Controlling Person

Judge Scheindlin found sufficient evidence of control to warrant denial of the motion for summary judgment on that issue. 2009 WL 29649, at *13. Despite the indirect parent-subsidiary relationship, Citco Group argued (1) there was no evidence that it dictated the policies and procedures employed by Citco NV,3 and (2) there was no evidence that it had actual control over the day-to-day administrative services provided by Citco NV to the funds.4

Judge Scheindlin found those assertions contradicted by evidence that an employee of another Citco Group subsidiary was acting on behalf of the corporate parent in overseeing the activities of Citco NV and reporting regularly to Citco Group’s executive committee.

Culpable Participation

As Judge Scheindlin observes, the Second Circuit has not defined the requirement that a controlling entity be a “culpable participant.” 2009 WL 29649 at *13 n. 192. The issue is one of both pleading and proof. Must the plaintiff plead, either in conformity with the general pleading standard of Rule 8 or the more stringent standards of Rule 9(b) and the Private Securities Litigation Reform Act, and prove scienter, or is it the defendant’s burden to prove that it acted in “good faith”?5

Judge Scheindlin did not resolve the scienter issue finding sufficient evidence that Citco Group may have been a culpable participant, even under the stricter liability standard, because an employee of a separate Citco Group subsidiary was acting on behalf of Citco Group in overseeing the fund administrator’s business.

In a potential counterpoint to Judge Kaplan’s view of vicarious liability, Judge Scheindlin was careful to note that she rejected the argument that a subsidiary employee’s knowledge of the fraud alone could be imputed to the corporate parent to establish culpable participation because it “could result in the imposition of liability on parent companies based merely on the suggestion that one of its subsidiary companies’ employees was an agent of the parent company and that he or she was aware of the fraudulent scheme.” Id., n. 191. She focused instead upon the evidence that the employee here had been specifically delegated the task of overseeing the administration of the fund’s operations on behalf of Citco Group.

Despite finding it unnecessary to determine the issue, Judge Scheindlin noted that she previously held, in deciding motions to dismiss in Pension Comm. III, that scienter need not be pled on a §20(a) claim for control person liability. Judge Schneidlin ruled similarly in In re IPO Sec. Litig., 241 F. Supp. 2d 281, 395-96 (S.D.N.Y. 2003), as did Judge Denise Cote in In re WorldCom Inc. Sec. Litig., 294 F. Supp. 2d 392, 415 (S.D.N.Y. 2003).

Although Judge Kaplan also recognized that the scienter issue “is a point of debate within the Circuit,” he agreed with Judge Scheindlin that the defendant bears the burden of proving lack of culpable participation or good faith as an affirmative defense to a §20(a) claim. In re Parmalat Sec. Litig., 2009 WL 179920 at *3 n. 32. Judges Kenneth Karas and John Koeltl have disagreed, finding that scienter must be plead with the particularity required under Rule 9(b) and the Private Securities Litigation Reform Act, and proven to sustain control person liability claims under §20(a).6

Those courts holding that no pleading or proof of scienter on the part of the controlling person is required point to the express language of §20(a):

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


They argue that the text requires that defendants bear the burden of establishing good faith. They also argue that the “culpable participation” requirement delineated by the Second Circuit in First Jersey does not equate with scienter, but rather conduct that is blameworthy, which may be unintentional or unknowing. See IPO Sec. Litig., 241 F. Supp. 2d at 394 n. 182.

Those courts that would impose a scienter requirement for control person liability claims under §20(a) also cite to First Jersey. Indeed, in Lapin, Judge Karas pointed to the sequence of the discussion of control person liability in First Jersey, explaining the plaintiff’s burden to allege with particularity a primary violation, control of the primary violator, and culpable participation by the controlling person, and “[o]nce the plaintiff makes out a prima facie case of §20(a) liability, the burden shifts to the defendant to show he acted in good faith.” Lapin, 506 F. Supp. 2d at 247, citing First Jersey, 101 F.3d at 1472-73.

Conclusion

Issues of secondary liability, including vicarious and control person liability, are unresolved in the Second Circuit, and their resolution will have a major impact on current and future cases. Although the facts in In re Parmalat may have provided an easier vicarious liability analysis than in many cases, it remains open whether the Second Circuit will construe Stoneridge as essentially barring vicarious liability.

As Judge Kaplan noted, that would make corporate responsibility difficult to establish in many instances, including in many of the secondary or deep pocket relationships such as are involved in the Madoff fraud. Similarly, resolution of the control person liability issue, on which the district courts in the circuit are split, will have a major impact on Madoff-related cases as well as on other fraud cases.

The views of Judges Scheindlin and Kaplan would result, particularly at the pleading stage, in less difficulty for Madoff victims and others in sustaining claims against control persons, especially non-public, foreign-based corporations as to which little information may be available to support particularized pleading of the elements of control and culpable participation.

However, it seems doubtful the Second Circuit would agree that scienter is not required. While we look forward to Second Circuit clarification of these important principles of secondary, including deep pocket, liability, precedent would suggest agency principles will remain – score one for the plaintiffs looking for deep pockets – but pleading and proof of scienter will be required for control person liability – score one for the deep pockets.

Sarah S. Gold is a partner and Richard L. Spinogatti is senior counsel at Proskauer Rose.

Endnotes:

1. Judge Scheindlin’s earlier decisions in the Pension Committee case are reported as follows: 2006 WL 559811 (S.D.N.Y. Mar. 7, 2006) (Pension Comm. I); 2006 WL 708470 (S.D.N.Y. Mar. 20, 2006) (Pension Comm. II); 446 F. Supp. 2d 163 (S.D.N.Y. 2006) (Pension Comm. III); 2007 WL 528703 (S.D.N.Y. Feb. 20, 2007) (Pension Comm. IV); 2008 WL 4755734 (S.D.N.Y. Oct. 29, 2008) (Pension Comm. V).

2. ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 108 (2d Cir. 2007) and SEC v. First Jersey Securities, Inc., 101 F.3d 1450, 1472 (2d Cir. 1996)

3. Citco Group relied upon In re Alstrom SA, 406 F. Supp. 2d 433, 486-87 (S.D.N.Y. 2005) and First Jersey, 101 F.3d at 1472-73.

4. Citco Group relied upon In re Global Crossing, 2005 WL 1875445, at *3 (S.D.N.Y. August 5, 2005).

5. Rule 8(a)(2) requires only “a short and plain statement of the claim showing the pleader is entitled to relief,” whereas Rule 9(b) requires “particularity” and the PSLRA requires that a plaintiff “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” 15 U.S.C. § 78uD(b)(2).

6. Lapin v. Goldman Sachs Group, Inc., 506 F. Supp. 2d 221, 248 (S.D.N.Y. 2006) (Karas, J). Edison Fund v. Cogent Inv. Strategies Fund, Ltd., 551 F. Supp. 2d 210, 231 (S.D.N.Y. 2008) (Koeltl, J).