The court explained that “[Mr.] Romano is a primary violator despite the fact that someone else directed the market manipulation scheme.” Id. (emphasis supplied). Thus, under U.S. Environmental, one need not be the “architect” of a fraudulent scheme in order to be held liable as a primary violator.
In analyzing U.S. Environmental, Judge Koeltl found significant the court’s endorsement of First Jersey’s “participation” standard, “although it did not provide any bounds to that test because the defendant actually executed the trades that were alleged to be manipulative,” and left unclear what level of participation is sufficient to establish primary liability.
Judge Koeltl also analyzed the standard used to determine primary liability in private actions during the same period, including Wright v. Ernst & Young, 152 F.3d 169, 176 (2d Cir. 1998), and Shapiro v. Cantor, 123 F.3d 717, 720 (2d Cir. 1997), in both of which the Second Circuit rejected a substantial participation standard and found “secondary actors [could not] be held primarily liable under §10(b) for mere knowledge and assistance in the fraud.” Indeed, in Shapiro, a 10b-(5)b case, the court held that “a defendant must actually make a false or misleading statement in order to be held liable under §10(b). Anything short of such conduct is merely aiding and abetting, and no matter how substantial that aid may be, it is not enough to trigger liability under §10(b).” This standard is in accord with the Supreme Court’s Stoneridge decision holding that a private plaintiff must plead and prove that the defrauded party (in Stoneridge, the public) actually relied upon the deceptive act of the defendant. Judge Koeltl believed that the Wright standard used in private actions “undercut” the “participation” standard used in SEC actions. At least one court has stated that First Jersey was “effectively overruled by the Second Circuit’s decisions in Shapiro [and] Wright.” Ravens v. Republic N.Y. Corp., 2002 U.S. Dist. LEXIS 12162, at *39 (E.D. Pa. April 24, 2002). Another way to analyze these cases is that the court has simply applied a somewhat different standard to primary liability in SEC cases, or in deceptive acts cases, or in both.
In any event, the differing approaches has left Second Circuit authority in flux. Ultimately, Judge Koeltl applied the “participation” standard and found the complaint adequately pleaded defendants’ primary liability.
Observations
This case raises several interesting questions. First, as Judge Koeltl commented “[i]t is unclear why the SEC did not allege, at least in the alternative, that the defendants provided substantial assistance to the brokers who allegedly engaged in the late trading.” Id. at *23. For any litigant to take on a higher standard of proof than necessary is odd to say the least, and even more so when the higher burden generates motion practice over the complaint’s viability. Perhaps the SEC is (or at least pre-Stoneridge was) seeking to expand the scope of private actions by creating SEC case precedents, despite being repeatedly rebuffed in its expansion efforts by Congress and the courts. The SEC surely recognizes, as Judge Koeltl observed, that “[t]he Court of Appeals has not definitively described the bounds of primary liability, as opposed to aiding and abetting liability, particularly in an action brought by the SEC, and particularly when the action involves a claimed violation of Rule 10b-5(a) or (c), rather than Rule 10b-5(b).” Id. at *24. Litigants may be less-concerned in SEC actions with the line between primary and secondary liability since it is a Pyrrhic victory to be found not primarily liable, but nonetheless equally liable as an aider and abettor. And the courts, knowing that the SEC could bring aiding and abetting charges, may be tempted to stretch primary liability where the SEC fails to do so. Indeed, that may have occurred here. The SEC’s complaint describes Mr. Simpson as the “architect” who “orchestrated” the scheme and was “primarily responsible for all investment and trading decision,” whereas for Mr. Dowling, the SEC uses classic aiding and abetting language alleging that he “assisted” and “had knowledge of and implemented all decisions.”3 Nonetheless, both were alleged to be primary violators, the defendants jointly denied that liability, and the court found those pleading requirements to be met for both. The decision may have allowed potential aiding and abetting allegations against Mr. Dowling to state a primary violation, effectively collapsing the distinction between the two.
Another question is how will the courts analyze primary liability in Rule 10b-5(a) and (c) SEC cases going forward, and will that have an impact on the standard used in private actions as well? The Supreme Court in Stoneridge provided a way to identify primary liability by reference to the requirement of reliance, i.e., the defendant’s participation must be of a type and character as to have been relied upon by the defrauded party.
Should this same analysis be used in SEC cases to distinguish primary and aiding and abetting liability even though reliance is not an element in an SEC action? If so, one would ask: if Simpson were a private action, would the defendants have been found primarily liable? Maybe. Judge Koeltl did find the mutual funds were misled by the defendants’ own acts, which created the “false impression” that the trades were timely submitted.
On the other hand, it was the brokers, as in U.S. Environmental, who executed the transactions upon which the mutual funds directly relied. Perhaps this is a case, as contemplated in Stoneridge, where “an indirect chain” of reliance would not be too remote for primary liability to attach because both the hedge fund defendants and the brokers are in the “investment sphere” and not in “the realm of ordinary business operations.” Stoneridge, 128 S.Ct. at 770.
Either way, questions exist as to whether a defendant’s participation should be analyzed in the same manner in SEC actions as in private actions to determine whether a defendant is primarily or secondarily liable. To avoid confusion, as well as a potential expansion of primary liability in private actions through the back door of SEC precedents, we hope the courts will opt for uniformity.
Sarah S. Gold is a partner and Richard L. Spinogatti a senior counsel at Proskauer Rose. Andy S. Oh, an associate at the firm, assisted in the preparation of this article.
Endnotes:
1. Now Rule 10b-5(1) and (3).
2. Late trading is the practice of placing orders to buy, redeem, or exchange mutual fund shares after the 4:00 p.m. (EST) market close while still receiving the current day’s mutual fund price. Late trading allegedly harms shareholders in mutual funds by diluting the value of their shares.
3. See, e.g., Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 119 (2d Cir. 1982) (aiding and abetting a violation of §10(b) requires knowledge of the violation and “substantial assistance in the accomplishment of the violation”).
