Partners in crime: Enron and WorldCom couldn't have happened without the help of accountants, bankers, and lawyers. After a decade of lax regulation and laissez-faire court decisions, these secondary actors are facing harsher scrutiny.

Wall Street has been rocked by a series of accounting scandals that have taken a staggering toll on the economy and investors' pocketbooks. According to one study, recent corporate malfeasance has cost Americans more than $200 billion in lost investment savings, jobs, pension funds, and tax revenue. (1)

These enormous losses, however, tell only part of the story. Many investors have lost faith in the integrity of U.S. equity markets. Many more lack confidence in the accuracy of financial reporting. This loss of trust, although not easy to quantify, could ultimately cost the U.S. economy billions of dollars in lost revenues, profits, exports, and jobs.

The factors that have led to the current spate of mega-fraud cases are complex. But even as investors and regulators continue to sift through the rubble of Enron, WorldCom, Global Crossing, and dozens of other high-profile accounting cases, one factor has emerged as a primary culprit: the relative ease with which dishonest corporate executives enlisted the support of accountants, lawyers, bankers, financial advisers, and others in devising shady business transactions and falsifying the finances of large, publicly traded companies. To paraphrase Hillary Rodham Clinton, it takes a village to commit securities fraud. In the case of Enron and WorldCom, it took a virtual metropolis.

Breakdown of corporate governance 

Why have so many accountants, bankers, and lawyers abandoned their ethical, if not legal, obligations and helped corporate clients engage in wrongdoing? Why have so many become "enablers" of securities fraud rather than watchdogs and whistleblowers?

The answer is that beginning in the early 1990s, a number of events had the combined effect of greatly reducing the liability exposure of accountants, lawyers, bankers, and other secondary actors under federal securities law. In 1990, the Seventh Circuit ruled in DiLeo v. Ernst & Young--a securities case arising from the collapse of Continental Illinois Bank--that it was "irrational" to assume that an accounting firm would risk its reputation by aiding a client's fraud, since the accountant stood to gain nothing but relatively nominal audit fees. (2) The court stated, "An accountant's greatest asset is its reputation for honesty, followed closely by its reputation for careful work. Fees for two years' audits could not approach the losses [the accountant] would suffer from a perception that it would muffle a client's fraud." (3) DiLeo heavily influenced judicial thinking throughout the 1990s, with many courts adopting its logic in dismissing accounting firms from securities cases, at both the pleading and summary judgment stages.

In 1991, the Supreme Court's Lampf v. Gilbertson decision drastically shortened the statute of limitations for securities fraud claims--also known as Rule 10b-5 claims--to one year from the date of discovery of the facts constituting the violation, but in no event more than three years after the violation. (4) Three years later, the Court handed down its decision in Central Bank of Denver v. First Interstate Bank of Denver, eliminating aiding and abetting as a basis for liability. (5) This decision was a watershed event that underscored the 1990s trend toward reduced legal accountability of secondary actors in securities fraud cases. Following Central Bank, many courts concluded that even if a plaintiff could show that an accountant or lawyer knowingly and substantially assisted a fraud, there would nevertheless be no basis for liability unless the defendant was actually involved in making a false or misleading statement.

Following heavy lobbying by the accounting industry, Congress passed the Private Securities Litigation Reform Act (PSLRA) in 1995 over President Clinton's veto. The act drastically reshaped the securities litigation landscape, erecting barriers that made it even more difficult to plead and prove liability against accountants, lawyers, and other secondary actors. Among other things, the PSLRA created stricter pleading standards for securities fraud claims, adopted broad protections for projections and forecasts, and eliminated joint and several liability in favor of proportionate-fault liability. (6)

At the same time that accountants, lawyers, bankers, and advisers began enjoying diminished liability, corporate managers became increasingly motivated to put the best possible gloss on their companies' reported finances, sometimes committing fraud to do so. A significant incentive to cheat was the tremendous growth of stock options as a primary component of executive compensation. Another trend that undermined the accuracy of financial reporting was the growing importance of consulting fees to the bottom line profits of large public accounting firms. Throughout the 1990s, these firms became increasingly dependent on the sale of consulting services to enhance their revenues and profits, with audit and accounting services becoming largely a commodity business. The desire to protect lucrative consulting fees compromised outside accountants' independence and weakened their resolve to challenge corporate clients on questionable and risky accounting practices.

Rethinking secondary-actor liability

In the wake of Enron and other major accounting scandals, courts are confronting the catastrophic breakdown of corporate governance and investor protection. Repudiating the logical underpinnings of DiLeo and its progeny, and tacitly acknowledging the ruinous consequences caused by diminished risk to secondary actors, courts are now rethinking the degree to which accountants, lawyers, bankers, and financial advisers should be held legally responsible for their role in corporate fraud. Recent developments indicate that the pendulum is swinging back toward greater accountability.

To state a securities fraud claim under [section] 10(b) of the Securities Exchange Act of 1934 (7) and Securities and Exchange Corn mission (SEC) Rule 10b-5 promulgated under the act, (8) a plaintiff must make several allegations related to the purchase or sale of securities: He or she must claim a misstatement or omission of a material fact, made with scienter--that is, the "intent to deceive, manipulate, or defraud" (9)--on which the plaintiff relied and which proximately caused the plaintiff's injury. (10) Under Rule 10b-5, liability is not limited to untrue statements or omissions. The rule also for bids the use, "in connection with the purchase or sale of any security," of "any device, scheme, or artifice to defraud" or any other "act, practice, or course of business" that "operates ... as a fraud or deceit." (11)

On December 20, 2002, Judge Melinda Harmon issued her opinion on motions to dismiss filed by various secondary-actor defendants in the Enron class action pending in the U.S. District Court for the Southern District of Texas. (12) The decision gives a detailed analysis of Central Bank and the applicable standards for pleading primary liability under Rule 10b-5 against secondary actors. Harmon denied motions to dismiss, which had been filed by Enron's former accounting finn, Arthur Andersen, eight investment banks and brokerage firms that had provided financing and other services to Enron (including Citigroup Inc., J.P. Morgan Chase & Co., and Merrill Lynch & Co.), and Enron's former chief outside law firm, Vinson & Elkins of Houston. The court was careful not to tread on Central Bank's prohibition against aiding-and-abetting liability, and observed that the Supreme Court had left it to lower courts to determine the circumstances under which a secondary actor's conduct might constitute a primary Rule 10b-5 violation.

The Enron court detailed two divergent approaches that courts adopted following CentralBank. One view uses a strict "bright line" test, which requires that a secondary actor not only make the challenged misstatement, but also that the misstatement be publicly attributable to the actor at the time it is made or broadcast. (13) The other approach places liability on a secondary actor who has "substantial participation or intricate involvement" in issuing false public statements, even if "that participation might not lead to the actor's actual making of the statements." (14)

The Enron court rejected the strict "bright line" approach and adopted a more expansive test at the urging of the SEC: "When a person, acting alone or with others, creates a misrepresentation [on which the investor-plaintiffs relied], the person can be held liable as a primary violator if he acts with the requisite scienter." (15) Under this test, a secondary actor can be held liable as a cocreator of a misstatement, even if someone else initiated the misrepresentation.

More significant, this test permits a claim for Rule 10b-5 liability against a secondary actor even if the actor is not publicly identified or associated with the misrepresentation. (16) In this regard, the test adopted by the Enron court represents a significant departure from the "bright line" test and a potential broadening of liability against accountants, lawyers, bankers, and other secondary players.

Liability for a scheme, device, or artifice to defraud

As the Enron court noted, Rule 10b-5 liability against secondary actors is not limited to those who make false statements or omit important facts. Liability also extends to those who employ a scheme, device, or artifice to defraud. (17)

The Enron court's analysis on this point relied heavily on the Supreme Court's recent decision in Securities and Exchange Commission v. Zandford, which confirmed that liability applies in cases not based on misstatements or omissions of material facts. (18)

The Court held that allegations of a stockbroker's "continuous series of unauthorized sales of securities" and improper retention of the proceeds constituted a fraudulent scheme in violation of Rule 10b5. (19) The Court observed that "neither the SEC nor this Court has ever held that there must be a misrepresentation about the value of a particular security in order to run afoul of the [Securities Exchange] Act." (20)

Even Central Bank recognized that liability can attach to secondary actors who allegedly use a manipulative device:

   The absence of [section] 10(b) aiding-and-abetting
   liability does not mean that secondary actors
   in the securities markets are always free from
   liability under the securities acts. Any person
   or entity, including a lawyer, accountant, or
   bank, who employs a manipulative device or
   makes a material misstatement (or omission)
   on which a purchaser or seller of securities
   relies may be liable as a primary violator
   under 10b-5, assuming all of the requirements
   for primary liability under Rule
   10b-5 are met.... In any complex securities
   fraud, moreover, there are likely to be multiple
   violators. (21)

The Enron court significantly expanded on this point, making it clear that a group of defendants who act together to violate federal securities laws can be held liable as primary violators, as long as each is alleged to have committed a manipulative or deceptive act in furtherance of the scheme. Thus, if a plaintiff meets the requirements of pleading primary liability as to each defendant--that is, alleges with factual specificity a misstatement or omission, a manipulative or deceptive act to defraud, scienter, and reliance on the information--he or she can plead a primary violation of Rule 10b-5 against each defendant and still satisfy Central Bank. (22)

Applying these standards, the Enron court held that the allegations regarding the intricate involvement of Enron's accounting firm, outside lawyers, banks, and financial advisers in devising and financing methods that allowed the company to conceal its debt, unlawfully maintain its credit rating, and falsify its publicly reported financial condition were sufficient to meet the standards for pleading primary liability under Rule 10b-5.

Defective reviews of financial statements

The Enron decision and other recent developments make it likely that accountants will face Rule 10b-5 liability for false statements or omissions in unaudited financial statements that they review. Previously, many courts had refused to hold accountants liable for botched reviews because, in the absence of an audit report, the accountant could not be said to have "made" a statement. Thus, under Central Bank, he or she could not be liable as a primary violator. (23) However, in light of Zandford and Enron, accountants now are potentially liable for reviews of interim financial statements that are determined later to be materially false and misleading.

Under SEC rules, accountants are obligated to review quarterly financial statements. These statements are included in Form 10-Q and 10-K reports, which publicly traded corporations must file with the SEC. (24) The accountant must confirm that the quarterly financial statements adhere to Generally Accepted Accounting Principles (GAAP) (25) and make required disclosures. (26) The SEC rules mandate that the accountant employ "professional standards and procedures for conducting such reviews." (27) These procedures include tracing financial statement amounts to the general ledger and other records, inquiring into the adequacy of internal controls, considering fraud risk factors, and performing analytical reviews. (28)

When viewed against the backdrop of Zandford and Enron, these affirmative reporting and disclosure obligations suggest that accountants will no longer be able to escape liability for failure to properly review interim statements or disclose materially false and misleading statements.

As the Supreme Court stated in Zandford, the provisions of the Securities Exchange Act of 1934 must be "construed not technically and restrictively, but flexibly" to effectuate their remedial purposes. (29)

As trial courts confront the post-Enron world, with the task of helping to rebuild investor confidence and ensuring the integrity of markets, it now appears increasingly likely that accountants, lawyers, advisers, bankers, and others who help perpetrate fraud on the investing public will be held accountable.

Notes

(1.) NO MORE ENRONS COALITION, THE COST OF CORPORATE RECKLESSNESS (2002), available at www.americanfamilyvoices.org/pdf /costofcorporaterecklessnessreportfinal.pdf.

(2.) 901 F.2d 624, 629 (7th Cir. 1990).

(3.) Id.

(4.) 501 U.S. 350, 364 (1991).

(5.) 511 U.S. 164, 191 (1994).

(6.) Pub. L. No. 104-67, [subsection] 27(a)(2)(A), 27A(c), 201(g)(2), 109 Stat. 737, 738, 750, 758-59 (1995).

(7.) 15 U.S.C. [section] 78(j)(b).

(8.) 17 C.F.R. [section] 240.10b-5.

(9.) Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976).

(10.) Abrams v. Baker Hughes, Inc., 292 F.3d 424, 430 (5th Cir. 2002).

(11.) 17 C.F.R. [section] 240.10b-5 (2002).

(12.) In re Enron Corp. Sec., Derivative & ERISA Litig., 235 F. Supp. 2d 549 (S.D. Tex. 2002).

(13.) Wright v. Ernst & Young, 152 F.3d 169, 175 (2d Cir. 1998), cert. denied, 525 U.S. 1104 (1999).

(14.) In re Software Toolworks, 50 F.3d 615, 628 n.3 (9th Cir. 1994); Adam v. Silicon Valley Bancshares, 884 F. Supp. 1398, 1401 (N.D. Cal. 1995); In re ZZZZ Best Sec. Litig., 864 F. Supp. 960, 970 (C.D. Cal. 1994); Cashman v. Coopers & Lybrand, 877 F. Supp. 425, 432 (N.D. Ill. 1995).

(15.) In re Enron Corp., 235 F. Supp. 2d 549, 588, 692.

(16.) Id. at 586-88.

(17.) See 15 U.S.C. [section] 78j(b); 17 C.F.R. [section] 240.10b-5.

(18.) 122 S. Ct. 1899 (2002).

(19.) Id. at 1903.

(20.) Id. at 1906.

(21.) Central Bank, 511 U.S. 164, 191.

(22.) In re Enron Corp., 235 F. Supp. 2d 549, 592.

(23.) In re Kendall Square Research Corp. Sec. Litig., 868 F. Supp. 26, 28 (D. Mass. 1994). (24.) 17 C.F.R. [section] 210.10-01(d).

(25.) AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS, INTERIM FINANCIAL INFORMATION, STATEMENT ON AUDITING STANDARDS No. 71 (1992).

(26.) 17 C.F.R. [section] 210.10-01(a).

(27.) 17C.F.R. [section] 210.10-01(a).

(28.) AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS, PRACTICE ALERT 2000-4, QUARTERLY REVIEW PROCEDURES FOR PUBLIC COMPANIES (2000).

(29.) 122 S. Ct. 1899, 1903.

Steven O. Sidener is a partner with Gold Bennett Cera & Sidener in San Francisco.