Class Action Litigation Against Enron’s Advisors and Bankers

The blizzard of litigation that followed the collapse of Enron will probably result in important judicial precedents. In particular, a class action suit, In re Enron Corporation Securities, Derivative & ERISA Litigation, has important implications for accountants and other corporate advisors.

In the case, the Regents of the University of California and other plaintiffs sued Enron’s auditor, Arthur Andersen; some of Andersen’s individual partners and employees; two of Enron’s law firms; and nine of Enron’s banks or other financial institutions. Judge Melinda Harmon’s rulings on the defendants’ motions to dismiss, and the probable appeals, may affect the scope of the exposure of corporate advisors to class actions under section 10(b) of the Securities and Exchange Act of 1934. In particular, these rulings may, in the future, impact the following:

In the class action, the plaintiffs charge that Enron was engaged in “an enormous Ponzi scheme, the largest in history.” Enron, the plaintiffs assert, was in constant need of new capital to stay afloat in the face of massive losses and insiders’ self-dealing. Enron could attract that new capital only by concealing its debts, inflating its assets, and reporting fictitious profits, through “phony, non–arm’s-length transactions with Enron-controlled entities and improper accounting tricks.” The defendants are accused of participating in Enron’s scheme by structuring improper transactions, drafting misleading registration statements, failing to warn investors of known distortions in Enron’s reports, and helping to create fraudulent documentation.

Certain defendants moved to dismiss the case against them, citing the Supreme Court’s 1994 decision in Central Bank of Denver v. First Interstate Bank of Denver, which held that secondary actors may not be held liable under section 10(b) for merely “aiding and abetting” a primary violator. The defendants also argued that the plaintiffs failed to meet the specificity requirements of the Private Securities Litigation Reform Act of 1995.

On December 20, 2002, Judge Harmon issued a memorandum and an order dismissing certain of the claims against the firms and companies involved, but allowing other claims to proceed. On January 28, 2003, she dismissed some claims against individual Andersen employees and partners.

A key issue in the Enron litigation is how to distinguish between advisors who “merely give some degree of aid” to a fraud-bound management, and those who “employ a manipulative device” or “make a material misstatement (or omission),” thereby becoming primary violators. Judge Harmon noted that different courts employed different tests to determine whether, in particular circumstances, advisors or other “secondary actors” could be held liable to injured shareholders under section 10(b) of the 1934 Act. (See the Sidebar for a brief description of the underlying statute and regulations.)

Two Supreme Court decisions are especially important. The 1976 ruling in Ernst & Ernst v. Hochfelder held that section 10(b) forbids only deceptions made with scienter. The plaintiff, the court ruled, must prove that the defendant acted with such a state of mind. Simple negligence will not do.

In 1994, in Central Bank, the court held that section 10(b) “does not cover aiding and abetting, since liability for aiding and abetting would extend beyond persons who engage, even indirectly, in a proscribed activity to include those who merely give some degree of aid to the violators.” This does not mean, however, that corporate advisors may never be held liable to private plaintiffs under the 1934 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 [Rule] 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. [Emphasis in the original.]

Judge Harmon noted that the lower courts have adopted two divergent standards for determining whether secondary actors become primary violators. Some have adopted a narrow “bright line” test, where “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.’”

Others have adopted a broader “substantial participation” test, under which an advisor can be considered a primary violator only if it has “substantial participation or intricate involvement” in the false statements “even though that participation might not lead to the actor’s actual making of the statements.” Such “intricate involvement” by attorneys and accountants might include drafting financial statements or registration statements. The distinction between this standard and “aiding and abetting” is unclear.

The SEC filed an amicus curiae brief in the Enron case, urging Judge Harmon to adopt the broader standard. The SEC argued that “makes” in the Supreme Court’s phrase “makes a material misstatement (or omission)” should be interpreted as “creates” rather than “signs.” Because both direct and indirect deceptive acts are forbidden by section 10(b), the SEC argued that the narrower bright-line test “would have the unfortunate and unwarranted consequence of providing a safe harbor from liability for everyone except those identified with the misrepresentations by name.” Judge Harmon agreed:

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. … [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. 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. … 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.” (Excerpted from pp. 52–54 of the Memorandum and Order.)

Applying this standard, the judge found that the following acts, among others, if proved at trial, could make Enron’s advisors liable as primary violators of section 10(b):

Judge Harmon ruled, however, that attorneys could not be held liable to nonclients simply for creating deceptive SPEs. The court dismissed the claims against Kirkland & Ellis, noting that the SPEs it helped create were used by Enron, not the attorneys, to deceive the plaintiffs. Therefore, the firm itself did not “employ” manipulative devices. Because this firm’s opinion letters were not included in public disclosures, it did not “make” misrepresentations.

Scienter, to the court, means “intent to deceive, manipulate or defraud,” which can include severe recklessness. Severe recklessness is “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.”

Courts have held numerous factors to be insufficient in themselves to show scienter, including:

These factors considered together, however, may indeed find severe recklessness, and Judge Harmon did just that, noting a “regular pattern of related and repeated conduct” to shift debt and inflate Enron’s profits. “Furthermore, the intrinsic nature of these devices and contrivances was fraudulent so that those intimately involved in structuring the entities and arranging the deals, especially more than one, would have to have been aware that they were an illicit and deceptive means to misrepresent Enron’s actual financial state and mislead investors about Enron securities, or at minimum, would have had to have been severely reckless as to that danger.”

Congress enacted the Private Securities Litigation Reform Act to limit baseless securities class-actions. In particular, plaintiffs must have information to support specific allegations at the time the suit is filed. They cannot make general allegations against parties they presume to have been involved and then use the discovery process to search for evidence to support the initially unsubstantiated charges. The act states that “the complaint shall specify each statement alleged to have been misleading, the reasons or reasons why the statement is misleading, and … the complaint shall state with particularity all facts on which that belief is based.” Also, “the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind.”

Judge Harmon applied these requirements strictly. For example, while she believed that the circumstances surrounding the creation and funding of the special purpose entity called LJM2 would “raise red flags to any objective party investing in it,” she also noted plaintiffs’ failure to give details about “how, when, where, or who of the investors learned what about the various entities and transactions.” She found that merely showing that certain banks and law firms made exceptional profits by helping to create or fund LJM2 did not meet the law’s burden to file suit.

When Judge Harmon considered the motion to dismiss filed by 18 individual former Andersen employees and partners, she found that the plaintiffs had failed to specifically identify which individuals personally performed specific allegedly fraudulent audits. (The lead partner on the engagement, who had actually signed the audit opinions, was not among these 18 defendants.) In January 2003 she dismissed all of the section 10(b) claims against the 18 individuals. (Other claims against many of these defendants, based on their alleged ability to control the firm of Arthur Andersen, were allowed to proceed.)

The Enron plaintiffs, of course, enjoyed an advantage: the wealth of information available in the public record due to the size and notoriety of the Enron collapse. Newspapers, books, congressional hearings, registration statements, and related court proceedings (including the criminal trial of Arthur Andersen & Co.) have placed huge amounts of useful information in the public domain that would normally be unavailable outside the company.

Judge Harmon’s rulings demonstrate how corporate advisors that knowingly help draft misleading disclosures, or that jointly “employ” deceptive devices to mislead investors, can be sued under federal securities laws. This suggests that auditors that knowingly approve materially false disclosures will not be able to claim immunity from civil litigation under the Central Bank holding that mere aiding and abetting is not actionable.

While the judge stressed that liability under section 10(b) arises both for making misstatements and for “employing” deceptive devices and “engaging in practices” that would act as a fraud, her decisions with regard to the two law firms engaged in the suit suggest that making misstatements is more critical. One law firm’s motion to dismiss was granted, on the basis it had not communicated with the plaintiffs, even though it had been intimately involved in the creation and structuring of SPEs used to further the fraud. This suggests that tax and other accounting professionals who help create structured finance arrangements but do not draft related disclosures or provide opinion letters to investors, will also be exempt from class action suits.

The requirements of the Private Securities Litigation Reform Act have substantially inhibited the ability of the Enron plaintiffs to sue individual auditors under 10(b). The plaintiffs were unable to provide sufficient specific information with regard to individuals to establish their liability. However, the judge’s finding that certain key Andersen defendants could be sued as “controlling parties” means that partners and those in charge of specific engagements may not fully benefit from the law’s protections.

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