March 22, 2007
In a decision having important implications both for the scope of liability under the securities laws and for class certification in general, on March 19, the Fifth Circuit ruled that a securities fraud action against certain financial institutions that participated in transactions with Enron Corporation could not proceed as a class action. The decision, Regents of the University of California v. Credit Suisse First Boston (USA), Inc., No. 06-20856, 2007 WL 816518 (5th Cir. March 19, 2007), adds to a growing body of federal caselaw that places limits on efforts by plaintiffs’ lawyers to plead securities fraud claims against secondary actors such as investment banks and other professional advisors, who did not themselves make any misrepresentations or omissions. The Fifth Circuit joins the Eighth Circuit in narrowly construing the scope of liability under such theories, and helps solidify a circuit split with the Ninth Circuit, which recently adopted a more liberal standard.
The Fifth Circuit’s decision denying class certification also represents another recent example of how federal courts are beginning to impose more rigorous standards for certification of investor classes in securities cases, and are permitting defendants to present more sophisticated "merits-based" arguments opposing class certification in appropriate cases. In December 2006, the Second Circuit reached a similar conclusion in the high-profile In re IPO Public Offerings Securities Litigation case, and denied class certification in that case as well.
Background of the Decision
As the Fifth Circuit observed, the facts underlying the Enron case "are difficult to detail but easy to summarize." In essence, purchasers of Enron securities alleged that various financial institutions engaged in transactions with Enron that enabled Enron to misstate its financial condition. According to the plaintiffs, the financial institutions knew the reason why Enron was engaging in the transactions, and that they were helping Enron carry out a long-term scheme to defraud investors.
Because the financial institutions themselves made no actionable statements concerning Enron’s financial condition, under the Supreme Court’s decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), they could not be held primarily liable for securities fraud under SEC Rule 10b-5(b), which prohibits material misrepresentations or omissions. Instead, as many plaintiffs have done in the years since Central Bank, the Enron plaintiffs alleged that the financial institutions could be held primarily liable under Rule 10b-5(a), which makes it unlawful to "employ any device, scheme, or artifice to defraud," and Rule 10b-5(c), which makes it unlawful to "engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person."
Early in the litigation, the financial institutions moved to dismiss the complaint, arguing that the complaint alleged, at most, that they aided and abetted Enron in committing securities fraud. The district court denied their motions, holding that the plaintiffs alleged a primary violation of the securities laws. When the plaintiffs moved for class certification several years later, the Court reconsidered the issue of primary versus secondary liability, but adhered to its earlier decision. Specifically, the district court adopted a test proposed by the SEC, which defined a "deceptive act" to include participating in a "transaction whose principal purpose and effect is to create a false appearance of revenues." In re Enron Corp. Sec. Derivative & Sec. Litig., Civ. Action No. H-01-3624, 2006 U.S. Dist. LEXIS 43146, at *167 (S.D. Tex. June 5, 2006). The district court went on to hold that the plaintiffs were entitled to a presumption of reliance under both the Affiliated Ute doctrine (providing that reliance may be presumed in Section 10(b) cases based primarily on a failure to disclose, Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972)) and the "fraud on the market" theory (providing that reliance is presumed where securities trade in an efficient market, because the market price purportedly reflects all material, public information and the investor is presumed to rely on the integrity of the market price). Id. at *272-373. Based in large part upon these holdings, the district court certified a class of investors.
The Majority Decision In the Fifth Circuit
The Fifth Circuit, in a majority decision by Judge Smith, joined by Judge Jolly, reversed and remanded. Judge Dennis wrote a separate concurring opinion.
Interlocutory Appeal Was Proper. The Court of Appeals first held that the appeal had been properly accepted under Rule 23(f). The Fifth Circuit recognized that "class certification may be the backbreaking decision that places ‘insurmountable pressure’ on a defendant to settle, even where the defendant has a good chance of succeeding on the merits," such that "it is appropriate to provide appellate review before settlement may be coerced by an erroneous class certification decision." (Although the court did not expressly refer to this fact in connection with this issue, the court noted elsewhere that other defendants have already settled with the Enron plaintiffs for approximately $7 billion in the aggregate.)
Court Must Consider "Merits" Facts. Most importantly, the Court of Appeals rejected the plaintiffs’ argument concerning the scope of review, holding that "[i]n a rule 23(f) appeal, this court can, and in fact must, review the merits of the district court’s theory of liability insofar as they also concern issues relevant to class certification." The court recognized that its review of the class certification decision might well be "practically dispositive of the merits." Nevertheless, "[t]he fact that an issue is relevant to both class certification and the merits . . . does not preclude review of that issue." Accordingly, it agreed to consider the "merits" arguments presented by the defendants.
No Presumption of Reliance. On the merits, the Court of Appeals noted that a class could not be certified when individual reliance of shareholders on the allegedly fraudulent conduct is an issue, and thus the district court’s decision finding a presumption of reliance was essential to the class certification decision. The Fifth Circuit held, however, that the district court erred in holding that class-wide reliance could be presumed, for several reasons:
First, the Fifth Circuit held that the Affiliated Ute presumption of reliance applied only where the case was primarily based on non-disclosure and where "the defendant owed [the plaintiff] a duty of disclosure." Because the financial institutions in the Enron case "were not fiduciaries and were not otherwise obligated to the plaintiffs," "[t]hey did not owe plaintiffs any duty to disclose the nature of the alleged transactions." Accordingly, the Affiliated Ute presumption was inapplicable.
Second, the Fifth Circuit held that the fraud-on-the-market theory was inapplicable, and that the district court’s erroneous conclusion that the theory applied depended on an "overly broad definition" of what constitutes a "deceptive act" under Rule 10b-5. The court recognized that other courts have struggled since Central Bank with defining the boundary between primary and secondary liability, and that the Eighth and Ninth Circuits have split on this issue. Compare In re Charter Commc’ns, Inc. Sec. Litig., 443 F.3d 987, 992 (8th Cir. 2006) ("[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."), petition for cert. filed (July 7, 2006) (No. 06-43), with Simpson v. AOL Time Warner, Inc., 452 F.3d 1040, 1048 (9th Cir. 2006) ("[T]o be liable as a primary violator of § 10(b) for participation in a ‘scheme to defraud,’ the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme."), petition for cert. filed (Oct. 19, 2006) (No. 06-560). The Fifth Circuit agreed with the Eighth Circuit, and expressly rejected the Ninth Circuit approach.
Third, the Fifth Circuit found that there was no duty of disclosure on the part of the defendant financial institutions that made their conduct "deceptive." The court based its decision on Supreme Court decisions that, it said, "establish that a device, such as a scheme, is not ‘deceptive’ unless it involves breach of some duty of candid disclosure." Because the financial institutions did not have a duty of disclosure to Enron’s shareholders, engaging in the transactions with Enron, "regardless of the purpose or effect of those transactions, did not give rise to primary liability under § 10(b)." As a result, the market was not entitled to rely on the bank’s conduct, and the fraud-on-the-market theory was inapplicable. “Because no class may be certified in a § 10(b) case without a classwide presumption of reliance,” the district court’s certification order was reversed.
The Concurring Opinion
Judge Dennis took a radically different approach in his concurring opinion. Judge Dennis believed that the court should not have addressed the scope of primary liability under the securities laws, because "[t]he mere fact that the resolution of a merits issue against a putative class of plaintiffs would, by definition, preclude the maintenance of a class action simply cannot be sufficient to warrant review of that issue on an interlocutory appeal." Assuming that it was appropriate to address that merits issue, Judge Dennis, quoting SEC v. Zandford, 535 U.S. 813, 819 (2002), wrote that the term "deceptive" should not be narrowly defined but, instead, should be construed "flexibly to effectuate its remedial purposes." Judge Dennis agreed with the more liberal test adopted by the district court and the Ninth Circuit. Judge Dennis also addressed an issue that the majority determined that it need not address. Specifically, he agreed with the district court that a defendant found to have knowingly violated the securities laws could be held jointly and severally liable "for all of the losses caused by Enron’s entire overarching fraudulent scheme," including conduct of other scheme participants about which it did not even know. Judge Dennis concluded, however, that the district court had gone too far, because the district court would have permitted recovery by investors who were not harmed in some way by the particular defendant’s conduct. “It would simply be inconsistent with the elements of a Section 10(b) claim to hold a knowing violator jointly and severally liable for the damages of any plaintiff to whom it is not primarily liable under Section 10(b).” Accordingly, Judge Dennis would have remanded the case to the district court to consider whether class certification was appropriate in light of this clarification of the applicable legal standard.
Implications of the Fifth Circuit Decision
The financial press is reporting that the immediate impact of the Fifth Circuit decision is that the trial of the case that was scheduled to commence on April 9, 2007 has been postponed. Bill Lerach, counsel for the plaintiffs, is quoted as saying the Fifth Circuit decision is "unfair and wrong" and has indicated that the plaintiffs likely will appeal to the U.S. Supreme Court.
The Fifth Circuit decision may encourage the U.S. Supreme Court to accept review of the Eight Circuit’s decision in Charter or the Ninth Circuit’s decision in Simpson, on the issue of the scope of primary liability under Section 10(b). In Charter, as noted earlier, the Eighth Circuit held that there is no primary liability under Section 10(b) unless a defendant actually makes a misrepresentation or omission or directly engages in a manipulative securities trading practice. 443 F.3d at 992. In Simpson, the Ninth Circuit expressed a more expansive view of primary liability, under which a secondary actor who makes no misrepresentation or omission, but who engages in conduct for the principal purpose of creating a false financial appearance, may be held primarily liable under Section 10(b). 452 F.3d at 1048. The Fifth Circuit has aligned itself with the Eighth Circuit. Petitions for certiorari in both Charter and Simpson are currently pending before the U.S. Supreme Court.
Finally, the Fifth Circuit decision may encourage the U.S. Supreme Court to resolve the conflict among the circuits over the standards for class certification under Rule 23 of the Federal Rules of Civil Procedure. In agreeing to consider the "merits" issues presented to the trial court in connection with class certification, the Fifth Circuit effectively aligned itself with the Second Circuit. In its decision in In re IPO Public Offerings Securities Litigation, 471 F.3d 24, 41 (2d Cir. 2006), the Second Circuit held that a district court must resolve factual disputes relevant to each Rule 23 requirement, even if the factual disputes overlap with or are identical to a merits issue. By contrast, in its recent decision in Dukes v. Wal-Mart, 474 F.3d 1214, 1227 (9th Cir. 2007), the Ninth Circuit stated that "arguments evaluating the weight of evidence or the merits of a case are improper at the class certification stage."
Gibson, Dunn & Crutcher’s Securities Litigation Practice Group is available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn attorney with whom you work or:
Jonathan C. Dickey – Palo Alto (650-849-5324, firstname.lastname@example.org),
Robert F. Serio – New York (212-351-3917, email@example.com),
Wayne W. Smith – Orange County (949-451-4108, firstname.lastname@example.org),
M. Byron Wilder – Dallas (214-698-3231, email@example.com),
Gail E. Lees – Los Angeles (213-229-7163, firstname.lastname@example.org),
Marshall R. King – New York (212-351-3905, email@example.com),
James L. Hallowell – New York (212-351-3804, firstname.lastname@example.org) or
Aric H. Wu – New York (212-351-3820, email@example.com).
© 2007 Gibson, Dunn & Crutcher LLP
The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.