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.

 

********************

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.

*******************

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.

 

 

 

Teaser-rates, Mortgages & Ponzi Schemes

To make mortgage-backed securities, securitizers needed MORTGAGES to BACK the securities (editorial decidion to save synthetic CDOs for another day) 

 

The incurable - and very foreseeable -flaw in a business model predicated on turning nonprime mortgages into securities is that the well of borrowers who can actually afford to own a home must eventually run dry.  

Guess what happened...  Some time around the end of 2004, the supply of potential new borrowers was evaporating quickly.   The solution?  Start lending to folks who can't afford to own a home (by that, we mean lending to people who can't afford to make mortgage payments).  Lord knows, there were and are millions of Americans who fall into that category.

Lenders, either owned or financed by Wall Street, responded to the dwindling supply of qualified borrowers by cutting underwriting standards.  First, Wall Street realized that the magic of two or three year teaser rates permitted people to buy homes they had no business buying.

As long as borrowers paid the artificially low teaser-rates long enough for financial institutions to stuff the new mortgages into mortgage-backed securities and sell off the MBS to investors (about a three to four month process), big fees could keep on flowing into Wall Street's coffers.

Mind you, Citi and Merill and Lehman and and Bear knew that these teaser rate loans had to be refinanced (at substantial cost to borrowers) before the teaser periods expired and new, UNAFFORDABLE rates kicked in.  That was the plan for the get-go (Wall Street Law Blog has never used the term get-go before - perhaps a freudian slip kind of thing? Get-go does sound a lot like Gekko).

The whole idea idea was to let borrowers' home equity grow for a few years, then refinance the loan so it did not reset to a higher rate.

Thus, these teaser-rate mortgages, mainly 2/28 Hybrid ARMs, were never meant to be 30 year mortgages.  Instead, such "affordability loans" were more like leases that had to be renewed every two to three years, or else...

This  teaser-rate carousel was a form of Ponzi scheme, and it played a leading role in making the mortgage-backed securities con game profitable.

 

 

In a traditional Ponzi scheme, the schemer (usually an investment advisor) uses money received from new investors to pay attractive, but phony, investment returns to prior investors.  In a Ponzi scheme, new money bails out the old money. When, eventually, there is a shortage of new victims/investors (ie if there is not enough new money to bail out the old), the Ponzi scheme collapses.

The Ponzi-like twist with teaser rate mortgages is that unqualified borrowers had to be refinanced into NEW mortgages with NEW low teaser rates before the initial (or prior) teaser period expired. Instead of new money bailing out the old, new teaser rate ARMs bailed out the old.  

Until, that is, home prices stopped climbing.

When home values stopped appreciating in late 2005, so (obviously) did home equity. Soon, prices started falling.  Without the additional wealth produced by ever-growing home equity,nonprime borrowers could not refinance. There were no new teaser periods to bail out the old. Each month, as more loans reset to higher rates, more borrowers could not afford their homes. The Ponzi-like scheme collapsed. Subprime and Alt-A Mortgage defaults skyrocketed.

Eventually, mortgage-backed securities faced cashflow shortfalls and, beginning with the riskiest tranches, issuers of mortgage-backed securities began to default on payments to investors.

So many ways to commit securities fraud... Somewhere Charles Ponzi is smiling.

By Brett Sherman, The Sherman Law Firm