In re Enron Corporation Securities, Derivative & ERISA Litigation

Brief Fact Summary.

A class action brought on behalf of purchasers of Enron Corp. securities alleged that banks, lawyers, and accountant/auditors violated securities laws by making false statements or failing to disclose adverse facts while selling Enron securities, and/or that they were involved in a scheme to defraud and/or a course of business, that operated as a fraud.  These secondary-actor defendants moved to dismiss.

Synopsis of Rule of Law.

Under § 10(b) of the Securities Exchange Act of 1934, a claim against secondary actors alleged to have been involved in a scheme to defraud survives dismissal where a primary violation of § 10(b) is alleged against each individual actor.

Facts.

A class action brought on behalf of purchasers of Enron Corp. securities claimed that numerous banks, lawyers, and accountant/auditors violated securities laws by making false statements or failing to disclose adverse facts while selling Enron securities, and/or that they were involved in a scheme to defraud and/or a course of business that operated as a fraud.  The scheme that these secondary actors were allegedly involved in was claimed to be “an enormous Ponzi scheme, the largest in history†involving illusory profits generated by phony, non-arm’s-length transactions with Enron-controlled entities and improper accounting for the purpose of inflating Enron’s reported revenues and profits, hiding its rising debt, maintaining its artificially high stock prices and credit ratings, as well as allowing the secondary actor defendants to personally enrich themselves by looting the corporation, while continuing to raise money from public offerings of Enron or related securities.  The scheme allegedly involved an elaborate network of off-the-books illicit partnerships, secretly controlled by Enron, and established to conceal Enron’s actual financial status.  These entities would typically purchase troubled assets from Enron by means of sham swaps, hedges, and transfers so that debt would not be reflected on Enron’s balance sheet.  All of the secondary actor defendants were alleged to have been “rubber stamps†for these deceitful transactions because they were all beneficiaries of enormous fees and increasing business.  The defendants allegedly violated GAAP (Generally Accepted Accounting Principles) and SEC rules, and caused Enron to present materially misleading statements in Enron’s financial statements, press releases, and SEC filings, such as Form 10-Qs and 10-Ks.  Enron also allegedly made misrepresentations regarding the second party defendants’ manipulations, all concealed by numerous accounting ploys.

 

(III.B.1) The Banks—Most of the allegations applied, with few exceptions, to all the banks:  Canadian Imperial Bank of Commerce (CIBC), CitiGroup Inc., J.P. Morgan Chase & Co., Barclays PLC, Credit Suisse First Boston, Bank of America Corp., Merrill Lynch & Co., Lehman Bros. Holdings Inc., and Deutsche Bank AG.  The general claims were that the banks participated in the scheme to enrich themselves through huge fees and continuing business, as well as to protect their interests once involved.  The banks allegedly advanced funds to SPEs (Special Purpose Entities) at key times so that they and Enron could complete bogus transactions to create fake profits and hide billions of dollars of Enron debt.  Supposedly aware of Enron’s true dire financial state, the banks also made loans to Enron to ensure its liquidity, while at the same time helping Enron sell its securities and keep the scheme going.  In addition, the banks allegedly supported the inflated price of these securities through glowing research reports that contained misleading information about Enron.  Some of the banks also allegedly disguised billions of dollars in loans to Enron as sales transactions.

 

(III.B.1.b.) CitiGroup—CitiGroup, along with the other banks, allegedly enjoyed spectacular underwriting, advisory, and transactional fees, interest, and commitment charges, and some of its executives participated in the illicit partnerships for lucrative returns.  It loaned over $4 billion to Enron, helped Enron raise $2 billion in securities sales, and helped Enron structure and refinance the illicit partnerships and SPEs that Enron used to inflate earnings and conceal debt.  Its executives were in contact with Enron executives daily and discussed its business in detail.  CitiGroup also purportedly made false and misleading statements in registration statements and prospectuses, as well as issued numerous analysts’ reports that contained false and misleading statements about Enron’s financial condition.

 

(III.B.2) Law Firms—Vinson & Elkins (V & E), Enron’s outside counsel, participated in writing, reviewing, and approving Enron’s SEC filings, shareholder reports, and financial press releases, and in creating various SPEs and handling related transactions.  Allegedly V & E knew that Enron insiders were on both sides of some of these transactions, to virtually ensure lucrative returns for the entities’ partners, and that the illicit entities were manipulative devices.  V & E allegedly provided “true sales†and other opinions that were false and that were indispensable for the sham deals.  Given V & E’s intimate involvement in the formation of and transaction with these blatantly fraudulent entities, V & E allegedly had to know that they were created solely to “cook Enron’s books.â€Â  Although Sherron Watkins, an Enron employee and whistle-blower, warned Enron’s CEO, Ken Lay, that V & E was involved in the fraud and had a clear conflict of interest, Lay still turned to top V & E partners to find out how to cover up the allegations.  Despite this obvious conflict, V & E agreed to conduct an investigation into the charges of its own misconduct, and issue a letter dismissing the allegations.  V & E also agreed not to review the accounting work of judgment of Arthur Andersen (Enron’s auditor).  Allegedly, during its investigation, V & E interviewed only top-level executives that it knew were involved in the fraud and would deny it.  Also, V & E advised that Watkins should not be fired, for fear that a wrongful termination suit would disclose her allegations, and she was shifted to another position where should have less exposure to information damaging to Enron.

 

(III.B.3) The Accountant/Auditor: Arthur Andersen LLP—Allegedly, Arthur Andersen abandoned its responsibilities to Enron investors and violated professional standards in perpetrating a massive accounting fraud.  Enron was Arthur Andersen’s second largest client and the auditing firm was economically dependent on Enron, which provided it with $50 million in annual fees.  Partners at the accounting firm were pressured to generate more fees, which created a conflict of interest for auditors and caused them to abandon their integrity and independence.  Even though Arthur Andersen was aware that the critical factor to increasing its fees was to maintain Enron’s high credit rating, it decided that the possibility of doubling the fees it received from Enron to $100 million was worth maintaining Enron as a client, despite the risk this would entail.  When partner Bass opposed Enron’s improper accounting practices, he was removed from his oversight role on the Enron audits.  Arthur Andersen allegedly helped structure hundreds of complicated partnerships, many with no purpose other than to hide losses and debt.  In many of the transactions, Enron maintained control of the entities and deliberately and improperly did not consolidate them.  Andersen knew that Enron used at least 600 offshore tax shelters to shift income, minimize taxation, circumvent laws, and maintain secrecy.  Even Andersen’s tax and consulting departments knew that Enron was using such entities excessively and without business justification.  Andersen documents revealed that it knew, was concerned about, yet covered up or ignored fraudulent accounting practices by Enron.  Minutes of a teleconference meeting of Andersen partners revealed that they knew of the accounting issues that ultimately caused the collapse of Enron.  In spite of this knowledge, they decided to retain Enron as a client and then issued a “clean†audit opinion on Enron’s financial statements.  In the audits of Enron’s 1997 financial statements, Andersen identified $51 million of adjustments where the accounting was improper, and that these accounted for almost 50 percent of Enron’s net income for that year.  Nevertheless, Andersen consented to Enron’s request not to make those adjustments—which would radically reduce the net income that would be reported.

Issue.

Under § 10(b) of the Securities Exchange Act of 1934, does a claim against secondary actors alleged to have been involved in a scheme to defraud survive dismissal where a primary violation of § 10(b) is alleged against each individual actor?

Held.

(Harmon, J.) Yes.  Under § 10(b) of the Securities Exchange Act of 1934, a claim against secondary actors alleged to have been involved in a scheme to defraud survives dismissal where a primary violation of § 10(b) is alleged against each individual actor.  Secondary actors, such as lawyers, accountants, banks, and underwriters, are not shielded from § 10(b) and Rule 10b-5 liability as primary violators where they create a misrepresentation that is relied on by investors and they do so with scienter.  In addition, as long as the secondary actor is acting with scienter, it is not necessary for them to be the initiator of the misrepresentation in order to be treated as a primary violator.  This rule, as construed by the SEC, is deferred to because it is not arbitrary, capricious, or manifestly contrary to the statute.  Therefore, to survive a motion to dismiss, a complaint alleging that more than one defendant participated in a scheme to defraud must allege a primary violation of § 10(b) by each defendant.

 

The defendants argue that the argument that they would pour millions of dollars into a Ponzi scheme and risk their reputations for huge fees, payments and profits, is irrational, implausible, and/or illogical.  However, in light of revelations of vast corporate corruption and fraud by auditors and banks, these allegations are not implausible.  The secondary-actor defendants are justified in objecting to boilerplate allegations made against them.  However, their objections that claims of misconduct based on what are common, legitimate business actions or practices that are not inherently improper must be viewed within the totality of the circumstances to determine if indeed such practices were legitimate and ordinary, or if they were contrivances and deceptive devices used to defraud.  The court, therefore, will ignore the boilerplate, and focus on specific allegations against each defendant.

 

As a factor common to all defendants, the scienter pleading requirement is partially met by allegations of a regular pattern of related and repeated conduct involving the creation of unlawful SPEs, the sale of unwanted Enron assets to those entities in non-arm’s-length transactions to shift debt off Enron’s balance sheet and sham profits onto its books—from which all those involved profited exorbitantly.  This pattern undermines claims of unintentional or negligent behavior and supports allegations of intent to defraud.  The common motive of extreme monetary gain has also been adequately pleaded.  Likewise, conclusory allegations asserted against almost all the secondary actor defendants, such as long-term, continuous, intimate and extensive relationships with Enron and daily interactions with top Enron executives, raises the possibility of opportunities to learn about and take an active role in the financial affairs of Enron, access to nonpublic information, “intimacy blending into complicity fueled by financial interest.â€Â  The provision by banks of both commercial and investment banking services raised the possibility of conflicts of interest and the standard mandatory in-depth credit analyses, which should have raised red flags.

 

These are all background factors that must be considered to determine if the secondary actors’ actions were within the bounds of the law, or were outside the boundary of legitimate and professionally acceptable activities in performing material acts to defraud the public.

 

(1) Attorneys—V & E:  With regard to attorneys, there is a tension between the need to provide a remedy to those suffering a loss as a result of attorney conduct and the need to preserve confidentiality, loyalty, and zealous representation.  A layer may not knowingly assist a client in conduct that is criminal or fraudulent.  Therefore, professionals, including lawyers and accountants, when they speak out affirmatively regarding a client’s financial condition, whether individually or a silent co-author in a statement or report, have a duty to third parties not to knowingly or with severe recklessness issue materially misleading statements on which they intend or have reason to believe that those third parties will rely.  In this case, the situation alleged is one where V & E was not only representing Enron, but joined with Enron and others where each participant made material misrepresentations or omissions or used a device, scheme, or ploy to defraud.  There were specific allegations of acts that furthered the scheme and that V & E violated its professional and ethical principles by not resigning in return for lucrative fees.  Had it remained silent, the attorney/client relationship may have protected it from liability.  However, the complaint presents many instances where V & E frequently chose to make public statements about Enron’s business and financial condition.  It was essentially a co-author of the reports and releases relied on by investors and others, and deliberately, or with severe recklessness, directed those public statements to them in order to influence them to purchase more securities, or to keep Enron’s credit rating high, or to keep providing loans to Enron.  V & E had a duty to be truthful, and numerous allegations have been made that it breached that duty.  As to the “white-wash†investigation it conducted in the wake of Watkins’ allegations, the investigation and report can serve as the basis of § 10(b) and Rule 10b 5(a) or (c) claim alleging use of a device, scheme, or ploy to defraud.  For these reasons, claims have been stated under § 10(b) against V & E.

(2) Accountant/Auditors—Arthur Andersen: There is no accountant/client privilege such as that accorded to lawyers.  Accountants owe ultimate allegiance to the corporation’s stockholders and creditors, as well as to the investing public.  In this case, specific facts were alleged to give rise to a strong inference that Andersen had scienter.  Its comprehensive services to Enron necessarily made it intimately privy to the smallest details of Enron’s alleged fraudulent activity.  A pattern of such conduct was also established, based on similar prior fraudulent audits of other companies.  It was pleaded that despite being aware of accounting improprieties, Andersen decided to retain Enron as its client because of extremely lucrative fees.  Because numerous violations of GAAP and GAAS have been pled, giving rise to a strong inference of scienter, a securities fraud claim has been pleaded against Andersen.

 

(3) The Banks: Viewing the specific allegations together, a claim has been stated against CitiGroup (and other banks) as a primary violator because it knowingly, or with severe recklessness, made a material representation or engaged in an act, practice, or course of business that operated as a fraud of deceit on Enron investors.  CitiGroup, through its offshore Cayman Island subsidiary, was also able to disguise $2.4 billion of loans to Enron so that they never appeared on its balance sheet, at double the going interest rate, netting CitiGroup with $70 million annually for its participation in the scheme.

Discussion.

The court reviews the Supreme Court’s holding in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) and concludes that under that decision, a private plaintiff may not bring an aiding and abetting claim under § 10(b) or Rule 10b-5, since the statute is concerned only with prohibiting the making of a material misstatement or a material omission or the commission of a manipulative act.  Therefore, liability under the statute may be imposed on secondary actors not as aiders or abettors, but as actors who themselves have made misstatements, or material omissions, or commissions of manipulative acts.  In this case, the court permits the use of circumstantial evidence to create an inference that the secondary actors acted with scienter.  However, it is arguable that by allowing such circumstantial evidence to prove scienter, it can always be possible to infer that a primary actor’s advisers had knowledge of wrongdoing of the primary actor, therefore gutting the Central Bank holding.