Wall Street Law Blog

10b-5 Claim for Securities Fraud: Whom to sue?

You can sue primary violators of Rule 10b-5.  You cannot sue those who merely aid and abet a securities fraud.  Trouble is, the line between primary violators and those who aid and abet a securities fraud moves like the San Andreas fault.

 

In the landmark Central Bank of Denver case, the US Supreme Court ruled that there is no private right of action available against those who aided and abetted another to commit securities fraud.  In other words, you can't sue people who merely helped another to defraud you.

Ever since the Central Bank decision, there has been considerable disagreement about where to draw the line between aiders and abettors and primary violators (who, unlike aiders and abettors, can be sued for investment losses). 


The debate about who can be sued for securities fraud cannot be settled until there is a consensus line in the sand type test for separating primary violators from mere helpers.

The following post, reprinted from Jim Hamilton’s World of Securities Regulation, describes the SEC's position on a major point of controversy in the "who to sue" debate.

 

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In an amicus brief filed in the Second Circuit Court of Appeals, the SEC said that attribution of a false or misleading statement to a person is only one means by which that person can create the statement and thus be a primary violator under the Central Bank rubric. A person who, acting with the requisite scienter, creates a misstatement is a primary violator regardless of whether the victim knows the person’s identity. Thus, the SEC disagreed with the district court’s holding that, in order for a person to be a primary violator with respect to a publicly disseminated false or misleading statement, the person must have been identified to potential investors as the maker of the statement or, in other words, the statement must have been attributed to the person at the time it was made. Pacific Management Company LLC v. Mayer Brown LLP, CA-2, on appeal from SD NY, 09-1619-cv.

This is a Rule 10b-5 private damages action. While the SEC, unlike a private party, has express statutory authority to bring aiding and abetting claims, there are instances where the Commission might need to assert a claim for primary liability. The SEC is concerned that the district court appeared to recognize language in the Second Circuit’s 2008 ruling in US v. Finnerty suggesting in dictum that attribution is required even in a government law enforcement action.

In Central Bank v. First Interstate Bank, the Supreme Court drew a distinction between persons who aid and abet securities fraud violations and primary violators of Rule 10b-5, ruling that private parties cannot bring actions against aiders and abettors, only against primary violators. The Court said that secondary actors, such as lawyers and accountants, could be primary violators if they made a false or misleading statement.

In the SEC’s view, a person makes a false and misleading statement and can thus be liable as a primary violator of Rule 10b-5 when he or she creates the statement. In this context, a person creates the statement if they write or speak the statement or if they provide the false or misleading information that another person puts into the statement or if they allow the statement to be attributed to them. For example, a person who actually drafted an offering document containing false or misleading statements can be a primary violator, as can a person who supplied the writer with the false or misleading information in the document, as can a person who signed the offering document or otherwise acknowledged to investors that the statements were his or her own.

The SEC argued that its position is consistent with the Court’s Central Bank ruling. The Court did two things in Central Bank, said the SEC, first the Court held that there is no private right of action for aiding and abetting under Rule 10-5 but only for primary violations and, secondly, it stated that a plaintiff would have a private cause of action against a secondary actor for primarily violating Rule 10b-5 when the secondary actor was a primary violator, that is, had, among other things, made a false or misleading statement. According to amicus, the Court thus excluded liability when a person’s responsibility for a false or misleading statement did not rise to the level of a primary violation and made clear that if a person’s liability did rise to that level, then the person would be liable even though he or she might not have been the principal actor in the alleged fraudulent activity.

The word ‘’make’’ as used in Central Bank, noted the SEC, does not give rise to a requirement that only a person who has been identified to investors can be deemed to have made a statement. A person can ``make’’ a false or misleading statement anonymously or indirectly through someone else.

A test imposing primary liability when a person creates a false or misleading statement reflects both of the Central Bank concerns, said the SEC. Such a person is, with regard to the statement, not just an aider and abettor, he or she is responsible for the statement coming into being. As such, the person should be held primarily liable. And, continued amicus, a person creating a false or misleading statement would be primarily liable without regard to whether he or she acted alone or with others. They would also be primarily liable regardless of whether they initiated the false or misleading statement.

The SEC also contended that an attribution requirement would shield significant misconduct from liability by allowing a person who created a false or misleading statement to escape primary liability by acting anonymously or in another’s name. Thus, the SEC reasoned that an attribution requirement could provide a defense for the person having the greatest culpability for a deception.

Thank you Jim Hamilton’s World of Securities Regulation.

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There is an answer to the "who to sue" question-

Sue anyone you have a reasonable and good faith belief may have played a core role in committing securities fraud.

Then just wait for the motion to dismiss based on Central Bank of Denver...

Contact The Sherman Law Firm.

 

 

 

Another Brick in the Wall of Securities Fraud at Bear Stearns (updated)

*FRAUD BY SILENCE AND COVER-UP*     

By Brett Sherman

An individual's creditworthiness is highly correlated to mortgage default risk. In other words, the worse a borrower's credit history, the more likely it is that the borrower will default. 

A subprime borrower is more likely to default than an individual with strong credit background. Indeed, it cannot be disputed that subprime mortgages have always been riskier for lenders than conforming mortgages. It is specifically because subprime loans have relatively high default rates - and are therefore risky by definition - that subprime borrowers must pay higher interest rates than individuals who qualify for conforming mortgages. 

To prevent lenders from taking excessive risks, both prime and nonprime mortgage applicants historically have been subject to a rigorous underwriting process. In the later years of the housing bubble, lending standards simply disappeared for subprime mortgage applicants. 

Today, it is well known that subprime lenders (including Bear Stearns' own mortgage subsidiaries) progressively reduced subprime underwriting requirements during the housing bubble.  At the time, however, Bear Stearns failed to disclose (a) that lending standards were eroding, or (b) that the reason for lowering underwriting requirements was to preserve the immense profits from sales of mortgage securities. 

By 2004-2005, Bear Stearns knew that the supply of "qualified" subprime borrowers was dwindling. To keep the Company's mortgage inventories large enough to maintain and expand its incredibly profitable mortgage securitization and sales platforms, new mortgage origination rates had to stay high.  The only way lenders could assure a steady supply of new mortgages for the securitization machines of Bear Stearns and others was to increase the universe of the subprime borrowers. And the only way to increase the number of "qualified" borrowers was to relax, and eventually almost eliminate, subprime lending standards. 

Because mortgage default risk grows as credit quality and income shrink, Bear Stearns cannot credibly argue that the firm did not know that new batches of collateralized debt obligations were backed by far more risky loans than in prior years. 

Bear Stearns certainly knew that the MBS and CDOs the firm sold to investors in the later years of the bubble were loaded with junk mortgages.  Therefore, there is no doubt that Bear Stearns knew that the inevitable disruption of rising home prices could very well produce vast numbers of mortgage defaults by low credit homeowners. 

Despite all that it knew about the ever precarious quality of subprime loans, Bear Stearns continued to collude with credit rating agencies to obtain investment grade ratings. Worse, Bear Stearns still publicly insisted that its mortgage securities were extremely safe investments.

Sales of newer "vintage" collateralized debt obligations grew at an incredible rate through early 2007. At the time, Bear Stearns' decision to omit material and specific new risk disclosures (and/or to lie about the prospects of its MBS businesses) allowed the Company's stock price to artificially inflate. 

When defaults of low quality MBS and CDOs started to spike in late winter/early spring 2007, the high risk nature of the more recent crop of mortgages became apparent.  Soon thereafter, Bear Stearns' stock price began its long slide into oblivion. 

Failing to make plain English, honest, accurate and specific risk disclosures about the junk mortgages in the MBS and CDOs the firm created and sold is one way Bear Stearns committed securities fraud during the financial crisis. 

There were many others...