranteed that it would buy the barges back within six months at a premium for Merrill Lynch. Six months later, Enron made good on its guarantee when an Enron-controlled partnership bought the barges from Merrill Lynch at a premium. When Enron reported its results for 1999, instead of booking the transaction as a loan, the characterization that Enron’s outside accountants state would have been appropriate had they known of the side agreement to buy back the barges, Enron booked the transaction as a sale and accordingly listed the revenue from the transaction in its year-end financial statement. Plaintiffs alleged that the banks knew exactly why Enron was engaging in seemingly irrational transactions such as this. They cited certain of the banks’ internal communications they characterize as proving that the banks were aware of the personal compensation Enron executives received as a result of inflating their stock price through the illusion of revenue and that the banks intended to profit by helping the executives maintain that illusion. Likewise, plaintiffs alleged that, although each defendant may not have been aware of exactly how each other defendant was helping Enron to misrepresent its financial health, the defendants knew in general that other defendants were doing so and that Enron was engaged in a “long-term scheme to defraud investors and maximize executive compensation by inflating revenue and disguising risk and liabilities through its partnerships and transactions with the banks.” Plaintiffs’ suits followed Enron’s collapse in 2001. The first action was filed on Oct. 22, 2001. By Dec. 12, 2001, the district court had consolidated more than 30 actions relating to Enron securities and had designated the Regents of the University of California as the lead plaintiff. Years of discovery ensued. Early in the litigation, the banks filed motions to dismiss, but the district court denied them in a Dec. 19, 2002, opinion. The district court reconsidered some of the issues relevant to those motions in its opinion regarding class certification, issued on June 5, 2006, in light of intervening developments in appellate case law. The district court determined that a “deceptive act” within the meaning of Rule 10b-5(c), promulgated at 17 C.F.R. �240-10b-5 under the Securities Exchange Act of 1934, included participating in a “transaction whose principal purpose and effect is to create a false appearance of revenues.” The district court decided that Rule 10b-5 prohibited any “scheme . . . to defraud” supports joint and several liability for defendants who commit individual acts of deception in furtherance of such a scheme. Implicit in that ruling was the conclusion that plaintiffs alleged that just such a scheme existed. The district court’s theory of scheme liability considerably simplified finding commonality among the plaintiffs with respect to loss causation. The district court stated that “a reasonable argument can be made that where a defendant knowingly engaged in a primary violation of the federal securities laws that was in furtherance of a larger scheme, it should be jointly and severally liable for the loss caused by the entire overarching scheme, including conduct of other scheme participants about which it knew nothing.” The district court concluded that plaintiffs were entitled under the U.S. Supreme Court’s 1992 decision in Affiliated Ute Citizens v. United States to rely on the class-wide presumptions of reliance for omissions and fraud on the market. The district court held that the Affiliated Ute presumption applied, because the facts indicated that the banks failed in their “duty not to engage in a fraudulent”scheme.’ ” Thus, in finding both deceptive acts and reliance on those deceptive acts by the plaintiffs, the district court found violations of Rule 10b-5. A month after issuing its opinion on class certification, the district court, after reviewing plaintiffs’ revised class definition and trial plan, issued its class certification order, dated July 5, 2006. It determined that, although the proportionate liability provisions of the Private Securities Litigation Reform Act were generally problematic, there was no necessary conflict between the district court’s theory of liability and that statute. The district court ordered defendants to prepare a list of nonparties to whom they intended to assign responsibility and declared that defendants would bear the burden to prove nonparties’ responsibility by a preponderance of the evidence. The district court certified a class of all persons who purchased Enron securities between Oct. 19, 1998, and Nov. 27, 2001. The class sought damages of $40 billion, against which the losing defendants could offset roughly $7 billion obtained by plaintiffs in previous settlements with co-defendants that previously settled with the plaintiffs. On Nov. 1, 2006, the 5th U.S. Circuit Court of Appeals granted defendants leave to appeal the class certification order. HOLDING:Reversed and remanded. The 5th U.S. Circuit Court of Appeals reviewed the class-certification decision for abuse of discretion in “recognition of the essentially factual basis of the certification inquiry.” Where a district court premises its legal analysis on an erroneous understanding of governing law, it has abused its discretion, the court stated. “Albeit with the best of intentions and after herculean effort,” the court found that the district court arrived at an erroneous understanding of securities law that gave rise to its application of classwide presumptions of reliance. Two of the banks’ arguments on appeal, the court stated, had considerable implications for the substantive legal merit of plaintiffs’ complaint. First, the district court’s definition of “deceptive act” undergirded its application of the class-wide presumption of reliance on fraud on the market. Likewise, the district court’s broad theory of “scheme” liability allowed it to certify a single class of plaintiffs whose losses were caused in common by the scheme rather than to certify subclasses whose losses were caused by the actions of individual defendants. In this case, the court stated, the meaning of “deceptive act” is critical to class-wide certification and ultimately dispositive of the appeal. The logic of Affiliated Ute, the court stated, is that, where a plaintiff is entitled to rely on the disclosures of someone who owes him a duty, requiring him to prove “how he would have acted if omitted material information had been disclosed” is unfair. It is natural, the court stated, to expect a plaintiff to rely on the candor of one who owes him a duty of disclosure, and it is fair to force one who breached his duty to prove that the plaintiff did not so rely. In this case, however, where the plaintiffs had no expectation that the banks would provide them with information, the court stated that there is no reason to expect that the plaintiffs were relying on their candor. Thus, defendants did not owe the plaintiffs a duty of disclosure. Accordingly, the court found that the Affiliated Ute presumption did not apply and held that the plaintiffs must prove that they individually relied on the banks’ omissions. Having determined that the Affiliated Ute presumption did not apply, the 5th Circuit proceeded to review the district court’s determination that the fraud-on-the-market presumption of the 1988 U.S. Supreme Court decision in Basic Inc. v. Levinson applied. The 5th Circuit found that it did not and that the district court predicated its ruling on an erroneous interpretation of the Securities Exchange Act of 1934, in particular 15 U.S.C. �78j-10(b), and as a result no misrepresentations occurred that would trigger the fraud-on-the-market presumption. “The district court’s definition of”deceptive acts,’ ” the court stated, “ thus sweeps too broadly; the transactions in which the banks engaged were not encompassed within the proper meaning of that phrase. Enron had a duty to its shareholders, but the banks did not. The transactions in which the banks engaged at most aided and abetted Enron’s deceit by making its misrepresentations more plausible. The banks’ participation in the transactions, regardless of the purpose or effect of those transactions, did not give rise to primary liability under � 10(b).” Having determined that the banks’ alleged actions were not “misrepresentations” in the sense of “deceptive acts” on which an efficient market may be presumed to rely, the 5th Circuit next found that the banks’ actions also did not constitute manipulation. Manipulation, the court stated, required that a defendant act directly in the market for the relevant security. Applying the definition of manipulation found in the U.S. District Court for the Northern District of Texas’ 1979 decision In Hundahl v. United Benefit Life Ins. Co., the 5th Circuit concluded that the banks’ actions were not alleged to be the type of manipulative devices on which an efficient market may be legally presumed to rely, because the banks did not act directly in the market for Enron securities. In summary, the 5th Circuit held that the Affiliated Ute presumption of class-wide reliance did not apply. Likewise, the district court, albeit with the best of intentions, misapplied the fraud-on-the-market presumption; the facts alleged did not constitute misrepresentations on which an efficient market may be presumed to rely. Because no class may be certified in a �10(b) case without a class-wide presumption of reliance, the 5th Circuit court stated that its analysis of reliance disposed of the appeal. OPINION:Smith, J.; Jolly and Smith, J.J. CONCURRENCE:Dennis, J. “Although I ultimately agree that the certification order must be reversed, I do not believe that the law necessarily prevents the plaintiffs from prosecuting this case as a class action. . . . I would remand the case to the district court for further consideration of whether the criteria for certification have been satisfied. . . . I would reverse the decision to certify the class on this ground only and remand the case to the district court to consider whether, in light of the proper interpretation of the PSLRA’s joint and several liability provision, the proposed class still satisfies the predominance and superiority requirements of Rule 23(b)(3).”