In a ruling of potentially great significance for financial institutions, auditors, lawyers and other so-called “secondary actors,” the Fifth Circuit earlier this week reversed a class certification in the massive Enron shareholder litigation. The case has already resulted in over $7bb in settlements. The ruling dramatically derailed — temporarily, at least — the trial scheduled to begin in Houston on April 16.

In its March 19th ruling, the Fifth Circuit highlighted an important question, hotly debated since the Supreme Court’s 1994 ruling in Central Bank that Section 10(b) and Rule 10b-5 do not impose liability for aiding and abetting: Exactly what sort of conduct by “secondary actors” will give rise to liability under the federal securities laws?

1. The Emergence of Rule 23(f) as a Means to Obtain Early Appellate Review

It is hardly a secret that most securities fraud cases settle before final judgment. Many of these cases (particularly where a motion to dismiss is denied) evade appellate review. Given the economic stakes and impact of securities fraud litigation upon our nation’s economy, there have been surprisingly few occasions for the appellate courts (including the Supreme Court) to give definitive guidance. What has emerged, instead, is a patchwork of sometimes inconsistent lower court rulings resulting in uncertainty and inconsistency for plaintiffs and defendants alike. That may be about to change. The Fifth Circuit in Enron seized the opportunity in the context of reviewing class certification under Rule 23(f) — over the plaintiffs’ strenuous objections — to examine the very heart of the plaintiffs’ legal theory.

The Fifth Circuit did so hard on the heels of a similar examination by the Second Circuit in late 2006 of the substantive legal theory underpinning the so-called “IPO Laddering” litigation.1 In both cases, the appellate courts reversed orders granting class certification because they found the underlying theory of liability wanting, in that it would not support the “presumption of reliance” necessary to meet the “commonality” requirement of class certification.

2. A Narrow Definition of “Deception” Under Rule 10b-5

Plaintiff’s principal theory was that Enron’s bankers committed “deceptive acts” under Rule 10b-5 by engaging in allegedly fraudulent transactions with Enron, allowing Enron to misstate its accounts. The Fifth Circuit repudiated this approach:

The district court’s conception of “deceptive act” liability is inconsistent with the Supreme Court’s decision [in Central Bank] that §10(b) does not give rise to aiding and abetting liability. An act cannot be deceptive within the meaning of Section 10(b) where the actor has no duty to disclose.

Thus, the Fifth Circuit held that the defendants’ actions were, at most, claims of aiding and abetting barred by the Supreme Court’s decision in Central Bank.

3. A Narrow Construction of the Term “Manipulation”

Next, the Fifth Circuit addressed the plaintiffs’ theory that the banks, by participating in allegedly fraudulent transactions with Enron, engaged in “manipulation” prohibited under Rule 10b-5. The Court concluded that manipulation is “virtually a term of art” requiring that a defendant “act directly in the market for the relevant security,” thus “creating the false impression that certain market activity is occurring when in fact such activity is unrelated to actual supply and demand or tampering with the price itself.” The Fifth Circuit held that allegations that the banks’ conduct “indirectly” affected the market for Enron securities would state a claim under Section 10(b) “only if [such conduct] constitutes deception.”

4. Prospects for Clarification of Fundamental Securities Law Concepts

The Fifth Circuit’s decision adds to the growing split among the Circuits concerning the important question of precisely what sort of secondary actor conduct may give rise to primary liability for securities fraud. The Eighth and Ninth Circuits split last year on the scope of primary liability for secondary actors. The Ninth Circuit largely adopted the position advocated by the Securities and Exchange Commission that primary liability attaches to any defendant that engages in a “‘transaction whose principal purpose and effect is to create a false appearance of revenues.’”2 Conversely, the Eighth Circuit held that the SEC’s position was “too broad to fit within the contours of §10(b)” in light of Supreme Court precedent holding that a device or scheme “is not ‘deceptive’ unless it involves a breach of some duty of candid disclosure.”3

Petitions for certiorari in the Eighth and Ninth Circuit cases were due to be considered by the Supreme Court on March 23, 2007. Counsel for lead plaintiff in Enron this week contacted the Clerk of the Supreme Court indicating their intention to seek certiorari within ten days, requesting that the Court consider its petition together with the petitions in the Eighth and Ninth Circuit cases. This deepening rift could increase the possibility that the Supreme Court will grant certiorari on this issue this term. A Supreme Court ruling could have broad implications for class actions against secondary actors, who have once again become popular targets, particularly in cases where the primary actors, like Enron, have gone into bankruptcy.

It should also be noted that the Supreme Court may have telegraphed renewed interest in addressing basic securities-law questions, when it recently granted certiorari, and ordered expedited briefing in Tellabs v. Makor,4 on appeal from the Seventh Circuit. Oral argument is scheduled for March 28, 2007. The Tellabs decision exacerbated an already deep split among the Circuits concerning the PSLRA’s requirement that a securities fraud complaint plead facts raising a “strong inference of scienter.” The Supreme Court’s resolution of this conflict is also likely to have a significant impact on class action securities litigation.