In Re Enron Corp. Securities, Derivative & ERISA Lit.

MEMORANDUM AND ORDER

RE SECONDARY ACTORS’ MOTIONS TO DISMISS

HARMON, District Judge.

The above referenced putative class action, brought on behalf of purchasers of Enron Corporation’s publicly traded equity and debt securities during a proposed federal Class Period from October 19, 1998 through November 27, 2001, alleges securities violations (1) under Sections 11 and 15 of the Securities Act of 1938 (“1933 Act”), 15 U.S.C. §§ 77k and 77o; (2) under Sections 10(b), 20(a), and 20A of the Securities Exchange Act of 1934 (“Exchange Act” or “the 1934 Act”), 15 U.S.C. §§ 783 (b), 78t(a), and 78t-l, and Rule 10b-5 promulgated thereunder by the Securities and Exchange Commission (“SEC”), 17 C.F.R. § 240 .10b-5; and (3) under the Texas Securities Act, Texas Rev. Civ. Stat. Ann. art. 581-33 (Vernon’s 1964 & 2002 Supp.).

Pending before the Court

inter alia

are motions to dismiss pursuant to Rules 8(e)(1),

1

9(b),

2

and 12(b)(6)

3

of the

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Federal Rules of Civil Procedure, the Private Securities Litigation Reform Act of 1995 (the “PSLRA”), codified at 15 U.S.C. § 78u-4(b)(3)(A), and

Central Bank of Denver v. First Interstate Bank of Denver,

511 U.S. 164 , 114 S.Ct. 1439 , 128 L.Ed.2d 119 (1994), filed by the following accounting firms, law firms, and investment banks/integrated financial services institutions (“secondary actors in securities markets”

4

): (1) Canadian Imperial Bank of Commerce (“CIBC”)(# 615); (2) CitiGroup Inc. (# 629); (3) J.P. Morgan Chase & Co.(# 632); (4) Vinson & Elkins L.L.P. (# 648); (5) Arthur Andersen LLP (#650); (6) Barclays PLC (#653); (7) Credit Suisse First Boston (# 658); (8) Kirkland & Ellis (#660); (9) Bank of America Corporation (# 664); (10) Merrill Lynch & Co. (# 667); (11) Lehman Brothers Holdings Inc. (# 679); and (12) Deutsche Bank AG (# 716).

5

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In essence Lead Plaintiffs consolidated complaint alleges that these and other named Defendants “are liable for (i) making false statements, or failing to disclose adverse facts while selling Enron securities and/or (ii) participating in a scheme to defraud and/or a course of business that operated as a fraud or deceit on purchasers of Enron’s public securities during the Class Period.... ” Consolidated complaint (# 441) at 254.

APPLICABLE LAW

The rapid collapse of Enron Corporation (“Enron”) and the resulting scope, variety, and severity of losses are unprecedented in American corporate history. It is not surprising that this consolidated action raises a number of novel and/or controversial issues that the law has thus far not addressed or about which the courts are in substantial disagreement. Lead Plaintiff Regents of the University of California’s claims are grounded in securities statutes, but judicial construction of those statutes spans the full spectrum of possibilities. After a careful review of frequently divergent case law and extensive deliberation, the Court applies the following law to the allegations in the consolidated complaint and, where appropriate, explains the bases for its selection.

I. Texas Securities Act

Plaintiff the Washington State Investment Board asserts a class action claim under the Texas Securities Act against Defendants Arthur Andersen LLP, JP Morgan, and Lehman Brothers and against individual Enron Defendants Bel-fer, Blake, Buy, Causey, Chan, John Duncan, Fastow, Foy, Gramm, Harrison, Jae-dicke, Lay, LeMaistre, Meyer, Jeffrey Skilling, Urquhart, Wakeham, Walker, Willison, Winokur in connection with the sale to the Washington Board and proposed subclass of $250 million of 6.95% Notes due July 15, 2028 and $250 million of 6.40% Notes due July 15, 2006.

Article 581-33 of the Texas Securities Act, Tex.Rev.Civ. Stat. (Vernon’s Supp.2002), provides in relevant portion,

Civil Liabilities

A. Liability of Sellers.

(2) Untruth or Omission. A person who offers or sells a security (whether or not the security or transaction is exempt under Section 5 or 6 of this Act) by means of an untrue statement of materi-. al fact or an omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they are made, not misleading, is liable to the person buying the security from him, who may sue either at law or in equity for rescission, or for damages if the buyer no longer owns the security. However, a person is not liable if he sustains the burden of proof that either (a) the buyer knew of the untruth or omission or (b) he (the offeror or seller) did not know, and in the exercise of reasonable care could not have known of the untruth or omission. The issuer of the security (other than a

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government issuer identified in Section 5M) is not entitled to the defense in clause (b) with respect to an untruth or omission (i) in a prospectus required in connection with a registration statement under 7A, 7B, or 7C, or (ii) in a writing prepared and delivered by the issuer in the sale of a security....

F. Liability of Control Persons and Aiders

(1) A person who directly or indirectly controls a seller, buyer, or issuer of a security is liable under Section 33A, 33B, or 33C jointly and severally with the seller, buyer, or issuer, and to the same extent as if he were the seller, buyer, or issuer, unless the controlling person sustains the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of the existence of the facts by reason of which the liability is alleged to exist.

(2) A person who directly or indirectly with intent to deceive or defraud or with reckless disregard for the truth or the law materially aids a seller, buyer, or issuer of a security is liable under Section 33A, 33B, or 33C jointly and severally with the seller, buyer, or issuer, and to the same extent as if he were the seller, buyer, or issuer....

Tex.Rev.Civ. Stat. art. 581-33(A)(2), (F)(1) and (2)(Vernon Supp.2002). “Person”

inter alia

includes a corporation, partnership, limited partnership, company, and firm. Art. 581-4(B). “Sells” is defined as any act by which a sale is made, including a solicitation to sell, an offer to sell, or an attempt to sell, and encompasses “subscription, an option for sale, a solicitation of sale, a solicitation of an offer to buy, an attempt to sell, or an offer to sell, directly by an agent or salesman, by circular, letter, or advertisement or otherwise.”

Texas Capital Securities Inc. v. Sandefer,

58 S.W.3d 760, 775 (Tex.App.-Houston [1st Dist.] 2001, review denied),

citing

art. 581-4(e). Moreover, liability may be imposed against a defendant as long as the defendant constituted any link in the chain of the selling process.

Brown v. Cole,

155 Tex. 624 , 291 S.W.2d 704, 708 (Tex.1956);

Rio Grande Oil Co. v. State,

539 S.W.2d 917, 922 (Tex.Civ.App.-Houston [1st Dist.] 1976, writ ref'd n.r.e.);

Texas Capital Securities, Inc. v. Sandefer,

58 S.W.3d at 775 . The Texas Securities Act is to be construed “to protect investors” and “because article 581-33 is remedial in nature in the civil context, it ‘should be given the widest possible scope.’ ”

Texas Capital Securities,

58 S.W.3d at 775 ,

citing

Tex. Rev.Civ. Stat. art. 581-10-1 (b)(Vernon 2001) and

Flowers v. Dempsey-Tegeler & Co.,

472 S.W.2d 112, 115 (Tex.1971).

Article 581-33(A) has some significant differences from § 10(b) and from common law fraud in that it does not require reliance by the purchaser on the seller’s material misrepresentation or omission, i.e., the purchaser does not have to demonstrate that it would not have bought the security if it had known of the misrepresentation or omission.

Granader v. McBee,

23 F.3d 120, 123 (5th Cir.1994);

Weatherly v. Deloitte & Touche,

905 S.W.2d 642, 648-49 (Tex.App.-Houston [14th Dist.] 1995, writ dism’d w.o.j.)(“An omission or misrepresentation is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding to invest. An investor is not required to prove that he would have acted differently but for the omission or misrepresentation .... [T]he focus under the Texas Securities Act is on the conduct of the seller or issuer of the securities, i.e., whether they made a material misrepresentation, not on the conduct of the individual buyers.”);

Anheuser-Busch Companies, Inc. v. Summit Coffee Co.,

858 S.W.2d 928, 936 (Tex.App.-Dallas 1993, writ denied);

Rio Grande Oil Co.,

539 S.W.2d at 921 ;

Summers v. WellTech, Inc.,

935 S.W.2d 228, 234 (Tex.App.-Houston [1st Dist.] n.w.h.).

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Nor does the plaintiff have to demonstrate scienter under the Texas Act.

Wood v. Combustion Engineering, Inc.,

643 F.2d 339, 345 (5th Cir.1981).

6

Where there are similarities, Texas courts turn to cases construing federal securities laws for guidance in interpreting the Texas Securities Act.

In re Westcap Enterprises,

230 F.3d 717, 726 (5th Cir.2000);

Beebe v. Compaq Computer Corp.,

940 S.W.2d 304, 306-07 (Tex.App.-Houston [14th Dist.] 1997, no writ)(“While eases dealing with the federal securities laws are not dispositive concerning our interpretation of the Texas Securities Act, they may provide persuasive guidance.”);

Searsy v. Commercial Trading Corp.,

560 S.W.2d 637, 639 (Tex.1977);

Star Supply Co. v. Jones,

665 S.W.2d 194, 196 (Tex.App.-San Antonio 1984, no writ);

Campbell v. Payne,

894 S.W.2d 411, 417 (Tex.App.-Amarillo 1995, writ denied).

Thus to prevail under art. 581-33(A)(2), a plaintiff must show that the defendant seller in offering or selling a security made an untrue statement of material fact or an omission of material fact that was essential to make the statement not misleading.

Duperier v. Texas State Bank,

28 S.W.3d 740, 745 (Tex.App.-Corpus Christi, 2000),

revieiu dismissed by agreement

(Jan. 4, 2001). A misrepresentation or omission is “material if there is a substantial likelihood that proper disclosure would have been viewed by a reasonable investor as significantly altering the total mix of information made available .... In other words, the issue is whether a reasonable investor would consider the information important in deciding whether to invest.”

Id.

(and cases cited therein). The investor/buyer has no duty to perform due diligence nor to discover the truth by exercising ordinary care.

Id.; In re Westcap Enterprises,

230 F.3d at 726 .

Although the Texas Securities Act does not define “control person,” comments to the statute note, “control is used in the same broad sense as in federal securities law” and that “[depending on the circumstances, a control person might include an employer, an officer or director, a large shareholder, a parent company, and a management company.” Art. 581-33F cmt. “The rationale for control person liability is that a control person is in the position to prevent the violation and may be able to compensate the injured investor when the primary violator (e.g., a corporate issuer which has gone bankrupt) is not.”

Summers v. WellTech, Inc.

935 S.W.2d 228, 231 (Tex.App.-Houston [1st Dist.] 1996);

Texas Capital Securities Management, Inc.,

80 S.W.3d at 268. To make a

prima facie

case for control person liability under the Texas statute, the plaintiff must demonstrate that the defendant had actual power or influence over the controlled person and that the defendant induced or participated in the alleged violation.

Texas Capital Securities,

80 S.W.3d at 261,

citing Dennis v. Gen. Imaging, Inc.,

918 F.2d 496, 509 (5th Cir.1990);

G.A. Thompson & Co. v. Partridge,

636 F.2d 945, 958 (5th Cir.1981). Status alone is insufficient to establish that a defendant is a control person within the ambit of the statute.

Id.

at 268,

citing Dennis,

918 F.2d at 509 . A control person at a corporation can be sued directly without joining the corporation as a defendant.

Summers v. WellTech, Inc.

935 S.W.2d at 231 . If the buyer still owns the securities at issue, rescission is the sole remedy available; only if he has sold the securities, may he

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obtain money damages.

Id.; Texas Capital

Securities,

Inc.,

58 S.W.3d at 775 .

To establish aider and abettor liability under art. 581-33(F)(2), a plaintiff must demonstrate (1) the existence of a primary violation of the securities laws, (2) that the aider has a general awareness of its role in the violation, (3) that the aider gave substantial assistance in the violation, and (4) that the aider intended to deceive the plaintiff or acted with reckless disregard for the truth of the representations made by the primary violator.

Frank v. Beat", Steams, & Co.,

11 S.W.3d 380, 384 (Tex.App.-Houston [14th Dist.] 2000, writ denied).

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II. Federal Securities Law

A. Section 10(b) of the 1934 Act and Rule 10b-5

Section 10(b) of the Exchange Act states in relevant part,

It shall be unlawful for any person, directly or indirectly ... (b) To use or employ, in connection with the purchase or sale of any security ... any manipulative

8

or deceptive

9

device or contri-

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vanee

10

in contravention of such rules and regulations as the [SEC] may proscribe as necessary or appropriate in the public interest or for the protection of investors.

15 U.S.C. § 788 (b).

Rule 10b-5, which implements § 10(b), in turn provides in relevant part,

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

17 C.F.R. § 240 .10b-5. The scope of Rule 10b-5 is coextensive with the coverage of § 10(b).

United States v. O’Hagan,

521 U.S. 642, 651 , 117 S.Ct. 2199 , 138 L.Ed.2d 724 (1997);

Ernst & Ernst,

425 U.S. at 214 , 96 S.Ct. 1375 ;

SEC v. Zandford,

535 U.S. 813 , 122 S.Ct. 1899 , 1901 n. 1, 153 L.Ed.2d 1 (2002).

One objective underlying the enactment of § 10(b) following the 1929 stock market crash was “to insure honest securities markets and thereby promote investor confidence.”

United States v. O’Hagan,

521 U.S. at 658 , 117 S.Ct. 2199 . Furthermore Congress tried “ ‘to substitute a philosophy of full disclosure for the philosophy of

caveat emptor

and thus to achieve a high standard of business ethics in the securities industry.’ ”

Affiliated Ute Citizens of Utah v. United States,

406 U.S. 128, 150 , 92 S.Ct. 1456 , 31 L.Ed.2d 741 (1972),

quoting SEC v. Capital Gains Research Bureau, Inc.,

375 U.S. 180, 186 , 84 S.Ct. 275 , 11 L.Ed.2d 237 (1963). The Supreme Court has indicated that the statute should be “construed ‘not technically and restrictively, but flexibly to effectuate its remedial purposes.’ ”

Affiliated Ute Citizens of Utah v. United States,

406 U.S. at 151 , 92 S.Ct. 1456 ,

quoting SEC v. Capital Gains Research Bureau, Inc.,

375 U.S. at 195 , 84 S.Ct. 275 ;

Zandford,

122 S.Ct. at 1903 .

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a. Misleading Statements or Omissions

The PSLRA amends the Exchange Act and applies to private class actions brought pursuant to the Federal Rules of Civil Procedure. Pub.L. No. 104-67, 109 Stat, 737, codified at 15 U.S.C. §§ 77k, 77Z, 77z-l, 77z-2, 78a, 78j-l. 78t, 78u, 78u-4, 78u-5.

Under the PSLRA, 15 U.S.C. § 78u — 4(b)(1) & (2),

(b) Requirements for securities fraud actions

(1) Misleading statements and omissions In any private action arising under this chapter in which the plaintiff alleges that the defendant—

(A) made an untrue statement of a material fact; or

(B) omitted to state a material fact necessary in order to make the statements made in the light of the circumstances in which they were made, not misleading;

the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.

(2) Required state of mind

In any private action under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

If the facts are not pled with the requisite particularity, the action is to be dismissed. 15 U.S.C. § 78u-4(b)(3)(A). The Fifth Circuit views the standard of the PSLRA to

“at a minimum,

incorporate the standard for pleading fraud under” Rule 9(b).

ABC Arbitrage Plaintiffs Group v. Tchuruk,

291 F.3d 336, 349-50 (5th Cir.2002). Thus to plead a false or misleading statement or omission as the basis for a § 10(b) and Rule 10b-5(b) securities fraud claim and avoid dismissal, a plaintiff must

(1) specify ... each statement alleged to have been misleading, i.e., contended to be fraudulent;

(2) identify the speaker;

(3) state when and where the statement was made;

(4)plead with particularity the contents of the false representations;

(5) plead with particularity what the person making the misrepresentation obtained thereby;

(6) explain the reason or reasons why the statement is misleading,

ie.,

why the statement is fraudulent .... the ‘who, what, when, where, and how’ required under Rule 9(b) ... [and] under 15 U.S.C. § 78u-M(b)(l), for allegations made on information and belief, ... and

(7) state with particularity all facts on which that belief is formed,

i.e.,

set forth a factual basis for such belief.

Id.

at 350.

In most cases, at the pre-discovery stage, the allegations in the complaint are not based upon a plaintiffs personal knowledge and thus are based on “information and belief’ regardless of whether they are so characterized. The Fifth Circuit, relying on the Second Circuit’s reasoning in

Novak v. Kasaks,

216 F.3d 300 , 313-14 & n. (2d Cir.2000),

cert. denied,

531 U.S. 1012 , 121 S.Ct. 567 , 148 L.Ed.2d 486 (2000), has held with respect to the last requirement,

[O]ur reading of the PSLRA rejects any notion that confidential sources must be named as a general matter. In our

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view, notwithstanding the use of the word “all,” [§ 78u-4(b)(l) ] does not require that plaintiffs plead with particularity every single fact upon which their beliefs concerning false or misleading statements are based. Rather, plaintiffs need only plead with particularity sufficient facts to support those beliefs. Accordingly, where plaintiffs rely on confidential sources but also on other facts, they need not name their sources as long as the latter facts provide an adequate basis for believing that the defendants’ statements were false. Moreover, even if personal sources must be identified, there is no requirement that they be named, provided they are described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged. In both of these situations, the plaintiffs will have pleaded enough facts to support their belief, even though some arguably relevant facts have been left out. Accordingly, a complaint can meet the new pleading requirement imposed by paragraph (b)(1) by providing documentary evidence and/or a sufficient general description of the personal sources of the plaintiffs’ beliefs.

Id.

at 352. Nevertheless “if the other facts,

ie.,

documentary evidence, do not provide an adequate basis for believing that the defendants’ statements or omissions were false

and

the descriptions of the personal sources are not sufficiently particular to support the probability that a person in the position occupied by the source would possess the information pleaded to support the allegations of false or misleading statements made on information and belief, the complaint must name the personal sources.”

Id.

at 353.

Moreover, the Fifth Circuit also noted that where the complaint states that its allegations were made on “investigation of counsel,” the same pleading requirements as for “upon information and belief’ apply.

Id.

at 351 n. 70,

citing In re Sec. Litig. BMC Software, Inc.,

183 F.Supp.2d 860 , 885 n. 33 (S.D.Tex.2001).

To state a securities fraud claim under § 10(b) of the Exchange Act and Rule 10b-5(b), a plaintiff must allege, in connection with the purchase or sale of securities, (1) a misstatement or omission (2) of a material fact, (3) made with scienter, (4) on which the plaintiff relied and (5) which proximately caused his injury.

Abrams v. Baker Hughes, Inc.,

292 F.3d 424, 430 (5th Cir.2002),

citing Shushany v. Allwaste, Inc.,

992 F.2d 517, 520-21 (5th Cir.1993);

Nathenson v. Zonagen, Inc.,

267 F.3d 400, 406-07 (5th Cir.2001). Scienter for a private cause of action under § 10(b), means “intent to deceive, manipulate or defraud”

(Abrams,

292 F.3d at 430 ,

citing Ernst & Ernst v. Hochfelder,

425 U.S. 185 , 193 n. 12, 96 S.Ct. 1375 , 47 L.Ed.2d 668 (1976)) or at least knowing misconduct

(Herman & MacLean v. Huddleston,

459 U.S. 375, 382-83 , 103 S.Ct. 683 , 74 L.Ed.2d 548 (1983)(mere negligence is insufficient)). Because the PSLRA does not define generally the required scienter for private securities fraud claims under § 10(b) and Rule 10b-5, but only mandates that the plaintiff plead facts with particularity to give rise to a strong inference of the requisite state of mind, the Fifth Circuit has held that severe recklessness, “limited to those highly unreasonable omissions or misrepresentations that involve not merely simple or even inexcusable negligence, but an extreme departure from the standard of ordinary care, and that present a danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it,” is sufficient to satisfy the scienter requirement.

Nathenson,

267 F.3d at 408 .

To survive a motion to dismiss, the plaintiff must plead specific facts with

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particularity giving rise to a “strong inference” of scienter.

Nathenson,

267 F.3d at 407 . Circumstantial evidence may be used to give rise to a strong inference of scienter.

Abrams,

292 F.3d at 430 ;

Nathenson,

267 F.3d at 410 . Rather than a piecemeal analysis, this court must view the totality of alleged facts and circumstances, together as a whole, to determine whether they raise the requisite strong inference of scienter.

Abrams,

292 F.3d at 431 .

Allegations of motive and opportunity to commit fraud, by themselves, are generally insufficient to plead scienter in the Fifth Circuit, but may be employed along with other facts and circumstances to reach the level of severe recklessness.

Abrams,

292 F.3d at 430 ;

Nathenson,

267 F.3d at 410-411 . Nor "does a conclusory assertion that a defendant should have known about internal corporate problems based merely on his position or status within the corporation suffice.

Id.

at 432 . Moreover, “[a]n unsupported general claim about the existence of confidential corporate reports that reveal information contrary to reported accounts is insufficient to survive a motion to dismiss. Such allegations must have corroborating details regarding the contents of the allegedly contrary reports, their authors and recipients.”

Id.

at 432 . Rejecting the need for pleading comprehensive, detailed evi-dentiary matter in securities litigation and embracing the more “sensible standard” of

Novak ,

discussed

supra,

the Fifth Circuit requires “at least some specifics from these reports,” such as “who prepared internal company reports, how frequently the reports were prepared and who reviewed them.”

ABC Arbitrage,

291 F.3d at 355 .

In addition, the Fifth Circuit has concluded that “the mere publication of inaccurate accounting figures or failure to follow GAAP,

11

without more, does not establish scienter; a plaintiff must show that the accounting firm deliberately misrepresented material facts or acted with reckless disregard about the accuracy of its audits or reports. The party must know that it is publishing materially false information, or must be severely reckless in publishing such information.”

Abrams,

292 F.3d at 430 .

12

See also Melder v.

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Morris,

27 F.3d 1097, 1103 (5th Cir.1994)(“boilerplate averments that the accountants violated particular standards are not, without more, sufficient to support inferences of fraud”).

Allegations that a defendant was motivated to commit fraud to enhance his incentive compensation or to raise capital are also inadequate to establish scienter because “the executives of virtually every corporation in the United States would be subject to fraud allegations.”

Abrams,

292 F.3d at 434 (“It does not follow that because executives have components of their compensation keyed to performance, one can infer fraudulent intent.”).

A plaintiff must also demonstrate that the challenged misrepresentations in dispute were material, that he relied on them, and that as a proximate result, he was damaged. Misrepresentations or omissions are material if there is a substantial likelihood that a reasonable investor would have viewed the allegedly false, misleading or omitted statement as having significantly altered the total mix of information available to him in deciding whether to buy or sell his stock or, phrased another way, “if there was a substantial likelihood that a reasonable investor would consider the information important in making a decision to invest.”

Basic Inc. v. Levinson,

485 U.S. 224, 230-31 , 108 S.Ct. 978 , 99 L.Ed.2d 194 (1988);

ABC Arbitrage,

291 F.3d at 359 . Although materiality is a mixed question of fact and law and generally a decision for the jury, nevertheless, in reviewing a motion to dismiss, the court can determine that representations are immaterial as a matter of law.

ABC Arbitrage,

291 F.3d at 359 ;

Nathenson,

267 F.3d at 422 .

“Reliance ... generally requires that the plaintiff have known of the particular misrepresentation complained of, have believed it to be true and because of that knowledge and belief purchased or sold the security in question.”

Nathenson,

267 F.3d at 413 .

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To satisfy the reliance element in § 10(b) and Rule 10b-5 securities violation action, where a plaintiff investor who may not have read or heard the purported misrepresentations, a plaintiff may employ the “fraud-on-the-market” doctrine. The Supreme Court has stated that this theory “is based on the hypothesis that in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business.Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. ....”

Basic,

485 U.S. at 241-42 , 108 S.Ct. 978 ,

citing Peil v. Speiser,

806 F.2d 1154 , 1160-61 (3d Cir.1986). Thus the presumption is that the plaintiff relied on the value of the stock, which is the market’s reflection of available material information about a company including the company’s fraudulent statements.

Fine v. American Solar King Corp.,

919 F.2d 290, 298 (5th Cir. 1990),

cert. dism’d sub nom. Main Hurdman v. Fine,

502 U.S. 976 , 112 S.Ct. 576 , 116 L.Ed.2d 601 (1991).

A defendant may rebut “the presumption of reliance by ‘any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price.’ ”

Id., citing Basic,

485 U.S. at 248 , 108 S.Ct. 978 . Thus the defendant can rebut the presumption by demonstrating that the nondisclosure had no effect on the stock’s market price or that the plaintiff would have purchased the stock at the same price even if he had known the information that was not disclosed to the market or that the plaintiff actually knew about the information that was not disclosed to the market when he purchased the stock.

Id.; Nathenson,

267 F.3d at 414 . As a corollary to the fraud-on-the-market doctrine and a defense to rebut that doctrine’s presumption that the defendant’s misrepresentations affected the price of the company’s stock, the truth-on-the-market doctrine views a misrepresentation as immaterial if the information is already known to the market because that misrepresentation therefore cannot defraud the market.

In re Sec. Litig. BMC Software, Inc.,

183 F.Supp.2d 860 , 905-06 n. 46 (S.D.Tex.2001).

The fraud-on-the-market theory is particularly relevant where a § 10(b) and Rule 10b-5 case alleges market manipulation.

Market manipulation schemes which are intended to distort the price of a security, if successful, necessarily defraud investors who purchase the security in reliance on the market’s integrity. Absent the ... theory, the parties injured by such manipulative schemes could not plead the necessary element of reliance.

Scone Investments, L.P. v. American Third Market Corp.,

No. 97 CIV 3802(SAS), 1998 WL 205338 , *5 (S.D.N.Y. Apr.28, 1998).

When the cause of action under § 10(b) is based on an allegation of a material omission, the plaintiff must demonstrate that the defendant had a fiduciary duty to disclose to the plaintiff.

Central Bank,

511 U.S. at 174 , 114 S.Ct. 1439 (“When an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak.”). Such a duty to disclose under the federal securities laws “arises from the relationship between parties.”

Dirks v. SEC,

463 U.S. 646, 657-58 , 103 S.Ct. 3255 , 77 L.Ed.2d 911 (1983). The plaintiff must be “entitled to know because of a fiduciary or other similar relation of trust and confidence between them.”

Chiarella v. United States,

445 U.S. 222, 226, 228 , 230 n. 12, 100 S.Ct. 1108 , 63 L.Ed.2d 348 (1980)(holding that when a person engages in insider trading, thus not disclosing inside information, to violate § 10(b) the trader must have an

*575

independent duty of disclosure; in dicta the court observed that corporate insiders violate a fiduciary duty to shareholders when they trade on nonpublic information).

14

The PSLRA establishes a “safe harbor” shielding a “forward-looking” statement from Rule 10b-5 liability where such a statement is made by a natural person unless defendants prove that it was made with “actual knowledge ... that the statement was false and misleading.” 15 U.S.C. § 78u-5 and § 78u-5(e)(l)(B)(i). A statement is “forward-looking” if,

inter alia,

it is

(A) a statement containing a projection of revenues, income (including income loss), earnings (including earnings loss) per share, capital expenditures, dividends, capital structure, or other financial items;

(B) a statement of the plans and objectives of management for future operations, including plans or objectives relating to the products or services of the issuer;

(C) a statement of future economic performance, including any such statement contained in a discussion and analysis of financial condition by the management or in the results of operations included pursuant to the rules and regulations of the Commission;

(D) any statement of the assumptions underlying or relating to any statement described in subparagraph (A),(B), or (C);

(E) any report issued by an outside reviewer retained by an issuer, to the extent that the report assesses a forward-looking statement made by the issuer ....

15 U.S.C. § 78u-5(i)(l)(A).

The safe harbor protects individuals and corporations from liability for forward-looking statements that prove false if the statement is “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement” or where the forward-looking statement is immaterial. 15 U.S.C. § 78u-5(c)(l)(A)(i) and (ii). If a statement is “accompanied by meaningful cautionary statements,” the defendants’ state of mind is not relevant.

Harris v. Ivax Corp.,

182 F.3d 799 , 803 (11th Cir.1999),

citing

H.R. Conf. Rep. 104-369, at 44 (1995), reprinted in 1995 U.S.C.A.A.N. 730, 743 (“The first prong of the safe harbor requires courts to examine only the cautionary statement accompanying the forward-looking statement. Courts should not examine the state of mind of the person- making the statement.”)

See also Shaw v. Digital Equipment Corp.,

82 F.3d 1194, 1213 (1st Cir.1996)(“when statements of ‘soft’ information such as forecasts, estimates, opinions, or projections are accompanied by cautionary disclosures that adequately warn of the possibility that actual results or events may turn out differently, the ‘soft’ statements may not be materially misleading under the securities laws”). Where the forward-looking statement is not accompanied by cautionary language, plaintiffs must demonstrate that the defendant made the statement with “actual knowledge” that it was “false or misleading.” 15 U.S.C. § 78u-5(c)(l)(B).

*576

The safe harbor provision does not apply where the defendants knew at the time that they were issuing statements that the statements contained false and misleading information and thus lacked any reasonable basis for making them.

Shaw v. Digital Equipment Corp.,

82 F.3d 1194, 1213 (1st Cir.1996);

Gross v. Medaphis Corp.,

977 F.Supp. 1463, 1473 (N.D.Ga.1997);

In re MobileMedia Sec. Litig.,

28 F.Supp.2d 901, 930 (D.N.J.1998).

The PSLRA restricts review of forward-looking statements to those specified in the complaint. 15

U.S.C. §

78u-4(b)(l). Thus the Court must examine piecemeal the statements made by the company as expressed in the pleadings.

There is a judicially created equivalent to the PSLRA’s “safe harbor” provision, the “bespeaks caution” doctrine, which the Eleventh Circuit in

Bryant v. Avado Brands, Inc.,

187 F.3d 1271 , 1276 n. 7 (11th Cir.1999) explains “operates similarly, protecting statements in the nature of projections that are accompanied by meaningful cautionary statements and specific warnings of the risks involved, so as to ‘bespeak caution’ to investors that actual results may differ, thereby shielding the statements from § 10(b) and Rule 10b-5 liability.”

Id., citing Saltzberg v. TM Sterling/ Austin Assoc.,

45 F.3d 399 (11th Cir.

1995)(per curiam

)(holding that explicit cautionary language in private placement memorandum rendered alleged misstatements immaterial and made them not actionable under the “bespeaks caution” doctrine).

The Fifth Circuit has rejected the application of the “bespeaks caution” doctrine as a

per se

bar to liability.

Rubinstein v. Collins,

20 F.3d 160, 162 (5th Cir.1994). Observing that the use of the doctrine by district courts “reflects a relatively recent, ongoing, and somewhat uncertain evolution in securities law,” the Fifth Circuit skeptically comments,

In essence, predictive statements are just what the name implies: predictions. As such, any optimistic projections contained in such statements are necessarily contingent. Thus the “bespeaks caution” doctrine has developed to address situations in which optimistic projections are coupled with cautionary language— in particular, relevant specific facts or assumptions — affecting the reasonableness of the reliance on and the materiality of those projections. To put it another way, the “bespeaks caution” doctrine merely reflects the unremarkable proposition that statements must be analyzed in context.

Id.

at 167 [footnotes and citations omitted]. Under Fifth Circuit precedent, “[Cautionary

language is not

necessarily sufficient in and of itself, to render predictive statements immaterial as a matter of law. Rather, ... materiality is not judged in the abstract, but in light of the surrounding circumstances.”

Id.

at 167-68 ,

citing Krim v. BancTexas Group,

989 F.2d 1435, 1448-49 (5th Cir.1993). The Fifth Circuit has defined the test: “The appropriate inquiry is whether, under all the circumstances, the omitted fact or the prediction without a reasonable basis ‘is one [that] a reasonable investor would consider significant in [making] the decision to invest, such that it alters the total mix of information available about the proposed investment.’ ”

Id.

at 168,

citing Krim,

989 F.2d at 1445 .

Similarly, vague optimistic statements are not actionable because a reasonable investor would not rely on them in deciding to buy or sell securities.

Grossman v. Novell, Inc.,

120 F.3d 1112, 1119 (10th Cir.1997);

San Leandro Emergency Medical Group Profit Sharing Plan v. Philip Morris Cos.,

75 F.3d 801, 811 (2d Cir.1996)(statement that company was “ ‘optimistic’ about [its earnings] in 1993” and

“should

deliver income growth consis

*577

tent with its historically superior performance” held to be “puffery” and to “lack the sort of definitive positive projections that might require later correction”);

Raab v. General Physics Corp.,

4 F.3d 286, 289 (4th Cir.1993)(statements in Annual Report that corporation predicted “10% to 30% growth rate over the next several years” and was “poised to carry the growth and success of 1991 well into the future” held to be mere puffery or immaterial statements);

In re Sec. Litig. BMC Software, Inc.,

183 F.Supp.2d 860, 888 (S.D.Tex.2001)(“Vague, loose optimistic allegations that amount to little more than corporate cheerleading are ‘puffery,’ ‘projections of future performance not worded as guarantees,’ and are not actionable under federal securities law because no reasonable investor would consider such vague statements material and because investors and analysts are too sophisticated to rely on vague expressions of optimism rather than specific

facts”)(citing Krim v. BancTexas Group, Inc.,

989 F.2d 1435, 1446 (5th Cir.1993)).

b. Manipulative or Deceptive Contrivance or Scheme to Deceive or Course of Business

Securities fraud actions under § 10(b) and Rule 10b-5 are not merely limited to the making of an untrue statement of material fact or omission to state a material fact. Section 10(b) prohibits “any manipulative or deceptive contrivance,” which, as indicated above, the Supreme Court, relying on

Webster’s International Dictionary,

includes “a scheme to deceive” or “scheme, plan or artifice.”

Ernst & Ernst,

425 U.S. at 199 n. 20, 96 S.Ct. 1375 . While subsection (b) of Rule 10b-5 provides a cause of action based on the “making of an untrue statement of a material fact and the omission to state a material fact,” subsections (a) and (c) “are not so restricted” and allow suit against defendants who, with scienter, participated in “a ‘course of business’ or a ‘device, scheme or artifice’ that operated as a fraud” on sellers or purchasers of stock even if these defendants did not make a materially false or misleading statement or omission.

Affiliated Ute Citizens v. United States,

406 U.S. 128, 152-53 , 92 S.Ct. 1456 , 31 L.Ed.2d 741 (1972).

See also Superintendent of Ins. v. Bankers Life & Cas. Co.

404 U.S. 6 , 11 n.7, 92 S.Ct. 165 , 30 L.Ed.2d 128 (1971)(“[I]t [is not] sound to dismiss a complaint merely because the alleged scheme does not involve the type of fraud that is ‘usually associated with the sale or purchase of securities.’ We believe that § 10(b) and Rule 10b-5 prohibit all fraudulent schemes in connection with the purchase or sale of securities, whether the artifices employed involve a garden type variety of fraud, or present a unique form of deception.”);

Zandford,

122 S.Ct. at 1903-04 (broker’s “continuous series of unauthorized” sales of securities and personal retention of the proceeds without his client’s knowledge to further his fraudulent scheme “are properly viewed” as a “ ‘course of business’ that operated as a fraud or deceit on a stockbroker’s customer” in connection with the sale of securities). Novel or atypical methods should not provide immunity from the securities laws.;

Santa Fe,

430 U.S. at 475-76 and n. 15, 97 S.Ct. 1292 (stating that § 10(b) covers deceptive “practices” and “conduct”);

Central Bank,

511 U.S. at 177 , 114 S.Ct. 1439 (“we again conclude that the statute prohibits only the making of a material misstatement or

the commission of a manipulative act

[emphasis added].”);

In re Splash Technology Holdings, Inc. Sec. Litig.,

2000 WL 1727377 , *13 (N.D.Cal. Sept.29, 2000)(“Whereas 10b 5(b) focuses on fraudulent statements, 10b-5(a) and (c) are not by their terms restricted to statements. In this case, plaintiffs allege both fraudulent statements and acts as their requisite manipulative or deceptive practices”).

*578

In

Zandford ,

a unanimous Supreme Court opinion, leaving aside the misrepresentation and omission language since it was not relevant to the case, the high court focused on § 10(b)’s alternative basis for liability, “unlawful for any person ... [t]o use or employ, in connection with the purchase or sale of any security ..., any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe” and Rule 10b-5’s ban on the use, “in connection with the purchase or sale of any security,” of “any device

scheme,

or artifice to defraud” or any other “act, practice, or

course of business

” that “operates ... as a fraud or deceit [emphasis added].” 122 S.Ct. at 1903 . The Supreme Court held that allegations of a stock broker’s fraudulent scheme of “selling his customer’s securities and using the proceeds for his own benefit without the customer’s knowledge or consent” constituted “fraudulent conduct ‘in connection with the purchase or sale of any security’ ” within the meaning of § 10(b) and Rule 10b-5. 122 S.Ct. at 1900-01 . The Court emphasized that “neither the SEC nor this Court has ever held that there must be a misrepresentation about the value of a particular security in order to run afoul of the Act.” 122 S.Ct. at 1903 .

Furthermore, employing a flexible approach to construing § 10(b), the Supreme Court clarified the statutory language, “in connection with the purchase or sale of any security.” Noting that the stock sales and the broker’s fraudulent practices were interdependent, the high court observed that the broker, who had discretion to manage his clients’ investment account and a general power of attorney to engage in securities transactions without their prior authorization or approval, wrote checks to himself from the clients’ mutual fund account that required the sale of securities to pay him. 122 S.Ct. at 1901 . Thus the broker did not merely lawfully sell his clients’ stock and then decide to misappropriate the proceeds. 122 S.Ct. at 1904 . Instead, the fraud coincided with the sales, each of which furthered his scheme, through a “course of business,” to defraud his clients and misappropriate their assets.

15

An insider’s trading in securities of his company based on material nonpublic information “qualifies as a ‘deceptive device’ under § 10(b).”

United States v. O’Hagan,

521 U.S. 642, 643 , 117 S.Ct. 2199 , 138 L.Ed.2d 724 (1997),

quoting Chiarella v. United States,

445 U.S. 222, 228 , 100 S.Ct. 1108 , 63 L.Ed.2d 348 (1980). The simple allegation that a defendant was motivated to sell his company stock at a high price without an allegation that the defendant profited from such inflation also will not give rise to a strong inference of scienter.

Abrams,

292 F.3d at 434 . To be probative of scienter, a plaintiff must allege insider trading that occurred in suspicious amounts or at suspicious times, “out of line with trading practices or at times calculated to maximize personal profit. Further, even unusual sales by one insider do not give rise to a strong inference of scienter when other defendants do not sell some or all of their shares during the Class Period.”

Id.

at 435 .

*579

Market manipulation, employment of a manipulative device, and engaging in manipulative schemes such as a scheme to artificially inflate or deflate stock prices, falsifying records to reflect non-existent profits, and creating and distributing false research reports favorably reviewing a company are other types of conduct prohibited by § 10(b)

16

and Rule 10b-5 that do not fall within the category of misleading statements and omissions.

17

See, e.g., United States v. Langford,

946 F.2d 798 (11th Cir.1991),

cert. denied,

503 U.S. 960 , 112 S.Ct. 1562 , 118 L.Ed.2d 209 (1992)

18

;

In re Blech Securities Litigation (Blech III),

No. 94 CIV. 7696 RWS, 2002 WL 31356498 , *3 (S.D.N.Y. Oct.17, 2002)(con-cluding that stock-purchaser plaintiffs’ allegations that Bear Stearns

&

Co.

19

with scienter “directed” or “contrived” and agreed to fund specific fraudulent trades by Blech & Company, which Bear Stearns knew had a history of sham trading, and also processed the transactions, in an attempt to artificially inflate the price of Blech securities and reduce Blech’s debit balance, and thereby knowingly engaged in a scheme to defraud through sham transactions, stated a claim for primary liability under § 10(b));

Scone Investments, L.P. v. American Third Market Corp.,

No. 97 CIV. 3802, 1998 WL 205338 , *5 (S.D.N.Y. Apr.28, 1998);

In re Blech Sec. Litig. (Blech II),

961 F.Supp. 569, 580 (S.D.N.Y.1997)(“a plaintiff asserting a [§ 10(b) and Rule 10b-5] market manipulation claim must allege direct participation in a scheme to manipulate the market for securities”),

citing Ernst & Ernst v. Hochfelder,

425 U.S. at 199 , 96 S.Ct. 1375 (defining market manipulation as conduct “designed to deceive or defraud investors by controlling or artificially affecting the price of securities”). In

Blech III,

the court identified as practices constituting manipulation of the market “trades with controlled entities, fictitious trades, wash sales, prearranged matched trades, and ‘painting the tape,’” together with lending money or securities or borrowing money or securities from a customer, guaranteeing any account against loss, entering purchase or sale orders designed to raise or lower the price of a security or to give the appearance of trading for purposes of inducing others to trade

(i.e.,

“marking the close” or “prearranged trading”) and “making arrangements to ‘park’ any security away from the true owner.” 2002 WL 31356498 , *5. The

Blech

court also made clear that plaintiffs in that suit had to allege facts giving rise to a strong inference of scienter and assert that “Bear Stearns

caused

or

directed

trading by Blech

&

Co.’s customers or

solicited

or

induced

them to buy Blech Securities at inflated prices,” i.e., “in addition to alleging scienter of the Blech scheme, Plaintiffs must also allege that Bear Stearns itself engaged in the kind of manipulative conduct that Section 10(b) prohibits in this context.”

Blech II,

961 F.Supp. at 582-83 (Section 10(b) requires allegation that Bear Stearns “directly and knowingly participated in deceptive or ma

*580

nipulative conduct that caused damage to the [plaintiff].”).

Furthermore, conclusory “allegations that are consistent with the normal activity” of such a business entity, standing alone, e.g., in

Blech

the normal legitimate activity of a clearing broker, are insufficient to state a claim of primary liability under

Central Bank. Blech II,

961 F.Supp. at 584 (“[T]he Complaint crosses the line dividing secondary liability from primary liability when it claims that Bear Stearns ‘directed’ or ‘contrived’ certain allegedly fraudulent trades. Under these circumstances, the Complaint adequately alleges that Bear Stearns engaged in conduct with scienter, in an attempt to affect the price of the Blech securities.”)

20

;

McDaniel v. Bear Stearns & Co., Inc.,

196 F.Supp.2d 343, 353 , (S.D.N.Y.2002)(“[W]here a clearing firm moves beyond performing mere ministerial or routine clearing functions and [with actual knowledge] becomes actively involved in the introductory broker’s [fraudulent] action, it may expose itself to liability with respect to the introductory broker’s misdeeds.”).

Thus to state a claim for market manipulation under § 10(b) and Rule 10b-5 against parties that employed manipulative and deceptive practices in a scheme to defraud, a plaintiff must allege (1) that it was injured (2) in connection with the purchase or sale of securities (3) by relying on a market for securities (4) controlled or artificially affected by defendants’ deceptive and manipulative conduct, and (5) the defendants engaged in the manipulative conduct with scienter.

21

Blech II,

961 F.Supp. at 582 ,

citing Ernst & Ernst v. Hochfelder,

425 U.S. at 199 , 96 S.Ct. 1375 .

Furthermore because courts acknowledge the difficulty of satisfying Rule 9(b) in pleading a claim of market manipulation, “where the exact mechanism of the scheme is likely to be unknown to the plaintiffs, allegations of the nature, purpose, and effect of the fraudulent conduct and the roles of the defendants are sufficient for alleging participation.”

Blech II,

961 F.Supp. at 580 ;

see also Vandenberg v. Adler,

No. 98 CIV. 3544 WHP, 2000 WL 342718 , *5 (S.D.N.Y. Mar.31, 2000);

In re Sterling Foster & Co., Inc. Sec. Litig.,

222

*581

F.Supp.2d 216, 278-79 (E.D.N.Y.2002)(“Courts have found allegations of fraud to have been pled with sufficient particularity when the complaint specifies (1) the manipulative acts performed; (2) which defendants performed them; and (3) the effect the scheme had on the market for the securities at issue.”).

Moreover, to effectuate the Congressional purpose behind the 1934 Act of “ ‘in-surfing] honest securities markets and thereby promotfing] investor confidence,’ ” by requiring full disclosure “ ‘to achieve a high standard of business ethics in the securities industry,’ ” the Supreme Court has repeatedly “construed [the statute] ‘not technically and restrictively, but flexibly.”

Zandford,

122 S.Ct. at 1903 (citations omitted). The SEC has also “consistently adopted a broad reading of the phrase, ‘in connection with the purchase or sale of any security’ ” and “maintained that a broker who accepts payments for securities that he never intends to deliver, or who sells customer securities with intent to misappropriate the proceeds” violates § 10(b) and Rule 10b-5, and the Supreme Court, in deference to the agency, followed suit in

Zandford. Id.

at 1903. In

Zand-ford,

concerned that “this statute must not be construed so broadly as to convert every common-law fraud that happens to involve securities into a violation of § 10(b)” and focusing on the broker’s scheme over a two-year period during which he made a number of transactions and converted the proceeds of the sales of his clients’ securities to his own use, the Supreme Court concluded,

The securities sales and [the broker’s] fraudulent practices were not independent events. This is not a case in which, after a lawful transaction had been consummated, a broker decided to steal the proceeds and did so. Nor is it a case in which a thief simply invested the proceeds of a routine conversion in the stock market. Rather respondent’s fraud coincided with the sales themselves.

Taking the allegations in the complaint as true, each sale was made to further respondent’s fraudulent scheme; each was deceptive because it was neither authorized by, nor disclosed to, the [clients].... In the aggregate, the sales are properly viewed as a “course of business” that operated as a fraud or deceit on a stockbroker’s customer.

The fact that [the broker] misappropriated the proceeds of the sales provides persuasive evidence that he had violated § 10(b) when he made the sales, but misappropriation is not an essential element of the offense.... It is enough that the scheme to defraud and the sale of the securities coincide.

Id.

at 1903-04. The high court found that this type of fraud, based on silence, “represents an even greater threat to investor confidence in the securities industry” than merely an affirmative misrepresentation, in view of the fiduciary duty owed by a broker to a client with a discretionary account and the fact that this relationship of trust and confidence therefore gives rise to a duty to disclose.

Id.

at 1905. The Supreme Court concluded that because the broker “sold the [clients’] securities while secretly intending from the very beginning to keep the proceeds” and deprive the clients of that benefit, the “SEC complaint describes a fraudulent scheme in which the securities transactions and breaches of fiduciary duty coincide” and the breaches were thus “ ‘in connection with’ securities sales within the meaning of § 10(b).”

Id.

at 1905-06.

c.

Central Bank

and Primary Violations

Of substantial relevance to the motions this Court now reviews is the Supreme Court’s holding in a 5^4 decision in

Central Bank of Denver, N.A. v. First

*582

Interstate Bank of Denver, N.A.,

511 U.S. 164 , 114 S.Ct. 1439 , 128 L.Ed.2d 119 (1994), based on the language and legislative history of the statute, that a private plaintiff may not bring an aiding and abetting claim under § 10(b) and Rule 10b-5.

22

The high court construed the general anti-fraud provision as prohibiting only the making of a material misstatement or a material omission or the commission of a manipulative act; therefore it does not prohibit giving aid to another, who then commits a primary § 10(b) violation.

Id.

at 177, 114 S.Ct. 1439 . It further emphasized that none of the express private causes of action in both the Securities Act of 1933 and the 1934 Exchange Act imposes liability on one who aids or abets such primary violators.

Id.

at 179, 184 , 114 S.Ct. 1439 . Thus it reasoned, “[t]here is no reason to think that Congress would have attached aiding and abetting liability only to § 10(b) and not to any of the express private rights of action in the Act.”

Id.

at 180, 114 S.Ct. 1439 ,

citing Blue Chip Stamps v. Manor Drug Stores,

421 U.S. 723, 736 , 95 S.Ct. 1917 , 44 L.Ed.2d 539 (1975)(it would be “anomalous to impute to Congress an intention to expand the plaintiff class for a judicially implied cause of action beyond the bounds it delineated for comparable express causes of action.”). The court rejected as implausible the argument that silence in the statute constituted an “implicit congressional intent to impose § 10(b) aiding and abetting liability.”

Id.

Furthermore, the Supreme Court pointed out that the critical element for recovery under Rule 10b-5, reliance, would be eliminated if liability were imposed for aiding and abetting.

Id.

at 180, 114 S.Ct. 1439 (“Were we to allow the aiding and abetting action proposed in this case, the defendant could be liable without any showing that the plaintiff relied upon the aider and abettor’s statements or actions.”). Nor did it find that anything in the legislative history “even implies that aiding and abetting was covered by the statutory prohibition on manipulative and deceptive conduct.”

Id.

at 183 , 114 S.Ct. 1439 .

23

Nevertheless, the Supreme Court did not conclude that secondary actors such as lawyers, accountants, banks, and underwriters were therefore always shielded from § 10(b) and Rule 10b-5 liability:

Because the text of § 10(b) does not prohibit aiding and abetting, we hold that a private plaintiff may not maintain an aiding and abetting suit under § 10(b). The absence of § 10(b) aiding and abetting liability does not mean that secondary actors in securities markets are always free from liability under the securities Act. Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 1 Ob-5, assuming

all

of the requirements for primary liability under Rule 10b-5 are met.In any complex securities fraud, moreover, there are likely to be multiple violators ....

Id.

at 191, 114 S.Ct. 1439 .

Furthermore, in

Central Bank

the defendant bank was the indenture trustee for $26 million in bonds issued by a public building authority, some in 1986 and more

*583

in 1988. The bonds were secured by landowner assessment liens and contained covenants requiring that the subject land had to be worth at least 160% of the bonds’ outstanding principal and interest and that the developer had to give the defendant bank an annual appraisal showing that the value of the land met this requirement. Even though the developer did so in 1998, the bank learned through the underwriter that the appraisal was questionable and that the value of the property securing the 1996 bonds may have declined, a fact confirmed by the bank’s own in-house appraiser. Nevertheless the bank continued working with the developer and delayed obtaining an independent review of the developer’s valuation of the land while the bank issued more bonds in 1988. Subsequently the building authority defaulted on the bonds and the bond purchasers did not only sue the authority, the bonds’ underwriters, and the land developer, but they also sued the bank, but only as “secondarily liable under § 10(b) for its conduct in aiding and abetting the [other defendants’] fraud.” 511 U.S. at 164 , 114 S.Ct. 1439 . The high court examined only the aiding and abetting claim pled against the bank and did not address the question whether the bank might be a primary violator, since the plaintiffs had not alleged such a claim.

In sum, the Supreme Court left it to the lower courts to determine when the conduct of a secondary actor makes it a primary violator under the statute. In the aftermath of

Central Bank ,

two divergent standards, the “bright line” test and the “substantial participation” test, have emerged.

Under the “bright line” test, in order for the conduct of a secondary actor to rise to the level of a primary violation, the secondary actor must not only make a material misstatement or omission, but “the misrepresentation must be attributed to the specific actor at the time of public dissemination,” i.e., in advance of the investment decision, so as not to undermine the element of reliance required for § 10(b) liability.

Wright v. Ernst & Young LLP,

152 F.3d 169, 175 (2d Cir.1998),

cert. denied,

525 U.S. 1104 , 119 S.Ct. 870 , 142 L.Ed.2d 772 (1999);

see also Shapiro v. Cantor,

123 F.3d 717, 720 (2d Cir.1997)(“ ‘If

Central Bank

is to have any real meaning, a defendant must actually make a false or misleading statement in order to be held liable under Section 10(b). Anything short of such conduct is merely aiding and abetting, and no matter how substantial that aid may be it is not enough to trigger liability under Section 10(b).’

”){quoting In re MTC Electronic Technologies Shareholders Litigation,

898 F.Supp. 974, 987 (E.D.N.Y.1995)). For example, according to the investor-plaintiffs’ complaint in

Wright,

152 F.3d 169 , Ernst & Young LLP, an outside auditor for BT Office Products, Inc. (“BT”), violated § 10(b) by privately and orally approving false and misleading financial statements that the auditor knew would be passed on to investors. BT subsequently made these statements public during a press release, but represented that the information was unaudited and did not mention Ernst & Young. The district court granted the accounting firm’s motion to dismiss based on

Central Bank’s

rejection of aiding and abetting liability. On appeal, the Second Circuit affirmed, finding that a contrary result would in effect “revive aiding and abetting liability under a different name, and would therefore run afoul of the Supreme Court’s holding in

Central Bank.” Id.

at 175. It also required that the defendant, to be liable, must have known or should have known that his representation would be disseminated to investors, although the defendant need not communicate the misrepresentation directly to them.

Wright,

152 F.3d at 175 ,

citing

*584

Anixter v. Home-Stake Production Co.,

77 F.3d 1215, 1226 (10th Cir.1996). The Second Circuit noted that because in BT’s press release BT did not mention Ernst

&

Young, nor Ernst & Young’s private prior approval of the statements made in the press release by BT, the auditor

neither directly nor indirectly communicated misrepresentations to investors. Therefore, the amended complaint failed to allege that Ernst

&

Young made “a material misstatement (or omission) on which a purchaser or 'seller of securities relie[d].” Moreover ... because the press release contained a clear and express warning that no audit had yet been completed, there is no basis for Wright to claim that Ernst

&

Young had endorsed the accuracy of those results.

152 F.3d at 175 . The Second Circuit has found that words such as “assisting,” “participating in,” “complicity in,” and synonyms employed throughout a complaint, “all fall within the prohibitive bar of

Central Bank.” Shapiro,

123 F.3d at 720 .

Other cases applying the “bright line” test include

In re Kendall Square Research Corporation Securities Litigation,

868 F.Supp. 26, 28 (D.Mass.1994)(account-ing firm’s “review and approval” of financial statements and prospectus were not sufficient to impose liability on it under § 10(b));

Vosgerichian v. Commodore International,

862 F.Supp. 1371, 1378 (E.D.Pa.1994)(the accountant’s advice to and guidance of a client, who then made allegedly false and misleading statements, were not enough to impose primary liability on accountant);

Anixter,

77 F.3d at 1223 -1227 & nn. 7-12;

Ziemba v. Cascade Intern’l, Inc.,

256 F.3d 1194 , 1205, 1207 (11th Cir.2001)(“[I]n order

for

[a secondary actor, such as a law firm or an accounting firm,] to be primarily liable under § 10(b) and Rule 10b-5, the alleged misstatement or omission upon which a plaintiff relied must have been publicly attributable to the defendant at the time that the plaintiffs investment decision was made”; for an omission there must be a duty to disclose as determined by a multi-factor test);

In re Kendall Square Research Corp. Securities Litigation,

868 F.Supp. 26 (D.Mass.1994)(aecountant’s review and approval of false or misleading financial statements does not support imposition of primary liability).

Unlike the Second Circuit, the Tenth Circuit does not require attribution of the alleged misrepresentation to the secondary actor at the time of the statement’s dissemination to the public. For instance, the Tenth Circuit in

Anixter ,

emphasizing that “[t]he critical element separating primary from aiding and abetting violations is the existence of a representation, either by statement or omission, made by the defendant, that is relied upon by the plaintiff,” states,

Clearly, accountants may make representations in their role as auditor to a firm selling securities.

See, e.g., Herman & MacLean v. Huddleston,

459 U.S. 375 , 103 S.Ct. 683 , 74 L.Ed.2d 548 (1983)(defendant accountant found primarily hable for violating § 10(b) based on representations filed with the SEC). Typical representations include certifications of financial statements and opinion letters.

See DiLeo v. Ernst & Young,

901 F.2d 624, 628 (7th Cir.),

cert. denied,

498 U.S. 941 , 111 S.Ct. 347 , 112 L.Ed.2d 312 (1990). An accountant’s false and misleading representations in connection with the sale of any security, if made with the proper state of mind and if relied upon by those purchasing or selling a security, can constitute a primary violation.

Central Bank of Denver,

511 U.S. at 190-91 , 114 S.Ct. at 1455 ; ... There is no requirement that the alleged violator directly communicate misrepresentations to plaintiffs for primary liability to attach.... Nevertheless, for an accountant’s misrepresentation to be ac

*585

tionable as a primary violation, there must be a showing that he knew or should have known that his representation would be communicated to investors because § 10(b) and Rule 10b-5 focus on fraud made “in connection with the sale or purchase” of a security.

Id.

at 1225.

The less stringent “substantial participation” test provides for primary liability where there is “substantial participation or intricate involvement” of the secondary party in the preparation of fraudulent statements “even though that participation might not lead to the actor’s actual making of the statements.”

Howard v. Everex Systems, Inc.,

228 F.3d 1057 , 1061 n. 5 (9th Cir.2000).

Cases applying the “substantial participation” rule include

In re Software Toolworks,

50 F.3d 615 , 628 n. 3, 629 (9th Cir.1994)(accountant may become a primary violator under antifraud provision of § 10(b) where it reviews and plays a “significant role in drafting and editing” two letters, one not identifying the accounting firm, sent by the issuer client to the SEC; a reasonable factfinder could find that the accountants “as members of the drafting group, ... had access to all information that was available and deliberately chose to conceal the truth”),

cert. denied sub nom. Montgomery Securities v. Dannenberg,

516 U.S. 907 , 116 S.Ct. 274 , 133 L.Ed.2d 195 (1995);

In re ZZZZ Best Securities Litigation,

864 F.Supp. 960, 970 (C.D.Cal.1994)(where accounting firm was “intricately involved” in the creation of false and misleading documents and the “resulting deception,” it may be liable as a primary violator of § 10(b));

Cashman v. Coopers & Lybrand,

877 F.Supp. 425, 432-34 (N.D.Ill.1995)(primary liability may be established against accountants “centrally involved” in preparation of alleged false or misstated information for prospectuses or promotional material issued to investors that the accounting firm certified, audited, prepared or reported.);

McNamara v. Bre-X Minerals Ltd.,

57 F.Supp.2d 396, 426 (E.D.Tex.1999)(“if a defendant played a ‘significant role’ in preparing a false statement actually uttered by another, primary liability will lie”).

A number of courts have criticized the substantial participation test as inconsistent with

Central Bank’s

prohibition of aiding and abetting liability under § 10(b).

See, e.g., Anixter,

77 F.3d at 1226 n. 10 (“To the extent that these cases allow liability to attach without requiring a representation be made by defendant and reformulate the ‘substantial assistance’ element of aiding and abetting liability into primary liability, they do not comport with

Central Bank of Denver.”).

Nevertheless the Court notes that this criticism typically issued before

Zandford ,

which made crystal clear that a misrepresentation need not be involved and that a suit could be based on Rule 10b-5(a) or (c).

This Court recognizes that without a clearer definition and a narrowing of the kind of conduct and circumstances required to constitute “substantial participation” or “intricate involvement,” the substantial participation test may fail to differentiate between primary liability and aiding and abetting, or even unrestricted conspiracy, and that the area of overlap may be significant under such an expansive test. Until or unless Congress addresses the question that definition appears -to be the task of the courts.

The SEC, in the role of

amicus curiae,

has filed a brief in this action that warrants consideration because it addresses the reasons why the bright-line test misses the mark. Brief attached to the SEC’s motion for leave, as

amicus curiae,

to submit briefs (instrument # 821). The majority of its pleading is a submission filed on behalf of the plaintiffs in a case that was pending in the Third Circuit, but

*586

which was settled before that appellate court could review the issue

en banc. Klein v, Boyd,

949 F.Supp. 280 (E.D.Pa.1996), aff

'd,

- F.3d -, 1998 WL 55245 , Fed. Sec. L. Rep. P 90,136 (3d Cir.1998),

rehearing en banc granted, judgment vacated

(Mar. 9, 1998).

24

As framed by the SEC, the issue is,

[i]s a person who makes a material misrepresentation, while acting with the requisite scienter, but who does not himself disseminate the misrepresentation to investors, and whose name is not made known to them, only an aider and abettor of the fraud, or is that person a primary violator subject to liability [under § 10(b)]?

Brief at 5. More specifically, the issue is whether the phrase, “makes a material misstatement (or omission),” in Rule 10b-5 “means that a law firm or other secondary actor can be primarily liable for a misrepresentation only if it signs the document containing the misrepresentation or is otherwise identified to investors,” in other words, does not disclose its identity to investors. The SEC argues that such a person is a primary violator under § 10(b), and in doing so, attacks the “bright line” test as an improper reading of

Central Bank .

First, the SEC highlights the fact that the Supreme Court’s use of the word, “makes,”

25

in

Central Bank

does not man

*587

date that an allegedly material misstatement be signed by or attributed to the secondary party so that the secondary party is identified to investors. Brief at 13-14. The statute only makes it unlawful “for any person, directly or indirectly ... [t]o use or employ ... any manipulative deceptive device or contrivance” and the interpretation of “makes” must be consistent with that “directly or indirectly” language.

Id.

at 10, 20. The SEC proposes “creates,” as opposed to the bright line test’s interpretation, “signs,” as the appropriate synonym for the term, “makes,” in

Central Bank ;

the SEC contends that “[a] person who creates a misrepresentation

26

but takes care not to be identified publicly with it, ‘indirectly’ uses or employs a deceptive device or contrivance and should be liable” under § 10(b).

Id.

at 14. The SEC argues that the bright line test’s requirement of identification of the misrep-resenter to investors at the time of dissemination

would have the unfortunate and unwarranted consequence of providing a safe harbor from liability for everyone except those identified with the misrepresentations by name. Creators of misrepresentations could escape liability as long as they concealed their identities. Not only outside lawyers would benefit from such a rule; others who are retained to prepare information for dissemination to investors, including accountants and public relations firms, could immunize themselves by remaining anonymous. Indeed, in-house counsel and other corporate officials and employees could avoid liability for misrepresentations they created, as long as their identities were not made known to the public. In sum, by providing a safe harbor for anonymous creators of misrepresentations, a rule that imposes liability only when a person is identified with a misrepresentation would place a premium on concealment and subterfuge rather than on compliance with the federal securities laws.

Id.

The SEC maintains that “[t]he Supreme Court did not set forth a bright line rule for liability, much less one that turns on whether the identity of a defendant is disclosed.”

Id.

at 15. Moreover, under the SEC’s construction of the statute, third-party defendants are still substantially protected from frivolous suits by the scienter requirement.

Id.

at 16. As for the element of reliance, the SEC insists that

[t]he reliance a plaintiff in a securities fraud action must plead is reliance on a misrepresentation, not on the fact that a particular person made the misrepresentation. The Supreme Court stated in

Central Bank

that liability exists where “[a]ny person or entity, including a lawyer, accountant, or bank ... makes a material misstatement (or omission) on which a purchaser or seller of securities relies.” ... Thus the Court placed the focus on the misrepresentation, not on the fact that a particular person made it.

*588

Id.

at 17,

citing Central Bank,

511 U.S. at 191 , 114 S.Ct. 1439 .

27

The SEC proposes instead the following rale for primary liability of a secondary party under § 10(b): “when a person, acting alone or with others, creates a misrepresentation [on which the investor-plaintiffs relied], the person can be liable as a primary violator ... if ... he acts with the requisite scienter.” Brief at 18. “Moreover it would not be necessary for a person to be the initiator of a misrepresentation in order to be a primary violator. Provided that a plaintiff can plead and prove scien-ter, a person can be a primary violator if he or she writes misrepresentations for inclusion in a document to be given to investors, even if the idea for those misrepresentations came from someone else.”

Id.

Furthermore, “a person who prepares a truthful and complete portion of a document would not be liable as a primary violator for misrepresentations in other portions of the document. Even assuming such a person knew of misrepresentations elsewhere in the document and thus had the requisite scienter, he or she would not have created those misrepresentations.”

Id.

at p. 19. Finally, of course, the plaintiff must plead and prove the elements of scienter and reliance.

Because § 10(b) expressly delegated rule-making authority to the agency,

28

which it exercised

inter alia

in promulgating Rule 10b-5, this Court accords considerable weight to the SEC’s construction of the statute since the Court finds that construction is not arbitrary, capricious or manifestly contrary to the statute.

Bragdon v. Abbott,

524 U.S. 624, 642 , 118 S.Ct. 2196 , 141 L.Ed.2d 540 (1998)(“[T]he well-reasoned views of the agencies implementing a statute constitute a body of experience and informed judgment to which courts and litigants may properly resort for guidance”);

Chevron, U.S.A., Inc. v. Natural Resources Defense Council,

467 U.S. 837, 842-44 , 104 S.Ct. 2778 , 81 L.Ed.2d 694 (1984)(“considerable weight should be accorded to an executive department’s construction of a statutory scheme it is entrusted to administer, and the principle of deference to administrative interpretations ‘has been consistently followed by this Court whenever a decision as to the meaning or reach of a statute has involved reconciling conflicting policies ... ’ ” if that construction is reasonable);

United States v. Mead Corp.,

533 U.S. 218, 226-27 , 121 S.Ct. 2164 , 150 L.Ed.2d 292 (2001)

29

;

SEC v. Zandford,

535 U.S. 813 , 122 S.Ct. 1899, 1903 , 153 L.Ed.2d 1

*589

(2002)(“[The agency’s] interpretation of the ambiguous text of § 10(b), in the context of formal adjudication, is entitled to deference if it is reasonable,”

citing Mead,

533 U.S. at 229-30 , 121 S.Ct. 2164 ).

Furthermore, this Court concludes that not only material misrepresentations, but also the statute’s imposition of liability on “any person” that “directly or indirectly” uses or employs “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of security should be “construed ‘not technically and restrictively, but flexibly to effectuate its remedial purposes.’ ”

30

15 U.S.C. § 78 (j)(b);

Affiliated Ute Citizens of Utah v. United States,

406 U.S. at 151 , 92 S.Ct. 1456 ,

quoting SEC v. Capital Gains Research Bureau, Inc.,

375 U.S. at 195 , 84 S.Ct. 275 ;

Zandford,

122 S.Ct. at 1903 .

31

The 1934 Act was designed to protect investors against manipulation of stock prices. See S.Rep. No. 792, 73d Cong., 2d Sess., 1-5 (1934). Underlying the adoption of extensive disclosure requirements was a legislative philosophy: "There cannot be honest markets without honest publicity. Manipulation and dishonest practices of the market place thrive upon mystery and se'crecy.” H.R.Rep. No. 1383, 73d Cong., 2d Sess., 11 (1934). This Court "repeatedly has described the ‘fundamental purpose' of the Act as implementing a philosophy’ of full disclosure.' ”

Santa Fe Industries, Inc. v. Green,

430 U.S. 462, 477-78 , 97 S.Ct. 1292 , 51 L.Ed.2d 480 ... (1977), quoting

SEC v. Capital Gains Research Bureau, Inc.,

375 U.S. 180, 186 , 84 S.Ct. 275 , 11 L.Ed.2d 237 ... (1963).

*590

This Court finds that the SEC’s approach to liability under § 10(b) and Rule 10b — 5(b) is well reasoned and reasonable, balanced in its concern for protection for victimized investors as well as for merit-lessly harassed defendants (including

*591

businesses, law firms, accountants and underwriters), in addition to the policies underlying the statutory private right of action for defrauded investors and the PSLRA. Moreover, it is consistent with the language of § 10b(b), Rule 10b-5, and

Central Bank .

Therefore since the SEC’s proposed test is a reasonable interpretation of the text of the statute and serves its underlying policies, the Court adopts and applies it in this litigation to claims under § 10(b) and Rule 10b — 5(b).

Central Bank’s

holding (that there is no cause of action for aiding and abetting under § 10(b) and that “all requirements for primary liability under Rule 10b-5” must be satisfied), 511 U.S. at 191 , 114 S.Ct. 1439 , affects pleading standards where the plaintiffs allege that a group of defendants participated in a scheme or a course of business to defraud investors under § 10(b) and Rule 10b-5. It is generally agreed that

Central Bank

foreclosed a cause of action merely for conspiracy to violate § 10(b) and Rule 10b-5, in addition to aiding and abetting.

See, e.g., Dins-more v. Squardron, Ellenoff, Plesent, Sheinfeld & Sorkin,

135 F.3d 837, 841 (2d Cir.1998)(and cases cited therein)

32

;

In re GlenFed, Inc. Sec. Litig.,

60 F.3d 591, 592 (9th Cir.1995);

In re Gupta Corp. Sec. Litig.,

900 F.Supp. 1217, 1243-44 (N.D.Cal.1994)(dismissing scheme claims as recharacterized conspiracy claims);

Stack v. Lobo,

1995 WL 241448 *10 (N.D.Cal. Apr.20, 1995)(noting that in civil cases, conspiracy is a theory of liability available only after a completed tort exists, so where there is no primary violation pled under § 10(b) and Rule 10b-5, any secondary conspiracy claims must fail as well). Nevertheless,

“Central Bank

does not pre-elude liability based on allegations that a group of defendants acted together to violate the securities laws, as long as each defendant committed a manipulative or deceptive act in furtherance of the scheme.”

Cooper v. Pickett,

137 F.3d 616, 624 (9th Cir.1997).

Cooper

relied on a key passage in

Central Bank,

511 U.S. at 191 , 114 S.Ct. 1439 :

The absence of § 10(b) aiding and abetting liability does not mean that secondary actors in the securities markets are always free from liability under the securities Acts. Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5, assuming

all

of the requirements for primary liability under Rule 10b-5 are met. In any complex securities fraud, moreover, there are likely to be multiple violators....

Thus whether or not the word “conspire” is used, to survive a motion to dismiss, a complaint alleging that more than one defendant participated in a “scheme” to defraud must allege a primary violation of § 10(b) by each defendant.

For example, in

SEC v. U.S. Environmental, Inc.,

155 F.3d 107 (2d Cir.1998),

cert denied,

526 U.S. 1111 , 119 S.Ct. 1755 , 143 L.Ed.2d 787 (1999), the Second Circuit held that the SEC had successfully pled a primary violation of § 10(b) (“the making of a material misstatement (or omission) or commission of a manipulative act”) by a secondary actor, i.e., an employee, John Romano, of a securities broker-dealer, Castle Securities Corporation (“Castle”).

*592

Castle allegedly had agreed to participate in a scheme with other entities to manipulate upward the price of stock of U.S. Environmental, Inc. The complaint asserted that the employee had knowingly and recklessly participated in and furthered the market manipulation in following a stock promoter’s directions to execute stock trades that the employee knew, or was reckless in not knowing, were manipulative. In that litigation the district court had dismissed the complaint because it had concluded that the employee was only an aider and abettor because he merely “followed directions ... and ‘did not, himself make wash sales, match orders, or use undisclosed nominees to artificially affect the price of securities’ ” and “did not share the promoter’s ultimate ‘manipulative ... purpose.’ ” 155 F.3d at 110. The Second Circuit disagreed. Noting that scienter was a separate issue and not relevant to the Supreme Court’s holding in

Central Bank

that aiders and abettors cannot be primary violators under § 10(b), the Second Circuit focused on the complaint’s allegations about the nature of the employee’s own acts, not his state of mind when he performed them.

Id.

at 111. The SEC claimed that the employee “ ‘participated in the fraudulent scheme,’ ” by “effecting the very buy and sell orders that artificially manipulated USE’s stock price upward,” i.e. by “committing] a manipulative act.”

Id.

at 112. The appellate court observed, “Indeed, if the trader who executes manipulative buy and sell orders is not a primary violator, it is difficult to imagine who would remain liable after

Central Bank.” Id.

It further found “of no relevance that [the stock promoter] masterminded the USE stock manipulation and that the ‘stock promoter’s’ group ‘directed’ [the employee] to effect the illegal trades.”

Id.

The Second Circuit emphasized,

Like lawyers, accountants, and banks who engage in fraudulent or deceptive practices at their clients’ direction, Romano is a primary violator despite the fact that someone else directed the market manipulation scheme. The Supreme Court in

Central Bank

never intended to restrict § 10(b) liability to supervisors or directors of securities fraud schemes while excluding from liability subordinates who also violated the securities law. In sum, the complaint alleges that Romano is primarily liable under § 10(b) and Rule 10b-5 for manipulation of USE stock.

Id.

Thus secondary actors may be liable for primary violations under an alleged scheme to defraud if all the requirements for liability under Rule 10b-5 have been satisfied as to each secondary-actor defendant and any additional heightened pleading requirements have been met.

Id.

If a plaintiff meets the requirements of pleading primary liability as to each defendant, i.e., alleges with factual specificity (1) that each defendant made a material misstatement (or omission) or committed a manipulative or deceptive act in furtherance of the alleged scheme to defraud, (2) scienter, and (3) rebanee, that plaintiff can plead a scheme to defraud and still satisfy

Central Bank. See, e.g., Cooper v. Pickett,

137 F.3d 616 (9th Cir.1997);

Dinsmore,

135 F.3d at 842 (“We simply hold that where the requirements for primary liability are not independently met, they may not be satisfied based solely on one’s participation in a conspiracy in which

other parties

have committed a primary violation”; “secondary actors who conspire to commit ... violations wib stib be subject to liability so long as they independently satisfy requirements for private liability.”);

Pegasus Holdings v. Veterinary Centers of America, Inc.,

38 F.Supp.2d 1158, 1163-65 (C.D.Cal.1998).

Lead Plaintiff, using older cases, argues that a defendant that participates in a

*593

scheme to defraud is liable for the damages caused by all the other acts taken by participants in a scheme in furtherance of the fraud. In addition to requiring that each participant be a primary violator of the act by itself making a material misrepresentation or omission or using a deceptive device or contrivance to defraud investors, this Court notes that under § 10(b), the PSLRA provides for joint and several liability only if the defendant is found to have knowingly committed the fraud, and otherwise the defendant, if only reckless, is hable only for the percentage of his responsibility for the fraud, i.e., proportionate liability. 15 U.S.C. § 78u-4(f). This express scheme for damages liability seems incompatible with Lead Plaintiffs argument that a participant is hable for damages caused by ah participants, known or unknown, in the scheme.

Since the passage of the PSLRA with its procedural hurdles and stringent pleading standards to eliminate strike suits, this country has been overwhelmed with corporate scandals that place Congress’ goal in enacting the PSLRA in a much wider perspective. Given the usual recent judicial focus on dismissing frivolous suits under the PSLRA, Judge Robert M. Parker provided balance in his concurrence in

Abrams,

292 F.3d at 435-36 ,

History reminds us of the consequences when financial statements of pubhcly held companies do not accord with reality. Indeed it was to protect against them that our nation’s securities laws were enacted. At the same time we must pay heed to a different set of consequences — ’those brought about by the overzealous prosecution of specious securities fraud actions. Congress, in passing the Private Securities Litigation Reform Act of 1995, took pains to deter such strike suits. Its findings and legislative history suggest that the cost of protecting against fraud was unduly impairing the efficient operation of lawful business. Today, when applying the PSLRA, courts must keep this policy consideration foremost in mind. But we must also recognize that Congress left unaffected shareholders’ right to sue for recompense when they are made the victims of self-dealing and deceit. The PSLRA is a mechanism for winnowing out suits that lack a requisite level of specificity. It was not meant to let business and management run amuck to the detriment of shareholders.

The PSLRA’s significance as a protective shield for business must be viewed within the context of the private right of action, granted decades before, to defrauded investors injured by corporate management, auditors, outside counsel, and investment bankers where their conduct allegedly violated the federal securities laws. The Supreme Court has repeatedly emphasized the deterrent value of those private rights of action, which “provide ‘a most effective weapon in the enforcement’ of the securities laws and are a ‘necessary supplement to Commission action.’ ”

J.I. Case Co. v. Borak,

377 U.S. 426, 432 , 84 S.Ct. 1555 , 12 L.Ed.2d 423 (1964).

See also Blue Chip Stamps v. Manor Drug Stores,

421 U.S. 723, 729-30 , 95 S.Ct. 1917 , 44 L.Ed.2d 539 (1975);

Randall v. Loftsgaarden,

478 U.S. 647, 664 , 106 S.Ct. 3143 , 92 L.Ed.2d 525 (1986). Indeed, in adopting the PSLRA, Congress emphasized that “[pjrivate securities litigation is an indispensable tool with which defrauded investors can recover their losses” and that private lawsuits “promote public and global confidence in our capital markets and help to deter wrongdoing and to guarantee that corporate officers, auditors, directors, lawyers and others properly perform their jobs.” Joint Explanatory Statement of the Committee of Conference, Conference Report on Securities Litigation Reform, H.R. Conf. Rep. No. 104-369, at 31 (Nov. 28, 1995), 1995

*594

U.S.C.A.A.N. at 730. The importance of this tool has been highlighted by recent disclosures of extraordinary corporate misconduct.

33

2. Controlling Person Liability Under the 1934 Act

Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a)(liability of controlling persons and those who aid and abet violations), establishes a derivative liability for persons who “control” those who are primarily liable under the Exchange Act. It provides,

Joint and several liability; good faith defense

Every person who, directly or indirectly, controls any person liable under any provision of this chapter or any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.

liability is an alternate ground for liability from that of a primary violation. Thus a plaintiff may allege a primary § 10(b) violation by a person controlled by the defendant and culpable participation by the same defendant in the perpetration of the fraud.

SEC v. First Jersey Sec., Inc.,

101 F.3d 1450, 1472 (2d Cir.1996),

cert. denied,

522 U.S. 812 , 118 S.Ct. 57 , 139 L.Ed.2d 21 (1997). A person charged with control liability may assert a defense that he acted in good faith with respect to the securities violation, i.e., that he acted reasonably and did not act recklessly. A defendant can meet the requirements of a good faith defense by showing that he used reasonable care to prevent the securities violation.

G.A. Thompson & Co. v. Partridge,

636 F.2d 945, 957-58, 960 (5th Cir.1981);

Donohoe v. Consolidated Operating & Prod. Corp.,

30 F.3d 907 , 912 (7th Cir.1994). Negligence alone is insufficient to support controlling person liability.

Id.

Although worded in different ways, the control person liability provisions of § 15 of the 1933 Securities Act and § 20(a) of the 1934 Exchange Act are interpreted the same way.

Pharo v. Smith,

621 F.2d 656, 672 ,

on rehearing in part,

625 F.2d 1226 (5th Cir.1980);

First Interstate Bank v. Pring,

969 F.2d 891, 897 (10th Cir.1992),

rev’d on other grounds,

511 U.S. 164 , 114 S.Ct. 1439 , 128 L.Ed.2d 119 (1994).

See also Abbott v. Equity Group, Inc.,

2 F.3d 613 , 619 n. 15 (5th Cir.1993)(“The control person sections of both acts are interpreted the same, at least with respect to the definition of ‘controlling person,’ ”

citing G.A. Thompson,

636 F.2d at 958 & n. 22), cert.

denied sub nom. Turnbull v. Home Insurance Co.,

510 U.S. 1177 , 114 S.Ct. 1219 , 127 L.Ed.2d 565 (1994). Further

*595

more, the provision for controlling person liability under the Texas Securities Act, article 581-3S(F), is modeled after and parallel to that for section 15 of the 1933 Securities Act and section 20 of the 1934 Act. Tex.Rev.Civ. Stat. Ann. art. 581-33 cmt;

Frank v. Bear, Stearns & Co.,

11 S.W.3d 380, 383-84 (Tex.App.-Houston [14th Dist.] 2000, review denied);

Busse v. Pacific Cattle Feeding Fund

#

1, Ltd.,

896 S.W.2d 807, 814 (Tex.App.-Texarkana 1995, writ denied);

Marshall v. Quinn-L Equities, Inc.,

704 F.Supp. 1384, 1391 (N.D.Tex.1988).

There is a split among the Circuits as to whether in a

prima facie

case a person must show that the alleged control person actually exercised control over the primary violator’s general affairs or merely that the control person had the power to exercise such control.

Maher v. Durango Metals, Inc.,

144 F.3d 1302 , 1306 n. 8 (10th Cir.1998)(and cases cited and discussed therein). The Fifth Circuit has stated that a plaintiff need only show that the alleged control persons possessed “the power to control [the primary violator], not the exercise of the power to control.”

G.A. Thompson,

636 F.2d at 958 (rejecting as a requirement for a

prima facie

case an allegation that the controlling person actually participated in the underlying primary violation);

Abbott v. Equity Group, Inc.,

2 F.3d at 620 . Nevertheless, a plaintiff needs to allege some facts beyond a defendant’s position or title that show that the defendant had actual power or control over the controlled person.

Dennis v. General Imaging, Inc.,

918 F.2d 496, 509-10 (5th Cir.1990);

Kunzweiler v. Zero.Net, Inc.,

No. CIV. A. 3:00-CV-2553-P, 2002 WL 1461732 , *13-14 (N.D.Tex. July 3, 2002). Furthermore, control person liability is derivative; a failure to plead a primary, independent violation by the controlled person § 10(b) and Rule 10b-5 precludes such a claim for secondary liability against the controlling person under § 20(a) of the Exchange Act, or, a violation of §§ 11 or 12 for control person liability under section 15 of the Securities Act of 1933. 15 U.S.C. §§ 78j(b), 78t(a); 15 U.S.C. § 770 ;

ABC Arbitrage,

291 F.3d at 348 n. 57, 362 n. 123.

34

*596

3. Section 11 of the Securities Act of 1933

Section 11, 15 U.S.C. § 77k(a), creates a private remedy for anyone who purchases a security based on a materially misleading registration statement at the time it became effective against the issuer of the securities, the issuer’s directors or partners, the underwriters of the offering, and accountants named as preparers or certifi-ers of the registration statement. Section ll(a)(l — 5) states in relevant part,

(a) Persons possessing cause of action; persons liable

In case any part of the registration statement, when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring such security (unless it is proved that at the time of such acquisition he knew of such untruth or omission) may, in any court of competent jurisdiction, sue—

(1) every person who signed the registration statement;

(2) every person who was a director of (or person performing similar functions) or partner in the issuer at the time of the filing of the part of the registration statement with respect to which his liability is asserted;

(3) every person who, with his consent, is named in the registration statement as being or about to become a director, person performing similar functions, or partner;

(4) every accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him, who has with his consent been named as having prepared or certified any part of the registration statement, or as having prepared or certified any report or valuation which is used in connection with the registration statement, with respect to the statement in such registration statement, report, or valuation, which purports to have been prepared or certified by him; [and]

(5)every underwriter with respect to such security.

Under § 77k(f), such individuals are jointly and severally liable.

To prevail on a claim under § 11, a plaintiff must show “(1) that the registration statement contained an omission or misrepresentation and (2) that the omission or misrepresentation was material, that it would have misled a reasonable investor about the nature of his or her investment.”

Kaplan v. Rose,

49 F.3d 1363, 1371 (9th Cir.1994),

cert. denied,

516 U.S. 810 , 116 S.Ct. 58 , 133 L.Ed.2d 21 (1995);

Krim v. BancTexas Group, Inc.,

989 F.2d 1435, 1445 (5th Cir.1993).

A plaintiff generally is not required to demonstrate scienter under § 11, and a defendant will be liable for innocent or negligent material misrepresentations.

Id.

Where claims under Sections 11 and 12 of the Securities Act are grounded in negligence rather than fraud, there is no scienter requirement and it need only satisfy the liberal pleading requirements of Fed. R. of Civ. P. 8.

See, e.g., In re NationsMart Corp. Sec. Litig.,

130 F.3d 309, 314-16 (8th Cir.1997)(“the particularity requirement of Rule 9(b) does not apply to claims under § 11 of the Securities Act because proof of fraud or mistake is not a prerequisite to establishing liability under § 11”),

cert. denied,

524 U.S. 927 , 118 S.Ct. 2321 , 141 L.Ed.2d 696 (1998);

Steiner v. Southmark Corp.,

734 F.Supp. 269, 277 (“Section 11 violations need not, however, be pleaded with the specificity required of fraud claims governed by Rule 9(b)”),

clarified on other grounds,

739 F.Supp. 1087 (N.D.Tex.1990);

Degulis v. LXR Biotechnology, Inc.,

928 F.Supp. 1301 , 1310

*597

(S.D.N.Y.1996)(Rule 9(b) does not apply to Sections 11 and 12(2) of the Securities Act of 1933 because proof of scienter is not required).

Nevertheless, where § 11 claims actually sound in fraud rather than negligence, the plaintiff is required to plead the circumstances constituting the alleged fraud with particularity satisfying Rule 9(b).

Melder v. Morris,

27 F.3d 1097 , 1100 n. 6 (5th Cir.1994);

35

In re Stac Electronics Sec. Litig.,

89 F.3d 1399 , 1405 & n. 3 (9th Cir.1996),

cert. denied sub nom. Anderson v. Clow,

520 U.S. 1103 , 117 S.Ct. 1105 , 137 L.Ed.2d 308 (1997). The Fifth Circuit subsequently limited the holding of

Melder

and made clear that where a complaint does not allege that the defendants are liable for fraudulent or intentional conduct, especially where it disavows and disclaims any allegations of fraud in its strict liability 1933 Securities Act claims, its claims do not “sound in fraud” and they cannot be dismissed for failure to satisfy Rule 9(b) if they can state a negligence claim under § 11.

Lone Star Ladies Inv. Club v. Schlotzsky’s Inc.,

238 F.3d 363, 368 (5th Cir.2001)(“The proper route is to disregard averments of fraud not meeting Rule 9(b)’s standard and then ask whether a claim has been stated.”).

See also In re Stac Electronics Securities Litig.,

89 F.3d at 1404 -05 and n. 3

36

;

In re NationsMart,

130 F.3d at 315 .

Section 11 of the 1933 Act provides that liability to be imposed on an issuer, underwriter, and anyone that signs a registration statement containing a materially false or misleading statement. All except an issuer may assert certain statutory defenses: (1) the person conducted a “reasonable investigation” under § ll(b)(3)(A)(the “due diligence” defense); (2) the person relied on the opinion of an expert under § 11(b)(3)(B); the person’s misconduct did not cause the investors’ loss under § 11(e); and the right of contribution from more culpable parties under § 11(f).

False statements in a registration statement can create liability under both the 1933 and 1934 Acts.

Huddleston,

459 U.S. at 382-83 , 103 S.Ct. 683 . The remedies are cumulative.

Id.

at 383 , 103 S.Ct. 683 .

4. Controlling Person Liability Under the 1933 Act

Title 15 U.S.C. § 77o, Section 15 of the 1933 Securities Act, entitled “Liability of controlling persons,” imposes joint and several liability upon controlling persons for acts committed by those under their control that violate §§ 11 and/or 12. Thus if a plaintiff fails to state a primary security violation under Section 77k, the plaintiff also fails to state a claim under § 15.

Lone Star Ladies Investment Club,

238 F.3d at 369 . Specifically §

77o

reads,

Every person, who, by or through stock ownership, agency, or otherwise, or who, pursuant to or in connection with an agreement or understanding with one or more other persons by or through stock ownership, agency, or otherwise, controls any person liable under sections 77k or

III

of this title, shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the con

*598

trolling person had no knowledge of or reasonable ground to believe in the existence of facts by reason of which the liability of the controlled person is alleged to exist.

15 U.S.C. § 77o (West 1997).

To survive a motion to dismiss a claim for controlling person liability under Section 15 of the 1933 Act, Lead Plaintiff must allege (1) an underlying primary violation of § 11 by the controlled person, (2) control by the defendant over the controlled person, and (3) particularized facts as to the controlling person’s culpable participation in (exercising control over) the “fraud perpetrated by the controlled person.”

Ellison v. American Image Motor Co.,

36 F.Supp.2d 628, 637-38 (S.D.N.Y.1999)(applying same test to 1933 Securities Act Section 15 claims and 1934 Exchange Act Section 20(a) claims, 15 U.S.C. § 78t(a))(“Every person who, directly or indirectly, controls any person liable under any provision of this chapter or rule or regulation thereunder shall also be hable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable”);

Sanders Confectionery Products, Inc. v. Heller Financial Inc.,

973 F.2d 474, 486 (6th Cir.1992),

cert. denied,

506 U.S. 1079 , 113 S.Ct. 1046 , 122 L.Ed.2d 355 (1993);

Metge v. Baehler,

762 F.2d 621, 631 (8th Cir.1985),

cert. denied,

474 U.S. 1057 , 106 S.Ct. 798 , 88 L.Ed.2d 774 (1986).

Because a primary violation of § 11 is a necessary element of a § 15 claim, if a plaintiff fails to state a claim for a primary violation, he has also failed to state a claim under § 15.

Cooperman v. Individual, Inc.,

171 F.3d 43, 52 (1st Cir.1999);

SEC v. First Jersey,

101 F.3d at 1472 .

Although whether a defendant is a control person is usually a question of fact, dismissal is appropriate where the plaintiff fails to plead any facts from which it can reasonably be inferred that the particular defendant was a control person.

Maher v. Durango Metals, Inc.,

144 F.3d at 1306 ;

Sanders,

973 F.2d at 485-86 . Control can be established by demonstrating that the defendant possessed the power to direct or cause the direction of the management and policies of a person through ownership of voting securities, by contract, business relationships, interlocking directors, family relationships, and the power to influence and control the activities of another.

Ellison,

36 F.Supp.2d at 638 .

C. Professional Conduct/Duty to Non-client Investors

1. Attorneys

The issue of attorney liability involving a duty to disclose nonmisleading information to nonclients and third parties is a thorny one, complicated by tension between the need to provide remedy to parties suffering monetary loss because of a lawyer’s conduct and the attorney-client relationship with its attendant confidentiality, loyalty and zealous representation requirements and policy concerns.

Ethical rules of conduct such as disciplinary rules do not create corresponding legal duties nor constitute standards for imposition of civil liability on lawyers.

See, e.g., Schatz v. Rosenberg,

943 F.2d 485, 492 (4th Cir.1991),

cert. denied,

503 U.S. 936 , 112 S.Ct. 1475 , 117 L.Ed.2d 619 (1992); Preliminary Statement, Model Code of Professional Responsibility (admonishing that the Code does not attempt “to define standards for civil liability of lawyers for professional conduct”); Section 15 of the Preamble to the Texas Disciplinary Rules of Professional Conduct (“These rules do not undertake to define standards of civil liability of lawyers for professional conduct. Violation of a rule does not give rise to a private cause of action nor does it create any presumption

*599

that a legal duty to a client has been breached.”)- They do, however, reflect public policy concerns.

See, e.g., Law Offices of Windle Turley v. Giunta,

No. 05-91-00776-CV, 1992 WL 57464 (Tex.App.Dallas Mar. 23, 1992);

Polland & Cook v. Lehmann,

832 S.W.2d 729, 736 (Tex.App.Houston [1st Dist.] 1992, writ denied);

Kuhn, Collins & Rash v. Reynolds,

614 S.W.2d 854, 856 (Tex.App.-Texarkana 1981, writ ref d n.r.e.).

ABA Model Rule of Professional Conduct 1.6 (2001) states, “A lawyer shall not reveal information relating to representation of a client unless the client consents after consultation,” except that the lawyer may, but does not have to, reveal confidential information (1) to the extent that the lawyer reasonably believes is necessary to prevent the client from committing a criminal act which the lawyer believes is likely to result in imminent death or substantial bodily harm,

37

or (2) to establish a claim or defense by the lawyer in a controversy between the lawyer and the client, or to establish a defense to a criminal or civil charge against the lawyer based on conduct in which the client was involved, or to answer any allegations in any proceeding about the lawyer’s representation of the client.

Pursuant to ABA Model Rule of Professional Conduct 1.2(d) an attorney “shall not counsel a client to engage, or assist a client in, conduct that the lawyer knows is criminal or fraudulent ...,”

38

but the attorney may discuss the legal consequences of any proposed conduct and help the client make a good faith effort to determine the application of the law to that proposed conduct. Comment 6 to the rule states, “The fact that a client uses advice in the course of action that is criminal or fraudulent does not, of itself, make a lawyer party to the course of action. However, a lawyer may not knowingly assist a client in criminal or fraudulent conduct. There is a critical distinction between presenting an analysis of legal aspects of questionable conduct and recommending the means by which a crime or fraud might be committed with impunity.”

If the attorney learns that his client is involved in ongoing criminal or fraudulent acts, under ABA Model Rule 1.16 (2001),

(a) Except as stated in paragraph (c), a lawyer shall ... withdraw from the representations of a client if: (1) the representation will result in violation of the rules of professional conduct or other law; ...

(b) except as stated in paragraph (c) a lawyer may withdraw from representing a client ... if: (1) the client persists in a course of action involving the lawyer’s services that the lawyer reasonably believes is criminal or fraudulent; (2) the client has used the lawyer’s services to perpetrate a crime or fraud; and ...

(c) When ordered to do so by a tribunal, a lawyer shall continue representation notwithstanding good cause for terminating the representation.

(d) Upon termination of representation, a lawyer shall take steps to the extent reasonably practicable to protect a client’s interests, such as giving reasonable notice to the client, allowing time for employment of other counsel, surrendering papers and property to which the client is entitled....

After withdrawal the lawyer must also refrain from disclosing the client’s confidences except as allowed under Rule 1.6.

*600

Model Rule 1.07 also bars a lawyer from representing a party where there is a substantial risk that the lawyer’s representation would be materially and adversely affected by the lawyer’s or his law firm’s own interest.

The Texas Rules of Professional Conduct have similar but not identical provisions. Under Rule 1.02 of the Texas Rules of Professional Conduct (1990)(emphasis added),

(c) A lawyer shall not assist or counsel a client to engage in conduct that the lawyer knows is criminal or fraudulent. A lawyer may discuss the legal consequences of any proposed course of conduct with a client and may counsel and represent a client in connection with the making of a good faith effort to determine the validity, scope, meaning or application of the law.

(d) When a lawyer has confidential information clearly establishing that a client is likely to commit a criminal or fraudulent act

that is likely to result in substantial injury to the financial interests or property of another,

the lawyer shall promptly make reasonable efforts under the circumstances to dissuade the client from committing the crime or fraud.

(e) When a lawyer has confidential information clearly establishing that the lawyer’s client has committed a criminal or fraudulent act in the commission of which the lawyer’s services have been used, the lawyer shall make reasonable efforts under the circumstances to persuade the client to take corrective action. [emphasis added]

Comment 8 to Rule 1.02 states,

When a client’s course of action has already begun and is continuing, the lawyer’s responsibility is especially delicate. The lawyer may not reveal the Ghent’s wrongdoing, except as permitted or required by Rule 1.05. However, the lawyer also must avoid furthering the client’s unlawful purpose, for example, by suggesting how it might be concealed. A lawyer may not continue assisting a client in conduct that the lawyer originally supposes is legally proper but then discovers is criminal or fraudulent. Withdrawal from the representation, therefore, may be required.

Rule 1.05(c)(7) allows the lawyer to reveal confidential information of the client or former client “[w]hen the lawyer has reason to believe it is necessary to do so in order to prevent the client from committing a criminal or fraudulent act.” Only where “the lawyer has confidential information clearly establishing that a client is likely to commit a criminal or fraudulent act that is likely to result in death or substantial bodily harm to a person,” must he disclose information adverse to the client; otherwise his first obligation is to try to dissuade the client from continuing is such conduct. Rule 1.05(e) and Comments 18 and 19. Nevertheless, if the client “persists in a course of action involving the lawyer’s services that the lawyer reasonably believes may be criminal or fraudulent” or “the client has used the lawyer’s services to perpetrate a crime or fraud,” the lawyer must withdraw. Rule 1.15(b)(2) and (3) and Comment 2.

See also

Rule 1.15(a)(1) (withdrawal required if “the representation will result in violation of ... rules of professional conduct or other law....”).

Relevant to Vinson & Elkins’ undertaking of the investigation for Enron in the fall of 2001, Rule 1.06(a)(2) bars a lawyer from representing a client where that representation “reasonably appears to be or becomes limited ... by the lawyer’s or law firm’s own interests.” Comment 5 provides in relevant part,

*601

The lawyer’s own interests should not be permitted to have an adverse effect on representation of a client.... If the probity of a lawyer’s own conduct in a transaction is in question, it may be difficult for the lawyer to give a client detached advice....

See also

Roger C. Cramton, “Enron and the Corporate Lawyer: Professional Responsibility Issues,” 1324 PLI/Corp. 841, 853 (Aug.2002). According to the Restatement of Law Governing Lawyers § 122(2)(c), a client’s consent is not effective “ ‘if, in the circumstances, it is not reasonably likely that the lawyer will be able to provide adequate representation ....’”

Id.

The common law regarding attorney liability to nonclients for misstatements that are attributed specifically to him has been evolving steadily to address increasing concerns about attorney accountability or the lack thereof.

The Fifth Circuit has only twice addressed the issue of an attorney’s duty to disclose information accurately to a third party in the context of alleged securities violations. In 1988, the Fifth Circuit, in a suit challenging the accountability of an underwriter’s counsel for the alleged inaccuracy of the underwriter’s offering statement to the investing public, reaffirmed the traditional rule that “lawyers are accountable only to their clients for the sufficiency of their legal opinions” because “any significant increase in attorney liability to third parties could have a dramatic effect upon our entire system of legal ethics,” established to require the attorney to avoid conflicting duties, “remain loyal to the client,” and “keep attorney client confidences.”

Abell v. Potomac Ins. Co.,

858 F.2d 1104 , 1124 & nn. 18 and 19(5th Cir.1988),

vacated on other grounds,

492 U.S. 914 , 109 S.Ct. 3236 , 106 L.Ed.2d 584 (1989). The panel observed, “In general, the law recognizes such suits [by third parties] only if the non-client plaintiff can prove that the attorney prepared specific legal documents that represent explicitly the legal opinions of the attorney preparing them, for the benefit of the plaintiff.”

Id.

at 1124

&

n. 20 (noting that this rule, adopted by a growing number of states, reflects the increasing influence of the Restatement (Second) of Torts § 552, discussed infra). The Fifth Circuit did concede that an attorney who prepared a signed opinion letter for use by a third party might be liable under Rule 10b-5, but otherwise declined to depart from the traditional rule because it found “no binding authority creating a special rule in the field of securities law.”

Id.

at 1124-25. In 1993 the Fifth Circuit held that even though its opinion in

Abell

was vacated by the Supreme Court as to issues under RICO, the decisions “remains authoritative on the non-RICO issues.”

Abbott v. The Equity Group, Inc.,

2 F.3d at 621 n. 23.

Nevertheless, in

Trust Company of Louisiana v. N.N.P.,

104 F.3d 1478 (5th Cir.1997), which makes only passing reference to Abell,

39

the Fifth Circuit concluded that

*602

the plaintiff, a non-client and the payee of notes (which the Court concluded were “securities” within the federal securities law) purportedly secured by the Government National Mortgage Association certificates (“GNMAs”), had satisfied all the elements of proof to show that the attorney and his firm owed the payee a duty under Louisiana law for negligent misrepresentation and for the imposition of primary liability under Rule 10b-5 (i.e., that the lawyer knowingly and with scienter made material misstatements in connection with the purchase of a security upon which the plaintiff justifiably relied and suffered injury). Specifically the attorney had assured the plaintiff that his firm had possession of and was the custodian for the GNMAs when counsel knew that the law firm did not have the certificates, but only assignments of interest in the certificates.

As noted earlier in footnote 24 of this memorandum and order, in

Klein v. Boyd,

a panel of the Third Circuit Court of Appeals held that once the law firm “elected to speak” by creating or participating in the creation of documents it knows would be distributed to investors, it could not make material misrepresentations or omit material facts in drafting the non-confidential documents. Fed. Sec. L. Rep. (CCH) ¶ 90,136 , 90,323. The law firm’s duty did “not arise from a fiduciary duty to the investors; rather, the duty arose when the law firm undertook the affirmative act of communicating with investors.... ”

Id.

at 90,323-24 .

40

Thus the Third Circuit panel concluded that although the firm may not have a duty to blow the whistle on its client, once it chooses to speak, a law firm does have a duty to speak truthfully, to make accurate or correct material statements, even where the document does not indicate that the attorney authored it.

Id.

and at 90,325. The panel did require that the lawyer’s “participation in the statement containing a misrepresentation or omission of a material fact [be] sufficiently significant that the statement can properly be attributed to the person as its author or co-author,” so that it would not fall within the parameter of conduct constituting aiding and abetting.

Id.

Similarly, in

Rubin v. Schottenstein, Zox & Dunn,

143 F.3d 263, 267 (6th Cir.1998), relying on the text of Rule 10b-5 (it is unlawful for any person [not excepting lawyers] to “omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading ....”), the Sixth Circuit, sitting

en banc,

concluded that an attorney for a corporation issuing securities, who agreed to speak directly to two potential investors about the corporation’s financial condition as it related to the investment, had a duty not to misrepresent or omit material facts to those investors. The Sixth Circuit explained,

Although under Rule 10b-5(b) and its predecessor, “only those individuals who had an affirmative obligation to reveal what was allegedly omitted can be held liable as primary participants in the alleged deception!, a] duty to disclose naturally devolve[s] on those who h[ave] direct contacts with ‘the other side.’ ”

SEC v. Coffey,

493 F.2d 1304, 1315 (6th Cir.1974). “Direct contacts may take many forms. An accountant or lawyer, for instance, who prepares a dishonest statement is a primary participant in a violation even though someone else may conduct the personal negotiations with a

*603

security purchaser.”

Id.

at 1315 n. 24. “A person undertaking to furnish information which is misleading because of a failure to disclose a material fact is a primary participant.”

SEC v. Washington County Util. Dist.,

676 F.2d 218, 223 (6th Cir.1982).

Id.

at 267 .

41

It concluded that initially the attorney could have remained silent with no affirmative duty to disclose, but that once he chose to speak and make representations on behalf of the issuer, either alone or in participation with others, he had a duty to be accurate and complete about material matters and could not hide behind the attorney/client privilege. “In sum, while an attorney representing the seller in a securities transaction may not always be under an independent duty to volunteer information about the financial condition of his client, he assumes a duty to provide complete and nonmisleading information with respect to the subjects on which he undertakes to speak.” 143 F.3d at 268 . In

dictum,

the appellate court commented, “Admission to the bar, if anything, imposes a heightened, not a lessened, requirement of probity.”

Id.

at 270 .

See also Caiola v. Citibank, N.A.,

295 F.3d 312, 331 (2d Cir.2002)(citing

Rubin,

143 F.3d at 267-68 , and concluding that if the plaintiff/investor can prove his allegations, “the lack of an independent duty [of Citibank to disclose its hedging strategy] is not, under such circumstances, a defense to Rule 10b-5 liability because upon choosing to speak, one must speak truthfully about material issues.”).

See also Ackerman v. Schwartz,

947 F.2d 841, 846, 848 (7th Cir.1991)(Easterbrook, J.)

42

(“Federal law requires persons to tell the truth about material facts once they commence speaking, but with rare exceptions it does not oblige them to start speaking”; “Under Rule 10b-5 ... the lack of an independent duty does not excuse a material lie. A subject of a tender offer or a merger bid has no duty to issue a press release, but if it chooses to speak it must tell the truth about material issues.... Although the

*604

lack of duty to investors meant that [attorney] Schwarz had no obligation to blow the whistle ..., Schwarz cannot evade responsibility to the extent he permitted the promoters to release his letter [to agents of the investors].”).

This Court notes that the circumstances in

Trust Company of Louisiana v. N.N.P.,

104 F.3d 1478 (5th Cir.1997), in which an attorney was found liable for direct misrepresentations to a nonclient-prospective investor, fall within the parameters of the Sixth Circuit’s

en banc

rule in

Rubin v. Schottenstein. See also Molecular Technology Corp. v. Valentine,

925 F.2d 910, 917-18 (6th Cir.1991)(holding under direct contacts test that an attorney who knowingly provided materially false or misleading information to investors may be liable as a primary participant under § 10(b)).

In Texas, it has long been established that a lawyer may be liable if he knowingly commits a fraudulent act or enters into a conspiracy with his client to defraud a third person.

Poole v. Houston & T.C. Ry. Co.,

58 Tex. 134, 138 (1882)(where an attorney acting on behalf of his client participates in fraudulent activities, his conduct is “foreign to the duties of an attorney”);

Likover v. Sunflower Teirace II, Ltd,.,

696 S.W.2d 468, 472 (Tex.Civ.App.-Houston [1st Dist.] 1985, no writ)(“an attorney is liable if he knowingly commits a fraudulent act that injures a third person, or if he knowingly enters into a conspiracy to defraud a third person”);

Lewis v. American Exploration Co.,

4 F.Supp.2d 673, 678 (S.D.Tex.1998);

Quemer v. Rindfuss,

966 S.W.2d 661, 666 , 670 & n. 1 (Tex.App.-San Antonio 1998, writ denied). In the instant action, Lead Plaintiff alleges that Enron’s lawyers, accountants, and underwriters participated together with Enron in a Ponzi scheme to enrich themselves, which, in a significant and essential part of the plan, defrauded third-party investors in Enron securities to keep funds flowing into the corporation.

The Restatement (Second) of Torts § 531 (1977) provides, “One who makes a fraudulent misrepresentation is subject to liability to the person or class of persons whom he intends or has reason to expect to act or to refrain from action in reliance upon the misrepresentation for pecuniary loss suffered by them through their justifiable reliance in the type of transaction in which he intends or has reason to expect their conduct to be influenced.” Although Texas has not formally adopted § 531, which does not require privity, the Texas Supreme Court recently stated that Texas’ “jurisprudence, which focuses on the defendant’s knowledge and intent to induce reliance, is consistent with the

Restatement

and with the law in other jurisdictions that have considered the issue.”

Ernst & Young, L.L.P. v. Pacific Mutual Life Ins. Co.,

51 S.W.3d 573, 578 (Tex.2001). The high court observed, “[Texas] fraud jurisprudence has traditionally focused not on whether a misrepresentation is directly transmitted to a known person alleged to be in privity with the fraudfea-sor, but on whether the misrepresentation was intended to reach a third person to induce reliance” and pointed out instances where Texas courts “have held that a misrepresentation made through an intermediary is actionable if it is intended to influence a third person’s conduct.”

Id.

The Texas Supreme Court further commented, “While it is true that Texas courts have not used the words ‘reason to expect’ when discussing fraud’s intent element, a defendant who acts with knowledge that a result will follow is considered to intend that result.”

Id.

at 579 ,

citing Formosa Plastics Corp. v. Presidio Eng’rs & Contractors, Inc.,

960 S.W.2d 41, 48-49 (Tex.1998).

The facts in

Pacific Mutual,

summarized at 51 S.W.3d at 575-77 , were that in

*605

1982 InterFirst Corporation issued a series of notes. Subsequently, encountering financial problems, InterFirst tried to negotiate a merger with RepublicBank, which appeared to be a more profitable bank and had Ernst & Young audit Re-publicBank’s financial statements for the year ending in December 1996. The auditor’s report gave an unqualified opinion

43

that these financial statements fairly represented Republic Bank’s financial situation.

RepublicBank then incorporated that audit report and the audited financial statement into the 1996 annual report that RepublicBank provided to its shareholders and the audited financial statement into its 1996 Form 10-K annual report filed with the SEC. The merger took place in June 1987, and RepublicBank contemporaneously offered several securities. With Inter-First, Republic Bank issued a Joint Proxy and Prospectus requesting their shareholders to vote to approve the merger, as well as several other prospectuses for other stock and notes that incorporated by reference the Joint Proxy and Prospectus. All three prospectuses incorporated Re-publicBank’s 1986 Form 10K. Furthermore Republic Bank incorporated all three prospectuses into the Form S-3 registration statements that it filed with the SEC. Ernst & Young consented to the inclusion of its audit opinion and of its accounting information, as well as mention of its name in the “Experts” section of the prospectuses. In 1987, after reviewing public information about the merger including the three prospectuses, Plaintiff Pacific Mutual Life Insurance purchased $415,725 of the 1982 InterFirst notes a month after the merger and another $8 million a few months later, allegedly in reliance

inter alia

on the audit reports. Significantly it did not purchase any of the securities that were offered in the three prospectuses. RepublicBank filed for bankruptcy soon afterwards, and Pacific Mutual sued the auditing firm among others for fraudulent misrepresentation and noncompliance with GAAS.

44

In

Pacific Mutual,

after the trial court granted summary judgment to Ernst & Young, the appellate court reversed, and Ernst & Young appealed. On review, rendering judgment, the Texas Supreme Court rejected Ernst & Young’s contention that Pacific Mutual had to show that the auditor had direct intent to induce Pacific Mutual to rely on Ernst & Young’s audit opinion and that Texas law requires privity to establish fraud. Nevertheless, the high court determined that the appeals court had not properly applied the reason-to-expect standard to the summary judgment evidence.

Id.

at 580 . Finding that “[general industry practice or knowledge may establish a basis for foreseeability to show negligence, but it is not probative of fraudulent intent,” the Texas Supreme Court focused on the language of comment d of § 531, stating that to show that an asserted “fraudfeasor had reason to expect reliance,”

[t]he maker of the misrepresentation

must have information

that would lead a reasonable man to conclude that there is

an especial likelihood

that it will reach those persons and will influence their conduct. There must be something in the situation known to the maker that would lead a reasonable man to govern his conduct on the assumption

*606

that this will occur.

If he has the information,

the maker is subject to liability under the rule stated here, [emphasis added]

51 S.W.3d at 581 .

During the summary judgment litigation Pacific Mutual submitted evidence consisting of affidavits from two experts and an Ernst & Young employee demonstrating, in essence, that Ernst & Young had reason to expect that Pacific Mutual (based on generalized industry practice or understanding that prospectuses and proxy materials are widely distributed throughout the investment community), like other investors, would rely on such information.

Id.

at 580-81 . Pacific Mutual cited as authority Restatement (Second) of Torts § 536 (1977), which states,

If a statute requires information to be ... filed ... for the protection of a particular class of persons, one who makes a fraudulent misrepresentation in so doing is subject to liability to the persons for pecuniary loss suffered through their justifiable reliance upon the misrepresentation in a transaction of the kind in which the statute is intended to protect them.

51 S.W.3d at 581 . Comment c to § 536 states that one who meets “a statutory filing [with the SEC] requirement is presumed to have reason to expect that the information will reach and influence the class of persons the statute is trying to protect.”

Id.

Comment d to § 536 further indicates that in identifying the protected class, “the focus is on the statute’s purpose rather than the person furnishing the information.”

Id.

Pacific Mutual argued that the laws and rules requiring SEC filings, which were enacted after the 1929 stock market crash, were “generally designed to protect investors.”

Id.

at 582. Pacific Mutual emphasized that in deciding to purchase the InterFirst 1982 notes, it had relied on all the publicly available information, including documents mandated by law to be filed with the SEC, that had incorporated subsequent audits prepared by Ernst.

Id.

at 581-82.

The Texas Supreme Court disagreed with Pacific Mutual and narrowly construed § 536.

Id.

at 582. It observed that Comment e of § 536 makes clear that the general purpose behind the law requiring public filings is to make the information available to anyone who considers it important in deciding what to do “in any type of transaction

with the corporation in question.” Id.

at 582 [emphasis added by this Court], Pacific Mutual’s purchase of In-terFirst notes that were issued by Inter-First in 1982 prior to the merger with Republic was not a transaction with Re-publicBank or with the proposed merger entity described in the offering by Repub-licBank that incorporated the SEC filings. The court expressly chose not to decide if purchasers of securities issued by the merged entity or Republic Bank shareholders, which did not include Pacific Mutual, could rely on SEC filings, but emphasized that § 536’s “reach [did not extend] to open-market purchases of unrelated securities.”

Id.

at 582. Moreover, (1) because there was no counterpart to § 536 in Texas common law and other courts have rarely applied it, (2) because the case was originally brought in federal court under § 10(b) but was dismissed as time-barred, and (3) because investors have other remedies under federal and state securities laws, the Texas Supreme Court stated that “we are reluctant to apply section 536’s presumption and subject market participants to liability for fraud damages to an almost limitless class of potential plaintiffs.”

Id.

Because Pacific Mutual therefore had failed to prove the element of intent, under the high court’s narrowly construed reason-to-expect standard, the court rendered judgment for the auditor.

*607

As a relevant standard for comparison, in 1991 Texas has also recognized a duty of a professional to a nonclient to use reasonable care to supply accurate information under certain circumstances by adopting the Restatement (Second) of Torts § 552 (1977), defining a tort of negligent misrepresentation.

Federal Land Bank Association v. Sloane,

825 S.W.2d 439, 442 (Tex.1991). Section 552 provides,

(1) One who, in the course of his business, profession or employment, or in any transaction in which he has a pecuniary interest, supplies false information for the guidance of others in their business transactions, is subject to liability for pecuniary loss caused to them by their justifiable reliance upon the information, if he fails to exercise reasonable care or competence in obtaining or communicating the information.

(2) Except as stated in Subsection (3), the liability in Subsection (1) is limited to loss suffered

(a) by the person or one of a limited group of persons for whose benefit and guidance he intends to supply the information or knows that the recipient intends to supply it; and

(b) through reliance upon it in a transaction that he intends the information to influence or knows that the recipient so intends or in a substantially similar transaction.

(3) The liability of one who is under a public duty to give the information extends to loss suffered by any of the class. of persons for whose benefit the duty is created, in any of the transactions in which it is intended to protect them.

Section 552 thus requires a species of intent that is closer to that for fraud than to that for negligence. Texas common law fraud requires that the defendant know that his representation was false or made recklessly without any knowledge of its truth and that the defendant intend to induce the plaintiff to act upon that representation.

Trenholm v. Ratcliff,

646 S.W.2d 927, 930 (Tex.1983).

Moreover, eleven years after the Fifth Circuit issued

Abell ,

which had followed the traditional rule that an attorney owes no duty regarding the sufficiency of its legal opinions to a third party in absence of privity of contract, but which also had noted the increasing influence of § 552, the Texas Supreme Court held that § 552 applies to lawyers.

McCamish, Martin, Brown & Loeffler v. F.E. Appling Interests,

991 S.W.2d 787 (Tex.1999).

The Texas Supreme Court observed that other courts, both state and federal, under Texas and other states’ laws, have applied § 552 to other professions in addition to lawyers, including auditors, physicians, securities placement agents, accountants, real estate brokers, title insurers, as well as other types of evaluations issued by the professional, e.g., warranty deeds, title certificates, offering statements, offering memoranda, placement memoranda, deeds of trust, annual reports, and opinion letters. It determined that there “was no reason to exempt lawyers.”

McCamish,

991 S.W.2d at 791, 793, 795 . Recognizing that “[t]he theory of negligent misrepresentation permits plaintiffs who are not parties to a contract for professional services to recover from the contracting professionals” and “imposes a duty to avoid negligent misrepresentation irrespective of privity,” the Texas Supreme Court held that where a nonclient, not in privity with the attorney, receives and relies on an evaluation, such an opinion letter, prepared by another entity’s attorney, he may sue under § 552 if the attorney is aware of the nonclient and intends that the non-client rely on the information.

Id.

at 792-93. The high court also noted that the application of section 552 to attorneys was validated by what was then a tentative

*608

draft of the Restatement (Third) of the Law Governing Lawyers § 73 (entitled “Duty of Care to Certain Nonclients”), which is now final.

45

That draft (as well as the final version) incorporates section 552 and provides in relevant part that irrespective of privity an attorney “owes a duty of care to a nonclient ‘when and to the extent that: (a) a lawyer ... invites the non-client to rely on the lawyer’s opinion or provision of other legal services, and the non-client so relies, and (b) the non-client is not, under applicable tort law, too remote from the lawyer to be entitled to protection.’ ”

McCamish,

991 S.W.2d at 794-95 .

The high court distinguished between liability for legal malpractice, which is based on “the breach of a duty that a professional owes his clients or others in privity,” and liability for negligent misrepresentation, which is “based on an independent duty to a nonclient based on the professional’s manifest awareness of the nonclient’s reliance on the misrepresentation and the professional’s intention that the nonclient so rely.”

Id.

at 792 . The Texas Supreme Court found that “applying section 552 to attorneys does not offend the policy justifications for the strict privity rule in legal malpractice cases” because a client still has control over the attorney-client relationship and potential liability to third parties does not create a conflict of duties nor threaten the attorney-client privilege because ethical rules, including Texas Disciplinary Rule of Professional Conduct 2.02 protect against such.

Id.

at 793 . Nor does § 552 expose an attorney “to almost unlimited liability” because of its limitation on potential claimants to known parties to whom the attorney provided information for a known purpose and who justifiably relied upon that information.

Id.

at 793-94. Comment h to § 552 explains the restrictions on standing to sue for negligent misrepresentation to “[pier-sons for whose guidance the information is supplied” and distinguishes it from standing to sue for fraudulent misrepresentation:

[The negligent supplier of information’s liability] is somewhat more narrowly restricted than that of the maker of a fraudulent misrepresentation (see § 531), which extends to any person whom the maker of the representation has reason to expect to act in reliance upon it. Under this Section, as in the case of the fraudulent misrepresentation (see § 531), it is not necessary that the maker should have any particular person in mind as the intended, or even the probable, recipient of the information. In other words, it is not required that the person who is to become the plaintiff be identified or known to the defendant as an individual when the information is supplied. It is enough that the maker of the misrepresentation intends to reach and influence either a particular person or persons, known to him, or a group or class of persons distinct from the much larger class who might reasonably be expected sooner or later to have access to the information and foreseeably take some action in reliance upon it. It is enough, likewise, that the maker of the representation knows that his recipient intends to transmit this information to a similar person, persons or group. It is sufficient, in other words, insofar as the plaintiffs identity is concerned, that the maker merely knows of the ever-present possibility of repetition to anyone, and the possibility of action in reliance upon

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it, on the part of anyone to whom it may be repeated.

See also Trust Co. of Louisiana v. N.N.P., Inc.,

104 F.3d 1478 (5th Cir.1997)(under Louisiana law, to prevail on a claim by a nonclient against an attorney for negligent misrepresentation, the plaintiff must show that the attorney provided legal services and knew that the third party intended to rely on them).

46

Thus, with respect to both fraudulent misrepresentation and negligent misrepresentation, Texas recognizes that an attorney has an established duty to third parties not to make material misrepresentations on which the attorney “knew or had reason-to-expect” that the parties would rely or the attorney intended to reach and influence a limited group that might reasonably be expected to have access to that information and act in reliance on it.

47

Plaintiffs must still prove

*610

that they did justifiably rely on the attorney’s (or accountant’s) misrepresentations about a corporation’s financial strengths and suffered monetary loss as a result in deciding to purchase that corporation’s securities. The standard for scienter (actual knowledge or reckless disregard) for liability under § 10(b) and Rule 10b-5 is closer to that for fraudulent misrepresentation than for negligent misrepresentation. Therefore in light of the Texas high court’s conclusion that § 531 is fully compatible with the Texas common law of fraud, the standard in § 531 is particularly relevant to this Court’s analysis of an attorney’s duty to third parties under § 10(b), although, as noted, the intent element in § 552 is closer to fraud than negligence.

This Court concludes that professionals, including lawyers and accountants, when they take the affirmative step of speaking out, whether individually or as essentially an author or co-author in a statement or report, whether identified or not, about their client’s financial condition, do have a duty to third parties not in privity not to knowingly or with severe recklessness issue materially misleading statements on which they intend or have reason to expect that those third parties will rely. Such a duty has been established in cases including

Klein v. Boyd, Caiola v. Citibank, Rubin v. Schottenstein, Ackerman v. Schwartz, Trust Company of Louisiana v. N.N.P.,

and

Ernst & Young v. Pacific Mutual Life Ins.

Moreover, with respect to the element of reliance, for purposes of § 10(b) as well as the tort of fraudulent misrepresentation, the Court is concerned about avoiding the danger of opening the professional liability floodgates to any and every potential investor or foreseeable user of the allegedly misleading informa

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tion who might obtain and rely on the statement. Therefore this Court finds that a restrictive approach with respect to the group to which the attorney or accountant owes the duty and which thus should have standing to sue, such as that taken by Texas, is appropriate and necessary. In this suit, Lead Plaintiff has alleged as a crucial part of the Ponzi scheme that at least some fraudulent misrepresentations were made by Vinson & Elkins and Arthur Andersen and were aimed at investors to attract funds into Enron, as well as at credit rating agencies to keep Enron’s credit rating high and bank loans flowing. Therefore the “limited group” that the attorneys or accountants allegedly intended,' or might reasonably have expected, to rely on their material misrepresentations, and who allegedly did rely and suffered pecuniary loss, included Plaintiffs in this suit.

2. Accountant/Auditor

There is no accountant/client privilege analogous to that accorded to lawyers. The United States Supreme Court has held, “By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public.”

United States v. Arthur Young & Co.,

465 U.S. 805, 817-18 , 104 S.Ct. 1495 , 79 L.Ed.2d 826 (1984).

Significantly, although a major goal of the PSLRA was to limit the exposure of corporations to frivolous strike suits targeting “deep-pocket” defendants by heightening pleading standards and imposing procedural hoops, in contrast Congress expanded independent public accountants’ watchdog duties. Harvey L. Pitt, et al., “Promises Made, Promises Kept: The Practical Implications of the Private Securities Litigation Reform of 1995,” 33 San Diego L.Rev. 845, 848-51 (1996). Under 15 U.S.C. § 78j-l(a)(l), every audit must have “procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts!.]” If the accountant discovers a possibly illegal act, he must decide whether if it is likely to have occurred and determine its potential effect. 15 U.S.C. § 78j-l(b)(l)(A). If he finds an illegal act has taken place and that it is of consequence, he must as soon as “practicable” inform the appropriate management personnel of the issuer and “assure” its audit committee or, if there is no audit committee, its board of directors of its conclusions. 15 U.S.C. § 78j-l(b)(l)(B). That committee or board must notify the SEC within one day and send a copy of the notice to the accountant. 15 U.S.C. 78j-l(b)(2). If the accountant does not receive that notice, he must resign and report to the SEC. 15 U.S.C. § 78j-l(b)(3). The report must be submitted to the SEC within one day, regardless.

Id. See generally

William F. Dietrich, “Legal and Ethical Issues for Attorneys Dealing with Financial Data: Heightened Scrutiny after the Enron and Andersen Debacle,” 1325 PLI/Corp 925, 945-46 (Aug.2002).

GAAS and GAAP represent the industry standard for measuring the performance of an examination by an accountant.

Escott v. BarChris Const. Corp.,

283 F.Supp. 643, 703 (S.D.N.Y.1968);

In re Ikon Office Solutions, Inc.,

277 F.3d 658 , 663 n. 5 (3d Cir.2002);

SEC v. Arthur Young & Co.,

590 F.2d 785 , 788 n. 2 (9th Cir.1979).

The discussions above regarding liability under § 10(b) and the duty of the professional to nonclients apply to accountants.

Under § 11, an accountant may be civilly liable for certifying or preparing any financial report that is included in a regis

*612

tration statement or prospectus which contains a material misrepresentation or omission. 15 U.S.C. § 77k.

See Herman & MacLean v. Huddleston,

459 U.S. at 382 n. 11, 103 S.Ct. 683 (“Accountants are liable under § 11 only for those matters which purport to have been prepared or certified by them.”). An accountant may establish a defense of due diligence to a § 11 claim if he demonstrates that “he had, after reasonable investigation, reasonable grounds to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading.” 15 U.S.C. § 77k(b)(3)(B)(i).

3. Underwriters

Section 11 imposes liability “[i]n case any part of [a] registration statement ... contain[s] an untrue statement of a material fact or omit[s] to state a material fact required to be stated therein or necessary to make the statements therein not misleading” on a number of players and specifically on “every underwriter with respect to such security.” 15 U.S.C. § 77k(a). An underwriter of a public offering risks exposure to such liability under § 11, as well as to liability under § 10(b) for any material misstatements or omissions in the registration statement made with scienter, and thus has a duty to investigate an issuer and the securities that the underwriter offers to investors.

Hanly v. SEC,

415 F.2d 589, 595-96 (2d Cir.1969)(holding that brokers and salesmen have a duty to investigate and to analyze sales literature and must not blindly accept recommendations made about a security);

Sanders v. John Nuveen & Co.,

554 F.2d 790, 793 (7th Cir.1977)(an underwriter has a duty to investigate an issuer and may be liable under Rule 10b-5 for reckless failure to do so);

SEC v. Dain Rauscher,

254 F.3d 852, 857-58 (9th Cir.2001).

This investigative duty is placed on the underwriter because, as noted by the Seventh Circuit, its role is critical to the integrity of the market and the confidence of the investing public:

An underwriter’s relationship with the issuer gives the underwriter access to facts that are not equally available to members of the public who must rely on published information. And the relationship between the underwriter and its customers implicitly involves a favorable recommendation of the issued security. Because the public relies on the integrity, independence and expertise of the underwriter, the underwriter’s participation significantly enhances the marketability of the security. And since the underwriter is unquestionably aware of the nature of the public’s reliance on his participation in the sale of the issue, the mere fact that he has underwritten it is an implied representation that he has met the standards of his profession in his investigation of the issuer [footnotes omitted].

Sanders,

524 F.2d at 1070. The Second Circuit has observed,

Self-regulation is the mainspring of the federal securities laws. No greater reliance in our self-regulatory system is placed on any single participant in the issuance of securities than upon the underwriter. He is most heavily relied upon to verify published materials because of his expertise in appraising the securities issue and the issuer, and because of his incentive to do so. He is familiar with the process of investigating the business condition of a company and possesses extensive resources for doing so. Since he often has a financial stake in the issue, he has a special motive thoroughly to investigate the issuer’s

*613

strengths and weaknesses. Prospective investors look to the underwriter, a fact well known to all concerned and especially to the underwriter, to pass on the soundness of the security and the correctness of the registration statement and prospectus.

Chris-Craft Industries, Inc. v. Piper Aircraft Corp.,

480 F.2d 341, 370 (2d Cir.1973), ce

rt. denied,

414 U.S. 910 , 94 S.Ct. 231 , 232, 38 L.Ed.2d 148 (1973).

The underwriter also may protect itself from liability by establishing a “due diligence” defense under Section 11, i.e., prove that it “had after reasonable investigation, reasonable ground to believe and did believe ... that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading.” 15 U.S.C. § 77k(b)(3). The legal standard for measuring whether the underwriter satisfies the due diligence test is “the standard of reasonableness ... required of a prudent man in the management of his own property.” 15 U.S.C. § 77 (k)(c);

Toolworks,

50 F.3d at 621 . Thus due diligence is “[i]n effect ... a negligence standard.”

Id., quoting Hochfelder,

425 U.S. at 208 , 96 S.Ct. 1375 .

The court in

Escott v. BarChris Construction Corp.,

283 F.Supp. 643, 697 (S.D.N.Y.1968), observed in an influential opinion,

To effectuate the statute’s purpose the phrase “reasonable investigation” must be construed to require more effort on the part of the underwriters than the mere accurate reporting in the prospectus of “data presented” to them by the company. It should make no difference that this data is elicited by questions addressed to the company officers by the underwriters, or that the underwriters at the time believed that the company’s officers are truthful and reliable. In order to make the underwriter’s participation in this enterprise of any value to the investors, the underwriters must make a reasonable attempt to verify the data submitted to them. They may not rely solely on the company’s officers or on the company’s counsel. A prudent man in the management of his own property would not rely on them.

In addition to the availability of a due diligence defense, an underwriter may rely on expertised parts of a prospectus, such as financial statements certified by an accountant, unless it had reasonable grounds to believe the statements were untrue. 15 U.S.C. § 77k(b)(3)(C);

In re Software Toolworks, Inc., 50 F.3d at 623 .

III. Lead Plaintiffs Allegations in Consolidated Complaint

A. The Scheme, Generally

Lead Plaintiff asserts that Defendants participated in “an enormous Ponzi scheme, the largest in history,” involving illusory profits “generated by phony, non-arm’s-length transactions with Enron-controlled entities and improper accounting tricks” in order to inflate Enron’s reported revenues and profits, conceal its growing debts, maintain its artificially high stock prices and investment grade credit rating, as well as allow individual defendants to personally enrich themselves by looting the corporation, while continuing to raise money from public offerings of Enron or related entities’ securities to sustain the scheme and to postpone the collapse of the corporation, a scenario characterized by Lead Plaintiff as “a hall of mirrors inside a house of cards.” Consolidated Complaint at 12. The consolidated complaint sets out an elaborate scheme of off-the-books, illicit partnerships, secretly controlled by Enron and established at times critical for requisite financial disclosures by Enron in order to conceal its actual financial status. These Enron-controlled entities typically

*614

would buy troubled assets from Enron, which Enron would have had difficulty selling in an arm’s length transaction to an independent entity and which otherwise would have to be reported on Enron’s balance sheet, by means of sham swaps, hedges, and transfers, to record phony profits and conceal debt on Enron’s balance sheet. Lead Plaintiff further paints a picture of participation in the scheme by Enron’s accountants, outside law firms, and banks, which all were the beneficiaries of such enormous fees and increasing business, as well as investment opportunities for personal enrichment, with the result that their opinions were rubber stamps that deceived investors and the public.

According to the consolidated complaint, in 1997 Enron suffered a substantial financial setback because of a British natural gas transaction, resulting in a loss of one-third of its stock’s value and analysts’ downgrading its stock and lowering then-forecasts of its future earnings’ growth. Moreover, Enron had been involved in transactions with a special purpose entity (“SPE”)

48

known as Joint Energy Development Incorporated (“JEDI”), which Enron, as a partner, had established in 1993 with an outside investor that held a 50% interest in JEDI. Because initially JEDI was independent, Enron was able to report JEDI’s profits, but not carry JEDI’s debt on Enron’s books. According to the complaint, JEDI generated 40% of the profits that Enron reported in 1997 alone. In December 1997, ten months before the Class Period, a crisis arose when the independent investor sought to withdraw, forcing Enron either to restructure with a new, independent investor or to consolidate JEDI with Enron, and thereby wipe out 40% of the profits that Enron had reported earlier in 1997, and to report JEDI’s $700 million debt on Enron’s balance sheet, as well as lose the ability to generate future profits by utilizing JEDI as an SPE.

Unable to find a legitimate, independent outside investor to 'replace the one withdrawing, Enron, along with Vinson & El-kins and Kirkland & Ellis, resorted to forming another entity, Chewco, totally controlled by Enron, to buy the outsider’s investment in JEDI. Enron then arranged with Barclays Bank to lend $240 million to Chewco to allow Chewco to invest in JEDI and obtain the necessary 3% equity interest to maintain the appearance that JEDI was independent. According to the consolidated complaint at 275, pursuant to advice from Vinson & Elkins, Michael Kopper (an Enron employee who worked for Andrew Fastow) was made manager of Chewco because he was not a senior officer of Enron and therefore his role in Chewco would not have to be disclosed. Vinson & Elkins prepared the legal documentation for JEDI and Chewco. On December 12, 1997 Kopper transferred his ownership interest in Chewco to his domestic partner, William Dodson, in a sham transaction effected solely to make it appear that Kop-per, and through him, Enron, had no formal interest in Chewco.

Because in actuality there was no outside, independent equity investor with a 3% stake in Chewco, Enron arranged for

*615

Barclays Bank to lend $11.4 million to two “straw” parties, Little River and Big River, to permit them to make the requisite 3% “equity” investment in Cheweo.

Id.

at 275-76.

According to the complaint, Kirkland & Ellis helped structure these deals and represented the straw parties, Little River and Big River, as part of the scheme to conceal Enron’s debt and losses, and therefore the law firm had knowledge of the manipulation. Consolidated complaint at 275, 277. Barclays and the Enron Defendants prepared the documentation characterizing the advances as loans, while Enron and Cheweo characterized them as equity contributions to serve as the 3% equity investment needed for nonconsoli-dation of JEDI. Consolidated complaint at 276. The loans were noted in documents that resembled promissory notes and loan agreements, but which were titled “certificates” and “funding agreements” that required the borrowers to pay “yield” at a particular percentage rate, i.e., interest.

Id.

Nevertheless, reflecting Barclays’ knowledge about Chewco’s lack of an independent third-party investor and the resulting creation of strawmen Little River and Big River, Barclays insisted that the borrowers/Enron secretly establish cash “reserve accounts” in the amount of $6.6 million to secure repayment of Barclay’s $11.4 million. The complaint further states that a clandestine agreement for Enron to provide the $6.6 million to fund Chewco’s reserve accounts for Big River and Little River was drawn up by Vinson & Elkins, which therefore had to have knowledge of the manipulation and of the absence of outside equity.

Id.

at 276, 277. To fund the reserve accounts, JEDI wired $6.58 million to Barclay’s on 12/30/97, thus cutting in half Chewco’s illusory 3% equity interest in JEDI, essential for JEDI to be independent of Enron.

Id.

Because Chew-co did not have the requisite equity at risk and did not qualify as an adequately capitalized SPE, it, like JEDI, should have been consolidated into Enron’s consolidated financial statements from the outset, but was not.

Id.

The complaint further alleges that Enron guaranteed the $240 million unsecured loan from Barclays to Cheweo in December 1997, and that in exchange, Cheweo agreed to pay Enron a guaranteed fee of $10 million up front (cash at closing) plus 315 basis points annually on the average outstanding balance of the loan. The fee calculation was not based on the risk involved, but on benefitting Enron’s financial statement. Furthermore, during the year the loan was outstanding, JEDI, through Cheweo, paid Enron $17.4 million under the fee arrangement. Enron characterized these payments as “structuring fees” and recognized income from the $10 million up-front fee in December 1997, when in actuality, the payments were improper transfers from one Enron pocket to another.

Thus Cheweo was allegedly financed with debt, not equity, and neither JEDI nor Cheweo was a valid SPE because neither met the requirements for nonconsoli-dation.

49

The establishment

of

Cheweo not only allowed Enron to report JEDI profits

*616

of $45 million illicitly, inflating Enron’s 1997 reported profits, and to keep $700 million of debt off Enron’s books, but it also provided Enron with the opportunity in the future to do non-arm’s-length-transactions with an Enron-controlled entity that no independent entity would have done nor agreed to do and which provided a stream of sham profits onto Enron’s books.

Chewco became a template for subsequent entities that Enron continued to establish in increasing numbers and size, all secretly controlled by Enron, which Enron and its banks would use to generate enormous phony profits and conceal massive debt. Moreover, contrary to representations made to investors, many of these entities were capitalized with Enron common stock, and Enron guaranteed that if the stock price declined below a certain “trigger” price level and Enron lost its investment grade credit rating, Enron would become liable for the debt of those entities. To pay such a debt, Enron would have to issue substantial amounts of new stock, which in turn would dilute the holdings of current stockholders to their detriment. In sum, Chewco was less than 3% owned by parties independent of Enron, was improperly excluded from Enron’s financial statements despite being controlled by Enron, and was never disclosed in Enron’s SEC filings during the Class Period. Furthermore, Enron continued to use Chewco/JEDI in non-arm’s-length transactions to generate false profits and conceal Enron’s actual indebtedness from 1997 through 2001 in transactions that Vinson & Elkins participated in structuring and provided false “true sale” opinions to effectuate.

Two other SPEs, LJM Cayman L.P. (“LJM1”)

50

and LJM2 Co-Investment, L.P. (“LJM2”), were structured, reviewed, and approved by Arthur Andersen LLP, Vinson & Elkins, Kirkland & Ellis, individual Enron Defendants, and certain Enron bankers, and controlled by Enron’s Chief Financial Officer Andrew Fastow to inflate Enron’s financial results by more than a billion dollars, as well as to enrich Fastow and selected others by tens of millions of dollars.

51

LJM1 provided En

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ron employees an opportunity to enrich themselves personally and quickly. For instance, in March 2000, Enron employees Andrew Fastow, Michael Kopper, Ben Glisan, Kristina Mordaunt, Kathy Lynn and Anne Yaeger Patel obtained financial interests in LJM1 for initial contributions of $25,000 by Fastow, $5,800 each for Gli-san and Mordaunt, and lesser amounts for the others, totaling $70,000. They quickly received extraordinary returns on their investments: on May 1, 2000, Fastow received $4.5 million, while Glisan and Mor-daunt within a couple of months received approximately $1 million. Consolidated complaint at 282.

Lead Plaintiff labels the transactions with the two Enron-controlled LJM partnerships (“where Enron insiders would be on both sides of the transactions”) as “the primary manipulative devices used to falsify Enron’s financial results during the Class Period.” Fastow, in particular, wore two hats, which allowed him to self-deal, according to the consolidated complaint. Because Enron insiders were on both sides of all LJM2 transactions, Defendants knew that LJM2 would be an extremely lucrative investment as the alleged Ponzi scheme proceeded, as evidenced by LJMl’s early dealings. Lead Plaintiff alleges that therefore, top Enron officials and Merrill Lynch sent a confidential private placement memorandum, which Vinson & Elkins participated in drafting, to certain favored investment banks (including JP Morgan, Merrill Lynch, CIBC, and CitiGroup) and the banks’ high-level officers and privileged Merrill Lynch clients. The memorandum, which was not a public document, invited them (1) to benefit from this “unusually attractive investment opportunity” arising from LJM2’s connection to Enron, (2) emphasized that Fastow was Enron’s CFO, (3) informed them that LJM2’s day-to-day activities would be managed by Enron insiders Fastow, Michael Kopper, and Ben Glisan, (4) explained that LJM2 “expects that Enron will be the Partnership’s primary source of investment opportunities” and that it “expects to benefit from having the opportunity to invest in Enron-generated investment opportunities that would not be available otherwise to outside investors,” (5) noted that Fastow’s “access to Enron’s information pertaining to potential investments will contribute to superior returns,” pointed out that investors in JEDI, another Fastow-controlled partnership, had done similar transactions with Enron and investors had tripled their investment in two- years, (6) anticipated overall returns of 2,500% for LJM2 investors, and (7) and assured that investors would not be required to contribute additional capital if Fastow’s dual role ended. Lead Plaintiff alleges that Enron’s banks and high-level bankers were offered this investment opportunity as a reward for their ongoing participation in the Ponzi scheme. JP Morgan, CitiGroup, Credit Suisse Boston, CIBC, Merrill Lynch, Lehman Brothers, Bank America, Deutsche Bank and/or their top executives invested about $150 million and, at the same time, continued to iss

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