In re Charter Communications, Inc. Securities Litigation and Simpson v. AOL Time Warner Inc.: Circuits Split Over the Validity of “Scheme” Liability Under Section 10(b) By Gregory A. Markel and Gregory G. Ballard * In its June 30, 2006 opinion in the case of Simpson v. AOL Time Warner Inc., the U.S. Court of Appeals for the Ninth Circuit wrote that a defendant may be held liable “as a primary violator of § 10(b) for participation in a ‘scheme to defraud’” if the defendant “engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme.”1 In reaching this conclusion, the Ninth Circuit rejected the defendants’ argument that such a rule would inappropriately impose liability on parties who were not involved in any securities transactions “for conduct other than a material misstatement or omission.”2 Thus, the Ninth Circuit embraced the theory of liability that securities litigation practitioners have come to refer to simply as “scheme liability” – liability for participating in a fraudulent scheme by some means other than a misstatement, omission, or manipulative securities trade. The Ninth Circuit’s decision stands in stark contrast to the April 11, 2006 opinion of the U.S. Court of Appeals for the Eighth Circuit in the case of In re Charter Communications, Inc. Securities Litigation.3 Accepting the defense argument which the Ninth Circuit rejected in Simpson, the Eighth Circuit held in Charter that “any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under § 10(b) or any subpart of Rule 10b-5.”4 That is, in the Eighth Circuit, there is no such thing as scheme liability. Why these two circuit courts came to issue, within a matter of weeks of one another, conflicting opinions on the scope and validity of scheme liability *

Gregory A. Markel and Gregory G. Ballard are partners at Cadwalader, Wickersham & Taft LLP.

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under Section 10(b) is rooted in the language of the statute at issue, Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act” or the “1934 Act”), the regulation promulgated thereunder by the U.S. Securities and Exchange Commission (the “SEC”), Rule 10b-5, and the seemingly conflicting statements that have emanated from the Supreme Court in its prior pronouncements in civil actions brought pursuant to these provisions. This article examines the nature of the controversy raging in many courts around the country over whether defendants who did not engage in a securities transaction and who did not make or participate in making a material misstatement or omission may be held liable under Section 10(b) and Rule 10b-5 for otherwise participating in a scheme to defraud. The theory of liability is attractive to plaintiffs and plaintiffs’ lawyers who seek to sue deeppocketed financial institutions or others who have engaged in business transactions with the primary wrongdoers, particularly in cases where the issuer of the securities in question has filed for bankruptcy protection and is unlikely to provide a significant source of funds for resolution of lawsuits. In the first section, we examine the statute, the regulation, and prior Supreme Court precedent for the genesis of the issue. In the second section, we review the decisions of the Eighth and Ninth Circuits in Charter and Simpson as well as several district court opinions and address some of the implications of these recent developments in the caselaw, including the likelihood of hotly contested litigation within the Ninth Circuit over the meaning of Simpson as well as the inevitability of further circuit court, and ultimately Supreme Court, opinions on the scope – and validity or invalidity – of “scheme” liability. In that section, we also deal with the inherent difficulty of distinguishing aiding and abetting, which is not actionable under Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.,5 from primary participation in a scheme. Part I – Section 10(b), Rule 10b-5, Santa Fe and Central Bank The language of Section 10(b) prohibits only conduct that is either “manipulative” or “deceptive.” Specifically, Section 10(b) makes it unlawful for any person “directly or indirectly”: To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement …, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.6

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The regulation enacted by the SEC is somewhat more elaborate. Rule 10b-5 states that it is unlawful for any person: (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or 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, 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.7 On its face, Rule 10b-5 reaches many types of conduct, not merely the kinds of misstatements typical of common law fraud claims. Only subsection (b) mentions misstatements (“to make any untrue statement of material fact”) or omissions (“to omit to state a material fact”). The other subsections contain broad language without reference to misstatements or omissions.8 For example, subsection (a) bars the employment of any “scheme … to defraud,” and subsection (c) proscribes any “course of business” that operates as a fraud. While Section 10(b) did not explicitly create a private right of action on behalf of those who claim to have been damaged by conduct in violation of the statute, the courts long ago recognized an implied private right of action in the statute. Thus, Section 10(b), along with the less sweeping non-scienter-based express private rights of action created in the Securities Act of 1933,9 has become one of the mainstays of aggrieved securities purchasers seeking redress in federal court. Justice Rehnquist has famously referred to Rule 10b-5 as the “judicial oak” that grew from a mere “legislative acorn.”10 That the statute does not contain an express private right of action has led to confusion over the elements of the claim. “[D]etermining the elements of the 10b-5 private liability scheme,” in the words of Justice Kennedy, “has posed difficulty because Congress did not create a private § 10(b) cause of action and had no occasion to provide guidance about the elements of a private liability scheme.”11 In the myriad of judicial opinions examining Section 10(b) and Rule 10b5, the Supreme Court has often observed that the statute and the rule are to be interpreted broadly to effect the statute’s remedial purposes.12 The statute was intended to capture not only traditional frauds, but also new types of frauds.

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For example, the Supreme Court has endorsed the idea “‘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.’”13 On the other hand, the Supreme Court has also on multiple occasions emphasized that Rule 10b-5 cannot be interpreted to impose liability beyond what Section 10(b) expressly prohibits by its terms, which is only conduct that is “manipulative” or “deceptive.”14 That section 10(b) reaches material misstatements or, where there is a duty to speak, material omissions is beyond question. This is the essence of the common law fraud claim upon which the section was loosely based. This is what the Supreme Court has interpreted the word “deceptive” in Section 10(b) to mean – a misstatement or where there is a duty to speak an omission.15 As for the other type of conduct that the statute prohibits – manipulative conduct – the Supreme Court, in an opinion written early in the development of Section 10(b) case law indicated that it is a term of art referring to securities trading practices such as wash sales, rigged prices, and matched orders. Santa Fe In the mid-1970s in the case of Santa Fe Indus., Inc. v. Green, the Supreme Court addressed an argument that, based on broad language regarding “schemes” and other devices in certain subdivisions of Rule 10b5, a defendant can be liable for securities fraud without ever having made a material misstatement or omission16 In the opinion that was on appeal to the Supreme Court, the Second Circuit observed that fraud under Rule 10b-5 is not limited to “the classic examples of misrepresentation and nondisclosure.”17 The Second Circuit reasoned that “only subdivision (2) of 10b-5 deals with nondisclosure and misrepresentation” and that the “two other subdivisions … state explicitly that fraud other than and in addition to a failure to disclose or truthfully represent is also actionable.”18 The Supreme Court reversed the Second Circuit’s decision and held that claims under Section 10(b) and Rule 10b-5 in fact must be based on an alleged misrepresentation or nondisclosure.19 The Supreme Court noted the Second Circuit’s view that “neither misrepresentation nor nondisclosure was a necessary element of a Rule 10b-5 action.”20 In reversing, the Supreme Court explained that, regardless of the language in particular subdivisions of Rule 10b-5, the rule may not be interpreted as imposing liability for conduct not expressly prohibited by Section 10(b).21 Consequently, focusing on the language of Section 10(b) of the 1934 Act, the

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Supreme Court held that Section 10(b) and Rule 10b-5 are violated only where “the conduct alleged can be fairly viewed as ‘manipulative or deceptive’” within the meaning of the statute.22 The Court wrote that the first of these two concepts, “manipulation,” is a term of art applicable only to securities trading practices like wash sales, matched orders, or rigged prices that were not at issue in Santa Fe.23 Absent manipulation, the Court held, the plaintiffs must allege some form of “deception,” which necessarily means a misrepresentation or omission.24 The Court found that because the complaint alleged mere corporate mismanagement, not involving a material misstatement or omission of manipulative securities trading, it did not state a cause of action under Section 10(b) and or any subpart of Rule 10b-5.25 Based on Santa Fe, therefore, it seemed to be settled law that no defendant could be held liable in a private action under Section 10(b) unless he made a material misstatement or omission or engaged in conduct defined by the Supreme Court to be certain securities trading practices. Central Bank The Supreme Court appeared to reinforce the point more recently in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.26 In Central Bank, the Supreme Court reiterated that Rule 10b-5 cannot be interpreted to prohibit conduct not barred by Section 10(b) and held that there can be no liability under either the statute or the rule for aiding and abetting a fraud committed by another person.27 Citing Santa Fe, the Court wrote as follow: “As in earlier cases considering conduct prohibited by § 10(b), we again conclude that the statute prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act.”28 But the Supreme Court also included the following language that, some have argued, left the door open to arguments about the scope of liability under Section 10(b) for actions other than misstatements, omissions, or manipulative acts as defined in Santa Fe: 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

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Rule 10b-5, assuming all of the requirements for primary liability under Rule 10b-5 are met.29 Part II – Charter, Simpson, and Recent District Court Decisions Courts that have rejected scheme liability arguments have generally held that conduct is actionable under Section 10(b) or any subpart of Rule 10b-5 only if it (a) involved a material misstatement or omission and is therefore “deceptive” or (b) it involved the manipulation securities trading practices that artificially affect market activity and is therefore “manipulative” within the meaning of Section 10(b). The Eighth Circuit in Charter followed this line of reasoning. On the other side, there are courts like the Ninth Circuit in Simpson that have embraced the idea of scheme liability. These courts fall into three camps. Some courts, including the Ninth Circuit in Simpson, have held that active participation in a fraudulent scheme, through actions other than material misstatement or omission or manipulation, can be actionable because “deceptive” within the meaning of Section 10(b). Other courts have held that active participation in a fraudulent scheme can be actionable because it is “manipulative” within the meaning of Section 10(b). Finally, there are courts that have not differentiated between the two concepts and have merely held that such conduct is actionable because it is “manipulative or deceptive.” All of the decisions have difficulty distinguishing between aiding and abetting, which is not actionable under Central Bank, and being a primary violator in a fraudulent scheme. As a result of the wide range of opinions regarding the scope of scheme liability, and its basis under Section 10(b), as well as the various courts’ divergent treatment of similar fact patterns, the state of the law as reflected in circuit court and district court opinions on scheme liability can only be described as confused and confusing. Charter Communications Charter Communications, Inc. was a large provider of cable television through set-top boxes placed on customers’ televisions. Plaintiffs alleged that Charter engaged in a scheme to artificially inflate its financial results through, among other things, “sham” transactions with two equipment vendors, Scientific-Atlanta, Inc. and Motorola, Inc., from which it purchased set-top boxes.30 According to the complaint, Charter and the vendors entered into “sham” transactions that had “no economic substance.”31 Specifically,

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while it already had contracts to purchase set-top boxes from the vendors, Charter agreed with the vendors to pay them an additional $20 per box, on top of the fixed prices in the existing contracts, in exchange for their “returning the additional payments to Charter in the form of advertising fees.”32 These arrangements, according to the plaintiffs, significantly inflated Charter’s cash flow and revenue numbers, as Charter “improperly capitaliz[ed] the increased equipment expenses while treating the returned advertising fees as immediate revenue.”33 The vendors, according to the plaintiffs, knew that Charter intended to account for the sham transactions improperly in order to inflate its reported results.34 The vendors did not, however, prepare or make any of the false and misleading financial statements or press releases that Charter allegedly used to mislead the markets.35 The district court granted the vendors’ motion to dismiss, and the plaintiffs appealed to the Eighth Circuit.36 In affirming the district court’s dismissal of the Section 10(b) claims against the vendors, the Eighth Circuit reasoned as follows. The Supreme Court has made clear that SEC Rule 10b-5 cannot be interpreted more broadly than Section 10(b), the provision from which the SEC derived the authority to promulgate the rule.37 Section 10(b) prohibits only conduct that is “manipulative or deceptive.”38 The Supreme Court’s decision in Santa Fe defined “deceptive” conduct as material misstatements or omissions and defined “manipulative” conduct as illegal trading practices such as wash sales, matched orders, or rigged prices that artificially affect market activity.39 The Supreme Court’s decision in Central Bank made clear that Section 10(b) does not reach those who merely aid and abet another person’s fraud.40 As for the Central Bank statement that secondary actors such as lawyers, accountants, and banks may nonetheless be held liable “as primary violators” if “all of the requirements for primary liability under Rule 10b5 are met,”41 the Eighth Circuit observed that this represented an “important caveat” and recognized that the case before it “tested the boundaries of that caveat.”42 The plaintiffs attempted to invoke the broad “scheme” language contained in subsections (a) and (c) of Rule 10b-5 to support their argument that the vendors’ entering into sham transactions knowing that Charter would account for them improperly to inflate its results made them primary violators, not mere aiders and abettors of Charter’s fraud.43 As the Eighth Circuit noted, however, this argument “depends on the assertion

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that Central Bank‘s analysis did not affect the scope of primary liability under subparts (a) and (c),” which is an improperly narrow interpretation of Central Bank.44 Rather, Central Bank and earlier cases such as Santa Fe, according to the Eighth Circuit, stand for three “governing principles,” as follows: (1) The Court’s categorical declaration that a private plaintiff “may not bring a 10b-5 suit against a defendant for acts not prohibited by the text of § 10(b),” including claims under Rule 10b-5(a) and (c), as well as Rule 10b-5(b). (2) A device or contrivance is not “deceptive,” within the meaning of § 10(b), absent some misstatement or a failure to disclose by one who has a duty to disclose. (3) The term “manipulative” in § 10(b) has the limited contextual meaning ascribed in Santa Fe.45 Based on these three principles, the Eighth Circuit in Charter concluded as noted above that “any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under § 10(b) or any subpart of Rule 10b-5.”46 Because the vendors did not make a misstatement or omission and did not engage in a manipulative securities transaction, the Eighth Circuit held, the claims against them were properly dismissed.47 Finally, the Eighth Circuit further explained as follows: To impose liability for securities fraud on one party to an arm’s length business transaction in goods or services other than securities because that party knew or should have known that the other party would use the transaction to mislead investors in its stock would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings. Decisions of this magnitude should be made by Congress.48 Simpson The Ninth Circuit reached a different conclusion in Simpson. The issuer of the securities at issue in Simpson, Homestore.com, was an Internet company that, according to the plaintiffs, entered into “sham” transactions with vendors that were designed to artificially inflate its reported revenues.49 Homestore like other Internet companies relied on “barter or round-trip transactions” in which Homestore would pay money to another company,

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which would in a separate transaction return some of the money back to Homestore, which would then record the returned money as revenue.50 In 2000, however, the SEC adopted accounting standards requiring companies that engaged in such barter transactions to record only net revenue on the two related transactions, not the gross revenue received on the second transaction.51 Thereafter, Homestore allegedly resorted to “triangular transactions” that hid from Homestore’s auditors the fact “that the revenue that Homestore recorded was related to a prior transaction funded by Homestore.”52 In these “triangular transactions,” Homestore essentially “purchased revenue for itself” and “then recorded that revenue in violation of SEC accounting rules.”53 Among the third parties allegedly involved in these transactions were defendants AOL Time Warner and two of its officers, Cendant Corporation and one of its officers, and L90, Inc. The defendants in Simpson argued that “Central Bank limited primary liability under § 10(b) to defendants who personally made a public misstatement, violated a duty to disclose or engaged in manipulative trading activity, and not to those engaged in a broader scheme to defraud.”54 But the U.S. Securities and Exchange Commission argued in favor of a broader view, and the Ninth Circuit agreed: The SEC argues in its amicus brief that “Any person who directly or indirectly engages in a manipulative or deceptive act as part of a scheme to defraud can be a primary violator.” The SEC defines “a deceptive act” as “engaging in a transaction whose principal purpose and effect is to create a false appearance of revenues.” We agree with the SEC that engaging in a transaction, the principal purpose and effect of which is to create the false appearance of fact, constitutes a “deceptive act.”55 Still, the Ninth Circuit observed in a footnote that “[t]o the extent that the SEC’s proposed test purports to include aiding and abetting or coconspirator liability, we are constrained to reject it.”56 Consequently, the Court made the following clarification: Participation in a fraudulent transaction by itself, however, is insufficient to qualify the defendant as a “primary violator” if the deceptive nature of the transaction or scheme was not an intended result, at least in part, of the defendant’s own conduct. We hold that to be liable as a primary violator of § 10(b) for participation in a “scheme to defraud,” the defendant must have engaged in conduct that had

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the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme. It is not enough that a transaction in which a defendant was involved had a deceptive purpose and effect; the defendant’s own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect.57 Moreover, in evaluating whether a particular defendant’s conduct meets the principal purpose and effects test, the Ninth Circuit wrote that “the conduct of each defendant, while evaluated in its context, must be viewed alone for whether it had the purpose and effect of creating a false appearance of fact in the furtherance of an overall scheme to defraud.”58 And for the complaint at issue in Simpson, the Ninth Circuit found the allegations inadequate.59 With respect to defendant AOL, plaintiffs had alleged that in the first half of 2001, Homestore entered into a series of triangular transactions as follows: Homestore entered into a series of sham transactions with various Third Party Vendors for some product or service that Homestore did not need. The Third Party Vendors would then contract with AOL for advertising on Homestore’s website and AOL would give this money back to Homestore under their advertising reseller agreement.60 Only the first leg of the transaction was alleged to be a “sham.”61 Plaintiffs did allege, however, that an AOL employee “jointly developed these transactions with Homestore.”62 Also, plaintiffs alleged that AOL willingly agreed to documentation designed to keep the substance of the transactions from Homestore’s auditors at PricewaterhouseCoopers (“PWC”): Homestore convinced AOL to accept less descriptive documents, which would not alert PWC to the nature of the round-trip transaction. AOL included a list of the ‘potential referral advertisers’ as a part of the second deal in 2001, but let Homestore add other companies not involved in the round-trip transactions so that the Third Party Vendors could not be identified.63 These allegations were inadequate because AOL or its employees were not alleged to have “actually engaged in a deceptive act.”64 AOL and its employees “helped Homestore to organize and create the triangular transactions” which “were necessary to allow Homestore to overstate its revenues,” and they

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“assisted Homestore in misrepresenting the revenues from these transactions,” but they did not “create[] sham business entities or engage[] in deceptive conduct as part of illegitimate transactions.”65 The “sham transactions” were with third party vendors, not AOL.66 AOL cannot be held liable, the Court explained, for “participating in legitimate transactions that became ‘deceptive’ only when distorted by the willful or intentional fraud of another party.”67 The Cendant transactions similarly did not “create a false appearance, independent from Homestore’s misreporting of the income from these transactions.”68 The allegations against Cendant were that it sold a website called Move.com, which Cendant considered a “bad asset,” to Homestore for an inflated price of $750 million worth of Homestore stock, contingent on its own promise “to recycle some of Homestore’s payment from Move.com back to Homestore.”69 Plaintiffs allege that Cendant set up and funded a separate corporate entity to accomplish this objective,70 but setting up this entity was not in and of itself deceptive.71 Because the allegations of the complaint at issue did not meet the test, the Ninth Circuit remanded the case with instructions that plaintiffs be given the opportunity to seek leave to amend their complaint “if that can be done consistent with this opinion.”72 The Ninth Circuit in Simpson based its holding on the theory that, if plaintiffs can allege participation in a scheme that satisfies the principal purpose and effects test, then such conduct would be “deceptive” – not that it would be “manipulative” – within the meaning of Section 10(b).73 In this respect, the Ninth Circuit’s opinion reflects a relatively new take on the legal basis underpinning scheme liability. Some of the early post-Central Bank decisions on scheme liability addressed the theory as premising liability on the contention that the defendants’ conduct was “manipulative.” For example, the district court in In re Global Crossing, Ltd. Securities Litigation held that allegations of participation in a fraudulent scheme under Rule 10b-5(a) and (c) were actionable because the alleged conduct was “manipulative” – not that it was “deceptive” under Section 10(b).74 Plaintiffs in Global Crossing brought claims pursuant not only to Rule 10b-5(b), but also Rule 10b-5(a) and (c). Plaintiffs alleged that, in addition to participating in the making of material misstatements actionable under Rule 10b-5(b), Global Crossing, Ltd.’s outside auditors from Arthur Andersen LLP engaged in a fraudulent scheme under Rule 10b5(a) and (c).75 Specifically, they alleged, Andersen “masterminded the misleading accounting” for certain transactions involving “indefeasible

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rights of use” as well as “swap transactions used to circumvent [Generally Accepted Accounting Principles] and inflate” revenues, that it “actively participated in structuring each swap,” that it was “intimately involved in” the accounting and “directly participated in the creation of the misleading ‘pro forma’ numbers that concealed these practices from investors.”76 Andersen argued that these allegations did not suffice as they did not allege “market manipulation” in the form of “tie-in agreements, wash sales, matched orders, or rigged prices,”77 and the Court agreed that these allegations did not amount to “market manipulation” claim because they did not involve trading activity.78 But that did not bar the claim, according the Judge Lynch, because subsections (a) and (c) of Rule 10b-5 “encompass more than illegal trading activity.”79 As for the specific conduct alleged, Judge Lynch observed that if it did not amount to conduct that operated as a fraud under Rule 10b-5(a) and (c), then “it is hard to imagine what would.”80 As for why such conduct could be viewed as actionable under Section 10(b), Judge Lynch found that it was within the meaning of the term “manipulative” in the statute: The use of the term ‘manipulative’ in section 10(b) itself “connotes intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities.” Plaintiffs allege precisely such manipulative conduct, with precisely such a result.81 Thus, according to Judge Lynch, Plaintiffs did not allege a “market manipulation” claim, but they did allege “manipulative” conduct under Section 10(b). Courts that have premised scheme liability on the theory that it is “manipulative” under Section 10(b), like Judge Lynch in Global Crossing, have downplayed the Supreme Court’s definition of the term in Santa Fe.82 The district court in In re Dynegy, Inc. Securities Litigation considered only whether the alleged conduct might be viewed as “manipulative.”83 In Dynegy, Judge Lake rejected an effort by plaintiffs to assert scheme liability claims against Citigroup Inc. and certain of its affiliates based on their alleged business dealings with Dynegy, Inc.84 Plaintiffs alleged that Citigroup promoted and structured (a) an off balance sheet transaction called Black Thunder “to disguise an $850 million loan to Dynegy as an equity interest investment” and (b) a transaction called Project Alpha “to disguise a $300 million loan as cash flow from operations and to generate

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bogus tax savings of $79 million.85 Among the many claims brought by plaintiffs in the case were claims under Section 10(b) and Rule 10b-5 against Citigroup based on its alleged structuring and promotion of Black Thunder and Project Alpha.86 Specifically, plaintiffs alleged that “Citigroup structured, funded and executed two major series of transactions to hide off Dynegy’s balance sheet hundreds of millions of dollars in debt, and artificially inflate Dynegy’s reported net income and cash flows.”87 Citigroup allegedly provided promotional statements to Dynegy employees in which it stated that the $850 loan in the Black Thunder transaction “would be presented on Dynegy’s balance sheet as an equity investment,” and Citigroup allegedly prepared “sample balance sheets” for both Dynegy and the special purpose entities involved.88 Additionally, Citigroup allegedly provided disclosure language to Dynegy, which Dynegy used in initial disclosures about Black Thunder that it later had to restate.89 As for Project Alpha, Citigroup allegedly made similar promotional statements to Dynegy employees about how rating agencies would view the proceeds from credit-linked notes offerings and required that all credit risk be eliminated through hedging and tear-up agreements that were hidden from Dynegy’s auditors.90 The Dynegy Plaintiffs argued that Citigroup’s conduct was “manipulative” under Section 10(b) and subsections (a) and (c) of Rule 10b-5.91 Judge Lake read Central Bank to mean that there can be no “liability based on allegations that a group of defendants acted together to violate the securities laws unless each defendant committed a manipulative or deceptive act in furtherance of the scheme.”92 The language in Central Bank regarding secondary actors remaining liable where all of the requirements for liability are met meant just that – that an actor such as an attorney or a bank that would ordinarily be thought of as a secondary actor may nonetheless be held liable as a primary violator only if that actor engages in conduct that fully satisfies the requirements for primary liability under Section 10(b).93 Plaintiffs’ allegations regarding Citigroup’s involvement with Black Thunder and Project Alpha, the Court held, could be viewed at most as aiding and abetting Dynegy’s fraud and were therefore not actionable under Section 10(b) and Rule 10b-5.94 The Court rejected plaintiffs’ argument that Citigroup’s conduct could be viewed as “manipulative” under Rule 10b-5(a) and (c) on the ground that Citigroup’s conduct was not alleged to have “coincided with sales of Dynegy securities.”95 As the Court explained:

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Plaintiffs’ allegations regarding Citigroup’s participation in the structuring of Black Thunder and Project Alpha do not identify Citigroup’s actions as manipulative; plaintiffs’ claims are that Dynegy improperly reported Black Thunder and Project Alpha on its financial statements and that Citigroup helped Dynegy do so by structuring, funding, and executing Black Thunder and Project Alpha. Under Central Bank the aid that Citigroup provided Dynegy is not actionable under § 10(b), and plaintiffs cannot invoke subsections (a) and (c) of Rule 10b-5 to circumvent Central Bank‘s limitations on liability for a secondary actor’s involvement in the preparation of false and misleading statements.96 A Clear Circuit Split In addition to Charter and Simpson, there are several other circuit court opinions that address, at least indirectly, the question of whether liability attaches for participation in a scheme to defraud, short of making an affirmative misstatement or omission or engaging in a manipulative securities trade. The Eighth Circuit in Charter cited several circuit court decisions – the Sixth Circuit’s decision in Fidel v. Farley,97 the Eleventh Circuit’s decision in Ziemba v. Cascade Int’l, Inc.,98 the Second Circuit’s decision in Wright v. Ernst & Young LLP,99 the Tenth Circuit’s decision in Anixter v. Home-Stake Prod. Co.,100 and the Ninth Circuit’s decision in In re Software Toolworks, Inc. Securities Litigation101 – as in accord with its analysis.102 Others might argue about the import of some of these decisions on the ground that the facts of those cases did not present the question as clearly as did Charter and Simpson. For example, in In re Global Crossing, Ltd. Securities Litigation, Judge Lynch, a district court judge in the Southern District or New York, did not read the Second Circuit’s decision in Wright v. Ernst & Young LLP as precluding scheme liability.103 Similarly, the Ninth Circuit panel in Simpson did not view Software Toolworks as an impediment to recognizing scheme liability.104 But the two recent cases, Charter and Simpson, addressed the issue squarely, and the two decisions published by the circuit courts in those cases are directly at odds with each other on the validity of scheme liability.105 Charter held that there can be no liability under Section 10(b) or Rule 10b-5 absent a material misstatement or omission or a manipulative securities trade such as a wash sale or rigged price – i.e., “no scheme liability” as commonly defined. Simpson held that there can be liability, even absent a material misstatement or omission or a manipulative act, as

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long as the defendants conduct had the “principal purpose and effect of creating a false appearance of fact in furtherance of the scheme.”106 What the Ninth Circuit wrote about scheme liability is dicta. The Circuit affirmed the dismissal. It did not uphold any finding of liability based on any conduct deemed to be part of a scheme to defraud. Nor did the Court sustain a complaint based on allegations of that nature. The Court did give advice as to how a plaintiff might plead allegations sufficient to state a claim based on the theory. If a plaintiff is able to do so, then the Circuit, if it follows the guidance contained in this opinion, will sustain the claim. Thus, with the decision in Simpson, there is now a clear circuit split over the validity of scheme liability under Section 10(b).107 A Not So Clear Line These developments in the case law raise an even thornier question, at least in jurisdictions where some form of scheme liability is recognized. Exactly where is the line between participation in a fraudulent scheme that gives rise to primary liability under Section 10(b) and participation that constitutes mere aiding and abetting and is therefore not actionable under Central Bank? No court has offered a clear definition of scheme liability that provides a reliable guide. It is difficult to predict how particular fact patterns will be treated under any of the standards articulated to date.108 Take, for example, the Ninth Circuit’s definition of scheme liability in Simpson. Immediately after stating its primary holding (“that to be liable as a primary violator of § 10(b) for participation in a ‘scheme to defraud,’ the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme”), the Ninth Circuit in Simpson clarified that: It is not enough that a transaction in which a defendant was involved had a deceptive purpose and effect; the defendant’s own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect.109 As an initial matter, the basic test formulated by the Ninth Circuit – that the “principal purpose and effect” of the defendant’s conduct be to create a false appearance of fact – appears extremely difficult to satisfy. Requiring that the “principal” purpose of a defendant’s participation be to create a false appearance can limit significantly the conduct that can be viewed as actionable. And the additional qualification – requiring that the

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defendant’s “own conduct” and not merely the “transaction” have a deceptive purpose – suggests an exclusion that is potentially as wide as the concept of scheme liability itself. As discussed above, the Ninth Circuit found that the allegations of the complaint did not state a claim under the theory. The allegations about AOL’s participation included that it had jointly developed the triangular transactions at issue, but AOL had not created sham business entities, and there was no indication that the transactions that AOL engaged in were “completely illegitimate.”110 Indeed, it is unclear whether the facts alleged in other cases where scheme liability has been recognized would survive the Ninth Circuit’s test. The Ninth Circuit in Simpson cited other decisions that have addressed scheme liability, which the Court contended similarly involved fraudulent transactions that had “a principal purpose and effect of creating a false appearance of fact in furtherance of the scheme to defraud.”111 In Quaak v. Dexia, S.A., the defendant was the primary architect of the scheme to finance the sham entities”; in Global Crossing, the defendant auditors “masterminded” misleading accounting practices; in In re Lernout & Hauspie Securities Litigation, the defendants “invented sham corporate entities” that allowed a company to hide expenses and inflate revenues); in In re Enron Corp. Securities, Derivative and ERISA Litigation, certain defendants allegedly engaged in “sham business transactions with no legitimate business purpose.”112 But when the Ninth Circuit turned to the facts alleged in Simpson, it applied its newly articulated “principal purpose and effects” test stringently to deem the facts alleged to be inadequate, even though in some respects the conduct alleged in Simpson arguably resembled the conduct alleged in the earlier cited cases. The problem is compounded by the apparent circularity in the Ninth Circuit’s test. On one occasion, the Court described the test as follows: Thus, when determining whether a defendant is a ‘primary violator,’ the conduct of each defendant, while evaluated in its context, must be viewed alone for whether it had the purpose and effect of creating a false appearance of fact in furtherance of an overall scheme to defraud.113 And at a later point in the opinion, the Court described it in this manner: We conclude that conduct by a defendant that had the principal purpose and effect of creating a false appearance in deceptive transactions as

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part of a scheme to defraud is conduct that uses or employs a deceptive device within the meaning of § 10(b).114 In these passages, and throughout, the Court thus uses the very language of fraud to define what fraud under the statute means. What did the Court intend the phrases “in furtherance of an overall scheme to defraud” and “as part of a scheme to defraud” in the above passages to mean? These phrases refer back to the very concept of “fraud” or “scheme to defraud,” which is what the Court is trying to define to begin with. Similarly, the second quote above also employs the phrase “deceptive transaction” in elaborating on what constitutes a “deceptive device.” In short, it is not clear exactly where the Ninth Circuit intends the line to be drawn. Where the “principal” purpose of the defendant’s conduct was not to deceive, the defendant’s conduct will not meet the test and will be deemed instead to constitute, at most, aiding and abetting another person’s fraud. So, precisely what types of conduct would satisfy the “principal purpose and effect” test? What conduct in furtherance of a fraudulent scheme has, in and of itself, a deceptive purpose and effect? This will have to be addressed in the context of specific fact patterns in future cases. The lack of clarity on this point stems in part from the nature of the opinion itself, that it provides guidance in dicta while affirming the dismissal of a claim for failure to meet the test, as well as the vagueness of the test quoted above and the difficulty of drawing a clear line consistent with Central Bank. One federal judge explicitly acknowledged the difficulty of drawing a line between primary and secondary liability in scheme liability cases. In In re Lernout & Hauspie Securities Litigation, Judge Saris wrote as follows: While both sides make strong arguments in an area of sparse law, the better reading of § 10(b) and Rule 10b-5 is that they impose primary liability on any person who substantially participates in a manipulative or deceptive scheme by directly or indirectly employing a manipulative or deceptive device (like the creation or financing of a sham entity) intended to mislead investors, even if a material misstatement by another person creates the nexus between the scheme and the securities market.115 Judge Saris then observed that “[t]o be sure, the line between primary and secondary liability in a scheme or course of business case can be murky and fact-sensitive.”116

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Judge Lynch’s comments in Global Crossing are also telling. While several paragraphs of the opinion are devoted to explaining the parties’ arguments regarding scheme liability, in the end Judge Lynch rejected the defendant’s argument with the following statement: “If the behavior alleged does not make out a claim for engaging in ‘any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,’ then it is hard to imagine what would.”117 Thus, Judge Lynch, like other judges confronted with scheme liability cases, examined the facts alleged and, without much explanation, simply concluded that the particular fact pattern at issue reflected a primary violation, not mere aiding and abetting. The difficulty of defining what constitutes a primary violation versus aiding and abetting, and the tendency of courts to deem particular conduct one thing or the other in conclusory fashion, is reminiscent of Justice Stewart’s remarks about hard-core pornography: It is possible to read the Court’s opinion in Roth v. United States and Alberts v. California, in a variety of ways. In saying this, I imply no criticism of the Court, which in those cases was faced with the task of trying to define what may be indefinable. I have reached the conclusion, which I think is confirmed at least by negative implication in the Court’s decisions since Roth and Alberts, that under the First and Fourteenth Amendments criminal laws in this area are constitutionally limited to hard-core pornography. I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that.118 Finally, Judge Harmon’s opinions in the In re Enron Corp. Securities, Derivative and ERISA Litigation further highlight the difficult of linedrawing in this area. In a June 2006 opinion on class certification issues, Judge Harmon candidly remarked that “[t]his Court and others have continued to struggle to define parameters for [scheme] liability.”119 In this opinion, Judge Harmon reviewed case law developments in the years following the Court’s acceptance of the pleading of scheme liability in denying certain secondary actors’ motions to dismiss.120 “A major difficulty in the wake of Central Bank,” Judge Harmon observed, “is defining clearly what conduct constitutes aiding and abetting and what would qualify as a

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primary violation of § 10(b).”121 Ultimately, Judge Harmon endorsed the SEC’s proposed test: [I]f a third party enters into a legitimate transaction with a corporation where it knows that the corporation will overstate revenue generated by that transaction, the third party is merely aiding and abetting; in contrast, if the third party and the corporation engage in a transaction whose principal purpose and effect is to create a false appearance of revenues, intended to deceive investors in that corporation’s stock the third party may be a primary violator.122 Thus, Judge Harmon accepted the SEC’s proposed “principal purpose and effect” formulation.123 Judge Harmon filed this opinion on June 5, 2005, after the Eighth Circuit rejected scheme liability in Charter, but before the Ninth Circuit filed its June 30, 2006 opinion in Simpson, which as discussed above accepted the SEC’s proposed test with certain modifications. Significantly, Judge Harmon’s view of scheme liability as expressed in her June 2006 opinion represented a “refinement” of the Court’s prior opinions on scheme liability issued in connection with motions to dismiss.124 The difficult of formulating a clear test of what constitutes a primary violation consistent with Central Bank has resulted in multiple decisions with different definitions in the same case. Conclusion As noted above, the standard set forth in the Ninth Circuit’s opinion in Simpson cannot be reconciled with that of the Eighth Circuit’s opinion in Charter, and there are other circuit court opinions that at least arguably address the issue indirectly. Given the frequency with which the issue is being presented in securities cases, other circuits will undoubtedly be called upon to visit, or revisit, the question. There are those who would say that the securities law must be interpreted flexibly to achieve Congressional purposes. One might say that Simpson reflects a more flexible approach than Charter. On the other hand, Charter is a straightforward application of Supreme Court precedent. Additionally, the basic holding of Simpson appears to be circular in its reasoning, and it raises as many questions as it answers. In the end, if the reasoning of Charter is correct, then the reasoning of Simpson cannot be. The Supreme Court will in all likelihood resolve the question of which circuit is correct, but we may have a long wait as other circuits weigh in on the topic. It took nearly two decades before the Su-

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preme Court answered the question left open in footnote seven of Ernst & Ernst v. Hochfelder regarding aiding and abetting liability.125 Only after eleven circuits embraced the concept126 did the Supreme Court rule in 1994 that Section 10(b) does not reach those who merely aid and abet another’s fraud.127 And, the Supreme Court still has not reached the question left open in footnote 12 of Ernst & Ernst v. Hochfelder, whether recklessness satisfies the scienter element,128 although numerous circuit courts have held that it can.129 In Ernst & Ernst v. Hochfelder, the SEC argued that certain subsections of Rule 10b-5 could be read to reach conduct that was merely negligent. The Supreme Court rejected this argument on the ground that the language of Rule 10b-5 cannot be read to extend beyond what is expressly prohibited in Section 10(b).130 Similarly, in Santa Fe, the Supreme Court held that mere corporate mismanagement is not actionable under Rule 10b-5, again rejecting an argument based on language in certain subsections of Rule 10b-5 that appears on its face to extend beyond the contours of Section 10(b).131 And, in Central Bank, the Supreme Court held that aiding and abetting another person’s fraud is not actionable, once again invoking the proposition that Rule 10b-5 cannot be interpreted more expansively than Section 10(b).132 Scheme liability is the latest theory that relies on a parsing of the subsections of Rule 10b-5. It seems inevitable that the Supreme Court will be called upon to determine whether it too represents an improper attempt to expand Rule 10b-5 beyond the contours of Section 10(b). And in the meantime, in jurisdictions where scheme liability is recognized, courts and parties will continue to struggle over exactly how to differentiate between primary participation in a fraudulent scheme versus mere aiding and abetting. NOTES 1. 452 F.3d 1040, 1048 (9th Cir.), petition for cert. filed, 75 U.S.L.W. 3236 (U.S. Oct. 19, 2006) (No. 06-560). 2.

Simpson, 452 F.3d at 1049. 443 F.3d 987 (8th Cir.), petition for cert. filed, 75 U.S.L.W. 3034 (U.S. July 7, 2006) (No. 06-43). 4. Charter, 443 F.3d at 992. 5. 511 U.S. 164 (1994). 6. 15 U.S.C. § 78j(b) (emphasis added). 7. 17 C.F.R. § 240.10b-5. The subdivisions of Rule 10b-5 are sometimes identified as (a), (b), and (c), and sometimes as (1), (2), and (3). 3.

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8.

Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 152-53 (1972) (“To be sure, the second subparagraph of the rule specifies the making of an untrue statement of a material fact and the omission to state a material fact. The first and third subparagraphs are not so restricted.”). 9.

Section 11, 15 U.S.C. § 77k(b)(3); Section 12(a)(2), 15 U.S.C. § 77l(a)(2). Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 737 (1975) (“When we deal with private actions under Rule 10b-5, we deal with a judicial oak which has grown from little more than a legislative acorn.”). 10.

11.

Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 173 (1994). See, e.g., SEC v. Zandford, 535 U.S. 813, 819 (2002) (§ 10(b) “should be construed not technically and restrictively, but flexibly to effectuate its remedial purposes”) (citation omitted). Zandford is sometimes cited as supportive of scheme liability. Like many Supreme Court decisions, Zandford contains language about interpreting Section 10(b) flexibly, and it did address an alleged “scheme to defraud,” Zandford, 535 U.S. at 820. But the case did not involve “scheme liability” in the sense used here and in the cases discussed in this article (referring to liability for participating in a fraudulent activity by means other than a misstatement, omission, or manipulative securities trading practice). In fact, Zandford involved a material omission – the failure of a discretionary account manager who owed his clients fiduciary duties to disclose that he intended to misappropriate their securities – and therefore fit squarely within the traditional kind of misstatement or omission cases brought under Section 10(b). Zandford, 535 U.S. at 82223. The decision did not analyze the requirement that the conduct be “manipulative or deceptive” under Section 10(b); rather, it addressed a different requirement of Section 10(b), the requirement that the fraudulent activity occurred “in connection with” the purchase or sale of a security. Zandford, 535 U.S. at 819. Also, the decision does not support efforts to parse the subdivisions of Rule 10b-5 which are central to most arguments in favor of scheme liability. Zandford, 535 U.S. at 816 n.1 (“The scope of Rule 10b-5 is coextensive with the coverage of § 10(b); therefore, we use § 10(b) to refer to both the statutory provision and the Rule.”) (citing United States v. O’Hagan, 521 U.S. 642 (1997) and Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976)). 12.

13.

See, e.g., Superintendent of Ins. v. Bankers Life &Cas. Co., 404 U.S. 6, 10 n.7 (1971) (citation omitted). 14. See Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 173 (1994) (“Of course, a private plaintiff now may bring suit against violators of § 10(b). But the private plaintiff may not bring a 10b-5 suit against a defendant for acts not prohibited by the text of § 10(b).”); Central Bank, 511 U.S. at 177-78 (“As in earlier cases considering conduct prohibited by § 10(b), we again conclude that the statute prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act…. We cannot amend the statute to create liability for acts that are not themselves manipulative or deceptive within the meaning of the statute.”); Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 472 (1977) (“the language of the statute must control the interpretation of the Rule”); Santa Fe, 430 U.S. at 473 (“language of § 10(b) gives no indication that Congress meant to prohibit any conduct not involving manipulation or deception”); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 214 (1976) (“despite the broad view of the Rule advanced by the Commission in this case, its scope cannot exceed the power granted the Commission by Congress under § 10(b)”). 15.

Santa Fe, 430 U.S. at 476 & n.15. 430 U.S. 462, 471-74 (1977). 17. Green v. Santa Fe Indus., Inc., 533 F.2d 1283, 1289 (2d Cir. 1976), rev’d, 430 U.S. 462 (1977). 18. 533 F.2d at 1286-87. 19. Santa Fe, 430 U.S. at 471-74. 20. Santa Fe, 430 U.S. at 470. 16.

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21.

Santa Fe, 430 U.S. at 472-73 (“The scope of the Rule cannot exceed the power granted to the Commission by Congress under § 10(b).”). 22.

Santa Fe, 430 U.S. at 474, 476-77. Santa Fe, 430 U.S. at 476 (“manipulation” is “virtually a term of art” referring “generally to practices, such as wash sales, matched orders, or rigged prices, that are intended to mislead investors by artificially affecting market activity”). Some courts have more recently held that Section 10(b)’s prohibition of “any manipulative … device or contrivance” extends beyond the narrow class of securities trading practices alluded to in Santa Fe. See, e.g., In re Global Crossing, Ltd. Securities Litigation, 322 F. Supp.2d 319 (S.D.N.Y. 2004). 23.

24.

Santa Fe, 430 U.S. at 476 & n.15. Santa Fe, 430 U.S. 462. 26. 511 U.S. 164 (1994). 27. Central Bank, 511 U.S. at 173-75, 191. 28. Central Bank, 511 U.S. at 177 (citing Santa Fe). 29. Central Bank, 511 U.S. at 191 (emphasis added). 30. Charter, 443 F.3d at 989. 31. Charter, 443 F.3d at 989-90. 32. Charter, 443 F.3d at 989-90. 33. Charter, 443 F.3d at 990. 34. Charter, 443 F.3d at 990. 35. Charter, 443 F.3d at 990. 36. Charter, 443 F.3d at 989. 37. Charter, 443 F.3d at 990. 38. Charter, 443 F.3d at 990. 39. Charter, 443 F.3d at 990. 40. Charter, 443 F.3d at 990. 41. Central Bank, 511 U.S. at 191. 42. Charter, 443 F.3d at 991. 43. Charter, 443 F.3d at 991. 44. Charter, 443 F.3d at 991-92. 45. Charter, 443 F.3d at 992 (citations omitted). 46. Charter, 443 F.3d at 992. 47. Charter, 443 F.3d at 992. 48. Charter, 443 F.3d at 992-93. 49. Simpson v. AOL Time Warner Inc., 452 F.3d 1040, 1042 (9th Cir. 2006). 50. Simpson, 452 F.3d at 1043. 51. Simpson, 452 F.3d at 1043. 52. Simpson, 452 F.3d at 1043. 53. Simpson, 452 F.3d at 1042. 54. Simpson, 452 F.3d at 1043. 55. Simpson, 452 F.3d at 1048. 25.

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56.

Simpson, 425 F.3d at 1043. Simpson, 425 F.3d at 1048 (emphasis in original). The Court explained that the “principal purpose” aspect of this test is different from the separate element of scienter. Simpson, 425 F.3d at 1048 n.5. A defendant might have the required scienter, yet not engage in conduct that would satisfy this test for primary liability: “A defendant may intend to deceive the public by substantially assisting another’s misconduct as part of a scheme to defraud, but fail to perform personally any action that created a false appearance as part of this scheme.” Simpson, 425 F.3d at 1048 n.5. The Court seems to draw a distinction between scienter, which focuses on the defendant’s state of mind, and the purpose and effect test, which focuses on the defendant’s conduct: “In applying the ‘scienter’ element, we look at whether a defendant’s state of mind was sufficiently culpable for § 10(b) liability. By contrast, we may examine the ‘principal purpose and effect’ of the defendant’s challenged conduct in a fraudulent scheme as an aid to assessing whether the defendant’s conduct was sufficiently deceptive for § 10(b) liability.” Simpson, 425 F.3d at 1048 n.5. 57.

58.

Simpson, 425 F.3d at 1050. Simpson, 425 F.3d at 1043. 60. Simpson, 452 F.3d at 1044. 61. Simpson, 452 F.3d at 1044. 62. Simpson, 452 F.3d at 1044. 63. Simpson, 452 F.3d at 1044. 64. Simpson, 425 F.3d at 1052. 65. Simpson, 425 F.3d at 1052. 66. Simpson, 425 F.3d at 1053. 67. Simpson, 425 F.3d at 1053. 68. Simpson, 425 F.3d at 1053. 69. Simpson, 452 F.3d at 1044. 70. Simpson, 452 F.3d at 1044-45. 71. Simpson, 425 F.3d at 1053. Finally, the allegations against L90, which merely followed a triangular transaction model created by AOL, were also insufficient for similar reasons. Simpson, 425 F.3d at 1045, 1054. Plaintiffs did not allege that L90’s officers had helped develop the transactions. Simpson, 452 F.3d at 1045 n.1. 72. Simpson, 452 F.3d at 1055. 73. Simpson, 452 F.3d at 1048 (“We agree with the SEC that engaging in a transaction, the principal purpose and effect of which is to create the false appearance of fact, constitutes a ‘deceptive act.’”). 59.

74.

322 F. Supp.2d 319 (S.D.N.Y. 2004). Global Crossing, 322 F. Supp.2d at 335. 76. Global Crossing, 322 F. Supp.2d at 336. 77. Global Crossing, 322 F. Supp.2d at 336. 78. Global Crossing, 322 F. Supp.2d at 336 (“It is true that plaintiffs fail to assert a market manipulation claim, as those claims are technically understood – they have alleged no illegal trading activity that would artificially cause stock prices to rise.”). 75.

79.

Global Crossing, 322 F. Supp.2d at 336. Judge Lynch wrote that “a cause of action exists under subsections (a) and (c) for behavior that constitutes participation in a fraudulent scheme, even absent a fraudulent statement by the defendant” and that “[c]laims for engaging in a

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fraudulent scheme and for making a fraudulent statement or omission are thus distinct claims, with distinct elements.” Global Crossing, 322 F. Supp.2d at 335. 80.

Global Crossing, 322 F. Supp.2d at 337. Global Crossing, 322 F. Supp.2d at 337 (citation omitted). In contrast, “deceptive” conduct in the form of misstatements and omissions, Judge Lynch pointed out, is actionable only under Rule 10b-5(b). Global Crossing, 322 F. Supp.2d at 337 n.17. 81.

82. The only reference to Santa Fe in Global Crossing is a citation to the defendants’ reply brief, which cites In re Initial Public Offering Sec. Litig., 241 F. Supp.2d 281 (S.D.N.Y. 2003), which in turn cites Santa Fe. Global Crossing, 322 F. Supp.2d at 336; see also In re Lernout & Hauspie Sec. Litig., 236 F. Supp.2d 161, 170 (D. Mass. 2003) (“In Santa Fe v. Green, the Supreme Court stated ‘[m]anipulation is ‘virtually a term of art when used in connection with securities markets,’ and refers generally to practices, such as wash sales, matched orders, or rigged prices, that are intended to mislead investors by artificially affecting market activity.’ But the Supreme Court stressed that despite its status as a ‘term of art,’ the term ‘manipulative’ does not limit § 10(b)’s coverage to traditional securities schemes such as wash sales or matched orders; to the contrary, ‘Congress meant to prohibit the full range of ingenious devices that might be used to manipulate securities prices.’”) (citations omitted). 83.

339 F. Supp.2d 804, 913-16 (S.D. Tex. 2004). Dynegy, 339 F. Supp.2d at 913-16. 85. Dynegy, 339 F. Supp.2d at 819-20. 86. Dynegy, 339 F. Supp.2d at 913-14. 87. Dynegy, 339 F. Supp.2d at 913-14 (quoting complaint). 88. Dynegy, 339 F. Supp.2d at 915. 89. Dynegy, 339 F. Supp.2d at 915. 90. Dynegy, 339 F. Supp.2d at 915. 91. Dynegy, 339 F. Supp.2d at 914 (“Plaintiffs respond that their allegations against Citigroup allege primary violations under Rule 10b-5(a) and (c) for engaging in manipulative acts.”). Thus, the Dynegy court’s opinion presumes that the alleged conduct could not be viewed as “deceptive” and addresses only the argument that such conduct could be “manipulative.” 84.

92.

Dynegy, 339 F. Supp.2d at 915. Dynegy, 339 F. Supp.2d at 915. 94. Dynegy, 339 F. Supp.2d at 915-16. 95. Dynegy, 339 F. Supp.2d at 916. 96. Dynegy, 339 F. Supp.2d at 916. 97. 392 F.3d 220, 235 (6th Cir. 2004). 98. 256 F.3d 1194, 1204-06 (11th Cir. 2001). 99. 152 F.3d 169, 175 (2d Cir. 1998), cert. denied, 525 U.S. 1104 (1999). 100. 77 F.3d 1215, 1225-27 (10th Cir. 1996). 101. 50 F.3d 615, 628 n.3 (9th Cir. 1994). 102. Charter, 443 F.3d at 992. 103. Global Crossing, 322 F. Supp.2d 319, 330 (S.D.N.Y. 2004) (construing Second Circuit’s decision in Wright as limited to “cases brought under Rule 10b-5(b)” and therefore not applicable to cases under Rule 10b-5(a) and (c)). 93.

104.

Simpson, 452 F.3d 1040.

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105.

The Simpson court cites the Eighth Circuit’s decision in Charter without acknowledging the fundamental difference in the two circuits’ views. Simpson, 452 F.3d at 1050. 106.

Simpson, 452 F.3d at 1048. District courts are also divided. Compare, e.g., Dynegy, 339 F. Supp.2d at 913-16 (S.D. Tex. 2004) (“plaintiffs cannot invoke subsections (a) and (c) of Rule 10b-5 to circumvent Central Bank‘s limitations on liability for a secondary actor’s involvement in the preparation of false and misleading statements”) with Global Crossing, 322 F. Supp.2d at 335 (“It is apparent from Rule 10b-5’s language and the case law interpreting it that a cause of action exists under subsections (a) and (c) for behavior that constitutes participation in a fraudulent scheme, even absent a fraudulent statement by the defendant.”), 107.

108. This is in and of itself a problem, as it is a matter of fundamental fairness that potential defendants be put on fair notice of what conduct is prohibited by law. 109.

Simpson, 452 F.3d at 1048 (emphasis in original). Simpson, 425 F.3d at 1052 (emphasis added). 111. Simpson, 425 F.3d at 1049-50. 112. Simpson, 425 F.3d at 1049-50. 113. Simpson, 425 F.3d at 1050 (emphasis added). 114. Simpson, 425 F.3d at 1052 (emphasis added). 115. 236 F. Supp.2d 161, 173 (D. Mass. 2003); see Quaak v. Dexia, S.A., 357 F. Supp.2d 330, 342 (D. Mass. 2005) (Saris, J.) (declining to reconsider Lernout & Hauspie holding re scheme liability); see also In re Parmalat Sec. Litig., 376 F. Supp.2d 472, 502-03 (S.D.N.Y. 2005) (largely agreeing with Lernout & Hauspie formulation of scheme liability, but taking issue with “substantially participated” aspect of it, and observing that “[t]hese words of course will have to be applied in each case, and there will be disputes over whether they apply to particular fact patterns”). 110.

116.

Lernout & Hauspie, 236 F. Supp.2d at 173. Global Crossing, 322 F. Supp.2d at 337. 118. Jacobellis v. Ohio, 378 U.S. 184 (1964) (Stewart, J., concurring) (citation and footnotes omitted). 117.

119. In re Enron Corp. Securities, Derivative and ERISA Litigation, 2006 U.S. Dist. LEXIS 43146, at *155 (S.D. Tex. June 5, 2006). 120. Enron, 2006 U.S. Dist. LEXIS 43146, at *157 (“This Court has accepted the pleading of scheme liability based on nonrepresentational conduct in this litigation, but recognizes that the controversy about its viability persists. Case law has slowly developed regarding claims under Rule 10b-5(a) and/or (c) and in some cases highlighted, if not clarified, key issues regarding such claims.”). 121. Enron, 2006 U.S. Dist. LEXIS 43146, at *168. 122. Enron, 2006 U.S. Dist. LEXIS 43146, at *168. 123. Enron, 2006 U.S. Dist. LEXIS 43146, at *173 (“It is obvious that courts are divided over the scheme liability issue…. This Court continues to agree with the SEC because its interpretation appears not only reasonable, but consistent with the purposes behind the federal securities laws.”). 124.

Enron, 2006 U.S. Dist. LEXIS 43146, at *390 (“If, in light of this Court’s refinement of its primary violator standard, any other party wishes to challenge claims against it on the grounds that they are merely aiding and abetting allegations, it shall do so by summary judgment and not re-urge or move to reconsider motions to dismiss at this stage of the litigation.”); see In re Enron Corp. Securities, Derivative and ERISA Litigation, 235 F. Supp.2d 549, 577-94 (S.D. Tex. 2002);

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In re Enron Corp. Securities, Derivative and ERISA Litigation, 310 F. Supp.2d 819, 829-30 (S.D. Tex. 2004). 125.

425 U.S. 185, 193 n.7 (1976). See Farlow v. Peat, Marwick, Mitchell & Co., 956 F.2d 982, 986 (10th Cir. 1992); K & S Partnership v. Continental Bank, N. A., 952 F.2d 971, 977 (8th Cir. 1991); Levine v. Diamanthuset, Inc., 950 F.2d 1478, 1483 (9th Cir. 1991); Schatz v. Rosenberg, 943 F.2d 485, 496-497 (4th Cir. 1991); Fine v. American Solar King Corp., 919 F.2d 290, 300 (5th Cir. 1990); Schlifke v. Seafirst Corp., 866 F.2d 935, 947 (7th Cir. 1989); Schneberger v. Wheeler, 859 F.2d 1477, 1480 (11th Cir. 1988); Moore v. Fenex, Inc., 809 F.2d 297, 303 (6th Cir. 1987); Cleary v. Perfectune, Inc., 700 F.2d 774, 777 (1st Cir. 1983); IIT v. Cornfeld, 619 F.2d 909, 922 (2d Cir. 1980); Monsen v. Consolidated Dressed Beef Co., 579 F.2d 793, 799-800 (3rd Cir. 1978). 127. Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). 128. 425 U.S. 185, 193 n.12 (1976). 129. See, e.g., Hackbart v. Holmes, 675 F.2d 1114, 1117-18 (10th Cir. 1982); Broad v. Rockwell Int’l Corp., 642 F.2d 929, 961-62 (5th Cir. 1981); McLean v. Alexander, 599 F.2d 1190, 1197-98 (3d Cir. 1979); Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1025 (6th Cir. 1979); Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977). 130. Ernst & Ernst v. Hochfelder, 425 U.S. at 212-13. 131. Santa Fe, 430 U.S. 462. 132. Central Bank, 511 U.S. 164. 126.