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Los Angeles Lawyer
The Magazine of the Los Angeles County Bar Association

February 2002
Featured Article

Tied to the Stake

Trends in federal securities fraud legislation and case law may not fully protect attorneys from the reach of common law negligence claims

By John W. Cotton
John W. Cotton is a partner in the law firm Cotton & Gundzik LLP in Los Angeles.

It should come as no real surprise that the collapse of the Internet boom portends a likely rise in claims against the lawyers who helped fuel its
growth.1 After all, the large number of start-ups that went public overnight—and in an equally short time became bankrupt—has left investors searching for deep-pocket defendants to cover their losses. As evidenced by the savings and loan crisis in the 1980s and the collapse of the junk bond market in the 1990s, lawyers and their insurers may well fit the bill.

One significant factor in many of the recently brought securities fraud cases stemming from the dot-com crash is the well-publicized fact that securities lawyers were often paid with an equity stake in their start-up clients. The news stories of the last few years were tantalizing with their details of partners in law firms forming investment pools with client equities and even compensating associates with a share in those in-house investment funds. This was one of the many hallmarks of the new economy, in which lawyers threw off the shackles of traditional practices in an effort to look and act more like their younger start-up clients. Instead of billing the old-fashioned way, they hitched their success (or failure) to the prospects of their new economy clients. Those lawyers will certainly look like their former dot-com clients in at least one respect, if the plaintiffs’ bar has its way: diminished assets.

Whether and to what extent any claims against dot-com lawyers will survive will be a product of other lawyers’ creative and successful spinning of facts and their ability to fashion new economy claims within the previously established old economy liability guidelines of the courts and Congress. The chief focus will be on the role of lawyers in helping new economy clients gain (and keep) access to public equity markets and whether that role was sufficiently flawed to support claims for either statutory or common law liability. The possibility that such claims will survive motions to dismiss or for summary judgment may be greater than generally believed, in part because of lawyers’ equity stakes in their clients.
A commonly held but flawed belief is that a lawyer is only a scrivener for the client and not the auditor or guarantor of the correctness of the client’s representations. In reality a lawyer is an integral and irreplaceable gatekeeper to the public fund marketplace when he or she assists in securities offerings and required public filings. Were it otherwise, lawyers would be hard pressed to justify the significant time and cost involved in providing legal services for clients going public. Lawyers are not merely taking dictation from their clients. Considering the complexity and multiplicity of federal and state regulations, and the severe penalties meted out to the public company that fails to follow the maze of regulatory requirements correctly, lawyers have been recognized by many courts as being much more than just scriveners. The more difficult question faced by the courts, however, is when and under what circumstances to hold lawyers responsible for misstatements or material omissions in documents that they draft with their publicly held clients.

Section 10(b) of the Securities and Exchange Act of 1934 provides the basis for most of the federal securities fraud lawsuits filed when publicly traded securities are involved.2 Public market participants who intentionally or recklessly misstate material facts in connection with the raising of equity capital are held liable under Section 10(b) when others have relied on those misstatements in making investment decisions to their economic detriment. When the misstatements are directly attributable to the issuer, or its employees and agents, the claims are said to be “primary” liability claims.

Section 10(b) claims have been made against accountants, underwriters, and lawyers when they assisted their clients in gaining access to the public marketplace. In the past, these claims were brought only infrequently as Section 10(b) primary violations. More often the claims were brought as claims for aiding and abetting and were usually referred to as “secondary” liability claims because the accountants, underwriters, and lawyers were said to be helping primary violators achieve their unlawful ends. The elements of proof for a claim for aiding and abetting are somewhat less stringent than those for a claim of primary liability, particularly with regard to the necessary element of intent.

The ease with which claims could be brought against nonissuer professionals such as accountants, underwriters, and lawyers for aiding and abetting came to an end in 1994, when the U.S. Supreme Court decided Central Bank of Denver v. First Interstate Bank of Denver.3 In Central Bank of Denver, the court held that the text of Section 10(b), as well as the intent of Congress at the time of passage of the antifraud rule, did not support charges for aiding and abetting.4 The plaintiff in the case, a commercial bank, was seeking to make the charge for aiding and abetting under Section 10(b) against another commercial bank, the Central Bank of Denver, which acted as indenture trustee in a public improvement bond financing. Though widely criticized by securities law experts for its very rigid analysis, Central Bank of Denver did not involve accountants or lawyers, and, more important, did not involve any alleged misstatements by the issuer authority in the bond offering documents prepared by the accountants and lawyers. It involved an alleged failure by the defendant trustee, the Central Bank of Denver, to supervise required indenture real estate valuations that ran with the bonds.

The U.S. Supreme Court in Central Bank of Denver determined that Section 10(b) had no implied private right of action for securities violations caused by alleged aiders and abettors. Holding that its job was to look to the clear meaning of the statutory text of Section 10(b) first, and congressional intent in passing Section 10(b) second, the Court found no support for the charge. According to the Court, the language “directly or indirectly” used in the text of Section 10(b) was too broad and imprecise to support the inference of liability for aiding and abetting, because it reached far beyond those who merely give some degree of aid to violators.5 Further, the Court felt that since Congress did not impose liability on aiders and abettors in those sections of the Securities and Exchange Act of 1934 in which it did grant express private causes of action, the Court inferred that Congress did not intend such a cause of action in Section 10(b).6
Central Bank of Denver was immediately hailed by the defense bar as a silver bullet to stop claims against securities professionals such as lawyers and accountants. In actuality, the Central Bank of Denver Court recognized specifically that primary violation claims could be brought against securities professionals under Section 10(b), even though its main holding had undermined vicarious or secondary liability claims such as aiding and abetting.7 Central Bank of Denver has forced investors and their lawyers to dig a bit deeper in their pleading bag and bring their claims under the somewhat more onerous five-element framework for primary liability under Section 10(b), instead of the easier-to-plead three-element test for aiding and abetting.8 This result is not really novel, because primary violator claims had been brought (albeit sparingly) against lawyers and accountants before the Central Bank of Denver decision and continue to be filed in its wake.

Lawyers as Primary Violators
The courts have not universally agreed on whether and to what extent lawyers can be held responsible for misstatements in their clients’ offering documents. Prior to the decision in Central Bank of Denver, the courts were split on this issue. One line of cases held that Section 10(b) claims against the issuer’s or underwriter’s law firm were an improper attempt to impose a “duty to correct” false statements that did not exist under either the federal securities laws or ethical guidelines.9 These courts even refused to permit claims against lawyers to survive when the lawyer was actively involved in the drafting process.10

Another line of cases, arising chiefly from decisions in the Sixth Circuit, expressed the judicial belief that when lawyers become involved in the drafting process—depending on how substantial their involvement is—they could become primary participants in a misstatement and share equally in their clients’ liability for a primary violation.11 In order to justify this result, the courts that have upheld the primary violation claim against lawyers have required two evidentiary prerequisites. Courts have required facts supporting charges that 1) the lawyers themselves made the actual representations at issue in the offering documents, and 2) the lawyers have undertaken some responsibility in the due diligence process to verify the information used by their clients in the offering documents.12

In Molecular Technology Corporation v. Valentine, the Sixth Circuit held that if an attorney drafted a client’s documents, the attorney assumed an affirmative duty to adequately disclose accurate and reliable information that, absent his or her drafting, would have been provided by others.13 This duty also includes within its scope a duty to correct when later discovery reveals material inaccuracies in the original representations. Even before Central Bank of Denver, courts outside of the Sixth Circuit followed the holding in Molecular Technology, including at least one district court in the Ninth Circuit. In that case, Koehler v. Pulvers, the U.S. District Court for the Southern District of California held that an attorney’s failure to conduct a reasonable investigation of the offering documents he drafted, and his later failure to correct the inaccurate statements he made, could constitute a primary violation under Section 10(b).14

After Central Bank of Denver, there have been a handful of cases that have addressed the issue of lawyers assuming primary violator status as a result of their role in the offering document process. One from the Central District of California contains perhaps the strongest acceptance of the theory yet. In Employers Insurance of Wausau v. Musick, Peeler & Garrett, the district court, ruling on a claim made under Section 10(b), held that lawyers who draft offering documents for their clients can be primarily liable for misstatements and omissions in those same documents just as the offeror can be held liable.15

In support of this ruling, the district court relied in part on a Ninth Circuit decision that accountants could be held as primary violators under Section 10(b) when they played a “significant role” in the drafting of a letter to the Securities and Exchange Commission that contained material misrepresentations.16 The district court in Employers Insurance of Wausau saw no theoretical distinction between a misrepresentation in a letter to regulators and a misrepresentation contained in an offering document to a prospective investor. The court also apparently saw no practical distinction between the roles played in the offering document process by accountants and lawyers.17

In a similar decision after Central Bank of Denver, a district court in the Third Circuit held that lawyers should not be held liable under Section 10(b) unless the misstatements or omissions actually appear in parts of the offering document they authored or coauthored and their participation in the drafting process was “sufficiently significant.”18 The only conclusion one can reach from the holdings in the Sixth Circuit and district courts in the Third and Ninth Circuits is that when a lawyer’s role in the drafting process is direct and sufficiently significant, and the misstatement he or she authored or coauthored is an important part of the information offered to the public, the lawyer faces liability as a primary violator under Section 10(b).

State of Mind
It is one thing to find a duty to disclose and correct on the part of the securities professional. The duty alone, though, is not enough to establish liability even when a significant role is played in the drafting process. To be held liable as a primary violator, the lawyer, like any alleged Section 10(b) violator, must also have the requisite intent to violate the securities laws. Courts are split on what constitutes the requisite intent now that Congress has passed the Public Securities Law Reform Act.19 The PSLRA was enacted by Congress in 1995.

The chief aim of the PSLRA is to restrict the race to the courthouse to file securities class action suits by setting standards for the selection of counsel for the lead plaintiff. The law also sets forth specific pleading requirements for securities fraud actions that allege deception by misstatement or omission of material facts. The PSLRA requires the complaint to specify each statement alleged to be misleading and the reason why it is misleading—and if any allegation is based on “information and belief,” all facts that have formed the belief must be set forth.20 Moreover, the PSLRA also requires that if proof of “state of mind” is required under the Securities and Exchange Act of 1934, the complaint must state with “particularity” the facts giving rise to an inference the defendant acted with the required state of mind.21 While at first glance this provision seems to be no more than a reiteration of Rule 9(b) of the Federal Rules of Civil Procedure, some courts have taken a different view.

Prior to the 1995 passage of the PSLRA, courts believed that scienter allegations must lead to a strong inference of fraudulent intent. A plaintiff could accomplish this by alleging facts that either 1) showed the defendant had both motive and opportunity to commit fraud or 2) constituted strong circumstantial evidence of conscious misbehavior or recklessness. After the passage of the PSLRA, the Second Circuit articulated this standard, which became known as the Second Circuit standard for scienter, in Press v. Chemical Investment Services Corporation.22 The PSLRA did not change the fact that negligence is not enough to meet the scienter standard for a violation under Section 10(b).

When the PSLRA was passed, many commentators and several circuit courts concluded that it “elevated” the scienter standard. While the circuits are still split on this view, the Ninth Circuit is an adherent to it and has required that scienter be pled “in great detail, [with] facts that constitute strong circumstantial evidence of deliberately reckless or conscious misconduct.”23 The Second Circuit still adheres to its pre-PSLRA standard, as do the Third and Sixth Circuits.24 The net effect is that, at least in the Ninth Circuit, allegations of motive and opportunity to commit fraud, without more, are not enough to survive a motion to dismiss for failure to state a claim.

Whatever else may be said about the role motive should play in pleading a securities fraud claim, and however the Supreme Court ultimately rules on the scienter issue under the PSLRA, evidence of an equity ownership in a client takes the pleader a long way toward defeating a motion to dismiss, even under the heightened standard enunciated by the Ninth Circuit. Ownership in the client not only implicates such factors as divided loyalty and potentially impaired judgment but gives life to a claim that the lawyer had more at stake than just a professional fee. Considering the public attention that was lavished on the lucrative value of the “equity for fee” portfolios of outside counsel, the issue of lawyers taking an equity interest in a client in lieu of standard fees will clearly become a focal point of shareholder litigation in the right case. The loftier the value of a lawyer’s equity stake at the time of the alleged violation, the greater will be the claim that it impeded clear judgment, or worse, that it caused the lawyer to act recklessly in the face of known disclosure failures. This claim will be made in spite of the fact that the equity became worthless.

Common Law Negligence
Whatever the final decision is regarding the scope of Section 10(b) liability for lawyers, aggrieved third parties—such as franchisees, limited partners, and investors—also may utilize a simple theory of common law negligence for the drafter of a misleading disclosure document. In a negligence action, Central Bank of Denver likely will have no protective effect and may actually drive investors toward state law claims in jurisdictions hospitable to them. California is a state with strong case law supporting the theory of a lawyer’s duty of care to third parties.25

In cases finding a common law duty of care to third parties, California courts have not been troubled by the argument that lawyers’ professional duties only extended to the client corporation that issued the documents and not to third parties. The argument that there was no privity between lawyers and third parties did not find favor, either. Courts have found a duty of care by holding that attorneys undertake separate and distinct disclosure duties to third parties by participating in the preparation of client documents upon which third parties will clearly rely in making an investment decision.26

Courts in California that disregard the privity barrier conclude that the underlying nature of the work for the client was undertaken for a broader audience—that is, intended users beyond the client. For example, in In re ZZZZ Best Securities Litigation, a federal court in the Central District of California, applying California law, sensibly reasoned that the client corporation only hired the lawyers to satisfy a duty of full disclosure of material facts to investors, and the lawyers could best achieve that duty through drafting. In this case the court found the lawyers could be held responsible for the materials they drafted.27 Therefore, when a plaintiff investor is induced to rely on the statements made by a corporation, the basis for tort liability for a lawyer is present.

If the effect of Central Bank of Denver is to direct more claims to the arena of common law negligence, lawyers for defendants may find a stronger argument for coverage from their legal malpractice insurers. Because a Section 10(b) claim is an intentional fraud claim, it requires allegations that a lawyer intended to deceive investors. This likely would allow the insurance carrier to reserve rights under the fraud exemption to most malpractice policies. The common law negligence claim, however, requires no such showing of intent and instead permits the argument that a lawyer has a right to coverage under a malpractice policy. This is precisely what happened in Employers Insurance of Wausau.
Much like the PSLRA, its companion legislation, the more recent Securities Litigation Uniform Standards Act, which Congress passed in 1998, is an attempt to raise the bar to the filing of securities fraud class action suits. SLUSA mandates that federal securities law preempts the majority of state law securities fraud class actions and compels the removal to federal court of any covered action filed in state court.28 Covered actions largely include claims of fraud or omission in connection with the sale of covered securities, which are defined as securities traded on a national securities exchange. Covered securities include individual equities as well as shares in a mutual fund.

Congress enacted SLUSA to create national standards for securities fraud and extend the PSLRA’s more rigorous pleading requirements. The intent was to make it harder to file and prevail in class action securities fraud claims because the claims, according to Congress, drained the national economy by inhibiting the ability of smaller start-up companies to raise capital.

While SLUSA will have an effect on securities fraud class actions in state court that allege fraud by omission or deceptive device—the typical Section 10(b) claim masquerading as a state claim—it will not have an effect on common law negligence claims. SLUSA is only intended to reach those claims that, like those under Section 10(b), are required to allege scienter, or intent to defraud. It also will have no effect on a securities claim that is based on conduct alleging fraud in connection with securities not yet publicly traded or exempt from registration under federal law.

In one recent post-SLUSA case in California, a district court granted a remand motion and sent a negligence-based securities claim back to state court.29 Thus, while SLUSA does provide protection to lawyers, that protection will not extend to claims similar to those made in Employers of Wausau, in which the lawyer’s duty to investors was breached by a failure to meet a standard of care. Ironically, SLUSA will have a perverse effect on securities claims against lawyers, making claims alleging the lawyer acted as a participant (for example, the lawyer was part of the scheme to defraud investors) harder to plead than those alleging the lawyer acted as a lawyer (for example, the lawyer was the scrivener to the defrauders).

California, like many states, has a statutory scheme involving the regulation of securities and those who offer to sell or actually sell them as well as those assisting the offerees or sellers in reaching their audience. Corporations Code Sections 25504 to 25504.2 provide for joint and several liability for those who “materially” assist the offeror in activity constituting a violation of the Corporations Code. Most cases alleging securities claims against lawyers filed in California have also alleged some form of aiding and abetting under the state Corporations Code. Prior to SLUSA, courts allowed aiding and abetting claims under the Corporations Code so long as plaintiffs alleged the statutorily required intent to deceive or defraud. Courts held that recklessness was not sufficient to plead properly under Corporations Code Section 25504.1, and claims based on conduct short of intentional were usually dismissed.30

The combined effect of Central Bank of Denver and SLUSA is the likely demise of class action claims against lawyers based on state law for aiding and abetting in the national securities marketplace. To the extent SLUSA federalizes all state claims of covered class action securities fraud, Central Bank of Denver assures that claims against lawyers who aid and abet the issuers of covered securities will be dismissed whether they are brought as implied claims under Section 10(b) or as statutory claims under Corporations Code Section 25504.1. Either way, the claims will fail, leaving as viable claims only the aiding and abetting claims under state law against noncovered securities, negligence claims brought under common law as malpractice actions, and primary federal securities fraud claims (such as those alleged in Molecular Technology).

Claims by Regulators for Aiding and Abetting
Central Bank of Denver does not completely end the possibility of claims against lawyers for aiding and abetting under Section 10(b). Those claims may be brought as part of a regulatory action by the SEC or the California Department of Corporations. While not armed with the threat of economic disaster in the form of a massive tort damages award, charges by regulators can seriously disrupt, if not destroy, the careers of lawyers who practice before those agencies.

After Central Bank of Denver, it was believed by regulatory law practitioners that lawyers who previously had been charged by the SEC in its enforcement actions with aiding and abetting would now be free from such entanglements. Not so, according to the Ninth Circuit. In the only case to decide the issue, the Ninth Circuit held that Section 104 of the PSLRA provided that aiding and abetting any violation of Title 15 of the USC Sections 78a through 78kk (Section 10(b) is included within those sections) may be brought by the SEC and that injunctive relief and monetary damages may be sought.31 According to the Ninth Circuit, while Central Bank of Denver found an absence of congressional intent to support a cause of action for aiding and abetting under federal securities laws, the case did not have any application to another part of the federal regulatory scheme governing securities, for which Congress decided to create a cause of action for aiding and abetting, albeit one limited to the SEC.
While no cases have yet been brought by the SEC under Section 104 of the PSLRA, the statute gives the SEC the authority to seek penalties and enjoin lawyers from practicing before it.32 The latter remedy is of particular concern to those law firms that assisted dot-com companies in the capital markets. A finding of a violation of any provision of the federal securities laws as a result of Section 104’s provision for aiding and abetting can be a separate basis for an order disallowing the law firm from filing registration statements or other required filings on behalf of publicly held clients. While seldom used, this draconian relief effectively can prevent a firm from engaging in a large part of its corporate practice. For an individual corporate lawyer, the penalty essentially prevents him or her from practicing at all in the lucrative public capital markets.
What is clear from the past 20 years of litigation against lawyers in the securities arena is that the taking of equity positions and board seats with clients carries a measure of exposure to severe economic and professional pain in a market gone sour. The old saw that a rising tide lifts all boats has equal application in reverse and is particularly poignant to securities lawyers today. Once the equity markets began to falter, a lot of professionals became exposed to potential liability. In the world of floundering start-up companies, the lawyers for the companies may meet the plaintiffs’ class action bar, or the SEC, in trying circumstances. Thus lawyers, too, may become casualties of the Internet slowdown, particularly when their activities with their clients lead to the inescapable inference that their judgment was clouded by a motive to enrich themselves all too quickly in the once-booming new economy.

1 James Q. Walker, Lawyers Take Risks by Taking Equity in Clients, N.Y. L.J., Dec. 11, 2000, at 4; Scott Brede, Equity Ethics: Looking for a Stock Answer, Conn. L. Tribune, May 1, 2000, at 13.
2 The Securities and Exchange Act of 1934 §10(b), 15 U.S.C. §78j(b).
3 Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 114 S. Ct. 1439 (1994).
4 Id. at 177.
5 Id. at 176.
6 Id. at 176, 177.
7 Id. at 191.
8 Id. at 191, 194.
9 Abell v. Potomac Ins. Co., 858 F. 2d 1104, 1125-26 (5th Cir. 1988).
10 Friedman v. Arizona World Nurseries, 730 F. Supp. 521, 531 (S.D. N.Y. 1990), aff’d sub nom., Friedman v. Arizona World, 927 F. 2d 594 (2d Cir. 1991).
11 Molecular Tech. Corp. v. Valentine, 925 F. 2d 910 (6th Cir. 1991); In re Rospatch Sec. Litig., 760 F. Supp. 1239, 1250 (W.D. Mich.), aff’d, 933 F. 2d 1008 (6th Cir. 1991).
12 Employers Ins. of Wausau v. Musick, Peeler & Garrett, 871 F. Supp. 381, 389 (C.D. Cal. 1994); Koehler v. Pulvers, 614 F. Supp. 829 (S.D. Cal. 1985).
13 Molecular Tech. Corp., 925 F. 2d at 918.
14 Koehler, 614 F. Supp. at 843, 844.
15 Employers Ins. of Wausau, 871 F. Supp. at 389.
16 In re Software Toolworks, Inc., 50 F. 3d 615, 628 n.3 (9th Cir. 1994).
17 Employers Ins. of Wausau, 871 F. Supp. at 389, 390.
18 Klein v. Boyd, 949 F. Supp. 280, 282 (E.D. Penn. 1996).
19 The Public Securities Law Reform Act (PSLRA), 15 U.S.C. §78u-4.
20 15 U.S.C. §78u-4(b)(1).
21 15 U.S.C. §78u-4(b)(2).
22 Press v. Chemical Inv. Servs. Corp., 166 F. 3d 527 (2d Cir. 1999).
23 In re Silicon Graphics, 183 F. 3d 970, 974 (9th Cir. 1996).
24 In re Comshare Inc. Sec. Litig., 183 F. 3d 542 (6th Cir. 1999); In re Advanta Corp. Sec. Litig., 180 F. 3d 525 (3d Cir. 1999).
25 Roberts v. Ball, Hunt, Hart, Brown & Baerwitz, 57 Cal.  App. 3d 104 (1976); Koehler v. Pulvers, 614 F. Supp. 829 (S.D. Cal. 1985); Courtney v. Waring, 191 Cal. App. 3d 1434 (1987); Bily v. Arthur Young & Co., 3 Cal. 4th 370 (1992).
26 In re ZZZZ Best Sec. Litig., 1989 U.S. Dist. LEXIS 8083, at*79 (C.D. Cal. 1994).
27 Id.
28 The Securities Litigation Uniform Standards Act (SLUSA), 15 U.S.C. §78bb.
29 Simon v. Internet Wire Co., 2001 U.S. Dist. LEXIS 4086 (C.D. Cal. 2001).
30 In re Diasonics Sec. Litig., 599 F. Supp. 447, 459 (N.D. Cal. 1984); Orloff v. Allman, 819 F. 2d 904, 907-08 (9th Cir. 1987).
31 SEC v. Fehn, 97 F. 3d 1276 (9th Cir. 1996).
32 Id.
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