A Renewed Push to Hook Companies for Counterparties’ Actions

Investor advocates prod for expanding which companies can be considered primarily responsible for securities fraud. But opponents say a change in law would raise the cost of doing business.

Regulators and lawmakers are trying to widen the net of securities-fraud liability. If they’re successful, more companies could be ensnared in private litigation because of their business partnerships with fraudulent companies.

In an amicus brief filed in an appeals court last week, the Securities and Exchange Commission disagreed with a lower court judge’s decision to drop an investor lawsuit against an outside lawyer convicted of conspiracy and securities fraud related to Refco Inc.’s $2.4 billion scheme. The bankrupt commodities brokerage was involved in hiding the full extent of its bad debt from investors before filing for Chapter 11 protection.

Refco’s trustees had asked for more than $2 billion in damages from accounting, financial, and legal advisers — including Mayer Brown LLP partner Stephen Collins, Grant Thornton, Ernst & Young, PricewaterhouseCoopers, Credit Suisse Securities, and Banc of America Securities — but their case was dismissed earlier this year.

More recently, Sen. Arlen Specter (D-Pa.) introduced a bill, co-sponsored by three Democrat senators, that would reverse Supreme Court decisions on which those dismissals were largely based. If passed, the legislation would greatly expand the number of parties that could be found in violation of securities laws and could make business partnering riskier, say observers.

Specter’s two-page bill includes among the liable those companies that knowingly helped another business commit fraud, as well as companies that were reckless in not knowing they had a hand in the fraud. The legislation would raise the status of so-called secondary actors — such as suppliers, bankers, and accounting firms — to primary violators of securities fraud.

Moreover, the bill could have a serious financial effect on market prices for professional services, say opponents. A recent Supreme Court decision to drop the plaintiffs’ claim against the vendors that had supplied services to a fraudulent cable company noted that expansion of laws designed to limit private litigation in these types of cases “would expose a new class of defendants to risks…. Contracting parties might find it necessary to protect against these threats, raising the costs of doing business.”

Indeed, opponents of Specter’s legislation, including the U.S. Chamber of Commerce, are using the current economic downturn to blunt interest in changes to existing rules. “Specter’s bill would once again throw American business to the trial lawyer wolves, weakening our competitive position, at a time when our economy needs all the help it can get,” wrote Stephen Bainbridge, a law professor at the University of California, in a recent blog post. He has said that an expanded interpretation of the law could force companies to extend the monitoring of their internal controls to those of their vendors and other business partners.

Lawmakers and courts have previously rejected taking an approach similar to Specter’s bill because “counterparties to a transaction shouldn’t be held responsible for the accounting decisions of their counterparty,” says Herbert Washer, a partner at Shearman & Sterling, which represented Merrill Lynch in a similar type of case involving Enron shareholders that was dismissed. “It shouldn’t be the responsibility of a [business] to look over the shoulder of their counterparties.”

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