'Secondary actors' would lose protections against private lawsuits under Senate proposal
Among the proposed amendments to the larger financial regulatory overhaul bill wending its way through the Senate is one that would allow shareholders to file private lawsuits against anyone who aids or abets corporate fraud -- potentially exposing lawyers, accountants, investment bankers and others who advise public companies to a category of litigation to which they have previously been immune.
The amendment, introduced by Sen. Arlen Specter (D-Pa.) with the support of 11 other Democratic senators, would essentially overturn nearly two decades of legal precedent and establish that "any person that knowingly provides substantial assistance" to individuals and companies committing securities fraud would be as liable as those they were assisting.
"The critical players in our capital markets are often the gatekeepers -- the investment bankers, the accountants, the lawyers -- and they may often be immune ... even though they are aiding and abetting a fraud," said Columbia University law professor John C. Coffee Jr.
Under current law, which is rooted in the Supreme Court's decisions in Central Bank of Denver v. First Interstate Bank of Denver and Stoneridge Investment Partners v. Scientific-Atlanta, private lawsuits typically can't be filed against "secondary actors," as they are known, that are implicated in securities fraud. Only the Securities and Exchange Commission or the Justice Department can initiate legal action against them. Only when a secondary actor becomes a "primary actor" -- say an accounting firm that knowingly files a fraudulent prepared statement -- does it become subject to civil lawsuits brought by disgruntled shareholders.
"In Central Bank and Stoneridge there was a pretty clear line drawn as to who was a primary actor and who would be a secondary actor; expanding that range opens up a host of new defendants to these cases," said William F. Sullivan, a Paul Hastings partner in Los Angeles.
The Stoneridge decision protected the law firm Mayer Brown last year after a client's shareholders sued the firm and one of its partners in a securities class action. Mayer Brown attorneys had drafted a prospectus for the initial public offering of financial services company Refco, which collapsed shortly thereafter due to fraudulent accounting. Though U.S. District Court Judge Gerard E. Lynch dismissed the claim against Mayer Brown -- a partner was later convicted in a criminal suit -- he called the interpretation in Stoneridge "ripe for legislative re-examination" and compared secondary actors with the Godfather ordering a hit.
Specter last July heeded Lynch's call when he introduced the Liability for Aiding and Abetting Securities Violation Act, but that effort stalled in committee. On May 3 he used the same language in the proposed amendment to the Restoring American Financial Stability Act, which is currently being debated in the Senate. In mid-April, a nearly identical stand-alone measure was introduced in the House by Rep. Maxine Waters (D-Calif.).
"Politically, I think today there are probably fewer headwinds than there used to be -- and a lot more grass-roots support for -- such an amendment," Sullivan said.
A gallery of vocal critics, including corporate defense attorneys and the U.S. Chamber of Commerce, say that tinkering with Stoneridge is a mistake that would subject a slew of companies to a financially devastating barrage of litigation. Hans von Spakovsky, a legal scholar at conservative think tank Heritage Foundation, characterized it as a move by plaintiffs attorneys to go after those with "deep pockets" after other companies become insolvent.
"It's really informative if you go back and look at the case Specter and his friends are trying to overturn, it shows how ... the plaintiffs bar wants to expand liability so they can easily go after anybody who has any relationship with the company that is the target in their lawsuit," von Spakovsky said.
In Stoneridge, Charter Communications allegedly overpaid vendors, which then repaid the excess by purchasing advertising, to inflate company revenue. The court found that the vendors were not liable because they in no way misrepresented themselves to Charter's shareholders, but von Spakovsky said that under the language of the proposed amendment, outside vendors and almost "every industry in America" could be sued.
Coffee conceded that there are times when internal fraud within a company leaves its outside accountants "hoodwinked," but said that opening up aiders and abettors to civil lawsuits could be an effective deterrent. Primary violators, he explained in his testimony before a Senate subcommittee in September, often have to make a choice between fraud and bankruptcy. Typical secondary actors do not directly benefit from the fraud but might be deterred if shareholders could sue them along with the primary actor.
"We're never going to be able to compensate for the 2008 crisis; the most we can do is deter people," Coffee said.