Amicus Curiae Brief — Stoneridge Inv. Partners v. Scientific-Atl.

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Supt eme Court. U.S '

3404 &) JUN 1 4 2007

No. 06-43 OFFICE OF THE CLERK |

IN THE

Supreme Court of the Anited States

STONERIDGE INVESTMENT PARTNERS, LLC,

Petitioner,

SCIENTIFIC-ATLANTA, INC. AND MOTOROLA, INC.,

Respondents.

On Writ of Certiorari

to the United States Court of Appeals

for the Eighth Circuit

BRIEF OF COUNCIL OF INSTITUTIONAL INVESTORS

AS AMICUS CURIAE IN SUPPORT OF PETITIONER

JEFFREY P. MAHONEY MARK C. HANSEN

COUNCIL OF INSTITUTIONAL PRIYA R. AIYAR

INVESTORS Counsel of Record

888 17th Street, N.W. KELLOGG, HUBER, HANSEN,

Suite 500 TODD, EVANS & FIGEL,

Washington, D.C. 20006 P.L.L.C.

(202) 822-0800 1615 M Street, N.W.

Suite 400

Washington, D.C. 20036

(202) 326-7900

Counsel for Amicus Council of Institutional Investors

June 11, 2007

p= ____________________...___

TABLE OF CONTENTS

Page

_ |) £ . Tear er nn ii

INTEREST OF AMICUS CURIAE ..00....ccccccccesssseeeeseeeeeeeees 1

os i. a TT 2

iat iidieictineichtnsitetiibinininidalinininacaiannioseneicbeietapinenens 3

I. ADEQUATE DETERRENCE OF SEC.-

ONDARY ACTORS IS CRUCIAL TO

py ys spe C8 y 7 | 6) | en 3

A. Secondary Actors’ Function as Gate-

TIIIIIN sichesinsinsisiiictipeispbinietebeaneniebenedeinnebecteserepesmenn 4

B. Explaining Gatekeeper Failure ....................... 5

C. The Need for Adequate Deterrence ................. 9

Il. THE STRICT TEST FOR PRIMARY

LIABILITY WOULD CREATE A SAFE

ee a ccseccsieccecsviecdunensesevinansecnses 11

Ill. FEARS OF OPENING THE FLOOD-

GATES TO FRIVOLOUS LITIGATION

ici ciinniicuidesiibinantigtenaseseieses 15

A. The PSLRA Has Reduced Frivolous

Litigation Against Secondary Actors............. 16

B. Allegations of Primary Violations by

Secondary Actors Are Not Presump-

tive Efforts To Evade Central Bank............... 18

C. Plaintiffs Must Still Prove Reliance .............. 19

IV. ELIMINATION OF PRIVATE LAW-

SUITS AGAINST SECONDARY AC-

TORS WILL RESULT IN INADEQUATE

COMPENSATION FOR INVESTORS ................ 20

GAY cnnterceviensnssnntenenraceneenioesabapenmenceiannneonsenssonenten 23

‘3

TABLE OF AUTHORITIES

Page

CASES

Amchem Prods., Inc. v. Windsor, 521 U.S. 591

STInIETTitetiieicinie eibenmeiichainaaas iach aaiaiaiaciatiia ian ieilainipainans 22

Bernstein v. Crazy Eddie, Inc., 702 F. Supp. 962

(1988), vacated in part on recon., 714 F. Supp.

RES SC 19

Blue Chip Stamps v. Manor Drug Stores,

a ee Se ibiiliniiiada ends tindtinstistictninsincsinnintenncnit 15

CalPERS v. Felzen, 525 U.S. 315 (1999) ............ccccccccsseeeees 1

Carley Capital Group v. Deloitte & Touche, LLP,

27 F. Supp. 2d 1324 (N.D. Ga. 1998) ...................cc000es 13

Cascade Intl Sec. Litig., In re, 840 F. Supp. 1558

(1993), modified on recon., 894 F. Supp. 437

Ses MUNI SIE cick dcaiiehidscditneddnndecmmadiasceadbdadeeibeaneiuietetedneen 12

Cendant Corp. Litig., In re, 264 F.3d 201 (3d Cir.

Se aie hein einai i eahibienmanees 22

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

Bank of Denver, N.A., 511 U.S. 164 (1994)...... 8, 12, 13,

15, 16, 17, 18, 19

Charter Communications, Inc. Sec. Litig., In re,

443 F.3d 987 (8th Cir. 2006), cert. granted,

127 S. Ct. 1873 (2007) (No. 06-43) .0......... cece eeeeeseeeteeeees 2

Copland v. Grumet, 88 F. Supp. 2d 326 (D.N.J.

SIT cinceieshisstiiaduiaistiatiinetgiapddiiapanbadstinhiedadiibinnitpidanctentiiiesinnmeeniie 14

Devlin v. Scardelletti, 536 U.S. 1 (2002)................ccecce eee 1

DiLeo v. Ernst & Young, 901 F.2d 624 (7th Cir.

Tenaill ccrisbdedsiaenndtininaitinniclasseitienstadaasiiaibeeiiiipabniaiiiatiaminrbriepeseets 5, 6

Employers Ins. of Wausau v. Musick, Peeler, &

Garrett, 871 F. Supp. 381 (1994), amended on

recon., 948 F. Supp. 942 (S.D. Cal. 1995)................... 13

Enron Corp. Sec. Litig., In re, 235 F. Supp. 2d

ID, Sis Sci a icncnssnsendemninrbennnnedeheniniinentn 7,19

Hundahl v. United Benefit Life Ins. Co., 465 F.

Supp. 1349 (N.D. Tex. 1979) ................ccccccsrcsseseses 15, 16

ICN/ Viratek Sec. Litig., In re, No. 87 Civ. 4296,

1996 WL 164732 (S.D.N.Y. Apr. 9, 1996)................... 14

Lampf, Pleva, Lipkind, Prupis & Petigrow v.

Gilbertson, 501 U.S. 350 (1991) .................ccccccseesssseeeens 8

Lernout & Hauspie Sec. Litig., In re, 230 F. Supp.

Fk nee 13, 14

Mace v. Van Ru Credit Corp., 109 F.3d 338

TINA MUN did 22

Melder v. Morris, 27 F.3d 1097 (5th Cir. 1994).............. 5, 6

Merrill Lynch, Pierce, Fenner & Smith, Inc. v.

es See Tees SE IIE centenitichsiddcsiniecientinninceonssins 19

Molecular Tech. Corp. v. Valentine, 925 F.2d 910

SEI UII IIIT ict icinasihdtetiaeacimaiastiaiincneistsiitiamtigsareuneceees 19

Regents of Univ. of California v. Credit Suisse

First Boston (USA), Inc., 482 F.3d 372 (5th

Cir. 2007), petition for cert. pending, No.

06-1341 (U.S. filed Mar. 5, 2007).......................0000 2,15

Rocker Mgmt., LLC v. Lernout & Hauspie Speech

Prods. N.V., No. Civ. A. 00-5965, 2005 WL

3658006 (D.N.J. June 7, 20085).............ccsccccccercrveereveees 12

Stewart v. Wyoming Cattle Ranche Co., 128 U.S.

Nn eet on ae ee ll

Winkler v. NRD Mining, Lid., 198 F.R.D. 355

SETI? ies ETD stcretesninidinhideereenheincieednienediadinanienibiammedneniainen 12

Wright v. Ernst & Young LLP, 152 F.3d 169

I I idl sah cechalpaeidlilaasnrlaebdedebaiaoeilibcpbaes 2

Ziemba v. Cascade Intl, Inc., 256 F.3d 1194

Ee hiereimemtivepebiniinsatiniaiiniaes 2, 12

ZZZZ Best Sec. Litig., In re, 864 F. Supp. 960

I ignated alls 13

STATUTES, REGULATIONS, AND RULES

Private Securities Litigation Reform Act of 1995,

Pub. L. No. 104-67, 108 Stat. 737 ...........ccccccssssecsscsecess 8

I ec adrcmmlil 8

Be 8

2 fe ee 8

ED 8

Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204,

I TE nittiareteehitaicininaatiditebiinciiottakecunenienintinmrabinsionse 7,9

Securities Exchange Act of 1934, 15 U.S.C.

§§ 78a et seq.:

Ry Tie Ws OF PD ctictsccccnicssocscccosnesecsesse 2, 13, 14

B,C Ry Oe PID dissntsccncenciccccinctscsctscsensocincs 9

§ 21D(f)(2)(A), 15 U.S.C. § 78u-4(f)(2)(A)................... 17

§ 21D(f)(2)(B)(i), 15 U.S.C. § 78u-4(f)(2)(B)(i)............ 17

Securities Litigation Uniform Standards Act of

1998, Pub. L. No. 105-353, 112 Stat. 3227 .................. 8

17 C.F.R. § 240.10b-5 (SEC Rule 10b-5)..........0....0....cceeeeeee 2

Ss Ss TI ici iliiccheihiechiisininmdiderianiesninesinnisitcicpinndadepeenaines 1

LEGISLATIVE MATERIALS

H.R. Conf. Rep. No. 104-369 (1995), reprinted in

RAIDS PIU énnbsntdnencnestcsnesennetensece 1, 16, 17, 21

Prepared Testimony. of Arthur Levitt, SEC

Chairman, and Isaac C. Hunt, SEC Com-

missioner, The Securities Litigation Uniform

Standards Act of 1997: Hearing on S. 1260

Before the Subcomm. on Securities of the S.

Comm. on Banking, Housing, and Urban

Affairs, 105th Cong. (Oct. 29, 1997), avail-

able at http://banking.senate.gov/97_10hrg/

1OZ99Twitness/sec. Ntim. ..........-.cccrrcccssssssesssseeseccsees 21-22

S. Rep. No. 104-98 (1995), reprinted in 1995

Rees MIIIEE snnscssacictianiderniitnictreentamcannedeiiiitaniimetiaies 16, 17

Testimony of Richard C. Breeden, SEC Chair-

man, Securities Investor Protection Act of

1991: Hearing Before the Subcomm. on Secu-

rittes of the S. Comm. on Banking, Housing,

and Urban Affairs, 102d Cong. (Oct. 2, 1991)............ 22

Testimony of Thomas Donaldson, Mark O.

Winkelman Professor, The Wharton School,

University of Pennsylvania, Penalties for

White Collar Crime: Are We Really Getting

Tough on Crime?, Before the S. Comm. on the

Judiciary, 107th Cong. (July 10, 2002), avail-

able at http://judiciary.senate.gov/testimony.

CETERA BD ROGET UG on... coccccccccccceccccoccecccovsceseceee 10-11

ADMINISTRATIVE MATERIALS

Brief of the Securities and Exchange Commis-

sion, Amicus Curiae, in Support of Posi-

tions that Favor Appellant, Simpson ov.

Homestore.com, Inc., No. 04-55665 (9th Cir.

RR yok eh Tene eR 20

Stephen M. Cutler, Director, Division of Enforce-

ment, U.S. Securities and Exchange Com-

mission, The Themes of Sarbanes-Oxley as

Reflected in the Commission's Enforcement

Program, Speech at UCLA School of Law

(Sept. 20, 2004), available at http://www.sec.

gov/news/speech/spch092004smc. htm ..................c..000 4

Office of the General Counsel, SEC, Report to

the President and the Congress on the First

Year of Practice under the Private Securities

Litigation Reform Act of 1995 (Apr. 1997),

available at http://www.sec.gov/news/studies/

SHINN cisosiccsiscnccinsccidocsonsicinneitematitintaadinsmndaindaliiaiatabice 17-18

Report of the Securities and Exchange Commis-

sion: Section 703 of the Sarbanes-Oxley Act of

2002 — Study and Report on Violations by

Securities Professionals (Jan. 2003), available

at hitp://www.sec.gov/news/studies/sox703

ESS as ea

United States General Accounting Office, Report

to the Chairman, Committee on Banking,

Housing, and Urban Affairs, U.S. Senate,

Financial Statement Restatements: Trends,

Market Impacts, Regulatory Responses, and

Remaining Challenges (Oct. 2002), available

at http://www.gao.gov/new.items/d03138.pdf......... 6,

United States Government Accountability Office,

Report to the Ranking Minority Member,

Committee on Banking, Housing, and Urban

Affairs, U.S. Senate, Financial Restatements:

Update of Public Company Trends, Market

Impacts, and Regulatory Enforcement Activi-

ties (July 2006), available at http://www.gao.

SD Te PE occcccccccscccsecesessccesesccsceccescececes

OTHER MATERIALS

Austrian Bank To Pay Millions In Refco Case,

N.Y. Times, June 6, 2006, at C3 .0..........cccceeeceeeeeeeeees

Nick Bunkley, S.E.C. Sues Ex-Officials Of

Delphi, N.Y. Times, Oct. 31, 2006, at C1...............00.

Stephen Choi, Do the Merits Matter Less After the

Private Securities Litigation Reform Act?, 23

J.L. Econ. & Org. (forthcoming 2007) (Am.

Law & Econ. Ass’n, Am. Law & Econ. Ass’n

15th Annual Meeting, Working Paper 25,

2005), available at http://law.bepress.com/

icici aerate ntenennennennenemmenneneenn

See ee EE GIP OIED cecersccncscncsmncnecscenszensvessnsnnsesstscnsseosnees

John C. Coffee, Jr.:

Gatekeeper Failure and Reform: The Chal-

lenge of Fashioning Relevant Reforms, 84

ey Ce hs He I cicieccesiicibitaisenernnenccinteenetinnentnewces 8,9

Reforming the Securities Class Action: An

Essay on Deterrence and Its Implementation,

106 Colum. L. Rev. 1534 (2006) .................ccccceceeeeeeeees 18

The Acquiescent Gatekeeper: Reputational

Intermediaries, Auditor Independence and the

Governance of Accounting 2-5 (Columbia Law

School, The Center for Law and Economics

Studies, Working Paper No 191, May 21,

2001), available at http://papers.ssrn.com/id=

Understanding Enron: “It’s About the Gate-

keepers, Stupid”, 57 Bus. Law. 1403 (2002) ....4, 6-7, 17

Cornerstone Research:

Post-Reform Act Securities Settlements: 2005

Review and Analysis (2006), available at

http://securities.cornerstone.com/pdfs/

ka eee 20, 22

Securities Class Action Case Filings, 2005:

A Year in Review (2006), available at http://

www.cornerstone.com/securities/pdfs/

I iaciichidiininardietinibiniabentcidibbciinsitidenilinpideiinieeineiininearuntnne 18

Securities Class Action Case Filings, 2006:

A Year in Review (2007), available at http://

www.cornerstone.com/securities/pdfs/

Securities Class Action Settlements: 2006

Review and Analysis (2007), available at

http://securities.cornerstone.com/pdfs/

ETL ESTE eo ee 20

Deloitte and Banks to Pay $455 Million to

Adelphia Investors, N.Y. Times, Dec. 9, 2006,

i icithaiiieniatiiiinintcdinainnenpaniniiiiiitpnniniatitinialatdaateaiiieaiiniaitininamais 21

Joel S. Demski, Corporate Conflicts of Interest,

17 J. Heom. Porep. 51 (2008) ......cccccorcccccccoccsccccsseeee

Geraldine Fabrikant, Rigas Family To Cede

Assets To Adelphia, N.Y. Times, Apr. 26,

RRS EASE Wench See ee ER

dill E. Fisch & Kenneth M. Rosen, Is There a

Role for Lawyers in Preventing Future

Enrons?, 48 Vill. L. Rev. 1097 (2003) ...................

Dan Fischel, Secondary Liability Under Section

10(b) of the Securities Act of 1934, 69 Calif. L.

SN, TE IED wteiencecctnisntnecnesincinsspseneniapuieniesnsessenee

Todd Foster et al.,. NERA Economic Consulting,

Recent Trends in Shareholder Class Action

Litigation: Filings Plummet, Settlements

Soar (Jan. 2007), available at http://www.

nera.com/image/BRO_Recent_Trends_

SEC1288_FINAL_0307.pdf.................scccscscssseeeeees

Charles Gasparino & Tom Hamburger, Congress

Broadens Probe of Enron Fall and Wall Street

Role, Wall St. J., Mar. 7, 2002, at C1 ..............0000

Assaf Hamdani, Gatekeeper Liability, 77 S. Cal.

ee ST, GP Qi csccssseccessscenccnnnsssssscesnnsonnesessensneveste

Bill Hensel, Jr., Settlement adds $2.4 billion to

the kitty, Houston Chron., Aug. 3, 2005,

available at http://www.chron.com/disp/story.

mpl/special/enron/3293828.html.........................+-

Marilyn F. Johnson et al., Do The Merits Matter

More? The Impact of the Private Securities

Litigation Reform Act (Univ. of Mich., John

M. Olin Center for Law & Economics, Work-

ing Paper No. 02-011, 2006), available at

http://ssrn.com/abstract=883684.....................eee

Reinier Kraakman, Gatekeepers: The Anatomy of

a Third-Party Enforcement Strategy, 2 J.L.

ee Sa Ce esinicnetctientecntinitnennennnnieneieente

Donald C. Langevoort:

Managing the “Expectations Gap” in Investor

Protection: The SEC and the Post-Enron

Reform Agenda, 48 Vill. L. Rev. 1139 (2003) ......

Words from on High About Rule 10b-5:

Chiarella’s History, Central Bank’s Future,

20 Del. J. Corp. L. 865 (1995)............cccccsereeeseeeeees

Jonathan Macey & Hillary A. Sale, Observations

on the Role of Commodification, Independ-

ence, and Governance in the Accounting

Industry, 48 Vill. L. Rev. 1167 (2003)..................

Michael J. de la Merced, Finance Chief Of Refco

Is Indicted, N.Y. Times, Oct. 25, 2006 at C3.......

Gretchen Morgenson, Global Crossing Settles

Suit on Losses, N.Y. Times, Mar. 20, 2004, at

Frank Partnoy, Barbarians at the Gatekeepers?:

A Proposal for a Modified Strict Liability

Regime, 79 Wash. U. L.Q. 491 (2001)..................

Tod Perry & Marc Zenner, CEO Compensation in

the 1990s: Shareholder Alignment or Share-

holder Expropriation, 35 Wake Forest L. Rev.

BI Geis cikictinienssnensssanensnncsnscenninensensncnensnsusnsesveess

Robert A. Prentice:

Locating that “Indistinct” and “Virtually Non-

existent” Line Between Primary and Secon-

_ dary Liability Under Section 10(b), 75 N.C. L.

Be GS COP crsesressesscsssnscecesnsspsesenseccnsmnesnansecesees

The Case of the Irrational Auditor: A Behav-

toral Insight Into Securities Fraud Litigation,

OB Boer. U. Le, Bee. BBB CODD nccccccoccccccccccccccscocccces

Restatement (Second) of Torts (1977) ...............000000+-

Hillary A. Sale, Banks: The Forgotten Partners in

Fraud, 73 U. Cin. L. Rev. 139 (2004)...................

Jathon Sapsford, Executives See Rise in ‘Tying’

Loans to Other Fees, Wall St. J., June 9, 2004,

Joel Seligman, The Implications of Central Bank,

49 Bus. Law. 1429 (1994) .0..................cccccccceseceeesseeeeees

Deborah Solomon, Salomon Draws Focus by SEC

Over Adelphia, Wall St. J., June 5, 2002, at

Lynn A. Stout, Type I Error, Type II Error, and

the Private Securities Litigation Reform Act,

INTEREST OF AMICUS CURIAE!

The Council of Institutional Investors (“Council”) is a

not-for-profit association of more than 130 public, labor,

and corporate pension funds with assets exceeding $3 tril-

lion. Its members are major long-term shareowners with

duties to protect the retirement assets of millions of

American workers. The Council is an advocate for strong

corporate governance standards. Its members seek to

protect plan assets through proxy votes, shareowner reso-

lutions, pressure on regulators, discussions with man-

agement, and, when necessary, litigation. The Council

has previously appeared as an amicus in cases affecting

shareowner rights. See, e.g., Tellabs, Inc. v. Makor Issues

& Rights, Ltd., No. 06-484 (U.S., argued Mar. 28, 2007);

Devlin v. Scardelletti, 536 U.S. 1 (2002); CalPERS uv.

Felzen, 525 U.S. 215 (1999).

The interests of the Council and its members are di-

rectly implicated by this case. Congress has recognized

that institutional investors are America’s largest share-

owners and “‘have the most to gain from meritorious

securities litigation.” H.R. Conf. Rep. No. 104-369, at 34

(1995) (quoting testimony of Maryellen Andersen, then-

treasurer of the Council), reprinted in 1995 U.S.C.C.A.N.

730, 733. The Council thus has a strong interest in pro-

tecting investors’ ability to obtain redress from secondary

actors who commit securities fraud.

! Pursuant to Supreme Court Rule 37.6, counsel for amicus repre-

sents that it authored this brief and that no person or entity other than

amicus or its counsel made a monetary contribution to the preparation

or submission of the brief. Counsel for amicus represents that counsel

for all parties have consented to the filing of this brief. Petitioner has

filed with the Clerk a letter granting blanket consent to the filing of

amicus briefs, and a letter reflecting the consent of respondents to the

filing of this brief has been filed with the Clerk.

SUMMARY OF ARGUMENT

The Council does not take a position on the precise legal

standard for determining when a so-called “secondary

actor” — such as a law firm, accounting firm, investment

bank, or counterparty in a fraudulent transaction — is a

primary violator of § 10(b) of the Securities Exchange

Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 of the

Securities and Exchange Commission (“SEC”), 17 C.F.R.

§ 240.10b-5. The Council believes, however, that the

strict test for primary liability endorsed by some lower

courts would have undesirable policy consequences. Un-

der that test, a secondary actor is a primary violator of

§ 10(b) and Rule 10b-5 only if it makes a misstatement

that is publicly attributed to the actor at the time of the

plaintiff's investment decision, owes a fiduciary duty to

the plaintiff investors, or illegally trades in the issuer's

securities. See, e.g., Wright v. Ernst & Young LLP, 152

F.3d 169, 175 (2d Cir. 1998) (“[A] secondary actor cannot

incur primary liability under the [Securities] Act for a

statement not attributed to that actor at the time of its

dissemination.”); Ziemba v. Cascade Int, Inc., 256 F.3d

1194, 1205 (11th Cir. 2001) (“[I]n order for the defendant

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 defen-

dant at the time that the plaintiff's investment decision

was made.”).?

2 See also In re Charter Communications, Inc. Sec. Litig., 443 F.3d

987, 992 (8th Cir. 2006) (deception within the meaning of § 10(b)

includes only misstatements or failure to disclose by one with a duty

to disclose, while manipulation includes only illegal trading in the

issuer's securities), cert. granted, 127 S. Ct. 1873 (2007) (No. 06-43);

Regents of Univ. of California v. Credit Suisse First Boston (USA), Inc..,

482 F.3d 372, 389-91 (5th Cir. 2007) (a “deceptive” device must involve

breach of a duty of disclosure, while “manipulation” requires that the

defendant act directly in the market for the relevant security), petition

for cert. pending, No. 06-1341 (U.S. filed Mar. 5, 2007); id. at 394

(Dennis, J., concurring in the judgment) (according to the Credit Suisse

majority and Charter Communications, secondary actors cannot be

primary violators unless they “(1) directly make public misrepresenta-

Adoption of the strict test would undercut lessons

learned in the aftermath of recent financial scandals re-

garding the complexity of securities fraud today and the

importance of deterring secondary actors from participat-

ing in fraud. See Point I, infra. It would give account-

ants, investment bankers, lawyers, and other third par-

ties a “safe harbor” for fraud so long as they do not pub-

licly announce their involvement with an issuer's mis-

statements. See Point II, infra. Contrary to the reason-

ing of some courts, the strict test is not required to stem a

tide of frivolous litigation against secondary actors. See

Point III, infra. Finally, neither lawsuits against issuers

themselves nor SEC enforcement will adequately compen-

sate investors in the face of the strict test. See Point IV,

infra.

ARGUMENT

I. ADEQUATE DETERRENCE OF SECONDARY

ACTORS IS CRUCIAL TO PREVENTING FRAUD

A common thread in the massive financial scandals of

recent years — such as Enron, WorldCom, Tyco, Adelphia,

and Global Crossing — is the involvement of accountants,

lawyers, investment bankers, and financial advisers in

structuring complex transactions designed to falsify com-

panies’ financial statements. See, e.g., Joel S. Demski,

Corporate Conflicts of Interest, 17 J. Econ. Persp. 51, 65-

66 (2003) (“Enron carried out countless highly complex

and carefully crafted financial transactions. These all in-

volved selling of additional financial services by consult-

ants, attorneys and investment banks. In many cases,

these transactions were designed with no apparent pur-

pose other than manipulating recorded debt and earnings

and often provided an opportunity for a financial institu-

tion to collect fees on both sides of a transaction.”).

tions; (2) owe the issuer's shareholders a duty to disclose; or (3) directly

‘manipulate’ the market for the issuer's securities through practices

such as wash sales or matched orders’).

While large-scale securities fraud is not a new phe-

nomenon, recent scandals have been particularly devas-

tating because they illustrate the failure of outside profes-

sionals to check corporate management. See, e.g., John C.

Coffee, Jr., Understanding Enron: “It’s About the Gate-

keepers, Stupid”, 57 Bus. Law. 1403, 1404-05 (2002) (in

contrast to prior frauds, which “have not generally dis-

turbed the overall marketj,] ... Enron has clearly roiled

the market”; “[bJehind this disruption lies the market's

discovery that it cannot rely upon the professional gate-

keepers — auditors, analysts, and others — whom the mar-

ket has long trusted to filter, verify and assess compli-

cated financial information”). Adoption of the strict test

would ignore the role of secondary actors in protecting

the integrity of securities markets; the evidence that in-

creased profits from fraud and decreased risks of liability

led secondary actors to fail in that role; and the need to

establish adequate deterrence of secondary actors.

A. Secondary Actors’ Function as Gatekeepers

Academics as well as policymakers have recognized the

function of secondary actors as “gatekeepers” in the

securities markets. See, e.g., Stephen M. Cutler, Director,

Division of Enforcement, U.S. Securities and Exchange

Commission, The Themes of Sarbanes-Oxley as Reflected

in the Commission’s Enforcement Program, Speech at

UCLA School of Law (Sept. 20, 2004) (describing “the

auditors who sign off on companies’ financial data” and

“the lawyers who advise companies on disclosure stan-

dards and other securities law requirements” as “gate-

keepers” and “sentries of the marketplace”), available

at http://www.sec.gov/news/speech/spch092004smc.htm.

These third-party professionals verify companies’ state-

ments for investors and enable companies to execute

transactions. Their involvement may be public — e.g., cer-

tifying financial statements and signing opinion letters —

as well as non-public — e.g., designing transactions, draft-

ing press releases and prospectuses, and producing non-

public opinions for issuers and underwriters.

Secondary actors have long been regarded as a critical

check on fraud by corporations. Executives may face

overwhelming temptation to inflate corporate profits

through fraud, especially if their compensation is largely

equity-based. See, e.g., Tod Perry & Marc Zenner, CEO

Compensation in the 1990s: Shareholder Alignment or

Shareholder Expropriation, 35 Wake Forest L. Rev. 123,

132-34 (2000) (during the 1990s, compensation of both

CEOs and directors became more dependent on stock

price). Secondary actors, however, have less motive to

participate in fraud. A prominent accounting firm, law

firm, or investment bank logically should not sacrifice the

reputational capital on which it trades for the fees associ-

ated with a single engagement. Thus, requiring secon-

dary actors to approve corporate statements and to facili-

tate transactions ought to minimize fraud, because these

actors are easier to deter than management. See, e.g.,

DiLeo v. Ernst & Young, 901 F.2d 624, 629 (7th Cir. 1990)

(“An accountant’s greatest asset is its reputation for hon-

esty, followed closely by its reputation for careful work.

Fees for two years’ audits could not approach the losses

{Ernst & Whinney] would suffer from a perception that it

would muffle a client's fraud. ... E & Ws partners shared

none of the gain from any fraud and were exposed to a

large fraction of the loss. It would have been irrational for

any of them to have joined cause with Continental.”);

Melder v. Morris, 27 F.3d 1097, 1103 (5th Cir. 1994) (“[I]t

seems extremely unlikely that Coopers & Lybrand was

willing to put its professional reputation on the line by

conducting fraudulent accounting work for URCARCO.”).

See generally Reinier Kraakman, Gatekeepers: The Anat-

omy of a Third-Party Enforcement Strategy, 2 J.L. Econ. &

Org. 53 (1986).

B. Explaining Gatekeeper Failure

The business scandals of recent years, however, re-

vealed that reputational incentives were frequently in-

adequate to deter secondary actors from participating in

fraud. See, e.g., John C. Coffee, Jr., The Acquiescent

Gatekeeper: Reputational Intermediaries, Auditor Inde-

pendence and the Governance of Accounting 2-5 (Columbia

Law School, The Center for Law and Economics Studies,

Working Paper No 191, May 21, 2001), available at

http://papers.ssrn.com/id=270944; Hillary A. Sale, Banks:

The Forgotten Partners in Fraud, 73 U. Cin. L. Rev. 139,

140-41 (2004). The failure of professional gatekeepers

was reflected not only in a few high-profile cases, but also

in a decline in the overall quality of financial reporting.

Ten percent of publicly listed companies restated their

earnings because of accounting irregularities between

1997 and 2001.° Restatements continued to rise between

2002 and 2005.4 These restatements were not technical;

the stock prices of restating companies between 1997 and

2001 suffered immediate, market-adjusted declines of

more than 10%. See 2002 GAO Report at 24-25; see also

2006 GAO Report at 23-24 (market capitalization of re-

stating companies between 2002 and 2005 decreased an

estimated $36 billion in the days surrounding a restate-

ment, adjusted for overall market movements).

One explanation of gatekeeper failure is that the poten-

tial profits to secondary actors that committed fraud were

greater than recognized in cases like Dileo and Melder.

For example, accountants’ incentive to acquiesce in cli-

ents’ demands was not just their audit fees, but also their

desire to retain consulting revenue from audit clients that

could easily threaten to take their consulting business

elsewhere. See, e.g., Coffee, 57 Bus. Law. at 1410-11

3 See United States General Accounting Office, Report to the Chair-

man, Committee on Banking, Housing, and Urban Affairs, U.S. Sen-

ate, Financial Statement Restatements: Trends, Market Impacts, Regu-

latory Responses, and Remaining Challenges 15 (Oct. 2002) (“2002

GAO Report”), available at http://(www.gao.gov/new.items/d03 138.pdf.

4 See United States Government Accountability Office, Report to the

Ranking Minority Member, Committee on Banking, Housing, and Ur-

ban Affairs, U.S. Senate, Financial Restatements: Update of Public

Company Trends, Market Impacts, and Regulatory Enforcement Activi-

ties 11 (July 2006) (“2006 GAO Report”) (finding a five-fold increase in

the number of restatements between 1997 and 2005), available at

http://www.gao.gov/new. items/d06678.pdf.

& n.36 (“Consulting fees paid by audit clients exploded

during the 1990s.”); see also Robert A. Prentice, The Case

of the Irrational Auditor: A Behavioral Insight Into Secu-

rities Fraud Litigation, 95 Nw. U. L. Rev. 133, 186-217

(2000) (identifying a host of reasons why it may be eco-

nomically rational for individual auditors and auditing

firms to participate in fraud).5 Moreover, the advent of

new limited liability corporate forms reduced the incen-

tives of partners to monitor one another, decreasing the

predictive value of focusing on the reputation of a firm as

a whole. See Jonathan Macey & Hillary A. Sale, Observa-

tions on the Role of Commodification, Independence, and

Governance in the Accounting Industry, 48 Vill. L. Rev.

1167, 1170-72, 1186 (2003).

Like accounting firms, many investment banks also

profited from client business at the same time that they

allegedly neglected due diligence obligations with respect

to clients’ other transactions. For example, Citigroup and

Salomon Smith Barney allegedly serviced more than $3

billion in loans to a partnership owned by the family that

controlled Adelphia, while leading public offerings of

Adelphia stock. See Deborah Solomon, Salomon Draws

Focus by SEC Over Adelphia, Wall St. J., June 5, 2002, at

C1. With respect to Enron, bank executives allegedly

invested their own funds in off-balance-sheet special-

purpose entities, while designing and profiting from sham

transactions that were intended to let Enron book reve-

nue when it was actually incurring debt. See In re Enron

Corp. Sec. Litig., 235 F. Supp. 2d 549, 637-56, 695-704

(S.D. Tex. 2002); Charles Gasparino & Tom Hamburger,

Congress Broadens Probe of Enron Fall and Wall Street

Role, Wall St. J., Mar. 7, 2002, at Cl. Financial institu-

tions’ practice of making loans in exchange for underwrit-

ing and other fees may be on the rise. See, e.g., Jathon

Sapsford, Executives See Rise in ‘Tying’ Loans to Other

Fees, Wall St. J., June 9, 2004, at Al; see also Frank Part-

5 Congress addressed this problem in the Sarbanes-Oxley Act of

2002. See infra p. 9.

noy, Barbarians at the Gatekeepers?: A Proposal for a

Modified Strict Liability Regime, 79 Wash. U. L.Q. 491,

524-25 (2001) (“[A]bundant anecdotal evidence suggests

that investment banks engage in potentially reputation-

depleting activities in order to maximize profits. .. . Sub-

stantial agency costs at investment banks prevent man-

agers from restraining lower-level employees who have

incentives to deplete the firm’s reputation to increase

their own profits.”).

An increase in available profits, however, is not the only

explanation for participation in fraud by secondary actors

during the 1990s and early 2000s. As Professor Coffee

has observed, those years also saw a marked decrease in

the risk of liability for such actors because of decisions by

the Court and Congress. See John C. Coffee, Jr., Gate-

keeper Failure and Reform: The Challenge of Fashioning

Relevant Reforms, 84 B.U. L. Rev. 301, 318-21 (2004) (ex-

plaining that Lampf, Pleva, Lipkind, Prupis & Petigrow v.

Gilbertson, 501 U.S. 350 (1991), shortened the statute of

limitations applicable to securities fraud, while Central

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

N.A., 511 U.S. 164 (1994), eliminated a private right

of action for aiding and abetting). In 1995, Congress

enacted the Private Securities Litigation Reform Act

(“PSLRA”) and, in 1998, the Securities Litigation Uniform

Standards Act (““SLUSA”). PSLRA imposed a heightened

pleading standard in securities fraud class actions, see

§ 101, 109 Stat. 737-49; replaced joint and several liability

with proportionate liability, see § 201(a), 109 Stat. 758-62;

eliminated securities fraud as a predicate for RICO claims

for which plaintiffs could seek treble damages, see § 107,

109 Stat. 758; and created a safe harbor for forward-

looking statements, see § 102, 109 Stat. 749-56. SLUSA

required class actions alleging securities fraud to proceed

in federal court under the PSLRA, rather than in state

court. These developments combined to reduce the risk

that secondary actors that participated in fraud would be

held liable by investors. See infra pp. 16-18 (describing

the decline in securities litigation against secondary ac-

tors following the legal developments of the 1990s).

C. The Need for Adequate Deterrence

Thus, a central lesson of recent financial scandals is

that the cost-benefit analysis for secondary actors tipped

too far in the direction of encouraging fraud. Congress

took steps to address the benefit side of this equa-

tion when it enacted the Sarbanes-Oxley Act of 2002.

Sarbanes-Oxley attempted to eliminate problematic in-

centives for some secondary actors by, for example, bar-

ring accountants from providing certain consulting ser-

vices to audit clients, see 15 U.S.C. § 78)j-1(g). Congress,

however, did not address other categories of secondary

actors, such as investment bankers. See Sale, 73 U. Cin.

L. Rev. at 141 (Sarbanes-Oxley “ignores one key set of

gatekeepers — bankers’); see also Jill E. Fisch & Kenneth

M. Rosen, Is There a Role for Lawyers in Preventing

Future Enrons?, 48 Vill. L. Rev. 1097, 1101 (2003)

(Sarbanes-Oxley’s reporting-up obligation for lawyers “is

unlikely to be an effective response to the types of prob-

lems experienced at Enron”).

Moreover, Sarbanes-Oxley did not focus on the cost side

of the decision-making calculus for secondary actors by

strengthening deterrents against fraud. See, e.g., Assaf

Hamdani, Gatekeeper Liability, 77 S. Cal. L. Rev. 53, 55

(2003) (“despite the apparent consensus that insufficient

deterrence of gatekeepers (such as accountants) is to

blame for debacles like Enron, there has been virtually no

attempt to go down the simple path of making gatekeeper

liability more stringent”) (footnote omitted); Coffee, 84

B.U. L. Rev. at 337 (though Sarbanes-Oxley reduced ex-

pected benefits from participation in fraud, expected costs

remain reduced as well). In the wake of Enron and other

scandals, commentators have suggested various methods

of achieving more adequate deterrence of gatekeepers, for

example, a regime of stricter liability. See, e.g., Partnoy,

79 Wash. U. L.Q. at 546-47 (proposing modified strict li-

ability for gatekeepers based on material misstatements

or omissions in offering documents; explaining that, under

this proposal, investors who prevail against an issuer for

securities fraud would automatically win damages against

the relevant gatekeepers, with the only liability limita-

tions being those placed through indemnification or in-

surance agreements). Whether strict liability, negligence-

based liability, or knowledge-based liability for gate-

keepers is appropriate may depend on judgments about

how effectively gatekeepers can prevent wrongdoing.

Where the costs of prevention are unknown or large, a

knowledge-based liability standard may be a safe ap-

proach. It prevents at least some wrongdoing at low cost,

and it allows the costs of gatekeeper compliance to be

borne by clients that gatekeepers know to be wrongdoers.

See Hamdani, 77 S. Cal. L. Rev. at 104.

Without taking a position on what standard of liability

best serves public policy, it would certainly undermine the

goal of adequate deterrence to eliminate even knowledge-

based liability for fraud — the laxest standard for gate-

keepers — simply because no fraudulent statement is pub-

licly attributed to a secondary actor. Secondary actors

already confront significant incentives to participate in

fraud, as the profits allegedly derived by the investment

bank defendants in the Enron litigation illustrate. Allow-

ing such actors to insulate themselves against legal liabil-

ity simply by avoiding a public announcement of involve-

ment would create overwhelming temptation to enable

fraud. Even otherwise well-intentioned secondary actors

might acquiesce in a client's demands to consummate a

fra cdulent transaction or to issue a fraudulent statement

in such circumstances. See, e.g., Testimony of Thomas

Donaldson, Mark O. Winkelman Professor, The Wharton

School, University of Pennsylvania, Penalties for White

Collar Crime: Are We Really Getting Tough on Crime?,

Before the S. Comm. on the Judiciary, 107th Cong. (July

10, 2002) (“Corporate Watergates typically involve scores

and sometimes hundreds of people inside the corporation,

and all too often, scores of people outside the corporation,

i.e., in institutions such as accounting firms, investment

banks, and law firms. The plain truth is that many of

these thousands of people are not slime balls or bad ap-

ples but ordinary people under extraordinary presstres.”),

available at http://judiciary.senate.gov/testimony.cfm?id=

310&wit_id=712.

Il. THE STRICT TEST FOR PRIMARY LIABILITY

WOULD CREATE A SAFE HARBOR FOR

FRAUD

Both real and hypothetical examples ilustrate thai ‘he

strict test, under which a defendant is not a primary vio-

lator unless it signs a false statement or owes a fiduciary

duty to investors, permits secondary actors to escape li-

ability for clear fraud. At common law, participation in

fraud was enough to impose joint and several liability;

there was no requirement that the defendant be in privity

with the victim or personally speak the misrepresentation

to the victim. See, e.g., 37 C.J.S. Fraud §61, at 346

(1943); Restatement (Second) of Torts § 531, at 66 (1977);

see also Robert A. Prentice, Locating that “Indistinct” and

“Virtually Nonexistent” Line Between Primary and Secon-

dary Liability Under Section 10(b), 75 N.C. L. Rev. 691,

751-52 (1997) (collecting cases); Stewart v. Wyoming Cat-

tle Ranche Co., 128 U.S. 383, 388 (1888) (“[t]he gist of the

action is fraudulently producing a false impression upon

the mind of the other party; and, if this result is accom-

plished, it is unimportant whether the means of accom-

plishing it are words or acts of the defendant”). Commen-

tators have observed that fraud, by its very nature, may

involve hiding the true author of a mistatement. See, e.g.,

Donald C. Langevoort, Words from on High About Rule

10b-5: Chiarella’s History, Central Bank’s Future, 20 Del.

J. Corp. L. 865, 889 (1995) (“The very nature of securities

fraud often involves obscuring the source and interests of

its authors. People can have a significant influence on

how fraudulent disclosure is packaged, and hence how ef-

fective it is, without being identifiable to the victim.”).

Nevertheless, under the strict test for primary liability,

a secondary actor that creates and disseminates a fraudu-

lent statement, but is not publicly identified as the author

of the statement, will avoid liability for fraud. It is un-

controversial that an accountant who knowingly issues a

false audit opinion under his or her own name may be li-

able as a primary violator. See, e.g., Dan Fischel, Secon-

dary Liability Under Section 10(b) of the Securities Act of

1934, 69 Calif. L. Rev. 80, 107-08 (1981) (cited in Central

Bank, 511 U.S. at 191). Yet, under the strict test, an ac-

counting firm that designs a transaction so that a client

can report it in a misleading manner, prepares a false

statement regarding the transaction, and approves re-

lease of the statement will not be liable as a primary vio-

lator if the statement is issued to the public under the cli-

ent’s name, rather than the accounting firm’s name.

Similarly, a law firm that creates a fraudulent disclo-

sure for its client, using its expertise to craft the disclo-

sure in a manner that evades unwanted attention, would

not be liable. See, e.g., Ziemba, 256 F.3d at 1205-06 (alle-

gations that law firm created fraudulent letters and press

releases for issuance under client’s name did not state a

§ 10(b) claim); Rocker Mgmt., LLC v. Lernout & Hauspie

Speech Prods. N.V., No. Civ. A. 00-5965, 2005 WL

3658006, at *11 (D.N.J. June 7, 2005) (preparation of fi-

nancial statements could not give rise to primary liability

where statements were not publicly attributed to defen-

dant at time of plaintiffs’ investment decisions); In re Cas-

cade Intl Sec. Litig., 840 F. Supp. 1558, 1563-64 (1993)

(lawyers’ preparation of fraudulent SEC filings, press

releases, and letters to shareholders, as well as their

making false statements to members of the public could

not give rise to primary liability in the absence of any

fiduciary duty owed to plaintiff shareholders), modified on

other grounds on recon., 894 F. Supp. 437 (S.D. Fla. 1995).

Even if a secondary actor knowingly circulates false state-

ments to investors, inducing investors to rely on those

statements, it will escape liability under the strict test

if the statements are under its client’s name. See, e.g.,

Winkler v. NRD Mining, Ltd., 198 F.R.D. 355, 364-66

(E.D.N.Y. 2000) (director and public relations firm could

not be liable for drafting and disseminating releases

containing false statements that were not attributed to

them).

Courts that reject the strict test have similarly recog-

nized that it would prevent them from holding liable de-

fendants who author false statements that they know will

reach investors. See, e.g., In re Lernout & Hauspie Sec.

Litig., 230 F. Supp. 2d 152, 168 (D. Mass. 2002) (“Ab-

solving an auditor who prepares, edits, and drafts a

fraudulent financial statement knowing it will be publicly

disseminated simply because an affiliated auditor with

which it is working under a common trademark is the one

to actually sign it, would stretch Central Bank’s holding

too far.”); Carley Capital Group v. Deloitte & Touche, LLP,

27 F. Supp. 2d 1324, 1334 (N.D. Ga. 1998) (“Under the

Second Circuit standard, a secondary actor who is the ac-

tual creator and author of a material misstatement could

avoid liability simply due to the concealment of its iden-

tity.”); Employers Ins. of Wausau v. Musick, Peeler, &

Garrett, 871 F. Supp. 381, 389-90 (1994) (rejecting rigid

rule that accountant must certify or be named in a

document to be liable for misstatements; allowing § 10(b)

claim to proceed where accountants were allegedly archi-

tects of misleading prospectus), amended on other grounds

on recon., 948 F. Supp. 942 (S.D. Cal. 1995); In re ZZZZ

Best Sec. Litig., 864 F. Supp. 960, 970 (C.D. Cal. 1994)

(“While the investing public may not be able to reasonably

attribute the additional misstatements and omissions to

[Ernst & Young], the securities market still relied on

those public statements and anyone intricately involved

in their creation and the resulting deception should be

liable under Section 10(b)/Rule 10b-5.”).

The strict test would also create the perverse result

that, if the author of a fraudulent statement knew it was

false, but the entity under whose name the statement is-

sued did not, no actor would be liable as a primary viola-

tor under § 10(b). For example, courts have held, both

before and after Central Bank, that a corporation that

knowingly reviews and approves false statements in an

analyst's report may be liable as a primary violator of

§ 10(b). Yet, under the strict test, the corporation could

not be liable for statements that were publicly attributed

to the analyst. See In re ICN/Viratek Sec. Litig., No. 87

Civ. 4296, 1996 WL 164732, at *5, *7 (S.D.N.Y. Apr. 9,

1996) (explaining that, under the strict rule adopted by

some courts, “no matter how extensive a corporation’s

review and approval of statements in an analyst’s report,

that review and approval does not imply that the corpora-

tion, in effect, has ‘made’ the statements in the analyst’s

report, for the purposes of liability under § 10(b)”; reject-

ing that rule where it would immunize the defendant from

§ 10(b) liability for reviewing and editing a report that it

knew contained false statements about defendants’ AIDS

drug).®

In sum, applying the strict test, a secondary actor can

escape liability for creating a fraudulent statement that it

disseminates to investors, or knows will be disseminated

to the market, so long as it does not announce its author-

ship of the statement. Such a test rewards obfuscation

rather than disclosure, contrary to the aims of the securi-

ties laws. Allowing accountants, law firms, investment

banks, and other secondary actors to avoid § 10(b) liability

so long as misstatements do not issue under their names

would enable secondary actors to profit from frauds that

they mastermind while concealing their participation

from the investing public. That danger is hardly hypo-

thetical, as the evidence and allegations in the Enron lLiti-

gation demonstrate. Without taking a position on the

precise standard for primary liability under § 10(b), the

Council respectfully suggests that the strict test would

6 While plaintiffs might also try to sue on an agency theory, cf.

Copland v. Grumet, 88 F. Supp. 2d 326, 333 (D.N.J. 1999) (suggesting

that, when a defendant controls the content of another actor's state-

ment, the actor is operating as the agent of defendant), some courts

have questioned the scope of agency liability under § 10(b), see, e.g., In

re Lernout & Hauspie, 230 F. Supp. 2d at 172 (collecting cases). More-

over, if a corporation makes an ultimate decision to issue a statement

under its name, it may not be the “agent” of a secondary actor.

undermine incentives for secondary actors to maintain the

integrity of the securities markets.

Ill. FEARS OF OPENING THE FLOODGATES TO

FRIVOLOUS LITIGATION ARE UNFOUNDED

Some lower courts adopting the strict test have done so

partly out of concern that any other standard would open

the floodgates to meritless litigation against secondary

actors. For example, the Fifth Circuit admitted that its

decision in the Enron litigation allowed secondary actors

to “escape liability for alleged conduct that was hardly

praiseworthy,” but concluded that “the rule of liability

must be either overinclusive or underinclusive so as to

avoid what Hundahi called ‘in terrorem settlements’ re-

sulting from the expense and difficulty of, even meritori-

ously, defending this kind of litigation.” Credit Suisse,

482 F.3d at 392 (quoting Hundahl v. United Benefit Life

Ins. Co., 465 F. Supp. 1349, 1363 (N.D. Tex. 1979)); see

also id. at 393 (ascribing “a limited interpretation to the

words of § 10. viewing the statute as the result of Con-

gress’s balancing of competing desires to provide for some

remedy for securities fraud without opening the flood-

gates for nearly unlimited and frequently unpredictable

liability for secondary actors”). Hundahl was a 1979 deci-

sion expressing worries about “strike” suits brought solely

for their settlement value. 465 F. Supp. at 1363 & n.8.

Similarly, Central Bank itself, while focusing on the text

of the statute, observed that private securities litigation

“‘presents a danger of vexatiousness different in degree

and in kind from that which accompanies litigation in

general,” requiring “secondary actors to expend large

sums even for pretrial defense and the negotiation of set-

tlements.” 511 U.S. at 189 (quoting Blue Chip Stamps v.

Manor Drug Stores, 421 U.S. 723, 739 (1975)). The Court

suggested that these litigation and settlement costs might

ultimately be passed on to investors. See id.

A. The PSLRA Has Reduced Frivolous Litigation

Against Secondary Actors

Whether or not these fears were well-grounded at the

time of Hundahil and Central Bank, see Joel Seligman,

The Implications of Central Bank, 49 Bus. Law. 1429,

1433-34 1994) (arguing that Central Bank’s summary of

policy arguments, which “relied on a single Senator’s un-

corroborated assertion of litigation costs and fewer than

five printed pages on point in an article by Judge Winter,”

was “based on a mischaracterization of available evi-

dence”), they are far less relevant today. Congress re-

sponded to exactly such concerns about “strike suits” in

the PSLRA, aiming to reduce the settlement value of

meritless lawsuits by permitting dismissal before costly

discovery. See H.R. Conf. Rep. No. 104-369, at 39 & n.17,

reprinted in 1995 U.S.C.C.A.N. 738; S. Rep. No. 104-98, at

14 (1995), reprinted in 1995 U.S.C.C.A.N. 679, 693. The

pre-trial dismissal rate for securities class actions has

nearly doubled since enactment of the PSLRA, while set-

tlement sizes have increased, reflecting a higher propor-

tion of meritorious litigation.’ Indeed, the PSLRA’s

heightened pleading standard may have screened out

meritorious cases in addition to frivolous ones.®

7 See, e.g., Todd Foster et al., NERA, Recent Trends in Shareholder

Class Action Litigation: Filings Plummet, Settlements Soar 4-5 (Jan.

2007), available at http://)www.nera.com/image/BRO_Recent%20Trends

_%201288_FINAL-web.pdf; Marilyn F. Johnson et al., Do The Merits

Matter More? The Impact of the Private Securities Litigation Reform

Act (Univ. of Mich., John M. Olin Center for Law & Economics, Work-

ing Paper No. 02-011, 2006), available at http://ssrn.com/abstract=

883684.

8 See, e.g., Stephen Choi, Do the Merits Matter Less After the Private

Securities Litigation Reform Act?, 23 J.L. Econ. & Org. (forthcoming

2007) (Am. Law & Econ. Ass’n, Am. Law & Econ. Ass'n 15th Annual

Meeting, Working Paper 25, 2005), available at http:/Naw.bepress.

com/alea/15th/art25; Lynn A. Stout, Type I Error, Type II Error, and

the Private Securities Litigation Reform Act, 38 Ariz. L. Rev. 711, 714-

15 (1996).

The PSLRA’s requirement that plaintiffs plead facts

giving rise to a “strong inference” of scienter is especially

significant for secondary actors. While there may be facts

in the public domain enabling plaintiffs to plead scienter

with respect to corporate executives — e.g., insider stock

sales prior to the public disclosure of negative information

— it will be more difficult for plaintiffs to obtain, without

discovery, facts indicating intent to commit fraud on the

part of secondary actors. See, e.g., Coffee, 57 Bus. Law. at

1410 n.35. Another PSLRA reform with particular impact

on secondary actors is the statute’s substitution of propor-

tionate for joint and several liability in certain cases.

Congress was concerned about the pursuit of “deep pock-

ets” by plaintiffs’ lawyers, as well as the unfairness of im-

posing traditional joint liability on a secondary defendant

that might be minimally culpable. See H.R. Conf. Rep.

No. 104-369, at 37 (“Under current law, a single defen-

dant who has been found to be 1% liable may be forced

to pay 100% of the damages in the case.”), reprinted in

1995 U.S.C.C.A.N. 736; accord S. Rep. No. 104-98, at 20,

reprinted in 1995 U.S.C.C.A.N. 699. The PSLRA thus

provided that a defendant would be jointly and severally

liable only if the trier of fact “specifically determines that

such covered person knowingly committed a violation of

the securities laws.” 15 U.S.C. § 78u-4(f)(2)(A). When the

scienter of a secondary actor is based on recklessness,

the actor will “be liable solely for the portion of the judg-

ment that corresponds to the percentage of responsibility

of that [actor].” Jd. § 78u-4(f)(2)(B)(i). Finally, SLUSA

eliminated plaintiffs’ ability to avoid Central Bank’s pro-

hibition on private suits for aiding and abetting — as well

as the PSLRA pleading requirements — by pursuing class

actions against secondary defendants under state law.

These shifts in the legal landscape have to a substantial

extent protected secondary actors from liability. An SEC

study of the PSLRA’s impact found a decline in lawsuits

against secondary defendants. See Office of the General

Counsel, SEC, Report to the President and the Congress

on the First Year of Practice under the Private Securities

Litigation Reform Act of 1995 (Apr. 1997) (concluding

that “[s]lecondary defendants, such as accountants and

lawyers, are being named much less frequently in securi-

ties class actions”), available at http://www.sec.gov/news/

studies/lreform.txt. More recent studies have confirmed

that auditors and underwriters are named defendants in

a very small percentage of securities class actions. See

Cornerstone Research, Securities Class Action Case Fil-

ings, 2006: A Year in Review 20 (2007) (auditors and

underwriters were named in 1% and 5% of cases respec-

tively in 2006), available at http://www.cornerstone.com/

securities/pdfs/YIR2006.pdf; Cornerstone Research, Secu-

rities Class Action Case Filings, 2005: A Year in Review 16

(2006) (auditors and underwriters were named in 3%

and 4% of cases respectively in 2005, and in 4% and

1% of cases respectively in 2004), available at http://

www.cornerstone.com/securities/pdfs/YIR2005.pdf; see

also John C. Coffee, Jr., Reforming the Securities Class

Action: An Essay on Deterrence and Its Implementation,

106 Colum. L. Rev. 1534, 1550 (2006) (“Because the ma-

jority of securities class actions contain at least some alle-

gations of accounting fraud, this striking omission of audi-

tors and other secondary actors as defendants suggests

that they have been well insulated against securities

fraud liability.”) (footnote omitted).

Thus, the Court should not rely on any pre-PSLRA con-

cerns regarding the need for a strict test to protect inno-

cent secondary defendants. On the contrary, the Court

should be hesitant to further immunize secondary actors

that are already well-protected from liability by the

PSLRA and the SLUSA. Cf. Coffee, The Acquiescent

Gatekeeper at 4-5 (accounting irregularities predictably

increase as litigation risks diminish).

B. Allegations of Primary Violations by Secon-

dary Actors Are Not Presumptive Efforts To

Evade Central Bank

Nor are lawsuits alleging primary violations by secon-

dary actors a recent innovation that might be regarded as

a harbinger of frivolous litigation or an attempt to evade

Central Bank. Cf. Merrill Lynch, Pierce, Fenner & Smith,

Inc. v. Dabit, 126 S. Ct. 1503, 1511 (2006) (noting Con-

gress’s finding that state-law securities fraud suits were

rare before the PSLRA, and that their proliferation re-

flected an effort to evade the PSLRA). Central Bank itself

recognized that “[iJn any complex securities fraud ...

there are likely to be multiple violators.” 511 U.S. at 191.

Moreover, prior to the acceptance of aiding-and-abetting

liability in the courts of appeals, secondary actors were

frequently held liable as primary violators for passing on

clients’ communications that they knew were false, play-

ing integral roles in fraudulent misstatements, and par-

ticipating in fraudulent schemes. See Prentice, 75 N.C.

L. Rev. at 703-04 & nn.52-57 (collecting pre-1969 cases).

Later, courts often held that theories of primary liability

and aiding-and-abetting liability covered the same coii-

duct by secondary actors. See id. at 704-09 & nn.58-60;

see also, e.g., Molecular Tech. Corp. v. Valentine, 925 F.2d

910, 917-18 (6th Cir. 1991) (attorney’s participation in

preparing false statements could be primary and secon-

dary wrongdoing); Bernstein v. Crazy Eddie, Inc., 702 F.

Supp. 962, 978 (1988) (because the complaint adequately

pled primary liability, “[ijt follows that the complaint ade-

quately pleads aiding and abetting”), vacated in part on

other grounds on recon., 714 F. Supp. 1285 (E.D.NLY.

1989). Thus, adoption of something other than the strict

test would not lead to unprecedented expansion of liability

for secondary actors.

C. Plaintiffs Must Still Prove Reliance

A final check on securities litigation against secondary

actors is the requirement that plaintiffs prove reliance on

a defendant's misstatement or deceptive act. See, e.g., In

re Enron, 235 F. Supp. 2d at 588-91 (adopting SEC’s pro-

posed test, under which a secondary actor that acts with

scienter and creates a misrepresentation may be liable as

a primary violator, while emphasizing that plaintiffs must

still prove reliance). The Council does not take a position

on the precise definition of reliance the Court should

adopt. Cf. Brief of the SEC, Amicus Curiae, in Support

of Positions that Favor Appellant at 21, Simpson v.

Homestore.com, Inc., No. 04-55665 (9th Cir. filed Oct. 21,

2004) (arguing that reliance exists when “a plaintiff relies

on a material deception flowing from a defendant’s decep-

tive act, even though the conduct of other participants in

the fraudulent scheme may have been a subsequent link

in the causal chain leading to the plaintiff's securities

transaction”). However, under the strict test, the ele-

ments of a primary violation are not met even when the

defendant creates a misstatement and circulates it to in-

vestors who rely on it, simply because the misstatement

is not attributed to the defendant. The requirement that

plaintiffs rely on a fraudulent misrepresentation — as op-

posed to relying on attribution of the misrepresentation to

a particular defendant — does not mandate such a result.

IV. ELIMINATION OF PRIVATE LAWSUITS

AGAINST SECONDARY ACTORS WILL RE-

SULT IN INADEQUATE COMPENSATION FOR

INVESTORS

Preventing investors from suing secondary actors that

commit fraud will result in both inadequate deterrence

and inadequate compensation. Investors frequently can-

not obtain fraud damages from issuer firms, which may be

insolvent or distressed. See, e.g., Cornerstone Research,

Securities Class Action Settlements: 2006 Review and

Analysis 14 (2007) (“fo]ver 35% of the issuer firms in our

sample filed for bankruptcy or had their stock delisted

from a major exchange before the class action settlement

hearing date”; fact that defendant firm is distressed is

associated with a decrease in settlement size), available

at http://securities.cornerstone.com/pdfs/settlements_

2006.pdf; Cornerstone Research, Post-Reform Act Securi-

ties Settlements: 2005 Review and Analysis 14 (2006)

(“Cornerstone, 2005 Review and Analysis”) (30% of issuers

sued filed for bankruptcy or had their stock delisted),

available at http://securities.cornerstone.com/pdfs/settlements

_2005.pdf. The list of frauds following which investors

were able to recover nothing from issuers, with the bulk of

any compensation — usually pennies on the dollar — neces-

sarily coming from secondary actors, is long. It includes,

among others, Enron,’ Global Crossing,!° Adelphia,'!

Delphi, '? Refco,'* and Sunbeam.'*

Moreover, as both Congress and the SEC have repeat-

edly recognized, SEC enforcement is not sufficient to

deter wrongdoers and to compensate investors. See, e.g.,

H.R. Conf. Rep. No. 104-369, at 31 (private litigation is

“an indispensable tool with which defrauded investors

can recover their losses” and is crucial “to the integrity

of American capital markets”), reprinted in 1995

U.S.C.C.A.N. 730. The SEC does not possess the re-

sources to prosecute most instances of securities fraud.

See, e.g., Prepared Testimony of Arthur Levitt, SEC

Chairman, and Isaac C. Hunt, SEC Commissioner, The

Securities Litigation Uniform Standards Act of 1997:

Hearing on S. 1260 Before the Subcomm. on Securities of

the S. Comm. on Banking, Housing, and Urban Affairs,

105th Cong. (Oct. 29, 1997) (“Private actions are an

especially important supplement to the Commission’s

enforcement program today because of the phenomenal

growth of the securities industry during a time when the

Commission's staff and budget levels have remained rela-

tively constant.”), available at http://banking.senate.gov/

9 See Bill Hensel, Jr., Settlement adds $2.4 billion to the kitty,

Houston Chron., Aug. 3, 2005, available at http://www.chron.com/disp/

story.mpl|/special/enron/3293828. html.

10 See Gretchen Morgenson, Global Crossing Settles Suit on Losses,

N.Y. Times, Mar. 20, 2004, at C1.

*l See Deloitte and Banks to Pay $455 Million to Adelphia Investors,

N.Y. Times, Dec. 9, 2006, at C4; Geraldine Fabrikant, Rigas Family To

Cede Assets To Adelphia, N.Y. Times, Apr. 26, 2005, at C1.

12 See Nick Bunkley, S.E.C. Sues Ex-Officials Of Delphi, N.Y. Times,

Oct. 31, 2006, at C1.

13 See Michael J. de la Merced, Finance Chief Of Refco Is Indicted,

N.Y. Times, Oct. 25, 2006 at C3; Austrian Bank To Pay Millions In

Refco Case, N.Y. Times, June 6, 2006, at C3.

14 See 2002 GAO Report at 204-06.

97_10hrg/102997/witness/sec.htm; Testimony of Richard

C. Breeden, SEC Chairman, Securities Investor Protection

Act of 1991: Hearing Before the Subcomm. on Securities of

the S. Comm. on Banking, Housing, and Urban Affairs,

102d Cong. 15-16 (Oct. 2, 1991) (SEC is able to prosecute

only a fraction of the cases in which investors have suf-

fered losses).'5

Even when the SEC brings an enforcement action, it of-

ten recovers only a fraction of what private lawsuits yield

for investors. See Cornerstone, 2005 Review and Analysis

at 13, Fig. 12. For example, in the WorldCom litigation,

the SEC obtained $750 million for investors, while the re-

lated class action obtained $6.2 billion, see id.; in the Cen-

dant litigation, the SEC failed to recover any significant

amount for investors, while private suits recovered $3.2

billion, see In re Cendant Corp. Litig., 264 F.3d 201, 217

(3d Cir. 2001).!6

15 See also Donald C. Langevoort, Managing the “Expectations Gap”

in Investor Protection: The SEC and the Post-Enron Reform Agenda, 48

Vill. L. Rev. 1139, 1161 (2003) (“Unless there is a vastly enlarged

SEC, private actions inevitably must serve as an enforcement substi-

tute for deterrence purposes, as well as their more traditional role as

an avenue for appropriate compensation of victims.”); Report of the

SEC: Section 703 of the Sarbanes-Oxley Act of 2002 — Study and

Report on Violations by Securities Professionals 5 (Jan. 2003) (SEC

brought only 13 aiding-and-abetting actions against securities profes-

sionals in calendar years 1998 through 2001), available at http://www.

sec.gov/news/studies/sox703report.pdf.

16 Nor is the ability to file an individual state-law action against a

secondary actor, which would not be preempted by SLUSA, an ade-

quate substitute for the ability to file a class action under federal or

state law. Even institutional investors often do not have enough at

stake with respect to a particular issuer to warrant the expense of

an individual lawsuit. Moreover, for many ordinary shareowners, the

denial of class relief would mean no relief at all. As the Court has rec-

ognized, “‘[t}he policy at the very core of the class action mechanism is

to overcome the problem that small recoveries do not provide the in-

centive for any individual to bring a solo action prosecuting his or her

rights.” Amchem Prods., Inc. v. Windsor, 521 U.S. 591, 617 (1997)

(quoting Mace v. Van Ru Credit Corp., 109 F.3d 338, 344 (7th Cir.

1997)).

CONCLUSION

For the foregoing reasons, the Court should not adopt

the strict test for primary liability based on policy consid-

erations. Such a test would provide a safe harbor to sec-

ondary actors who manage to commit fraud without an-

nouncing their involvement to the public. It would not

only deny compensation to defrauded investors, but also

undermine ongoing efforts, in the aftermath of devastat-

ing financial scandals, to strengthen the role of secondary

actors in maintaining the integrity of the securities mar-

kets.

Respectfully submitted,