Opinion ID: 3037838
Heading Depth: 3
Heading Rank: 1

Heading: The Use or Employment of a Deceptive Device or

Text: Contrivance [1] The Supreme Court tells us that § 10(b) is intended to prohibit the use or employment of any deceptive device in 2 We do not consider the possibility of liability based on actionable omissions or manipulation sufficient to satisfy the requirement of a “manipulative or deceptive device or contrivance” under § 10(b). There are no allegations that any Defendant was subject to a duty to disclose in the context of these transactions or engaged in manipulative trading activity. See Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 476 (1977). 7248 CAL. STATE TEACHERS v. AOL TIME WARNER connection with the purchase or sale of securities, including deception as part of a larger scheme to defraud the securities market. See Ernst & Ernst, 425 U.S. at 199 n.20 (defining “device” as “an invention; project; scheme; often, a scheme to deceive”); Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6, 10 n.7 (1971) (“ ‘We believe that § 10(b) and Rule 10b-5 prohibit all fraudulent schemes in connection with the purchase or sale of securities, whether the artifices employed involve a garden type variety of fraud, or present a unique form of deception.’ ” (quoting A. T. Brod & Co. v. Perlow, 375 F.2d 393, 397 (2d Cir. 1967))). The Supreme Court has also held that a non-speaking actor who engages in a “scheme to defraud” has used or employed a deceptive device within the meaning of § 10(b). See SEC v. Zandford, 535 U.S. 813, 821-22 (2002). [2] In Central Bank, the Supreme Court held that liability under § 10(b) only extends to “primary violators” and there is no liability for merely “aiding and abetting” a violation. 511 U.S. at 191. Since Central Bank, it is the duty of courts to determine what constitutes a “primary violation” of § 10(b). With respect to the making of false statements or omissions, we have held that “substantial participation or intricate involvement in the preparation of fraudulent statements is grounds for primary liability even though that participation might not lead to the actor’s actual making of the statements.” Howard v. Everex Sys., Inc., 228 F.3d 1057, 1061 n.5 (9th Cir. 2000); see id. at 1061 (holding that signing and attesting to a statement, such that for all intents and purposes the signor-attestor made the statement, is sufficient to be considered a primary violator); see also In re Software Toolworks Inc. Sec. Litig., 50 F.3d 615, 628-29 & n. 3 (9th Cir. 1994) (holding that drafting or editing false statements that the drafter-editor knows will be publicly disseminated is sufficient to be considered a primary violator). [3] What it means to be a “primary violator” with respect to an alleged “scheme to defraud” has been less extensively CAL. STATE TEACHERS v. AOL TIME WARNER 7249 discussed. In Cooper v. Pickett, 137 F.3d 616, 624 (9th Cir. 1997), we held that to be liable for a “scheme to defraud,” “each defendant [must have] committed a manipulative or deceptive act in furtherance of the scheme.” The relevant inquiry is: what conduct constitutes a manipulative or deceptive act in the furtherance of a scheme to defraud sufficient to render the defendant a “primary violator” of § 10(b)? [4] The SEC argues in its amicus brief that “Any person who directly or indirectly engages in a manipulative or deceptive act as part of a scheme to defraud can be a primary violator.”3 The SEC defines “a deceptive act” as “engaging in a transaction whose principal purpose and effect is to create a false appearance of revenues.” We agree with the SEC that engaging in a transaction, the principal purpose and effect of which is to create the false appearance of fact, constitutes a “deceptive act.”4 Participation in a fraudulent transaction by itself, however, is insufficient to qualify the defendant as a “primary violator” if the deceptive nature of the transaction or scheme was not an intended result, at least in part, of the defendant’s own conduct. We hold that to be liable as a primary violator of § 10(b) for participation in a “scheme to defraud,” the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact 3 The arguments of the SEC are only persuasive authority to the extent that they are reasonable in light of the statutory authority. See Zandford, 535 U.S. at 819-20 (“[The SEC’s] interpretation of the ambiguous text of § 10(b), in the context of formal adjudication, is entitled to deference if it is reasonable”). To the extent that the SEC’s proposed test purports to include aiding and abetting or coconspirator liability, we are constrained to reject it. See In re GlenFed, Inc. Sec. Litig., 60 F.3d 591, 592 (9th Cir. 1995). 4 “The consideration of purpose and effect of challenged actions not infrequently assists in determining whether a prohibition is to be applied to complex conduct. . . . [and its] importance . . . [in] judg[ing] the legality of challenged action is also a recurring theme in statutory law.” The Wilderness Soc’y v. U.S. Fish & Wildlife Serv., 353 F.3d 1051, 1064 (9th Cir. 2003). 7250 CAL. STATE TEACHERS v. AOL TIME WARNER in furtherance of the scheme. It is not enough that a transaction in which a defendant was involved had a deceptive purpose and effect; the defendant’s own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect.5 Defendants argue that imposing liability for participation in an overall scheme to defraud would impose liability for conduct other than the making of a material misstatement or omission and would conflict with Central Bank. We disagree. We see no justification to limit liability under § 10(b) to only those who draft or edit the statements released to the public. To the contrary, § 10(b) prohibits any person or entity from 5 The “principal purpose” prong is related to but different from the element of scienter. For the element of scienter, we require “that a private securities plaintiff proceeding under the PSLRA must plead, in great detail, facts that constitute strong circumstantial evidence of deliberately reckless or conscious misconduct.” In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999). Previous cases have found the scienter requirement satisfied by indirect evidence of a culpable state of mind, such as suspicious insider trading activity or knowledge of accounting violations. See In re Daou Systems, Inc., 411 F.3d 1006, 1017 (9th Cir. 2005); Silicon Graphics, 183 F.3d at 986. While the scienter element ensures a culpable state of mind and must be satisfied for recovery under § 10(b), the “principal purpose” prong examines instead whether the challenged conduct of the defendant had a principal purpose, and not just an accidental effect, of creating a false appearance as part of a deceptive transaction or fraudulent scheme. Unlike the scienter requirement, the “purpose and effect” test is focused on differentiating conduct that may form the basis of a primary violation under § 10(b) from mere aiding and abetting activity that the Supreme Court has held does not constitute a primary violation. A defendant may intend to deceive the public by substantially assisting another’s misconduct as part of a scheme to defraud, but fail to perform personally any action that created a false appearance as part of this scheme. The scienter requirement, therefore, will not in all cases distinguish aiding and abetting from primary liability. In applying the “scienter” element, we look at whether a defendant’s state of mind was sufficiently culpable for § 10(b) liability. By contrast, we may examine the “principal purpose and effect” of the defendant’s challenged conduct in a fraudulent scheme as an aid to assessing whether the defendant’s conduct was sufficiently deceptive for § 10(b) liability. CAL. STATE TEACHERS v. AOL TIME WARNER 7251 using or employing any deceptive device, directly or indirectly, in connection with the purchase and sale of securities. See Robert A. Prentice, Locating That “Indistinct” and “Virtually Nonexistent” Line Between Primary and Secondary Liability under Section 10(b), 75 N.C. L. Rev. 691, 731 (1997) (asserting that “the view that one can be liable only for one’s own statements arguably ignores the fact that both Section 10(b) and Rule 10b-5 condemn those who employ devices or make misstatements ‘directly or indirectly’ ”). Furthermore, § 10(b) “should be construed not technically and restrictively, but flexibly to effectuate its remedial purposes.” Zandford, 535 U.S. at 819 (internal quotation marks omitted). Nor is “scheme to defraud” liability a substitute for aiding and abetting liability that the Supreme Court precludes in Central Bank. The focus of the inquiry on the deceptive nature of the defendant’s own conduct ensures that only primary violators (that is, only those defendants who use or employ a manipulative or deceptive device) are held liable under the Act. Trial courts which have imposed liability under a “scheme to defraud” theory have often required that the defendant’s actions in fraudulent transactions have a principal purpose and effect of creating a false appearance of fact in furtherance of the scheme to defraud. See Quaak v. Dexia S.A., 357 F. Supp. 2d 330, 342 (D. Mass. 2005) (finding sufficient allegations for primary liability under § 10(b) when “defendant was a primary architect of the scheme to finance the sham entities”); In re Global Crossing, Ltd. Sec. Litig., 322 F. Supp. 2d 319, 336-337 (S.D.N.Y. 2004) (allowing claims of primary liability to go forward where auditors “masterminded” company’s misleading accounting practices); In re Lernout & Hauspie Sec. Litig., 236 F. Supp. 2d 161, 173 (D. Mass. 2003) (denying a motion to dismiss for outside business partners who invented sham corporate entities that allowed a corporation “to hide research and development expenses, create fictitious revenue, and ultimately overstate profits in [its] financial reports”). 7252 CAL. STATE TEACHERS v. AOL TIME WARNER [5] Conduct by the defendant that does not have a principal legitimate business purpose, such as the invention of sham corporate entities to misrepresent the flow of income, may have a principal purpose of creating a false appearance. See In re Enron Corp. Sec., Derivative & “ERISA” Litig., 310 F. Supp. 2d 819, 830 (S.D. Tex. 2004) (“Sham business transactions with no legitimate business purpose that are actually guaranteed ‘loans’ employed to inflate Enron[’s] financial image are not above-board business practices.”). Conduct that is consistent with the defendants’ normal course of business would not typically be considered to have the purpose and effect of creating a misrepresentation. See In re Enron Corp. Sec., Derivative & ERISA Litig., 235 F. Supp. 2d 549, 580 (S.D. Tex. 2002) (finding that “conclusory allegations that are consistent with the normal activity of such a business entity, standing alone, . . . are insufficient to state a claim of primary liability under Central Bank” (internal quotation marks omitted)). Participation in a legitimate transaction, which does not have a deceptive purpose or effect, would not allow for a primary violation even if the defendant knew or intended that another party would manipulate the transaction to effectuate a fraud. See In re Charter Commc’ns, Inc., Sec. Litig., 443 F.3d 987, 992 (8th Cir. 2006) (refusing to impose primary liability “on a business that entered into an arm’s length nonsecurities transaction with an entity that then used the transaction to publish false and misleading statements to its investors and analysts”); In re Parmalat Sec. Litig., 376 F. Supp. 2d 472, 505 (S.D.N.Y. 2005) (“At worst, the banks designed and entered into the transactions knowing or even intending that Parmalat or its auditors would misrepresent the nature of the arrangements. That is, they substantially assisted fraud with culpable knowledge — in other words, they aided and abetted it.”). [6] If a defendant’s conduct or role in an illegitimate transaction has the principal purpose and effect of creating a false appearance of fact in the furtherance of a scheme to defraud, then the defendant is using or employing a deceptive device CAL. STATE TEACHERS v. AOL TIME WARNER 7253 within the meaning of § 10(b). A test that examines the purpose and effect of a defendant’s conduct in an alleged scheme to defraud, as a means to assess whether the defendant used or employed a deceptive device, ensures that the defendant’s conduct is sufficiently deceptive to justify imposing primary liability. Thus, when determining whether a defendant is a “primary violator,” the conduct of each defendant, while evaluated in its context, must be viewed alone for whether it had the purpose and effect of creating a false appearance of fact in the furtherance of an overall scheme to defraud. B. In Connection with the Purchase or Sale of Securities [7] In addition to the use or employment of a deceptive or manipulative device or contrivance, § 10(b) requires that the primary violation must be “in connection with the purchase or sale of any security.” 15 U.S.C. § 78j. In Zandford, the Supreme Court held that a broker’s misappropriation of a brokerage account was a fraudulent “scheme to defraud” that was “in connection with” the sale of securities despite lacking any deception about the value of a security or “manipulation of a particular security.” Zandford, 535 U.S. at 821. In Zandford, the broker fraudulently wrote checks to himself from a brokerage account that required the sale of securities in order to cash the checks. See id. Although the misappropriation of money did not affect the securities market until the check was later redeemed, the broker’s scheme to defraud was not complete until the victim’s securities were sold and the check was redeemed. See id. The Supreme Court held that the scheme to defraud “coincided” with the sale of securities, which satisfied the “in connection with” requirement of § 10(b). Id. at 820. [8] Similarly, a scheme to misrepresent the publicly reported revenue of a company may coincide with the purchase or sale of securities because the scheme will not be complete until the fraudulent information is introduced into the securities market. That every participant in the scheme did 7254 CAL. STATE TEACHERS v. AOL TIME WARNER not release the information to the public does not diminish the causal connection between all defendants in the scheme and the securities market. See Cent. Bank, 511 U.S. at 191 (stating that “[i]n any complex securities fraud, moreover, there are likely to be multiple violators”). If multiple participants used or employed a deceptive device in furtherance of a scheme to misrepresent the reported revenues of a company, then all participants may be viewed as having acted in connection with the purchase or sale of securities. C. Reliance [9] Another requirement for liability under § 10(b) is reliance. See Cent. Bank, 511 U.S. at 180. “Reliance provides the requisite causal connection between a defendant’s misrepresentation and a plaintiff’s injury.” Basic Inc. v. Levinson, 485 U.S. 224, 243 (1988). A plaintiff may be presumed to have relied on a misrepresentation if the misleading or false information was injected into an efficient market. “Indeed, nearly every court that has considered the proposition has concluded that where materially misleading statements have been disseminated into an impersonal, well-developed market for securities, the reliance of individual plaintiffs on the integrity of the market price may be presumed.” Id. at 247. The fraudon-the-market presumption requires the dissemination of the misrepresentation into an efficient market, but not personal involvement by the defendant in disseminating this statement. See Knapp v. Ernst & Whinney, 90 F.3d 1431, 1436 (9th Cir. 1996) (“Because a material misrepresentation or omission is generally embedded in the market price of the security, an investor who purchases or sells the security will have presumably relied on the misrepresentation.”). The requirement of reliance is satisfied if the introduction of misleading statements into the securities market was the intended end result of a scheme to misrepresent revenue. See In re ZZZZ Best Sec. Litig., 864 F. Supp. 960, 973 (C.D. Cal. 1994) (“Instead, the market’s overall reliance on the Z Best CAL. STATE TEACHERS v. AOL TIME WARNER 7255 fraudulent scheme, or at least the additional statements as released and issued by Z Best, is sufficient to satisfy the reliance element in the Rule 10b-5(a) & (c) claims.”); see also 4 Alan R. Bromberg & Lewis D. Lowenfels, Bromberg & Lowenfels on Securities Fraud § 7:469 (2d ed. 2006) (“Despite some earlier disagreement, it now seems settled that FOMT [the fraud-on-the-market-theory] applies to all three clauses of Rule 10b-5: (1) scheme to defraud, (2) misrepresentation or omission, and (3) fraudulent course of business, not just to clauses (1) and (3).”). The scheme to defraud would not be complete until the fraudulent information has entered the securities market. See Parmalat, 376 F. Supp. 2d at 509 (“The banks made no relevant misrepresentations to those markets, but they knew that the very purpose of certain of their transactions was to allow Parmalat to make such misrepresentations. In these circumstances, both the banks and Parmalat are alleged causes of the losses in question.”). We may presume, absent persuasive conflicting evidence, that purchasers relied on misstatements produced by a defendant as part of a scheme to defraud, even if the defendant did not publish or release the misrepresentations directly to the securities market. We conclude that conduct by a defendant that had the principal purpose and effect of creating a false appearance in deceptive transactions as part of a scheme to defraud is conduct that uses or employs a deceptive device within the meaning of § 10(b). Furthermore, such conduct may be in connection with the purchase or sale of securities if it is part of a scheme to misrepresent public financial information where the scheme is not complete until the misleading information is disseminated into the securities market. Finally, a plaintiff may be presumed to have relied on this scheme to defraud if a misrepresentation, which necessarily resulted from the scheme and the defendant’s conduct therein, was disseminated into an efficient market and was reflected in the market price. 7256 CAL. STATE TEACHERS v. AOL TIME WARNER