The theory of scheme liability begins with the language of Rule 10b-5, amplified by the Supreme Court in several decisions. The subsections of the rule use the word “scheme” and “device.” While it is clear that the provisions of the Rule cannot be broader than the statute, the Supreme Court repeatedly has referred to Section 10(b) liability using the term “scheme. See for example, SEC v. Zanford, 535 U.S. 813, which notes that the section prohibits a “scheme to defraud.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199 n.20 (1999) defines the word “device” to include a scheme to defraud. And, Superintendent of Ins. of N.Y v. Bankers Life & Casualty, 404 U.S. 6, 10 n. 7 notes that Section 10(b) prohibits “all fraudulent schemes.”
Building on this notion, the SEC, in amicus briefs filed in the district court in the Enron litigation (Regents of the Univ. of Calif. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. 2007)) and the circuit court in the Homestore case (Simpson v. AOL Time Warner, Inc., 482 F.3d 372 (5th Cir. 2007)), argued that vendors engaged in fraudulent schemes used to falsify an issuer’s books (and thus its shareholders) were primarily liable under Section 10(b). Under the SEC’s theory, a person can be primarily liable “for engaging in a scheme to defraud, so long as he himself, directly or indirectly, engages in a manipulative or deceptive act as part of the scheme.” Under this theory, a deceptive act is “engaging in a transaction whose principal purpose and effect is to create a false appearance of corporate revenue.” Reliance is established “where a plaintiff relies on a material deception flowing from a defendant’s deceptive act, even though the conduct of other participants in the fraudulent scheme may have been a subsequent link.”
This theory clearly differs from the bright line test developed by the Second Circuit or even the substantial participation test of the Ninth Circuit. Under this theory, a participant in the fraudulent scheme is liable where the result of the deception flows through to the shareholder. There is no requirement that the act of the defendant be identified or that the plaintiff rely on the specific conduct of the defendant.
The Ninth Circuit considered and adopted a version of the SEC’s theory in Homestore. The question in Homestore was whether third-party vendors who had participated in a so-called “round trip” transactions that permitted issuer Homestore to falsely inflate its revenue and thus defraud its shareholders is liable under Section 10(b). Although the Court did not rule in favor of plaintiffs, it adopted a version of the SEC’s scheme liability theory. On the key issue of reliance, the court held that plaintiff is “presumed to have relied on this scheme to defraud if a misrepresentation which necessarily resulted from the scheme and defendant’s conduct therein, was disseminated into an efficient market and was reflected in the market price,” citing Basic Inc. v. Levinson, 485 U.S. 224 (1988).
In contrast the Fifth Circuit in Enron reversed the class certification decision of the district court, which was based on the SEC’s scheme liability theory. The Enron plaintiffs alleged that the defendant investment banks participated in irrational sham transactions knowing that Enron would use them to falsify its financial statements and defraud its shareholders.
In reversing the district court, the Fifth Circuit held that there was no deception because there was no duty to disclose. The court narrowly defined deception to include only a misstatement, a failure to disclose or manipulation. The court went on to hold that the fraud on the market theory could not be used to establish reliance because of a failure to demonstrate deception. In making this ruling, the court expressed concern about imposing liability under Section 10(b) on ordinary business transactions.
The ruling in Homestore predated the decision of the Eighth Circuit in Stoneridge, while the decision in Enron followed that case. The rejection of scheme liability by the Eighth Circuit in Stoneridge, which will be discussed in more detail in the next segment of this series, set the stage for the ruling by the Supreme Court.