Partners in Liability?

A recent court decision could affect the outcomes of shareholder suits against J.P. Morgan Chase and Citigroup for their roles in the Enron scandal.

Are a company’s business partners liable in shareholder lawsuits against the company? A recent appeals court ruling on that question may have muddied the water enough to force the Supreme Court to impose a little clarity in this already murky area.

The case, Simpson v. AOL Time Warner, turns on whether shareholders in a public company have a right to sue that firm’s business partners for participation in transactions that aided and abetted fraud. The plaintiffs in the case are shareholders in a company that in 1996 launched the real estate website Homestore.com (now Move.com).

When news broke in 2001 that the company was under investigation for fraud and its stock price cratered, shareholders lost more than $100 million in market value. Homestore was found to have taken part in a number of “triangular” transactions aimed at creating phony revenue.

The company would buy products that it didn’t need from a third party, with the understanding that the third party would then use the proceeds from that sale to buy advertising space on Homestore’s website through America Online. That enabled the company to report higher earnings than most Web-based businesses and made Homestore, however briefly, a favorite of Internet investors.

Homestore itself settled with one of the primary plaintiffs in the case, the California State Teachers Retirement System, for $71 million. But the victims of the fraud have continued in their attempt to recover damages from AOL, Cendant Corp., and L90, all three of which engaged in the transactions in question.

The recent ruling, handed down by the Ninth U.S. Circuit Court of Appeals, in Pasadena, California, could also affect the outcomes of shareholder suits against J.P. Morgan Chase and Citigroup for their roles in deals that helped Enron cook its books. The appeals court found that in order to seek damages from a third party, a plaintiff must show that the principal purpose and effect of a defendant’s behavior was to create “a false appearance from illegitimate transactions in furtherance of a scheme” to commit fraud.

Fulfilling that description would qualify a defendant as a “primary violator” of Rule 10(b) of the Securities Exchange Act of 1934, which bars the use of “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of stock.

“What it seems to suggest is that there is a fine line between aiding and abetting for which you will have no liability … and being an effective participant in the transaction, which makes you liable,” said financial services attorney Gilbert Schwartz, a founder of the Washington, D.C. law firm Schwartz & Ballen.

The good news for banks like J.P. Morgan Chase and Citigroup, Schwartz said, is that the court has instituted a test that may allow firms to assess their potential liability in shareholder lawsuits. The bad news: Applying the rule doesn’t look like a simple process. “Rather than a bright line test it seems to be a sliding scale,” he added.

Others lawyers also find the ruling opaque. “It is not clear exactly where the Ninth Circuit came down and how that test will be applied,” agreed H. Rodgin Cohen, chairman and senior partner of Sullivan and Cromwell.

For one thing, the decision appears to have been a mixed blessing for the defendants. The three-judge panel affirmed the lower court’s decision to dismiss the case, for instance, but not its decision to dismiss with prejudice, thus leaving the door open to future lawsuits.

Nevertheless, because of its treatment of a supporting brief filed by the Securities and Exchange Commission, the ruling was a victory of sorts for the larger business community, says Cohen. The SEC, taking the plaintiff’s side in the case, had argued that the lower court was wrong to rule that simply aiding and abetting manipulative or deceptive behavior is not in itself enough to classify a person or firm as a primary violator of Rule 10(b).

The commission contended that even indirect involvement in the transaction should result in liability. The appeals court “did not resolve the issue, but at least told the commission that [it was] too extreme in [its] amicus brief,” said Cohen.

As inconclusive as it is, however, the ruling appears to make it increasingly likely that the Supreme Court will have to settle the issue of where liability ends in securities fraud cases. That’s especially true now, since a number of courts have recently tried to define the extent of business-partnership exposure. In April, for example, the Eighth Circuit Court of Appeals rejected arguments that would have imposed liability for fraud committed by Charter Communications Corp. on its business partners, laying out its own test for liability.

A similar case in the Southern District of New York involving shareholders suing the business partners of Italian dairy conglomerate Parmalat resulted in yet another liability test. With different methods for assessing liability emerging in the lower courts, the High Court may well be forced to step in and establish a binding precedent.

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