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Are Enron’s banks liable to Enron’s shareholders? A federal appeals court last month held that they are not. Its ruling has important implications for other banks, lawyers, and accountants potentially facing lawsuits over so-called scheme liability, and the Supreme Court will, no doubt, consider the case’s reasoning when it soon addresses the issue. In its March 19 decision in Regents of the University of California v. Credit Suisse First Boston (USA) Inc., the U.S. Court of Appeals for the 5th Circuit reversed the class-certification decision in securities-fraud litigation against financial institutions that allegedly actively participated in a “scheme” to defraud shareholders of Enron Corp. The banks whose conduct was at issue had not made any material misstatements to Enron’s shareholders, and, unlike Enron itself, they were under no legal obligation to make public disclosures about the energy company. The 5th Circuit held that the district court’s class-certification decision had accepted the theory of scheme liability based on an “erroneous understanding of securities law.” SCHEME LIABILITY? Scheme liability is the theory that a defendant that has not made a material misstatement or omission or engaged in manipulative activities may nonetheless be liable for participating in a scheme to defraud investors. The suits are usually based on Subsections (a) or (c) of Rule 10b-5, a rule that broadly prohibits fraud in conjunction with securities transactions. This rule was promulgated by the Securities and Exchange Commission under Section 10(b) of the Securities Exchange Act of 1934. The advocates of scheme liability must struggle to overcome a dichotomy established by the Supreme Court. In Central Bank of Denver N.A. v. First Interstate Bank of Denver N.A. (1994), the Supreme Court held that Section 10(b) reaches only primary violators, those who actually commit an act in violation of the statute, not those who merely aid and abet another person who violates the act. “As in earlier cases considering conduct prohibited by �10(b),” the Court wrote, “we again conclude that the statute prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act.” On the other hand, the Court observed that “[t]he absence of �10(b) aiding and abetting liability does not mean that secondary actors in the securities markets are always free from liability.” Consequently, “[a]ny person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) . . . may be liable as a primary violator under Rule 10b-5, assuming all of the requirements for primary liability under Rule 10b-5 are met” (emphasis added). In the case of Enron, when certifying a class in June, Judge Melinda Harmon of the U.S. District Court for the Southern District of Texas endorsed a formulation of “scheme” liability advocated by the SEC. It reflects an attempt to draw a line between primary participation in a fraudulent scheme and mere aiding and abetting. She wrote: “[I]f a third party enters into a legitimate transaction with a corporation where it knows that the corporation will overstate revenue generated by that transaction, the third party is merely aiding and abetting; in contrast, if the third party and the corporation engage in a transaction whose principal purpose and effect is to create a false appearance of revenues, intended to deceive investors in that corporation’s stock, the third party may be a primary violator.” In what now has resulted in a major split in the circuits, the 9th Circuit adopted a similar theory of scheme liability in Simpson v. AOL Time Warner Inc. (2006). NO SCHEME LIABILITY In reversing Harmon’s class-certification decision, a 2-1 majority of the 5th Circuit panel wrote that the Supreme Court has held that Rule 10b-5 may not be interpreted more broadly than its authorizing statute, Section 10(b). Under Section 10(b), conduct is not actionable unless it is “manipulative” or “deceptive.” The majority decided that “[m]anipulation requires that a defendant act directly in the market for the relevant security.” Thus, “practices in the marketplace which have the effect of either creating the false impression that certain market activity is occurring when in fact such activity is unrelated to actual supply and demand or tampering with the price itself are manipulative.” And “deception” applies only where the defendant made a misstatement or, where under a duty to disclose, an omission. Thus, a defendant who did not manipulate the securities market or deceive investors with a material misstatement or omission may not be held liable for participating by means of other kinds of actions in a fraudulent scheme. The 8th Circuit reached the same result with similar reasoning in In re Charter Communications Inc. Securities Litigation (2006). It concluded, “[A]ny defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under �10(b) or any subpart of Rule 10b-5.” The Supreme Court, presumably recognizing the different interpretations of “scheme” liability among the 9th, 8th, and 5th Circuits and a number of district courts, as well as the importance of the issue, granted a petition for certiorari in the 8th Circuit’s Charter case. The appellant’s brief is due in June, and the Court will not hear oral argument until the next term, which begins in October. HIGH PROFILE, HIGH STAKES It remains to be seen whether the Supreme Court will also review the more emotionally charged Enron case. It is noteworthy that in Enron — a closely watched and high-stakes case — the reasoning against scheme liability prevailed. Given that so many people lost so much in the collapse of Enron, the incentive for plaintiffs to find a way to make deep-pockets pay was great. The 5th Circuit noted that its decision might not be well-received by investors who lost money: “We recognize, however, that our ruling on legal merit may not coincide, particularly in the minds of aggrieved former Enron shareholders who have lost billions of dollars in a fraud they alleged was aided and abetted by the defendants at bar, with notions of justice and fair play.” There has been no shortage of emotions surrounding the Enron case. The class plaintiffs, in their petition for certiorari to the Supreme Court earlier this month, referred to the “Enron debacle” as “the worst securities fraud in recent history.” They claimed that the 5th Circuit’s decision “denied the victims of this notorious fraud even a chance to prove their �10(b) case.” They also wrote that the decision represented “an injustice to the victims of the Enron fraud, and an unjustified rebuke to a district judge who vigilantly oversaw and meticulously managed a highly complex case for years, pulling the rug out from under her just a few weeks before trial.” It is true that the alleged facts of Enron — as characterized by the plaintiffs — were incendiary. The banks allegedly “entered into partnership 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.” Plaintiffs alleged that “the banks knew exactly why Enron was engaging in seemingly irrational transactions.” The banks allegedly knew “that Enron was engaging 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.” Of course, it is easy to point a finger at the deep-pocketed banks and accuse them of being enablers of Enron’s wrongdoing. But the majority of the 5th Circuit panel found that the alleged conduct on the part of the financial institutions, even if true, was not the kind of conduct that the securities laws were designed to reach. The banks were not sued for making public statements to Enron’s shareholders. Rather, they engaged in business transactions with Enron. To the extent that shareholders of Enron were misled, they were misled by Enron, not the banks. As the 5th Circuit noted, the “common feature” of the alleged transactions “is that they allowed Enron to misstate its financial condition.” STICKING TO THE STATUTE Section 10(b) did not expressly create a private right of action, but 60 years ago the courts began to find an implied private right of action in the statute. Yet Supreme Court decisions over the past three decades have emphasized the importance of limiting the implied cause of action by the words of the statute. The Court, for example, has turned back efforts to extend Section 10(b) to negligent conduct, corporate mismanagement, and aiding and abetting securities fraud. To be sure, Section 10(b) should be interpreted flexibly to achieve Congress’ intended purposes, but it cannot be re-written by courts to reach conduct not covered by its terms. It is a fundamental precept of fairness that statutes must give fair notice of what is prohibited. More than 70 years after enactment of Section 10(b), the scope (indeed existence) of scheme liability is hotly contested. Moreover, the courts that have embraced scheme liability have acknowledged that the line between primary participation and mere aiding and abetting cannot be clearly drawn as to fully inform people in advance what types of conduct might run afoul of the law. The determination of the definition or existence of scheme liability by the Supreme Court in Charter is likely to have far-reaching effects for banks, lawyers, and accountants. It is not an answer to shift losses from one group of shareholders to another (for example, the banks’ shareholders) because there is fraud at an issuer of securities. Fairness and an efficient economy demand a clearer description of the standard of conduct that third parties, and particularly financial institutions, must meet. It should not include responsibility for the misdeeds of their clients.
Gregory A. Markel is chairman of the litigation department and a partner in the New York office of Cadwalader, Wickersham & Taft. Gregory G. Ballard is a litigation partner in the firm’s New York office. They represented one of Enron’s banks that settled out of the litigation.

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