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District Court Weighs Novel Theories of Rule 10b-5 Liability in Mutual Fund Market Timing Litigation

Polkes, Jonathan D.

(June 2006, Business & Securities Litigator)



Reprinted by permission from Securities Regulation Law Journal, Vol. 34, No. 1 (Spring 2006)

by Jonathan D. Polkes and Matthew L. Mustokoff

On September 3, 2003, New York Attorney General Eliot Spitzer announced his investigation of market timing and late trading in mutual funds. The investigation centered around allegations that several mutual funds permitted market timing and late trading by hedge funds, in contravention of the mutual funds’ prospectuses and to the detriment of the funds’ long-term shareholders. In the wake of Mr. Spitzer’s investigation, the Securities and Exchange Commission and various state attorneys general have, to date, settled fraud cases with over thirty-five mutual funds, hedge funds and financial institutions for an aggregate amount in excess of $3.2 billion.

It did not take long for class plaintiffs to commence parallel civil proceedings. The Judicial Panel on Multi-District Litigation has referred approximately 170 market timing class and derivative actions to a panel of three judges on the Federal District Court for the District of Maryland for consolidated pretrial proceedings. One of these Judges, J. Frederick Motz, recently issued the first decision in the market timing cases resolving motions to dismiss, inter alia, claims brought under Section 10(b) of the 1934 Securities Exchange Act and Rule 10b-5.[1] In re Mutual Funds Investment Litigation (in re Janus Subtrack), 384 F. Supp. 2d 845 (D. Md. 2005).

As discussed in more detail below, because the market timing cases provide a completely novel factual context in which to test Rule 10b-5 jurisprudence, Judge Motz was compelled to take a fresh look at certain previously well-established concepts. In particular, the Court revisited the doctrines of: (i) Blue Chip Stamps v. Manor Drug Stores[2] which established the standing requirements for plaintiffs under Section 10(b); (ii) Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.[3] which extinguished aiding and abetting liability in private Section 10(b) actions; and (iii) Basic, Inc. v. Levinson[4] and Affiliated Ute Citizens v. U.S.,[5] which set forth circumstances in which the element of reliance may be presumed.

How the Court interpreted and applied each of these well-known doctrines in an unprecedented factual setting, is the subject of this article.


The Allegations of Market Timing and Late Trading Fraud

Market timing is a form of arbitrage that involves the rapid purchases and sales of mutual fund shares. Traditionally, mutual funds are perceived of as long term investments, and the quick trades engaged in by market timers may cause dilution in the value of shares held by long term shareholders. This dilution is the result of, among other things, increased transaction costs incurred by the funds, as well as a disproportionate share of losses suffered by long term shareholders on days when the fund’s net asset value (“NAV”) declines, after the market timers have exited the funds and profited from their sales.

Thus, while market timing is not illegal per se,[6] many mutual funds in their prospectuses restrict the rights of investors to market time. Moreover, problems arise when, as alleged by regulators and the plaintiffs, mutual funds allow certain favored investors to market time with knowledge that this activity may harm other investors. As explained by Judge Motz, “[a]lthough market timing itself may be lawful, it nevertheless is prohibited by Rule 10b-5 if it is engaged in by favored market insiders at the expense of long-term mutual fund investors from whom it is concealed and who have a right to rely upon its prevention by fund advisers’ and managers’ good faith performance of their fiduciary obligations.”[7]

Late trading is a specific form of market timing that regulators have declared to be illegal. This practice involves the placing of orders to purchase or sell mutual fund shares after the close of the New York Stock Exchange trading session at 4:00 p.m. ET, but receiving the price based on the prior NAV already calculated as of 4:00 p.m. Late trading enables the trader to profit from knowledge of post 4:00 p.m. market-moving events that are not incorporated into that day’s NAV.[8]

The Janus consolidated amended complaint identifies three specific categories of defendants - and the theory of liability as to each is very different. First are the mutual funds, their trustees and their advisors (the “fund defendants”) that were alleged to have misleadingly represented in their prospectuses that market timing and late trading are restricted or prohibited. They were also alleged to have selectively enforced these prohibitions by allowing favored investors - mostly hedge funds - to engage in market timing, often in exchange for additional investments in other mutual funds controlled or managed by the same fund defendant.

Second, the complaint identifies the hedge funds and other arbitrageurs which allegedly conducted and profited directly from the market timing transactions (the “trader defendants”). They were alleged to be liable under Rule 10b-5, even though they did not themselves make any of the actionable misrepresentations or omissions in the mutual funds’ prospectuses. Rather, these defendants were alleged to have participated in an ongoing scheme to defraud mutual fund investors by entering into clandestine agreements with the fund defendants to engage in prohibited market timing trades. Some trader defendants were also alleged to have used specially designed trading platforms to place trades after 4:00 p.m.

Finally, the complaint names certain financial institutions which allegedly facilitated the trader defendants by executing, clearing and financing the market timing transactions (the “broker-dealer defendants”).[9] Like the trader defendants, the broker-dealer defendants were not alleged to have made fraudulent misrepresentations or omissions themselves. Rather, plaintiffs alleged that these financial institutions provided the trader defendants with execution of the mutual fund transactions, financing, securities clearing, and access to trading systems which allowed the trader defendants to market time and late trade.

Standing Under Rule 10b-5 For “Holders”: Blue Chip Stamps Reconsidered

As a threshold issue, the Court addressed plaintiffs’ standing under Rule 10b-5. Plaintiffs purported to bring claims on behalf of those shareholders who not only bought and sold mutual fund shares, but also those who merely held shares during the relevant period. Defendants argued that plaintiffs who simply held shares of mutual funds during the class period, as opposed to bought or sold shares, lack standing under the doctrine announced by the Supreme Court in Blue Chip Stamps.[10]

In Blue Chip Stamps, the Supreme Court held that only purchasers or sellers of securities may bring a private action for damages under Rule 10b-5. In so holding, the Court noted the “danger of vexatious litigation which could result from a widely expanded class of plaintiffs under Rule 10b-5.”[11] In particular, the Court explained that without placing a limitation on the universe of potential plaintiffs under the antifraud provisions of the federal securities laws, an action under Rule 10b-5, insofar as it purports to protect an investor who might have sold securities in the absence of fraud, “will turn largely on which oral version of a series of occurrences the jury may decide to credit, and therefore no matter how improbable the allegations of the plaintiff, the case will be virtually impossible to dispose of prior to trial other than by settlement.”[12] Thus the Court adopted the purchaser-seller holding requirement to limit Section 10(b) claims to those who have at least dealt in the security to which the allegedly fraudulent misrepresentationsor omissions relate - an “objectively demonstrable fact in an area of the law otherwise very much dependent upon oral testimony.”[13]

Eschewing a mechanical application of the purchaser-seller rule, Judge Motz “question[ed] whether Blue Chip Stamps bars suits under Rule 10b-5 by persons who held (but did not purchase or sell) mutual fund shares during a relevant class period when profits were allegedly being siphoned off from the funds by market timers and late traders.”[14] Emphasizing the distinctive nature of plaintiffs’ theory of damages which, unlike in more conventional securities fraud cases, does not focus on the drop of a stock price on a given trading day but rather the gradual dilution of share value over a period of time, the Court expressed concerns about “elevat[ing] rule over principle.”[15] As Judge Motz elaborated, plaintiffs’ claims are fundamentally different from the claims in the typical securities fraud case:

Here, the prudential consideration that led the Supreme Court to adopt (in my view wisely) the Blue Chip Stamps rule - the risk of vexatious, manufactured litigation - does not exist because holder plaintiffs by definition held mutual fund shares during the period that the value of the shares was diluted by late trades and market timing. Their claims are not based upon an inherently speculative inquiry into their subjective state of mind but upon the concrete fact of their continued share ownership. In this respect, the present case differs not only from the Blue Chip Stamps paradigm in which a plaintiff alleges he decided not to purchase a security because of a misrepresentation - but also from other holder actions in which a plaintiff alleges he would have sold but for a misrepresentation. Here, plaintiffs do not seek damages for the non-consummation of a hypothetical transaction but for value diminution and associated damages they suffered while holding their shares.[16]

The Court added that to apply the Blue Chip Stamps rule and permit suit by purchasers and sellers of mutual fund shares but not holders would have the “supremely ironic effect” of discriminating against those plaintiffs who suffered the greatest damage - namely, the long-term shareholders who may have purchased their shares well before the class period, but whose shares were exposed to the allegedly dilutive effect of market timing for more protracted periods of time.[17]

The Court, ultimately, was troubled that a uniform “national forum” in which “all who are similarly damaged are similarly treated” would be denied if Blue Chip Stamps were interpreted to bar the holders’ claims under federal law and force holders to seek redress in state court. Thus the Court allowed the holders’ claims to proceed at this stage of the litigation. In so doing, however, Judge Motz avoided a direct collision with Blue Chip Stamps. Rather than abrogate the purchaser-seller rule, the Court held that because plaintiffs’ claims were brought on behalf of a “mixed” class, or one comprised of both purchasers and holders, the holders’ claims were sufficiently pled with respect to standing and could proceed for the time being.[18] As the Court explained, “[p]laintiffs have asserted claims on behalf of a class that includes purchasers, as well as holders, and on that basis alone their claims survive defendants’ Blue Chip Stamps contention.”[19] Thus, while the Court was unwilling to recognize an exception to Blue Chip Stamps outright, it nonetheless refused to apply Blue Chip Stamps to dismiss the holders’ claims under the circumstances here, suggesting that strict adherence to the purchaser-seller rule would work an injustice.

Scheme Liability Claims Under Rule 10b-5(a) and (c)

Turning to the merits of the plaintiffs’ Section 10(b) and Rule 10b-5 claims, the Court denied the motions to dismiss the claims against the fund defendants. Plaintiffs alleged that the fund defendants failed to disclose that their funds allowed market timing and late trading by a select group of investors. These claims were brought pursuant to subsection (b) of Rule 10b-5 which prohibits misrepresentations and omissions of material fact.[20] Thus the Court had little trouble applying this traditional prong of Rule 10b-5 to the allegations.

Neither the trader defendants nor the broker-dealer defendants, however, were alleged to have had anything to do with the mutual fund prospectuses, nor were they alleged to have made any false statements or omissions. Therefore, the claims against the trader defendants and the broker-dealer defendants were not based on subsection (b), but rather what is known as “scheme” liability under subsections (a) and (c). Subsection (a) prohibits employment of a “device, scheme, or artifice to defraud,” while subsection (c) prohibits engaging in an “act, practice or course of business which operates or would operate as a fraud or deceit.” These subsections of Rule 10b-5 address a category of non-representation-based fraudulent conduct that is analytically distinct from the more familiar, garden-variety misrepresentations and omissions proscribed by subsection (b) of the rule.

The Rule 10b-5(a) and (c) claims in this case exemplify a growing trend by securities fraud plaintiffs to rely on the “scheme” liability prongs of the rule in an effort to evade the proscription against aiding and abetting liability recognized by the Supreme Court in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.[21] In Central Bank, the Court held that a plaintiff in a private damages action brought under Section 10(b) cannot recover against a party alleged merely to have aided and abetted another party’s violation of the statute.[22] In so holding, the Court reasoned that permitting aiding and abetting claims would allow a plaintiff to impermissibly establish a claim “without any showing that the plaintiff relied upon the aider and abettor’s statements or actions,” thereby allowing plaintiffs to circumvent the reliance requirement of Rule 10b-5.[23]

Ever since the Supreme Court barred aiding and abetting liability in Central Bank a little over a decade ago, plaintiffs have relied increasingly upon Rule 10b-5(a) and (c) to hold secondary actors accountable for their role in an alleged fraud, arguing that while these secondary actors may not themselves have made actionable representations, either by misstatement or omission, they are nevertheless liable for primary violations of Section 10(b) through their manipulative or deceptive acts.

In their motion to dismiss, the trader and broker-dealer defendants argued that, at most, plaintiffs had alleged that these outside financial institutions were aiders and abettors of the mutual funds’ fraudulent omissions, and that plaintiffs’ scheme liability claims were a thinly veiled attempt to avoid the rule of Central Bank. Plaintiffs, in response, contended that scheme liability is a valid form of primary liability under Section 10(b), and that it is enough to plead that the trader and broker-dealer defendants were part of the mutual funds’ fraudulent scheme, even if they made no misrepresentations or omissions themselves, and that such participation constituted more than mere aiding and abetting. In support of their position, plaintiffs relied heavily on District Judge Melinda Harmon’s decision in In re Enron Sec., Deriv. and ERISA Litig.[24] In Enron, the Southern District of Texas court held that a secondary actor is liable under Rule 10b-5(a) and (c) if it, acting with others, “creates a misrepresentation,” even if it does not initiate the misrepresentation, sign the document containing the misrepresentation, or disseminate the misrepresentation.[25]

In articulating a different standard for scheme liability than the standard set forth in Enron, the Court stated that for liability to attach defendants “must themselves have been co-designers of the scheme or have ‘committed a manipulative or deceptive act in furtherance of the scheme.’”[26] Judge Motz noted the lack of judicial clarity on the bounds of scheme liability, commenting that “different courts have viewed the demarcation between what constitutes a mere facilitatingact and a manipulative act somewhat differently.”[27] Ambiguity in the case law notwithstanding, the Court summarily rejected the trader defendants’ position that they were mere “secondary actors,” explaining that “the trader defendants are alleged to have been involved in the fraudulent scheme from the outset and to have been at least one of its architects.”[28] The Court added that “it is the trader defendants who received the profits that were siphoned off from the mutual funds as a result of late trades and market timed transactions. These are not the activities of a mere aider and abettor but those of a primary participant in the unlawful conduct.”[29] Accordingly, with the exception of one trader defendant, the Court denied the trader defendants’ motions to dismiss the Rule 10b-5 claims.[30]

With respect to the broker-dealer defendants, the Court remarked that they “stand in a different position” than the trader defendants.[31] As the Court explained, these defendants are not alleged to have been the “direct beneficiaries of the scheme’s proceeds,” and their “mere knowledge” that they were executing, clearing or financing market-timing and late trading on behalf of their customers is not sufficient to render them liable under Rule 10b-5; rather, something inherently “manipulative or deceptive” is required.[32] Avoiding application of any bright-line test, the Court analyzed the Rule 10b-5(a) and (c) allegations against each individual broker-dealer defendant, yielding different results.

Judge Motz found that the pleadings against several of the broker-dealers were insufficient to state claims under Rule 10b-5 (a) and (c). The Court noted that while the allegations against these financial institutions demonstrate that they may have been aiders and abetters to a market timing scheme, they do not charge that they “orchestrated the [allegedly fraudulent] scheme or committed manipulative or deceptive acts in its furtherance.”[33] Accordingly, the Court found that the fraud claims against these broker-dealers fail under Central Bank.

By contrast, the Court found that the allegations against two other broker-dealers stated claims sufficient to survive a motion to dismiss. In so holding, the Court focused on the allegations that Bank of America provided Canary - the first hedge fund to settle criminal charges with the New York Attorney General at the outset of the market timing scandal - with an electronic trading system that permitted Canary to place mutual fund trades as late as 8:30 p.m.[34] The Court also pointed to the allegations that one of the broker-dealers gave a network of brokers access to its electronic mutual funds trading system in order to place late trades and disabled the time stamp function on the system so that there was no record of when the trades were placed.[35] As the Court stated, while “mere financing or clearing of transactions, even with knowledge that they are part of a fraudulent scheme, are insufficient to subject a person to Rule 10b-5 liability under Central Bank,” the alleged acts of these broker-dealers “are ‘manipulative or deceptive’ on their face” and suggest that these institutions “participated in initiating, instigating and orchestrating the [allegedly fraudulent] scheme” - a hallmark of primary liability.[36]

Reliance: Fraud-On-The-Market Presumption Does Not Apply, But Affiliated Ute Presumption Does

The Court turned next to the element of reliance. Insofar as the only misrepresentations or omissions pled in the complaint involved the statements in the prospectuses from the mutual funds, the issue arose as to whether it would be necessary to plead that each individual plaintiff read the mutual fund prospectus and relied on its statements about market timing. In arguing that reliance was adequately pled with respect to all three groups of defendants, plaintiffs maintained that actual reliance by the shareholders need not be alleged because two judicially recognized presumptions of reliance are applicable on the facts presented: the “fraud-on-the-market” presumption recognized in Basic[37] and the presumption for omissions-based claims recognized in Affiliated Ute.[38] As discussed below, in determining whether the plaintiffs were entitled to rely upon either of these “proxies” for pleading actual reliance, the Court was confronted with arguments by the defendants that the allegations in the complaint did not fit the conventional fact patterns which typically lend themselves to application of these two frequently invoked doctrines in Rule 10b-5 cases.

First, plaintiffs argued that they were entitled to rely on the fraud-on-the-market presumption of reliance. This presumption was first recognized by the Supreme Court in Basic, where the Court reasoned that investors that buy or sell stock at the price set by the market do so “in reliance on the integrity of that price,” and that because all publicly available information has been reflected in that price, “an investor’s reliance on any public material misrepresentations . . . may be presumed for purposes of a Rule 10b-5 action.”[39] Importantly, however, the Basic Court emphasized that application of the fraud-on-the-market presumption is not mechanical and may be rebutted by “[a]ny showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price.”[40] For example, when a plaintiff fails to plead the existence of an efficient and developed market for the relevant security, the plaintiff is not entitled to the presumption and must allege actual reliance.[41]

Judge Motz quickly disposed of plaintiffs’ fraud-on-the market contention. The defendants argued that application of the Basic presumption made no sense in the case of mutual fund shares because fraud-on-the-market reliance may be presumed only when there is a clear connection between the alleged fraud and the market price of the security paid or received by the plaintiff. In the case of mutual fund shares, defendants maintained, the share price, or NAV, is a mathematical composite of the prices of the fund’s underlying securities and is generally unaffected by information in the marketplace about the fund itself. Persuaded by this argument, the Court held that plaintiffs could not avail themselves of the fraud-on-the-market presumption:

The difficulty with [plaintiffs’] contention is that the fraud on the market theory is based upon the proposition that material misrepresentations or failures to disclose material facts will result in inflated prices. Here, the effect of late trading and market timing was to depress share value. Moreover, the fraud on the market theory focuses on the point of sale whereas plaintiffs’ damage theory concentrates on the dilution of share value over time.[42]

Alternatively, plaintiffs invoked the doctrine of Affiliated Ute to evade the requirement of pleading actual reliance. In Affiliated Ute, the Supreme Court held that in Rule 10b-5 cases premised on omissions by a defendant owing a fiduciary duty of full disclosure to the plaintiff, “positive proof of reliance is not a prerequisite to recovery”; rather, all that is required is that the facts withheld by the defendant are material.[43] Applying this principle, Judge Motz reasoned that a potential mutual fund investor “might have considered it important to know whether (and to what extent) favored investors were being allowed to late trade in light of the fact that toleration of the practice could increase fund expenses and have a substantial effect upon future fund performance.”[44]

Significantly, the Court rejected defendants’ position that plaintiffs’ claims were not pure omissions claims because plaintiffs had also alleged that the fund defendants made several affirmative misrepresentations in their prospectuses, including statements that Janus enforces an excessive trading policy aimed at market timers and does not accept trades placed after 4:00 p.m. The Court noted that while “at a certain level of generalization” the Affiliated Ute presumption of reliance does not apply when a plaintiff alleges both omissions and affirmative misstatements, or so-called “mixed” claims, “a moreprecise and accurate statement of the rule is that the presumption applies only where a plaintiff’s claim is primarily based upon material omissions.”[45] Judge Motz concluded that the gravamen of the complaint is the fund defendants’ failure to disclose that they were permitting a select handful of investors to engage in market timing and late trading in violation of their fiduciary duties to their shareholders, thereby triggering application of the Affiliated Ute presumption.

Notably, the Court found the presumption to apply as to the claims against the trader and broker-dealer defendants as well, notwithstanding that these defendants had no direct relationship with the plaintiffs, let alone a fiduciary relationship giving rise to duties of disclosure. In rejecting the trader and broker-dealer defendants’ argument that they, unlike the fund defendants, said or did nothing upon which plaintiffs could have justifiably relied, Judge Motz invoked Central Bank: “Because Central Bank and its progeny recognize that a person other than a defendant with whom the plaintiff directly dealt may be held liable under Rule 10b-5, it necessarily follows that a person who is a principal, and not merely an aider and abettor, in a fraudulent scheme can be held responsible for his own acts committed in connection with a scheme founded on misrepresentations and omissions.”[46]

This articulation of the reliance element in the Rule 10b-5(a) and (c) context, however, is difficult to reconcile with the Supreme Court’s chief concern in Central Bank that by recognizing aiding and abetting liability, a “defendant could be liable without any showing that the plaintiff relied upon the aider and abettor’s statements or actions,” thereby circumventing an established element of Section 10(b) fraud.[47] Viewing the issue through the lens of this statement by the Supreme Court, Judge Motz’s reliance analysis appears more of a departure from - rather than an adherence to - the ­ critical reasoning of Central Bank that aiding and abetting liability is fundamentally inconsistent with the requirement of direct reliance.

Conclusion

The distinctive character of market timing and late trading - activities which up until now have been virtually unexplored by the courts - required the Court in In re Mutual Funds Investment Litig. to revisit the contours of several judicial doctrines construing Rule 10b-5 and to apply them in an unfamiliar context. The Court’s holdings with respect to standing for non-purchasers and non-sellers, the reach of scheme liability under Rule 10b-5(a) and (c) and presumptions of actual reliance are significant and can be expected to influence not only the emerging jurisprudence of mutual fund market timing, but application of the securities laws in general.

*  *  *

  1. The other judges sitting on this panel are Judge Catherine C. Blake and Andre M. Davis of the District of Maryland.
  2. 421 U.S. 723 (1975).
  3. 511 U.S. 164 (1994).
  4. 485 U.S. 224 (1988).
  5. 406 U.S. 128 (1972).
  6. Indeed, during the class period, at least one SEC Administrative Law Judge expressly stated in proceedings involving market timing that “[m]arket timing of mutual fund purchases and sales does not violate federal securities laws.” In re Flanagan, Rel. No. ID-160, 2000 WL 98210, at *5 (SEC Jan. 31, 2000) (emphasis added); see also In re Market Timing Sys. Inc., Rel. No. IA-2048, 2002 WL 1979381, at **1-2 (SEC Aug. 28, 2002) (in a case relating generally to the mutual fund market timing business, providing no indication that market timing practices could be considered in any way fraudulent or improper); First Lincoln Holdings, Inc. v. Equitable Life Assur. Soc’y of U.S., 164 F. Supp. 2d 383, 391 n.9 (S.D.N.Y. 2001) (noting that market timing “is not illegal”), aff’d, 43 Fed. Appx. 462 (2d Cir. 2002).
  7. 384 F. Supp. 2d at 856.
  8. See id. at 854.
  9. The Janus plaintiffs’ consolidated complaint names nineteen defendants. The fund defendants include Janus Capital Group, Inc., Janus Capital Management LLC, Janus Distributors LLC, Janus Investment Fund, and Janus Adviser Series. The trader defendants include Canary Capital Partners, LLC, Canary Capital Partners, Ltd. (collectively, “Canary”), Edward J. Stern, Gregory Trautman, Trautman Wasserman & Co., Rydex Investments, Round Hill Securities, Inc. and Canadian Imperial Bank of Commerce. The broker-dealer defendants include Bank of America Corp. (“Bank of America”), Bear, Stearns & Co. (“Bear Stearns”), CIBC, AST Trust Co., Prudential Securities, Inc. and Wachovia Securities, LLC.
  10. 421 U.S. 723.
  11. Id. at 740.
  12. Id.
  13. Id. at 747.
  14. 384 F. Supp. 2d at 854.
  15. Id. (“A court-made rule that is created in one context to implement a fundamental precept should not be mechanically applied in a new context without asking the threshold question whether the same principled considerations that gave rise to the rule dictate a different rule under different circumstances.”).
  16. Id.
  17. Id. at 854 n.6.
  18. The Court’s opinion leaves open the possibility that it will revisit the issue of the holders’ standing at a later stage of the litigation, perhaps at the class certification stage or the damages stage.
  19. Id. at 855. The Court further noted that because many of the mutual fund shareholders likely participated in dividend reinvestment programs, it is probable that many plaintiffs who purchased their shares prior to the class period nevertheless fall within a class of purchasers during the class period. See id.
  20. Rule 10b-5(b) makes it “unlawful for any person . . . to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which they were made, not misleading . . .”
  21. 511 U.S. 164, 188 (1994).
  22. Id. The Court in Central Bank noted that Congress could have expanded Section 10(b) liability to aiders and abettors, but chose not to do so. Id. at 176-77, 191.
  23. Id. at 180. The Court further cautioned that, unless precluded, the boundless and “unclear” limits of aiding and abetting liability could lead to inconsistent results “in ‘an area that demands certainty and predictability.’” Id. at 188 (quoting Pinter v. Dahl, 486 U.S. 622, 652 (1988)).
  24. 235 F. Supp. 2d 549, 692 (S.D. Tex. 2002).
  25. Id. The so-called “creator” test employed by Judge Harmon was proposed originally by the SEC in an amicus brief filed in 1998. The SEC’s amicus brief submitted in Enron was initially written for the Third Circuit Court of Appeals’ en banc review in Klein v. Boyd, 1998 WL 55245 (3d. Cir. 1998), rehearing en banc granted, judgment vacated (Mar. 9, 1998). Klein settled before the en banc panel could hear the case. See Brief of the SEC, Amicus Curiae, Klein v. Boyd, Nos. 97-143, 97-1261 (3d Cir. 1998).
  26. 384 F. Supp. 2d at 858 (quoting Cooper v. Pickett, 137 F.3d 616, 624 (9th Cir. 1997)).
  27. See id. One explanationfor the dearth of judicial precedent in this area is that prior to Central Bank, subsections (a) and (c) of Rule 10b-5 were rarely, if ever, invoked by plaintiffs. The reason for this, as one District Judge has recently surmised, is that during the pre-Central Bank era of aiding and abetting liability, the “path of least resistance” for a plaintiff alleging a fraud involving multiple actors was to plead that one defendant misrepresented or omitted a material fact and that the other defendants aided and abetted the making of that misrepresentation or omission. In re Parmalat Sec. Litig., 376 F. Supp. 2d 472, 497 (S.D.N.Y. 2005) (Kaplan, J.). Thus, before Central Bank, litigants and courts alike paid little attention to the distinction between the misconduct prohibited by subsection (b) - i.e., misstatements and omissions - and the less recognizable misconduct prohibited by subsections (a) and (c). To see how some courts have addressed Rule 10b-5(a) and (c) claims in recent decisions, see, e.g., In re Lernout & Hauspie Sec. Litig., 236 F. Supp. 2d 161, 173 (D. Mass. 2003) (denying motion to dismiss Rule 10b-5(a) and (c) claims against venture capital fund for funding and operating sham entities used by issuer to record revenue from bogus licensing contracts: “The better reading of § 10(b) and Rule l0b-5 is that they impose primary liability on any person who substantially participates in a manipulative or deceptive scheme by directly or indirectly employing a manipulative or deceptive device (like the creation or financing of a sham entity) intended to mislead investors, even if a material misstatement by another person creates the nexus between the scheme and the securities market.”); In re Homestore.com Sec. Litig., 252 F. Supp. 2d 1018 (C.D. Cal. 2003) (granting motion to dismiss Rule 10b-5(a) and (c) claims against business partners of principal defendant Homestore based on scheme to inflate Homestore’s revenues through a series of sham transactions: “No matter how a ‘scheme’ is defined, Central Bank dictates that only those participants who commit ‘primary violations’ of the securities laws may be held liable; those who merely facilitate or participate cannot . . . . [P]laintiff suffered damages through its reliance on [Homestore’s] false or misleading statements, not from the ‘scheme’ itself. . . . The principal ‘wrong’ alleged under the rule is the statement, not the scheme.”); In re Global Crossing, Ltd. Sec. Litig., 322 F. Supp. 2d 319, 335-37 (S.D.N.Y. 2004) (finding primary violation sufficiently alleged when defendant-auditor allegedly “masterminded” sham transactions and other misleading accounting practices and played a “central role in the [ ] schemes, as their chief architect and executor”: “It is apparent from Rule 10b-5’s language and the case law interpreting it that a cause of action exists under subsections (a) and (c) for behavior that constitutes participation in a fraudulent scheme, even absent a fraudulent statement by the defendant . . . .”) (emphasis added).
  28. Id. at 857.
  29. Id. at 857-58.
  30. The Court granted CIBC’s motion to dismiss the Rule 10b-5 claim on the ground that plaintiffs failed to plead CIBC’s alleged role as a trader with the requisite particularity under Rule 9(b) of the Federal Rules of Civil Procedure and the Private Securities Litigation Reform Act (“PSLRA”). See id. at 858 n.12.
  31. See id. at 858.
  32. Id.
  33. Id. at 859-860.
  34. See id. at 860.
  35. See id. at 860-861.
  36. Id. at 862.
  37. 485 U.S. 224.
  38. 406 U.S. 128.
  39. Id. at 247.
  40. Id. at 248.
  41. See id.; see also, e.g., Freeman v. Laventhol & Horwath, 915 F.2d 193, 198-99 (6th Cir. 1990) (presumption did not apply because market for newly issued tax-exempt municipal bonds was not efficient); Binder v. Gillespie, 184 F.3d 1059, 1064 (9th Cir. 1999) (presumption did not apply because of inefficient market (decertifying class)); Krogman v. Sterritt, 202 F.R.D. 467, 474-78 (N.D. Tex. 2001) (presumption did not apply because OTC Bulletin Board was not an efficient market).
  42. 384 F. Supp. 2d at 863 n.17.
  43. Affiliated Ute, 406 U.S. at 153-54.
  44. 384 F. Supp. 2d at 863.
  45. Id. at 863-64 (emphasis in original).
  46. Id. at 862.
  47. Central Bank, 511 U.S. at 180.
   
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