GAO Study - Securities Fraud Liability of Secondary Actors

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Government Accountability Office Dodd-Frank Mandated Study on Securities Fraud Liability for Secondary Actors
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    GAO-11-664Securities Fraud Liability of Secondary ActorsUnited States Government Accountability Office Washington, DC 20548 B-321063  July 21, 2011The Honorable Tim JohnsonChairmanThe Honorable Richard C. ShelbyRanking MemberCommittee on Banking, Housing, and Urban AffairsUnited States SenateThe Honorable Spencer BachusChairmanThe Honorable Barney FrankRanking MemberCommittee on Financial ServicesHouse of RepresentativesSubject:  Securities Fraud Liability of Secondary Actors Since the 1930s, publicly traded companies that commit fraud in the issuanceor sale of their securities have been liable to private investors under the U.S.securities laws, as well as subject to government enforcement of these laws.Entities commonly referred to as “secondary actors”—such as banks, brokers,accountants, and lawyers, who play important but generally lesser roles insecurities transactions 1 —may also be liable to investors and to thegovernment for certain securities law violations, but as of 1994, such entitiesare liable only to the government, not to investors, for substantially assisting—or “aiding and abetting”—securities fraud under section 10(b) of the SecuritiesExchange Act of 1934 (1934 Act). 2 Before 1994, courts had interpreted sec10(b), as implemented by the Securities and Exchange Commission’s (thetion 1 In general, “secondary actors” are persons charged with “secondary liability” because they donot directly commit violations of the anti-fraud provisions but instead are alleged to providesubstantial assistance to fraudulent conduct. Because transactions subject to the federalsecurities laws are often complex and involve multiple entities, it can be difficult to determine,at the time a violation occurs, who should be subject to primary versus secondary liability. Inthis report, we use the term “secondary actor” to refer to parties providing services to, orinvolved in transactions with, corporate issuers. 2 15 U.S.C. § 78j(b).  SEC) Rule 10b-5, 3 as implicitly authorizing investors to file aiding and abettinlawsuits even though the 1934 Act did not expressly authorize it.g , N.A. v.t filingredress. 4 The courtsfound that Congress had created an “implied private cause of action” undersection 10(b). In the landmark 1994 decision Central Bank of Denver  First Interstate Bank of Denver, N.A. , 5 however, the U.S. Supreme Courtclarified that section 10(b) and Rule 10b-5 do not create an implied privatecause of action for aiding and abetting, a determination the Court reaffirmed inits 2008 decision in  Stoneridge Investment Partners, LLC v. Scientific- Atlanta, Inc 6 and its 2011 decision in  Janus Capital Group, Inc. v. Firs Derivative Traders. 7 Congress took action in the wake of  Central Bank aswell; in 1995, it enacted the Private Securities Litigation Reform Act, 8 givingthe SEC express authority to seek enforcement against aiders and abettors of securities fraud, but imposing additional procedural restrictions on theof private securities fraud class action lawsuits—one of the primary vehiclesby which investors seek  Although the Supreme Court’s decisions in Central Bank ,  Stoneridge ,  Janus ,and other recent cases have established the contours of liability under section10(b) as the statute is currently written, debate continues over what theappropriate scope of liability should be. As the Supreme Court noted in Central Bank , “[t]he issue . . . is not whether imposing private civil liability onaiders and abettors is good policy but whether aiding and abetting is coveredby the statute.” 9 In response, legislation has been introduced to amend the1934 Act, most recently in 2010, to establish an express private right of actionfor aiding and abetting violations of the federal securities laws. 10 Proponentsof the legislation have argued that creating such private liability could have anumber of potentially positive implications for investors, the U.S. capitalmarkets, and public companies, while opponents have argued that creatingsuch liability could have the opposite effect.The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act or the Act) 11 requires GAO to analyze the impact of creating a private right of action for aiding and abetting securities law violations,including describing the factual and legal background against which creation 3 17 C.F.R. § 240.10b-5. 4    See, e.g. ,  Brennan v. Midwestern United Life Ins. Co. , 259 F. Supp. 673 (N.D. Ind. 1966). 5 511 U.S. 164 (1994). 6 552 U.S. 148 (2008). 7 131 S. Ct. 2296 (2011). 8 Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified as amended in scattered sections of titles 15& 18 of the U.S. Code). 9 511 U.S. at 177. 10    See, e.g. , H.R. 5042, 111th Cong. (2010). 11 Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified in scattered sections of titles 12 & 15 of the U.S. Code). GAO-11-664 Securities Fraud Liability of Secondary ActorsPage 2  of such authority would be considered. This analysis responds to thatmandate. 12  We conducted our work from August 2010 through July 2011 in accordancewith GAO’s quality assurance framework relevant to our objectives. Theframework requires that we plan and perform the engagement to obtainsufficient, appropriate evidence and legal support to meet our statedobjectives. We believe that the information we obtained and the analysis weconducted provide a reasonable basis for any findings and judgments in this product. A more detailed description of our scope and methodology isincluded in Enclosure I. SUMMARY  Following the stock market crash of 1929 and the ensuing Great Depression,Congress enacted two statutes that established the fundamental securitiesregulatory framework in place today. The Securities Act of 1933 (1933 Act)regulates public offerings of securities, while the Securities Exchange Act of 1934 (1934 Act) regulates trading in securities after they have been issued. 13  These laws require companies that issue securities to disclose specificinformation both before the security is first issued and periodically thereafter,to enable investors to make informed investment decisions.The securities laws also include a number of remedies for investors who areinjured by violations of the laws. The most prominent of these is section 10(b)of the 1934 Act, implemented by SEC Rule 10b-5, 14 which prohibits materialmisrepresentations or omissions and fraudulent conduct and provides ageneral anti-fraud remedy for purchasers and sellers of securities. 15 Starting in 12 Specifically, section 929Z of the Act directs GAO to study the impact of authorizing a privateright of action against any person who aids or abets another in violation of the securities laws,and identifies areas to be included in the study if practicable. This analysis addresses all of those areas. Part I of the analysis provides an overview of the general anti-fraud prohibitionsof section 10(b) and Rule 10b-5 and identifies the elements that private investors must show to prove a case for securities fraud. Part II discusses the roles that secondary actors, includingaccountants, attorneys, and underwriters, play in securities transactions. Part III reviewssignificant legislative and case law developments over the past two decades affectingsecondary actors’ liability for securities fraud. Part IV discusses other legal avenues for pursuing secondary actors and compensating investors. Part V sets out current standards forsecondary actor liability in light of these developments. Finally, Part VI identifies recent proposals to create a private cause of action for aiding and abetting securities fraud, describesarguments that have been advanced in favor of and against such proposals, and discussessteps that have been identified, if such a right were created, to mitigate potential concerns thathave been raised with creating such liability. 13 Securities Act of 1933, 48 Stat. 74 (1933) (codified as amended at 15 U.S.C. §§ 77a et seq. );Securities Exchange Act of 1934, 48 Stat. 881 (1934) (codified as amended at 15 U.S.C. §§ 78a et seq. ). 14 17 C.F.R. § 240.10b-5. 15 Section 10(b) of the 1934 Act makes it unlawful “to use or employ [by the use of any meansor instrumentality of interstate commerce], in connection with the purchase or sale of any GAO-11-664 Securities Fraud Liability of Secondary ActorsPage 3  the 1940s, federal courts determined that even though section 10(b) did notexpressly authorize private investors and sellers to sue under section 10(b)and Rule 10b-5, there was an “implied private cause of action” to do so basedon what the courts found to be congressional intent to ensure maximumenforcement. Using this implied cause of action, investors sued both the parties who carried out the fraud—using a theory of primary liability—andthose who assisted, or aided and abetted, the fraud—using a theory of secondary liability. Service providers that customarily assist companies withsecurities transactions were included in this category of secondary liabilityand became known as “secondary actors.” Secondary actors can includeaccountants, attorneys, underwriters, credit rating agencies, securitiesanalysts, and others. Some of these secondary actors have been characterizedas “gatekeepers” because they allegedly serve as intermediaries betweeninvestors and issuers of securities and verify or certify the accuracy of corporate disclosure or have the ability to use their special status to influencethe behavior of companies and thus prevent wrongdoing. At least some of these alleged gatekeepers vigorously disagree that they serve, or should serve,such a function.In order to bring a successful case for securities fraud, a private party must prove six basic elements. These elements have been developed by the courtsover the years, and some aspects have been affected by the requirements of the Private Securities Litigation Reform Act of 1995 (PSLRA). 16 The elementsare: (1) a material misrepresentation or omission; (2) fraudulent conduct “inconnection with” the purchase or sale of a security; (3) a wrongful state of mind, known as “scienter,” when making the misrepresentation or omission;(4) reliance upon the fraudulent conduct; (5) measurable monetary damages;and (6) a causal connection between the misrepresentation or omission andthe economic loss. Each of these elements has been extensively interpretedby the courts, and because these elements are not defined by statute, courtdecisions continue to shape how they are applied.The ability of investors to sue for aiding and abetting securities fraud (asdistinct from a direct suit for securities fraud) changed in 1994. In Central Bank, the Supreme Court clarified that section 10(b) does not establish a private cause of action for aiding and abetting. Relying on the language of thestatute, the Court found that Congress had not, expressly or even byimplication, created a private cause of action for aiding and abetting. TheCourt reasoned that the requisite securities fraud element of investor relianceis not present where a party aids or abets a fraud, because the aider andabettor’s conduct is not known to, and thus cannot be relied upon by, security . . . any manipulative or deceptive device or contrivance in contravention of such rulesand regulations as the Commission may prescribe as necessary or appropriate in the publicinterest or for the protection of investors.” 15 U.S.C. § 78j(b). 16 Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified as amended in scattered sections of titles 15& 18 of the U.S. Code). GAO-11-664 Securities Fraud Liability of Secondary ActorsPage 4
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