US courts are considering on Monday whether to bless a new legal theory thought up by plaintiffs’ lawyers that could put banks, lawyers and business partners on the hook for billions of dollars when a public company goes bust because of fraud.
The fifth circuit federal appeals court in New Orleans will take up the issue of “scheme liability” when it hears arguments on whether Enron’s shareholders can pursue a class action against Credit Suisse, Merrill Lynch and lawyer Vinson & Elkins.
Banks and lawyers have traditionally been protected by a 1994 Supreme Court decision that says shareholders cannot recover money from firms and people who simply “aided or abetted” securities fraud. But the recent corporate scandals prompted plaintiffs’ attorneys and angry investors to look for a way around that rule. They argue that the banks and lawyers participated in a “scheme” to hide Enron’s losses from investors and should be held “primarily responsible” for the company’s collapse.
Scheme liability “is almost indispensable. There would have been no way to hold the big banks responsible in Enron without scheme liability,” said Bill Lerach, the plaintiff’s attorney who represents Enron shareholders.
But Greg Markel, a lawyer for banks, warned that the theory “creates uncertainty for financial institutions and that uncertainty increases the costs of doing business.”
The trial judge in the Enron case initially agreed with investors, but other US courts have divided in cases involving fraud at Dynegy, Parmalat and HealthSouth. The Securities and Exchange Commission favours a limited form of scheme liability that could increase the number of companies targeted by such lawsuits.
“The scope of scheme liability is the single most important issue being litigated in securities class actions today,” says Bob Giuffra, an attorney with Sullivan & Cromwell, which defends companies against securities lawsuits.
The US Supreme Court is also considering whether to hear two scheme liability cases. One includes companies allegedly involved in sham transactions conducted by Homestore, the online estate agents site. The influential ninth circuit federal appeals court found that business partners can be held liable if their transactions with a company had “the principal purpose and effect of creating a false appearance of fact in the furtherance of a scheme to defraud” even if they did not directly mislead investors.
If that ruling stands, “lawyers will begin naming as defendants all manner of companies [particularly those with ‘deep pockets’], merely because they engaged in significant transactions with issuers who allegedly accounted for the transactions fraudulently,” claim papers filed by Cendant and Time Warner, targets in the Homestore case.
