Printer Friendly

Slouching towards Monell: the disappearance of vicarious liability under section 10(b).

Abstract

Liability under section 10(b) of the Securities Exchange Act is one of the primary mechanisms for enforcing the federal securities laws. Section 10(b), however, prohibits only intentional or reckless deception, and there has never been consensus as to how to determine whether an organization, rather than a natural person, harbors the relevant mens rea. Traditionally, organizational liability under federal law is determined according to agency principles, and most courts pay lip service to the notion that agency principles govern under section 10(b). As this Article demonstrates, they do not.

Many section 10(b) actions involve "open-market"frauds, whereby the allegedly fraudulent statements are issued publicly under the corporate imprimatur. These statements depend on agents operating at all levels of the company, who may intentionally or recklessly pass along inaccurate information through corporate reporting channels. In such circumstances, the actus reus that forms the basis of the section 10(b) violation--the false public statement--has been disaggregated from the actor who harbors mens rea. As this Article shows, courts have used this disaggregation to eschew the agency principles applied in other areas of law. Courts instead seek to impose a form of "direct" organizational liability tied to the actions and omissions of the organization's highest-level authorities. This regime is, in practical effect, strikingly similar to the regime used to determine the liability of local governments under [section] 1983, where vicarious liability has been formally rejected by the Supreme Court.

Though these two statutes would seem to have little in common, this Article argues that vicarious liability has been rejected under both regimes for similar policy reasons. Among other things, as federal corporate disclosure requirements--backed by the threat of section 10(b) liability--expand into a mechanism for substantively regulating the quality of corporate governance (a matter traditionally left to state law), courts have pushed back by limiting vicarious liability in order to distinguish "true "fraud claims from garden-variety mismanagement. Similarly, in the [section] 1983 context, the elimination of vicarious municipal liability functions, as a practical matter, to distinguish matters of federal constitutional concern from ordinary state law torts.

This Article ultimately concludes that, despite the criticisms that have been leveled at the current approaches to organizational liability under [section] 1983, [section] 1983 doctrine may in fact improve jurisprudence under section 10(b). Courts considering section 10(b) claims may borrow from jurisprudence developed under [section] 1983 to formulate objective standards of fault, in order to prevent high-level corporate authorities from insulating themselves from knowledge of wrongdoing at lower levels of the corporate hierarchy.
TABLE OF CONTENTS

INTRODUCTION
  I. ORGANIZATIONAL LIABILITY UNDER FEDERAL LAW
 II. THE DIFFERENT RULES APPLICABLE TO [section] 10(B)
      A. Courts Resist Application of Agency Principles in Open
         Market Section 10(b) Cases
      B. The Supreme Court Affirms that Section 10(b) Is Different
      C. Why the Difference?
         1. Many Instrumental Justifications for Vicarious
            Liability Do Not Apply to Section 10(b) Open-Market
            Claims
         2. Section 10(b) Has Taken on a More Expressive Role
         3. Distinguishing Poor Corporate Governance from
            Fraud
         4. The Puzzle of Secondary Actors
III. SECTION 10(B) AND DIRECT ORGANIZATIONAL LIABILITY
      A. Organizational Liability Under [section]
      B. Section 10(b) and [section] 1983: Similar Means to Similar Ends
 IV. MONELL AS APPLIED TO SECTION 10(B)--IMPLICATIONS AND
      PROBLEMS
      A. The Scope of the Final Authority Rule
      B. The Role of "Deliberate Indifference
CONCLUSION


INTRODUCTION

Securities fraud liability--and in particular, liability under section 10(b) of the Securities Exchange Act of 1934 (1)--is one of the primary mechanisms for enforcing the disclosure obligations imposed upon publicly traded corporations under the federal securities laws. Nonetheless, despite the long history of securities fraud litigation under section 10(b), courts have yet to announce a uniform standard for determining liability when the defendant is an organization. The sticking point is organizational mens rea: Professor Donald Langevoort recently described corporate scienter as "one of the greatly under-theorized subjects in all of securities litigation" (2)

Yet despite courts' failure to formally endorse a coherent standard for attributing mens rea to an organization, this Article demonstrates that the situation is less indeterminate than has been previously acknowledged. It turns out that when evaluating section 10(b) claims, courts increasingly seek to identify organizational "fault" in a manner that is strikingly similar to the regime that is used to determine the liability of local governments under the Civil Rights Act of 1871, 42 U.S.C. [section] 1983. Though these two statutes would seem to have little in common, and the case law under each has developed independently of the other, this Article shows that similar policy considerations have driven courts to eschew vicarious liability in both contexts, in favor of developing a form of "direct" organizational liability tied to the actions and omissions of the organization's highest-level authorities.

The story begins with the changing nature of the section 10(b) cause of action. The statute prohibits any person from engaging in manipulative or deceptive conduct in connection with securities transactions, (3) and requires proof that the defendant acted with "scienter"--either an "intent to deceive, manipulate, or defraud," (4) or reckless indifference to the "'danger of misleading buyers or sellers'" (5) Because the Exchange Act explicitly provides that organizations, as well as natural persons, can violate section 10(b), (6) courts must create rules for determining the "scienter" of an organizational defendant.

Traditionally, under federal law, mens rea is imputed to organizations via agency principles, such as respondeat superior. Because the earliest claims against organizational defendants under section 10(b) involved face-to-face frauds--corrupt brokers, for example, were common--they presented easy cases. (7) The fraudster, acting in his capacity as an employee, personally violated section 10(b), justifying strict liability for his employer. Over time, however, brokerage claims moved out of public view and into arbitration. (8) Simultaneously, courts began to entertain cases involving "open-market" frauds, whereby a publicly traded corporation is alleged to have issued false statements about the quality of its business. In such circumstances, courts would presume that the false statements affected the market price of the corporation's securities, thereby damaging investors who had traded at that price. (9) This legal theory, known as the fraud-on-the-market doctrine, left the corporation potentially liable to the entire marketplace of traders. It also radically altered the nature of the section 10(b) action with two significant consequences.

First, it allowed for disaggregation between the employee who committed the actus reus--the corporate official who issued the false statement--and the employee harboring the mens rea. This necessarily presented the question of which actors' mental states could be imputed to the corporation. Statements issued under the corporate imprimatur often have multiple anonymous authors, and include information supplied by employees scattered throughout the company. Any of these employees, or combinations of them, or business segments, may intentionally filter false information up through corporate reporting channels without the knowledge of the top officers.

Second, the extension of liability to open-market frauds exponentially expanded the number of potential plaintiffs damaged by a single fraudulent act, and the fraud-on-the-market doctrine facilitated the certification of classes of those plaintiffs, thus dramatically increasing corporations' damages exposure. With this change, the purpose of the section 10(b) was transformed. No longer is "compensation" for defrauded investors a realistic or achievable goal; (10) instead, section 10(b) actions--at least those based on open-market purchases--are now justified as a deterrent mechanism to protect the integrity of corporate communications. (11) But this justification extends section 10(b) far beyond the mere confines of fraud prevention, because corporate communications today serve broader purposes. Disclosure enhances internal corporate governance by, among other things, enforcing a duty of care on corporate managers and facilitating shareholders' ability to monitor managers' conduct. (12) Disclosure also has macroeconomic effects: Regulators make policy based on their understanding of how businesses operate; lenders extend credit based on their perception of the stability of the borrower; competitors change business strategies based on reports of their rivals; symbiotic industries make business plans based on their expectations of future dealings with customers and suppliers; employees choose where to invest their skills based on perceived demand. (13) All of these areas of economic activity depend on the accuracy and reliability of public corporate communications, yet the persons and institutions affected have few, if any, avenues for relief when those communications prove false. Thus, the securities laws--and in particular, the private section 10(b) cause of action--bear the practical responsibility of protecting these varied interests, despite the rather distant relationship between section 10(b) plaintiffs and the wide variety of persons injured by false public statements.

As a result, section 10(b) has shifted from a mechanism for making defrauded investors whole to a mechanism for representing the varied concerns that animate securities regulation more generally. In other words, the action itself is now less akin to a "private" law tort action, and more akin to "public" law, serving purposes associated with criminal, or at least regulatory, enforcement. Shareholder lawsuits do more than protect investors or even markets; they also act as a quasi-public mechanism for enforcement of societal norms. (14)

Commentators have previously argued that vicarious liability principles should not be used to determine organizational liability for section 10(b) open-market frauds. The usual claim is that for open-market frauds--where a corporation issues false statements about its business, but does not trade in its own securities--the corporation itself gains no benefit. It does not earn any profits from the fraud, nor is it spared any expenses. The only persons affected are secondary market traders who transact at the distorted market price, some of whom will gain by the fraud, and others of whom will lose. As a result, the usual instrumental justifications for vicarious liability do not apply. (15)

What has been largely overlooked, however, is that courts--sensitive to the transformation in the nature of the section 10(b) action--have already limited the application of vicarious liability. Aware that the justifications for vicarious liability no longer fit the modern section 10(b) cause of action, courts have used the disaggregation of actus reus from mens rea commonly exhibited in fraud-on-the-market cases as a lever to decouple corporate liability from misconduct that originates from lower level employees. Instead, courts are increasingly moving toward a doctrine of organizational fault that resembles, both in application and policy justification, the organizational liability doctrine that governs suits for civil rights violations under 42 U.S.C. [section] 1983. This form of liability, which the Supreme Court has deemed "direct," rather than "vicarious," only allows organizations to be held responsible for torts committed pursuant to official policies, actually or constructively adopted by the highest-level officials. This narrowed form of liability has been a feature of the section 10(b) case law ever since open-market frauds began to dominate the landscape, and has only accelerated with two recent Supreme Court decisions that dramatically narrowed the scope of the private section 10(b) action.

This interpretation of section 10(b) jurisprudence carries with it several important implications. First, courts should explicitly acknowledge that they are no longer applying vicarious liability principles to section 10(b) open-market frauds. This will free courts to reconcile conflicting strands in the case law and set clearer guidelines for organizational liability.

Second, courts considering section 10(b) claims may be informed by jurisprudence developed under [section] 1983, which (though subject to its own extensive criticism) at least includes standards for determining organizational fault in the absence of subjective mens rea of higher level authorities. Courts have failed to set such standards under section 10(b), focusing their attention on the mental states at the top of the corporate hierarchy, while simultaneously failing to clarity which mental states are sufficient to trigger organizational liability. Unless courts identity a form of organizational fault that does not depend on the subjective, provable mens rea of a corporation's top officers, corporate managers will be incentivized to tacitly encourage fraudulent behavior by their subordinates while maintaining plausible deniability of that behavior. And because the Supreme Court's recent jurisprudence essentially immunizes those subordinates from personal section 10(b) liability, they will have little reason to resist supervisory encouragement. This would represent a "worst of all worlds" scenario, resulting in increased levels of fraud and corporate misconduct. But by taking lessons from [section] 1983, courts entertaining section 10(b) claims may be able to formulate "gap-fillers" to prevent high-level authorities from insulating themselves from knowledge of lower level wrongdoing.

Third, because courts' changing approach to organizational liability is tied to the development of the fraud-on-the-market doctrine, this Article recommends that if that doctrine is pared back or eliminated--as scholars continuously advise (16)--courts should restore the ordinary agency rules for determining organizational liability. In the absence of fraud on the market, the section 10(b) action would more closely resemble the common law tort of deceit, and the traditional justifications for vicarious liability would once again counsel in favor of the application of agency principles.

Finally, and perhaps most importantly, Congress and the Securities Exchange Commission ("SEC") must make a determination as to the purposes that section 10(b) is designed to serve. As this Article argues, part of the reason for courts' discomfort with vicarious liability under section 10(b) is likely the expansion of the federal mandatory disclosure regime--and thus, section 10(b)'s role in the enforcement of that regime--well past protection against traditional fraud. That problem is one that only Congress and the SEC can solve by making their goals clearer, so that courts no longer feel the need to develop ad hoc doctrines to cabin the shifting contours of section 10(b) liability.

I. ORGANIZATIONAL LIABILITY UNDER FEDERAL LAW

Under federal law, organizational liability is typically vicarious, based on agency principles. (17) A principal is liable for the torts of its agents that are either accomplished within the scope of the agent's authority and for the principal's benefit, (18) or that are within the scope of the agent's apparent authority. (19) When a tort requires a particular mental state, the mental state of the agent who commits the tort is imputed to the organization: when the agent acts negligently, recklessly, or intentionally, liability follows accordingly. (20)

One of the more notable features of vicarious liability is that it does not matter whether the agent was a low-level employee, nor does it matter whether the agent was acting contrary to corporate policy or express instructions (21) (although such facts may be relevant to determine whether the agent was acting within the scope of her authority and to benefit the corporation). (22) Instead, liability is imposed "although the principal did not authorize, or justify, or participate in, or, indeed, know of such misconduct; or even if he forbade or disapproved of them." (23) For this reason, vicarious liability is commonly described as a form of "strict" liability--"[i]t neither requires the plaintiff to prove fault on the part of the employer nor allows the employer to exonerate himself by proving his freedom from fault." (24)

The purposes served by vicarious liability and agency principles are well-established. Courts have cited the master's duty to exercise control over his servants so as to avoid causing harm, and the simple justice of requiring that one who profits by use of servants also be forced to bear the costs associated with them. (25) As the Supreme Court put it,
   [t]he treasury of the business may not with impunity obtain the
   fruits of violations which are committed knowingly by agents of the
   entity in the scope of their employment. Thus pressure is brought
   on those who own the entity to see to it that their agents abide by
   the law. (26)


Absent vicarious liability, businesses may be tempted to encourage illegal but profitable behavior by their judgment-proof employees, thereby externalizing the costs of their torts on to the public.

Vicarious liability becomes a complicated question in the context of large corporations. Many organizational torts are not accomplished via a single actor, but instead require the cooperation or involvement of multiple employees, such that no single employee has personally committed all elements of the violation. In the case of torts that have a mens rea element, courts have developed the rough principle that organizational liability may be imposed so long as three conditions are met: (1) a harmful action committed by one agent; (2) an agent who harbors the specific mens rea required by the offense; and (3) a causal connection between the actions of the agent harboring mens rea and the ultimate harmful action.

The Ninth Circuit's rationale in United States v. Shortt Accountancy Corp. (27) provides a useful example. In that case, Shortt Accountacy, a CPA firm, was criminally convicted for making and subscribing false tax returns for a client in violation of 26 U.S.C. [section] 7206(1). Shortt's chief operating officer ("COO") designed an illegal tax shelter for the client. Pursuant to the scheme, a false return was prepared by a different Shortt employee based on information provided by the COO; the preparing employee had no knowledge of the impropriety and innocently subscribed to the return's correctness. (28) Under such circumstances, the Ninth Circuit had no trouble combining the mens rea of the COO and the actus reus of the innocent employee, holding that "[a] corporation will be held liable ... when its agent deliberately causes it to make and subscribe to a false income tax return." (29) Strikingly, the court did not resort to a simple respondeat superior analysis to impose organizational liability based solely on the COO's guilt, though it might have been able to do so. (30) Instead, the court aggregated the actions and states of mind among the different agents to reach its conclusion about the liability of the organization.

This type of liability should not be confused with an alternate scenario that most courts reject--namely, where no single employee harbors the mens rea required by the offense, but where several employees each separately, but innocently, have knowledge that, if aggregated, would suggest wrongdoing. For example, one employee might innocently make a false statement, while another employee--unaware of the first employee's actions--has information that demonstrates the statement's falsity. (31) Undoubtedly, if a natural person made a misstatement with knowledge of facts rendering it false, courts would have no trouble inferring that the person intentionally or recklessly misled her audience. (32) But with a corporate defendant, where knowledge and action reside in different agents and neither individually harbors mens rea--where, in short, the right hand does not know what the left hand is doing--courts generally agree that there is no organizational mens rea, (33) at least not unless communication failures between the right hand and left hand were so egregious, and evidenced such disregard for legal requirements, that they amount to organizational "willful blindness." (34)

But when there is at least one agent who personally harbors mens rea and causes the corporation to commit a harmful act, it is widely accepted in many areas of law that the corporation may be held responsible. (35) In the employment discrimination context, the concept is called "cat's paw" liability, a reference to a fable in which a monkey persuades a cat to grab chestnuts out of a fire, and then makes off with the chestnuts while the cat suffers burned paws. (36)

That said, the Supreme Court recently addressed the issue of cat's paw liability in Staub v. Proctor Hospital (37) and put its own spin on the case law. The plaintiff, army reservist Vincent Staub, claimed that his immediate supervisors at his employer, Proctor Hospital, resented his military obligations. The supervisors filed unjustified disciplinary actions against him, which ultimately caused the vice president of human resources to fire him. Staub sued Proctor under the Uniformed Services Employment and Reemployment Rights Act (USERRA), which prohibits employers from denying "retention in employment" (38) to a servicemember, where service membership is "a motivating factor in the employer's action." (39) The Supreme Court was thus forced to determine whether the mens rea of the supervisors could be combined with the actus reus of the vice president for the purposes of determining the hospital's USERRA liability.

Justice Scalia, writing for the majority, first held that the statutory language did not support such an aggregation:
   When a decision to fire is made with no unlawful animus on the part
   of the firing agent, but partly on the basis of a report prompted
   (unbeknownst to that agent) by discrimination, discrimination might
   perhaps be called a "factor" or a "causal factor" in the decision;
   but it seems to us a considerable stretch to call it "a motivating
   factor." (40)


The Court supported this reasoning by citing to the Restatement (Second) of Agency, which, it held, advised that the "malicious mental state of one agent cannot generally be combined with the harmful action of another agent to hold the principal liable for a tort that requires both." (41) The Court concluded, however, this problem could be solved with a close reading of the statutory text. As the Court put it:
   Animus and responsibility for the adverse action can both be
   attributed to the earlier agent (here, Staub's supervisors) if the
   adverse action is the intended consequence of that agent's
   discriminatory conduct. So long as the agent intends, for
   discriminatory reasons, that the adverse action occur, he has the
   scienter required to be liable under USERRA. And it is axiomatic
   under tort law that the exercise of judgment by the decisionmaker
   [in this case, the vice president] does not prevent the earlier
   agent's action (and hence the earlier agent's discriminatory
   animus) from being the proximate cause of the harm. (42)


Thus, the Court elided the question whether the harmful conduct of one agent can be combined with the harmful intent of another by redefining the concept of harmful conduct in the first place, interpreting the statute itself to mean both that decisionmakers may not discharge persons with a discriminatory motive, and that intermediate actors may not intentionally take steps that cause a discharge. As the Court put it, its new interpretation of the scope of the statute's prohibitions permitted it to "avoid[] the aggregation of animus and adverse action" (43) that it believed to be of questionable legitimacy.

Concurring in the judgment, Justice Alito, joined by Justice Thomas, rejected the Court's reliance on principles of agency and tort common law. Instead, they interpreted the statute to require that the same decisionmaker who took the adverse action must also harbor the discriminatory animus. (44) They believed that on this record, however, there was evidence that responsibility for the final decision to fire Staub had been partly delegated from the person with "formal decisionmaking authority" to one of Staub's supervisors. (45) Since that supervisor was motivated by animus, the requirements of the statute were met. (46)

One intriguing aspect of the majority opinion was its invocation of the Restatement (Second) of Agency. Contrary to the majority's view, the Second Restatement does not prohibit the combination of malicious mental state and action; instead, it draws the same distinction that the earlier case law does between a court cobbling together "innocent" pieces of knowledge, and an agent who intentionally manipulates the principal, allowing liability to be imposed in the latter circumstance. The Restatement accomplishes this by distinguishing between imputation of "notice" of a fact to a principal and imputation of "actual knowledge," which is akin to a subjective state of mind. Notice of a fact is not sufficient to impose liability for torts that require scienter, (47) but
   [i]f the agent consciously and purposely fails to reveal the
   information [in connection with a given transaction], the principal
   may be liable because, under the circumstances, the conduct of the
   agent has the same effect as if the agent had personally acted and
   were himself guilty of the fraudulent or other tortious conduct.
   (48)


Similarly, the Restatement provides that ordinarily, if an agent discovers information that he fails to communicate to the principal, and the principal makes a misrepresentation as a result, the principal is not liable for fraud--unless the agent "had intended [the principal] to make the misrepresentation." (49) Thus, the Restatement fully permits liability to be imposed on principals based on the manipulative behind-the-scenes actions of their agents, despite the Supreme Court's suggestion to the contrary. (50)

In any event, the implications of this line of case law is clear: In the ordinary course, an organization has the scienter of employees who either personally commit a prohibited act or who, acting with the relevant scienter, proximately cause the organization to commit the act.

II. THE DIFFERENT RULES APPLICABLE TO [section] 10(B)

Vicarious liability has long been viewed with suspicion in the context of section 10(b). Historically, the objection has been textual (51): because vicarious liability is a form of "strict" liability, many have argued that it conflicts with section 20(a) of the Exchange Act, which imposes liability on those who "control" others who violate section 10(b). (52) "Controlling persons" are permitted a good faith defense; thus, it has often been argued, vicarious liability principles, which do not permit a good faith defense, undermine the "controlling person" provisions.

After an initial flurry of court activity that roughly settled in favor of the application of ordinary agency principles to section 10(b), (53) the debate was rekindled in 1994, when the Supreme Court decided Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. (54) The Supreme Court held that under a strict textual analysis, section 10(b) "prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act," and does not extend to "aiding and abetting" another's fraud. (55) This decision sparked new arguments that vicarious liability represented a form of "extratextual" liability, akin to aiding and abetting, and equally void. (56) Tellingly, the Central Bank majority repeatedly cited to Professor Daniel Fischel's 1981 article, Secondary Liability Under Section 10(b) of the Securities Act of 1934, which argued that aiding and abetting, conspiracy, and respondeat superior all represented forms of liability that were not supported by section 10(b)'s text, (57) suggesting that vicarious liability would be the next to fall. Even Justice Stevens's Central Bank dissent argued that the majority's decision cast doubt on the continuing vitality of respondeat superior and related agency doctrines. (58)

Most courts, however, eventually concluded that vicarious liability survived Central Bank. For one thing, the Exchange Act explicitly makes corporations liable for section 10(b) violations, which most courts interpreted as being impossible without resort to agency principles. (59) Additionally, as the Third Circuit observed, unlike aiding and abetting, "courts imposing liability on agency theories are not expanding the category of affirmative conduct proscribed by the relevant statute; rather, they are deciding on whose shoulders to place responsibility for conduct indisputably proscribed by the relevant statute." (60)

A. Courts Resist Application of Agency Principles in Open-Market Section 10(b) Cases

Despite courts' ostensible acceptance of vicarious liability principles in the section 10(b) context, the reality is more complex, at least when it comes to open-market frauds committed by publicly traded corporations. This is because when it comes to open-market frauds, disaggregation is particularly salient. These frauds are, by definition, based on public announcements in the form of officially-sanctioned statements issued under the corporate imprimatur, such as SEC filings, press releases, or publicly broadcast conference calls between CEOs and market analysts. Official corporate statements may be attributed to top corporate officers, but they frequently depend on information provided by a myriad of anonymous agents operating at all levels of the company who may intentionally or recklessly pass along inaccurate or misleading information. In such circumstances, the actus reus that forms the basis of the alleged section 10(b) violation--the false public statement--has been disaggregated from the actor who harbors the relevant mental state. This disaggregation has become a pressure point that courts have used to narrow and eschew the agency principles applied in other areas of law.

With few exceptions, courts have been willing to aggregate mens rea and actus reus only where mens rea is harbored by another high level actor, who may be presumed to have caused, if only from behind the scenes, the false statement by approving or drafting it. Forms of causation most likely to emanate from lower level employees are disregarded, frequently without explanation.

For example, in Southland Securities Corp. v. INSpire Insurance Solutions, Inc., (61) the Fifth Circuit formally endorsed an approach similar to that used by courts outside the 10(b) context, namely, that the scienter of the "individual corporate official or officials who make or issue the statement (or order or approve it or its making or issuance, or who furnish information or language for inclusion therein, or the like)" is imputed to the corporation. (62) Just as courts had done previously, the Fifth Circuit refused to aggregate the innocently held knowledge of multiple agents to create a guilty state of mind, but it was willing to allow for a "cat's paw" style of liability, whereby corporate liability would exist if a behind-the-scenes agent intentionally funneled false information to the public via internal corporate reporting channels. (63) In making this decision, the Fifth Circuit cited the Second Restatement for the proposition that a principal is liable when an agent consciously and purposefully withholds information. (64)

Other appellate courts, however, have expressed varying degrees of discomfort with the Fifth Circuit's rule. The Seventh Circuit, while acknowledging that Southland stated the common law rule, refused to endorse it to the extent it would impute to the corporation the scienter of mid-level agents, apparently concerned that ordinary agency principles might stretch too far. (65) Three circuits have formally endorsed either

Southland or a similar formulation, but have then gone on to apply the rule in a more truncated fashion, considering only the scienter of high-level employees when determining organizational liability--even in the face of explicit allegations that the misstatements were the result of lower level employees intentionally filtering false information up through corporate reporting channels. (66) At least three other circuits, without declaring a general rule on the subject, have ignored company admissions that fraudulent information supplied by low-level officers and employees had been incorporated into public financial statements. In those cases, again, the courts focused their attention solely on whether the plaintiffs had demonstrated that the highest officers had intentionally or recklessly issued false public statements, and concluded they had not. (67) In all of these cases, the actions of the lower level employees were only relevant to the extent they created an evidentiary inference that the misinformation was known at the top of the corporate hierarchy; because the courts concluded the inference was not strong enough, the complaints were dismissed. (68)

Even the Fifth Circuit later seemed to dodge its own rule. In an unpublished opinion in Pipefitters Local No. 636 Defined Benefit Plan v. Zale Corp., (69) the Fifth Circuit dismissed a complaint where the company conceded that a mid-level vice president had falsified accounting entries in her department, causing the company to issue false public statements. (70) Rather than explicitly reject Southland and hold that the vice president's scienter would not be imputed to the organization, the Fifth Circuit instead held that she had "acted with the intent to maintain the good appearance of her department rather than to defraud investors," (71) and thus did not harbor the relevant mens rea. In reaching this conclusion, the Fifth Circuit actually quoted Southland but omitted Southland's reference to employees who furnish false information. (72)

To be sure, in many--though not all--of these cases, the wrongdoing occurred at a subsidiary, potentially raising issues of corporate separateness, and the propriety of attributing the mens rea of the subsidiary's agents to the parent. But it seems unlikely that respect for the corporate form was what motivated these decisions. Not only is it exceedingly rare for courts to voice such concerns, (73) but also many cases involve fact patterns that, at least at the pleading stage, seem appropriate for veil-piercing. (74)

The cases are very different, however, when the behind-the-scenes actor is of a high level, such as a top officer or a member of the board of directors. In these circumstances, the high-level actor's approval of the false statement--even if only presumed at the pleading stage--triggers liability not only against the actor personally, but also against the organization. (75)

Notably, courts rarely, if ever, are forced to confront these issues in the context of SEC enforcement actions rather than individual, fraud-on-the-market claims, likely because the SEC, apparently as a matter of policy, does not typically bring actions against organizations for open-market disclosure violations originating at lower levels of the company. As a result, the question of organizational liability under these circumstances almost always arises in private actions, brought using the fraud-on-the-market theory.

B. The Supreme Court Affirms that Section 10(b) Is Different

Two recent Supreme Court decisions have only lent further support to lower courts' refusal to impute the scienter of lower level actors to the corporation.

First, in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., (76) the Supreme Court narrowed the test for "causation" in private section 10(b) cases. Shareholders of Charter Communications alleged that two of Charter's vendors helped Charter report phantom revenue by jointly engaging in "wash" transactions. (77) The Supreme Court held that the vendors' conduct only constituted aiding and abetting, and thus could not trigger private liability under section 10(b) under Central Bank, because the chain of causation between the vendors' actions and Charter's false statements was "too remote." (78) In the Court's view, Charter chose to fraudulently account for the transactions; nothing the vendors did "made it necessary or inevitable for Charter to record the transactions as it did." (79) The Court acknowledged that its new "necessity" test was stricter than the common law, but justified its holding on the ground that Congress had not intended to provide broad liability against "the entire marketplace in which the issuing company operates." (80)

Stoneridge did not involve a cat's paw scenario: two different companies were involved, and Charter itself was not an innocent dupe. Nonetheless, courts have interpreted Stoneridge to apply even within a single corporation (or corporate group); thus, where "behind-the-scenes" agents were alleged to have funneled false information to the public, courts refused to impose liability on the agent, deeming the connection between the agent's act and the final misstatement too attenuated. (81) Where no higher level agents were alleged to have known of the fraud, claims against the organization were dismissed. (82)

Three years later, in Janus Capital Group, Inc. v. First Derivative Traders, (83) the Supreme Court was faced with another case involving a behind-the-scenes actor. This time, however, unlike in Stoneridge, the entity that issued the statement publicly had no knowledge of the misinformation. Nonetheless, the Court refused to hold the behind-the-scenes actor liable.

In Janus, a mutual fund, issued a prospectus that falsely claimed that the fund placed limits on trading that would protect the fund from damage caused by sophisticated arbitrage techniques. Though the prospectus was issued in the fund's name, the fund itself was a shell entity, owned by its investors, but entirely controlled by its investment adviser. All of the fund's officers were also officers of the investment adviser, and the adviser both drafted the false prospectus and set the policies that had been misdescribed. (84) The plaintiffs sued the adviser, alleging that as the drafter of the prospectuses, it was liable for the false statements contained therein. (85)

The Supreme Court, per Justice Thomas, rejected the argument that the adviser was responsible for the false statements in the prospectus it had drafted. The Court reasoned that under Central Bank and Stoneridge, the only person who "makes" a statement is "the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it." (86) Under this rule, one who merely provides false information for inclusion in a statement is not its maker and thus has not committed a primary violation under Central Bank, (87) The Court counseled that, though not dispositive of the question, "attribution within a statement or implicit from surrounding circumstances is strong evidence that a statement was made by--and only by--the party to whom it is attributed." (88) In one particularly telling sentence, the Court held that to impose liability on the adviser for the prospectus's contents would be to create a form of liability that is "similar to--but broader in application than--what Congress has already created expressly elsewhere" in section 20(a), i.e., the controlling person provision that sparked the original debates over the application of vicarious liability principles to section 10(b) claims. (89) The Court reconciled its holding with Stoneridge by reasoning that absent "ultimate authority," the Stoneridge causation test--requiring that the actor's conduct make the false statement "necessary or inevitable"--could not be met. (90)

Writing in dissent, Justice Breyer expressed concern that the majority's rule would leave plaintiffs without remedies, even for intentional frauds:
   The possibility of guilty management and innocent board is the 13th
   stroke of the new rule's clock. What is to happen when guilty
   management writes a prospectus (for the board) containing
   materially false statements and fools both board and public into
   believing they are true? Apparently under the majority's rule, in
   such circumstances no one could be found to have "ma[d]e" a
   materially false statement.... (91)


As it turns out, despite Justice Breyer's fears, most district courts have rejected the suggestion that an organization's board of directors--and not the corporate officers--are the ultimate authority for corporate actions. Instead, it is generally agreed that officers who approve statements for public distribution, or who personally speak to the public, are the "ultimate authority" and thus "maker" of corporate statements. When these officers act with scienter, they may be held liable, and so may the corporate entity. (92) Nonetheless, Justice Breyer's concern is well-taken: when Janus, Stoneridge, and the employment case of Staub are considered together, it becomes clear that the traditional rules courts have used to aggregate actus reus and mens rea no longer hold.

As discussed above, in Staub, the Court addressed a situation in which one agent fired the plaintiff, while another harbored a discriminatory animus. The defendant advocated, essentially, an "ultimate authority" rule--namely, that the only relevant action was that taken by the final decisionmaker, and only that decisionmaker's scienter could be considered. (93) The majority rejected this argument because it believed that the statute imposed organizational liability not only when a single employee took an adverse employment action with discriminatory animus, but also when an employee, acting with animus, took an intermediate action that was intended to, and proximately caused, the adverse action. (94)

In Janus, by contrast, the Court held that intermediate steps toward issuing a false statement do not violate the statute, while in Stoneridge, the Court rejected the use of traditional proximate cause to determine whether the actions of one person cause a false statement to be issued by another. In both cases, the majority reasoned that so long as another decisionmaker interpositions itself between the earlier action and the final one, it is that decisionmaker--and not the actor who took earlier steps--who is responsible for the false statement, even if the final decisionmaker is unaware of the earlier actor's misconduct. In other words, the precise reasoning that Staub used to justify imposing liability on an organizational employer is reasoning that Janus and Stoneridge have held is inapplicable in the context of section 10(b). In fact, the reasoning of Janus and Stoneridge is more similar to the rule endorsed by the Staub concurrence, which sought to focus attention on the employee with "formal decisionmaking authority," rather than the employees who had acted behind-the-scenes. (95)

Thus, the fact that Staub permitted the scienter of lower level, intermediate actors to be imputed to the corporation only by employing reasoning that is of at least questionable relevance when applied to section 10(b) necessarily raises the question whether the same "ultimate authority" rule that applies when determining who "made" a statement after Janus also applies when determining whose scienter should be imputed to the company. This is particularly so given the Staub majority's apparent distrust of imposing liability on a corporation based on aggregation of the actus reus of one agent and the scienter of another. (96)

In fact, it is striking just how far the Supreme Court's reasoning under section 10(b) diverges from the reasoning that previous courts have employed to impute scienter to a corporation. For example, in Shortt Accountancy, the Ninth Circuit attributed to an accounting firm the mens rea of a COO who caused the firm to prepare a false tax return, even though the COO had not personally signed the return. (97) In so doing, the Ninth Circuit rejected the argument that the COO had not "made" a false return, and had at most assisted in the preparation of a false return, (98) precisely because it saw no significant difference between aiding a violation and actually "making" a tax return, nor did it believe that to "make" a return was coextensive with the legal obligation to file one. (99) In Janus, however, not only did the Court distinguish between "making" a false statement and aiding the creation of one, but in so doing, the Court relied in part on the fact that only the fund--and not the investment adviser--had a statutory duty to file a prospectus. (100)

Here, more than the scenario of a guilty management and an innocent board of directors, is where the true thirteenth stroke of the clock lies. Open-market section 10(b) claims involve official corporate statements, which means that under Janus's rule, they are, at best, "made" only by high-level corporate officers and the corporation itself. If the Supreme Court has, or is on the verge of, formalizing the approach taken by lower courts--that only the scienter of these officers is relevant--then, as a practical matter, corporate liability in most section 10(b) cases must be derived exclusively from a corporation's highest management. This naturally begs the question whether organizational liability under section 10(b) is, in fact, based on agency principles at all, or is more properly described as "direct," on the theory that high-level actors represent the organization's "alter ego." (101)

Indeed, even though Janus commands that attributed statements are presumed to be "made by--and only by--the party to whom it is attributed," (102) lower courts interpreting Janus have freely allowed that multiple high-level actors may be liable for a single false statement, regardless of attribution, so long as they had a hand in reviewing or approving them, (103) with corporate liability to follow. (104) In other words, courts are less concerned with the formal rule of Janus--locating a single, final authority to whom a statement is attributed--and more concerned with seeking a general high level-endorsement of the fraud, demonstrating that it is not disaggregation per se that concerns them, but rather the notion of permitting section 10(b) liability to be imposed based on the actions of lower level actors. (105)

C. Why the Difference?

The dramatic difference between the way courts examine section 10(b) claims and the way they examine other kinds of federal claims begs an inquiry into what it is about the section 10(b) cause of action--and, in particular, the context of open-market frauds--that causes courts to resist the application of agency principles.

One answer might simply be that courts doubt the merits of securities claims and the usefulness of securities class actions, and thus seek to narrow section 10(b) claims. There is a long history of courts deriding securities actions as "vexatious," (106) and fraud-on-the-market class actions in particular may simply strain courts' ability to empathize with absent plaintiffs. In such cases, most members of the class have not lost enough money to justify an individual lawsuit, and the plaintiffs do not even claim the dignitary harm that might be associated with traditional fraud claims. (107)

Yet even if this is so, there are three interrelated features of the fraudon-the-market action that likely drive these impulses: (1) the fact that open-market frauds differ from traditional frauds in ways that challenge the usual justifications for vicarious liability; (2) the fact that section 10(b) actions have come to resemble criminal actions in terms of their social meaning; and (3) the need to distinguish fraud claims from claims that appear to be more targeted at the general quality of corporate governance.

1. Many Instrumental Justifications for Vicarious Liability Do Not Apply to Section 10(b) Open-Market Claims

The first reason why courts are unwilling to look to lower level actors when identifying organizational fault is likely that they share the concern that commentators have discussed for over a decade: namely, that there is a poor fit between the traditional justifications for vicarious liability and the unique nature of open-market frauds under section 10(b).

As explained above, the typical justification for vicarious liability is that if the employer reaps the benefits of the agent's misconduct, that employer should also be forced to bear the costs. (108) But when it comes to open-market frauds, the corporation does not obtain the "fruits of violations" while externalizing the costs onto the public. The corporation's false statements may influence traders in the secondary market and cause them to misvalue the corporation's securities. But unless the corporation itself trades, the corporation does not earn any direct benefit from the fraud. Instead, the fraud most directly "benefits" secondary market traders, who are presumed to be uninvolved in, and unaware of, the misconduct. (109) Indeed, in situations where the corporation most directly benefits--i.e., when it issues new securities--the corporation may be subject to liability under section 11 of the Securities Act, which imposes strict liability on issuers. (110) At the same time, the persons who are recognized as "injured" under section 10(b) are not a separate population, but are the corporation's owners, who suffer when the truth is revealed and the value of their investment is diminished. (111)

The point may stretch even further. Because fraud-on-the-market actions are unlikely to compensate investors for their losses, such actions today are justified largely in terms of deterrence, as a means of enforcing the mandatory disclosure regime of the federal securities laws. (112) But the purposes served by the extensive federal disclosure system go beyond merely protecting against fraud, or even ensuring that investors make informed choices when buying and selling securities. Instead, mandatory disclosure improves the allocation of resources across companies, with benefits felt across the economy. (113) Disclosure also facilitates the development of a deep and liquid trading market, (114) which in turn may spur growth and innovation. (115) Corporate disclosures also have an impact beyond the investment sphere, providing an important source of financial information for employees, competing firms, creditors, suppliers, customers, and even government actors making regulatory choices. (116)

As a result, when issuers disclose information pursuant to federal mandate, they are not merely engaged in an activity that generates private benefits or even one that prevents harm. They are also contributing to a public benefit that operates to improve society as a whole. (117) Though certainly each issuer reaps gains as a result of its access to the developed economy generated by such disclosures, on an individual basis, each issuer might very well have preferred to remain silent, at least as to some of the topics on which disclosure is required. (118) The more disclosures that corporations are obligated to make, the more avenues for private securities actions to enforce those obligations, (118) creating a symbiotic relationship between substantive regulation of corporate disclosures and private open-market section 10(b) actions. The size and scope of these actions, facilitated by the fraud-on-the-market doctrine makes them an effective regulatory tool. But with damages divorced from compensatory goals, and serving mainly a deterrent purpose--and with reporting obligations imposed on corporations that go well beyond fraud prevention and instead compel them to contribute to an affirmative public good--section 10(b) lawsuits stray far afield from the traditional instrumental justifications for vicarious liability.

In other areas of law, when the justifications for vicarious liability seem less appropriate, courts and commentators seek forms of "direct" liability that locate fault in the organization itself. The most prominent example is found within criminal law. It is often argued that civil regulatory liability is sufficient to deter corporate misbehavior and to force (113) corporations to internalize the costs of their conduct; thus, an additional justification is needed to prosecute a corporation criminally. Typically, that justification is described in moral terms--a criminal conviction signals a moral judgment by society regarding the egregiousness of the corporation's behavior. In that context, however, agency principles do not capture the moral fault associated with criminal liability. (120) Thus, in the criminal context, there have been several proposals to determine liability based on fault within the corporation itself, via some fundamental flaw in the corporation's functioning, such as the existence of corporate policies and practices that cause the corporation to violate the law. (121) In practice, however, because it is rare for corporations to officially sanction lawbreaking, these "direct" forms of liability are often operationalized as actions taken by higher level corporate actors. For example, the Model Penal Code, variations of which have been adopted by twenty-four states, (122) requires that a corporation's board of directors or a "high managerial agent" have "authorized, requested, commanded, performed or recklessly tolerated" the offense before corporate liability may be imposed. (123) High managerial agents appear to be good proxies for organizational misconduct because they implement corporate policy; their actions may influence those of their subordinates, and they may be responsible for a corporate "tone" that encourages fraud. (124) Because "tone" may be a real phenomenon but is difficult to define in precise terms, high managerial fault works as a next-best solution.

When it comes to section 10(b), courts may well have the same impulse as scholars who have criticized vicarious liability in the open-market fraud context, detecting a mismatch between vicarious liability and the policies that justify it. As a result they have, in practical effect, adopted a high-level authority rule that mimics the kinds of rules categorized as "direct" liability in other contexts.

The problem with this approach, however, as has often been observed in the criminal context, is that corporate misconduct is often the result of incentives and signals obliquely communicated to lower level employees, allowing top management to maintain plausible deniability; (125) a rule that focuses only on the actions of higher authorities "is apt to be, in practice, a rule of no liability at all." (126) And even when top management is uninvolved, lower level employees may still develop corrupt cultures that cause significant harm. (127) For these reasons, states that have adopted the Model Penal Code use a definition of "high management" that is very forgiving, often allowing anyone deemed an "officer," or who holds a supervisory role, to be equated with the corporation. (128)

Perhaps sensitive to these concerns, the Model Penal Code has not been adopted under federal law, where vicarious liability remains the official order of the day. Nonetheless, in the federal system, the search for organizational fault has shifted to other phases of the criminal prosecution. The U.S. Attorneys' Manual lists factors that federal prosecutors should consider when determining whether to prosecute a corporation, including "the pervasiveness of wrongdoing within the corporation, including the complicity in, or the condoning of, the wrongdoing by corporate management." (129) Similarly, the federal sentencing guidelines direct judges to consider markers of corporate culpability when setting penalties, such as the participation of high management and "pervasive" tolerance of the offense by "substantial authority personnel." (130) Though these are not liability rules, they do represent an attempt under federal law to impose a form of "direct" liability, tied specifically to higher level managers, because of the intuition that vicarious liability does not represent a good "fit" with criminal law.

Section 10(b), however, has no such equivalent. Either a company is liable for damages attributed to the fraud, or it is not; there is no sliding scale of fault. Moreover, private plaintiffs do not exercise the type of discretion that would be expected of a public prosecutor; they are not likely to determine whether a "policy" has been implemented, but instead will naturally try to expand the boundaries of corporate fault so long as damages are likely to exceed the costs of litigation. Thus, flexible standards are likely to be no standards at all, leaving courts dissatisfied with vicarious liability with only the extremely high-level authority rule they have, in practice, adopted.

2. Section 10(b) Has Taken on a More Expressive Role

Additionally, the mandatory disclosure regime, backed by the threat of liability under section 10(b), serves purposes that extend beyond economic regulation. The federal securities laws impose disclosure obligations that often seem geared toward what scholars have described as corporations' "publicness," namely, the responsibilities that they owe to the public as a result of their power and prominence in American life. (131) New demands have been placed on corporations to conduct themselves as accountable not just to their own investors, but to other stakeholders and the public generally. (132) For good or for ill, the federal securities laws have become the chief mechanism for accomplishing this, with an increasing number of regulations devoted to both ensuring the accuracy and completeness of public disclosures, and to forcing disclosure of internal arrangements and corporate conduct so as to enable greater public regulation and oversight. (133) Disclosure itself is a mechanism for improving a corporation's conduct as public citizens, by opening up the workings of the corporation to public scrutiny.

As the purposes of disclosure obligations change, so too does the meaning of the section 10(b) action. Just as criminal law serves an expressive purpose--particularly when it comes to organizational defendants--section 10(b) actions have taken on an expressive role, both to enforce and develop public norms regarding corporate behavior. (134) Securities lawsuits can go beyond enforcing existing obligations by educating other firms, setting new standards of behavior that can ripple through an industry. (135) Yet, as described above, it is in the realm of criminal law that the imposition of vicarious liability is most challenged. Accordingly, courts appear to have a corresponding instinct to identify an organizational "fault," which is again interpreted to mean actions taken by the policymaking organs of the corporation: its highest managers.
COPYRIGHT 2015 Washington University, School of Law
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2015 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:Abstract through II. The Different Rules Applicable to s. 10(b) C. Why the Difference? 2. Section 10(b) Has Taken on a More Expressive Role, p. 1261-1293
Author:Lipton, Ann M.
Publication:Washington University Law Review
Date:Jul 1, 2015
Words:9116
Previous Article:The limits of Second Amendment originalism and the constitutional case for gun control.
Next Article:Slouching towards Monell: the disappearance of vicarious liability under section 10(b).
Topics:

Terms of use | Copyright © 2017 Farlex, Inc. | Feedback | For webmasters