In re Refco, Inc. Securities Litigation

Brief Fact Summary.

Law firm helped client commit securities fraud by helping to hide fraudulent transactions.

Synopsis of Rule of Law.

Under federal law, there is no private right of action for victims of securities fraud against those who participated in a fraud, whether to a limited or great extent, that is executed by others.

Facts.

:  Refco, Inc. was one of the world’s largest providers of brokerage and clearing services in the international derivatives, currency, and futures markets.  Refco’s business model involved extending credit to its customers so they could make larger trades.  Over time, Refco began making loans without sufficiently gauging the credit-worthiness of customers.  In the late 1990’s, due to several global financial crises, customers suffered huge trading losses and were  not able to repay the loans.  Instead of revealing these multi-hundred million dollar losses, Refco hid the losses by essentially making loans to itself through third parties, which would remove the losses from Refco’s books at the end of each fiscal period until they were returned just days after the financial period closed.  These were referred to as “round-trip loans.â€Â  Mayer Brown, Rowe & Maw LLP (Mayer Brown) (Defendant) was Refco’s outside counsel from 1994 to Refco’s collapse in 2005.  Mayer Brown (Defendant) was familiar with Refco’s operations and finances and participated in 17 rounds of the round-trip loan transactions from 2000 to 2005.  Specifically, Defendant explained the structure and terms of the round-trip loans to potential third-party participants, negotiated the loans, and drafted and revised the documentation for the transactions.  Defendant later hid those losses in documents drafted for the Securities and Exchange Commission and for Refco’s initial public offering, during which Refco sold approximately one-fifth of its shares to investors.  In 2003, Thomas H. Lee Equity Fund V, L.P. (THL) (Plaintiff) became interested in purchasing an interest in Refco.  Defendant was responsible for responding to Plaintiff’s due diligence requests in connection with the purchase.  In doing so, Defendant purposely hid the round-trip loans from the fund.  In 2004, the fund acquired a majority ownership interest in Refco.  In 2005, Refco’s losses became public, its stocks plunged, and it filed for bankruptcy.  The fund suffered millions of dollars in losses as a result.  Plaintiff investors brought a class action against Mayer Brown (Defendant), claiming damages for Defendant’s knowledge and assistance regarding Refco’s fraudulent actions.  Plaintiff also sued, claiming damages under common law fraud for fraudulent statements that Defendant made directly to Plaintiff.  Defendant moved to dismiss all claims under Fed. R. Cov. P. 12(b)(6)

Issue.

Under federal law, if a client commits securities fraud, is a law firm liable for helping the client to commit the fraud?

 

Held.

(Lynch J.)  No.  Under federal law, if a client commits securities fraud, a law firm is not liable for helping the client to commit that fraud.  However, that firm may still be liable under state law covering common law fraud.  While the complaint alleged facts that, if true, would make Mayer Brown (Defendant) guilty of aiding and abetting the securities fraud that harmed the plaintiffs, under federal law, there is no private right of action for victims of securities fraud against those who participated in a fraud, whether to a limited or great extent, that is executed by others.  Section 10(b) of the Securities Exchange Act of 1934 imposes liability only on a person who makes a false or misleading statement of his own to the plaintiff.  Specifically, because § 10(b) only imposes liability for reliance upon a misrepresentation, the misrepresentation had to be directly attributable to the defendant.  Anything less was merely aiding and abetting, no matter how great that aid might be.  This requirement draws a “bright line†between the conduct of a secondary actor and that of a primary violator.  Ultimately, the plaintiffs were relying on statements made by Refco and shared or repeated by Mayer Brown (Defendant), not statements Defendant itself had made.

Discussion.

While criminal law in general, and other cases regarding professional ethics, focuses on a defendant’s intent, this case largely ignored the issue of intent in favor of a bright-line rule separating the primary violator of the Securities Exchange Act from the secondary actors.  Other courts, most notably in In re Enron, 235 F. Supp. 2d 549 (S.D. Tex. 2002), have found a firm liable as a primary violator when it was knowingly and deeply involved in a client’s securities fraud participation.