United States: Testing The Limits Of Primary Violations Under §10(b)

Originally published in New York Law Journal, Monday October 8, 2008

Although the line between primary and secondary violations of §10(b) and Rule 10b-5(b) in private civil litigation has been sharply drawn, particularly after Stoneridge, courts have struggled to articulate that distinction when the violations alleged are premised upon a course of deceptive conduct under Rule 10b-5(a) and (c)1 rather than upon misstatements and omissions under Rule 10b-(5)(b).

In Securities and Exchange Commission (SEC) actions which, unlike private litigation, do not require allegations or proof of reliance, loss causation or economic loss, and secondary violations are permitted, the line seems to have been drawn with disappearing ink. While it may not matter whether liability arises as a result of primary or secondary conduct in SEC cases (as the remedies are the same), the cases raise questions as to whether the standards used are the same and whether too permissive a primary liability standard in SEC cases could impact private actions, even after Stoneridge.

One example is the recent decision in SEC v. Simpson Capital Management Inc., 2008 U.S. Dist. LEXIS 67054 (S.D.N.Y. Sept. 11, 2008), in which Judge John G. Koeltl denied defendants' motion to dismiss, finding that the complaint adequately pleaded the defendants' primarily liability for a mutual fund late trading scheme. The defendants, an investment adviser, the owner of the firm and an employee, were alleged to have committed primary violations of Rule 10b-5(a) and (c), which prohibit "deceptive conduct," employing "any device, scheme or artifice to defraud" and engaging in any "act, practice, or course of business which operates or would operate as a fraud or deceit upon any person." The challenged activities in Simpson involved an allegedly fraudulent scheme to place "late trades" in mutual funds in violation of Rule 22c-1(a) promulgated by the SEC under the Investment Company Act of 1940.

Mr. Simpson was the founder, owner, president, and chief investment officer of Simpson Capital. He managed and directed the operations of the firm and was "primarily responsible for all investment and trading decisions." Mr. Dowling was the head trader responsible for research and daily trading execution. Mr. Simpson and Mr. Dowling allegedly engaged in late trading by submitting proposed trades to broker-dealers on "scenario sheets" before 4:00 p.m. and did business only with brokers who allowed them the opportunity to authorize the "tentative" trades after 4:00 p.m. and thus to incorporate after-market information into their investment decisions.2

The Decision

In their motion to dismiss, defendants argued that they were not primary Section 10(b) violators, the SEC's only claim. At best, "the allegations in the complaint support an inference that the defendants had knowledge of the regulatory violations of others, obtained an economic advantage from those violations, and did nothing to reveal or prevent those violations." 2008 U.S. Dist. LEXIS 67054 at *22. The SEC argued that Mr. Simpson and Mr. Dowling were primarily liable as the "architects" of the scheme, having devised, sought out and implemented it. Judge Koeltl first addressed whether the defendants' alleged actions constituted "deceptive conduct." He concluded that the allegations that the defendants had conveyed a "false impression" to mutual funds through complicit brokers as to the times at which trades were submitted, were sufficient. Id. at *20.

Judge Koeltl next analyzed the U.S. Court of Appeals for the Second Circuit standards for primary liability in both SEC and private actions, all pre-Stoneridge Investment Partners, LLC v. Scientific- Atlanta Inc., 128 S.Ct. 761 (2008). Judge Koeltl's analysis suggests that a different standard has been used to analyze primary liability in SEC cases from that used in private actions. In SEC v. First Jersey Securities Inc., 101 F.3d 1450, 1471 (2d Cir. 1996), the Second Circuit held that "[p]rimary liability may be imposed 'not only on persons who made fraudulent misrepresentations but also on those who had knowledge of the fraud and assisted in its perpetration'" (emphasis supplied). Although the facts in First Jersey demonstrated that defendant Brennan was the mastermind and architect of the fraudulent scheme, as Judge Koeltl noted, "it is difficult to see how the standard of 'knowledge and assistance' differs from 'aiding and abetting liability.'" 2008 U.S. Dist. LEXIS 67054, at *24-25.

First Jersey's "participation" standard was reiterated in SEC v. U.S. Environmental Inc., 155 F.3d 107 (2d Cir. 1998), where the court held that "a primary violator is one who 'participated in the fraudulent scheme.'" 155 F.3d at 111. Reversing U.S. District Judge Peter K. Leisure of the Southern District of New York, who had dismissed the complaint against a trader (Mr. Romano) on the ground that [Mr.] Romano was an aider/abettor, because he "followed directions...in carrying out buy or sell orders," Id. at 110, the court observed:

It is plain to us that the complaint alleged [Mr.] Romano to be a primary violator. [Mr.] Romano "participated in the fraudulent scheme," First Jersey Secs., 101 F.3d at 1471, i.e., the manipulation of USE's stock, by effecting the very buy and sell orders that artificially manipulated USE's stock price upward. Indeed, if the trader who executes manipulative buy and sell orders is not a primary violator, it is difficult to imagine who would [be] liable. Id. at 112.

The court explained that "[Mr.] Romano is a primary violator despite the fact that someone else directed the market manipulation scheme." Id. (emphasis supplied). Thus, under U.S. Environmental, one need not be the "architect" of a fraudulent scheme in order to be held liable as a primary violator.

In analyzing U.S. Environmental, Judge Koeltl found significant the court's endorsement of First Jersey's "participation" standard, "although it did not provide any bounds to that test because the defendant actually executed the trades that were alleged to be manipulative," and left unclear what level of participation is sufficient to establish primary liability.

Judge Koeltl also analyzed the standard used to determine primary liability in private actions during the same period, including Wright v. Ernst & Young, 152 F.3d 169, 176 (2d Cir. 1998), and Shapiro v. Cantor, 123 F.3d 717, 720 (2d Cir. 1997), in both of which the Second Circuit rejected a substantial participation standard and found "secondary actors [could not] be held primarily liable under §10(b) for mere knowledge and assistance in the fraud." Indeed, in Shapiro, a 10b-(5)b case, the court held that "a defendant must actually make a false or misleading statement in order to be held liable under §10(b). Anything short of such conduct is merely aiding and abetting, and no matter how substantial that aid may be, it is not enough to trigger liability under §10(b)." This standard is in accord with the Supreme Court's Stoneridge decision holding that a private plaintiff must plead and prove that the defrauded party (in Stoneridge, the public) actually relied upon the deceptive act of the defendant. Judge Koeltl believed that the Wright standard used in private actions "undercut" the "participation" standard used in SEC actions. At least one court has stated that First Jersey was "effectively overruled by the Second Circuit's decisions in Shapiro [and] Wright." Ravens v. Republic N.Y. Corp., 2002 U.S. Dist. LEXIS 12162, at *39 (E.D. Pa. April 24, 2002). Another way to analyze these cases is that the court has simply applied a somewhat different standard to primary liability in SEC cases, or in deceptive acts cases, or in both.

In any event, the differing approaches has left Second Circuit authority in flux. Ultimately, Judge Koeltl applied the "participation" standard and found the complaint adequately pleaded defendants' primary liability.

The complaint alleges that the defendants [Mr.] Simpson and [Mr.] Dowling, much like [Mr.] Brennan in First Jersey Securities, orchestrated the fraudulent scheme. According to the complaint, [Mr.] Simpson was responsible for all investment decisions, and [Mr.] Dowling was responsible for executing all trades.... The SEC is correct that the complaint alleges that the defendants devised the scheme to defraud and that they proceeded to deal only with brokers who agreed to continue to join with them in the scheme to defraud the mutual funds.... These allegations are sufficient to allege with particularity the primary liability of the defendants. Id. at *30-32.


This case raises several interesting questions. First, as Judge Koeltl commented "[i]t is unclear why the SEC did not allege, at least in the alternative, that the defendants provided substantial assistance to the brokers who allegedly engaged in the late trading." Id. at *23. For any litigant to take on a higher standard of proof than necessary is odd to say the least, and even more so when the higher burden generates motion practice over the complaint's viability. Perhaps the SEC is (or at least pre-Stoneridge was) seeking to expand the scope of private actions by creating SEC case precedents, despite being repeatedly rebuffed in its expansion efforts by Congress and the courts. The SEC surely recognizes, as Judge Koeltl observed, that "[t]he Court of Appeals has not definitively described the bounds of primary liability, as opposed to aiding and abetting liability, particularly in an action brought by the SEC, and particularly when the action involves a claimed violation of Rule 10b-5(a) or (c), rather than Rule 10b-5(b)." Id. at *24. Litigants may be less concerned in SEC actions with the line between primary and secondary liability since it is a Pyrrhic victory to be found not primarily liable, but nonetheless equally liable as an aider and abettor. And the courts, knowing that the SEC could bring aiding and abetting charges, may be tempted to stretch primary liability where the SEC fails to do so. Indeed, that may have occurred here. The SEC's complaint describes Mr. Simpson as the "architect" who "orchestrated" the scheme and was "primarily responsible for all investment and trading decision," whereas for Mr. Dowling, the SEC uses classic aiding and abetting language alleging that he "assisted" and "had knowledge of and implemented all decisions."3 Nonetheless, both were alleged to be primary violators, the defendants jointly denied that liability, and the court found those pleading requirements to be met for both. The decision may have allowed potential aiding and abetting allegations against Mr. Dowling to state a primary violation, effectively collapsing the distinction between the two.

Another question is how will the courts analyze primary liability in Rule 10b-5(a) and (c) SEC cases going forward, and will that have an impact on the standard used in private actions as well? The Supreme Court in Stoneridge provided a way to identify primary liability by reference to the requirement of reliance, i.e., the defendant's participation must be of a type and character as to have been relied upon by the defrauded party.

Should this same analysis be used in SEC cases to distinguish primary and aiding and abetting liability even though reliance is not an element in an SEC action? If so, one would ask: if Simpson were a private action, would the defendants have been found primarily liable? Maybe. Judge Koeltl did find the mutual funds were misled by the defendants' own acts, which created the "false impression" that the trades were timely submitted.

On the other hand, it was the brokers, as in U.S. Environmental, who executed the transactions upon which the mutual funds directly relied. Perhaps this is a case, as contemplated in Stoneridge, where "an indirect chain" of reliance would not be too remote for primary liability to attach because both the hedge fund defendants and the brokers are in the "investment sphere" and not in "the realm of ordinary business operations." Stoneridge, 128 S.Ct. at 770.

Either way, questions exist as to whether a defendant's participation should be analyzed in the same manner in SEC actions as in private actions to determine whether a defendant is primarily or secondarily liable. To avoid confusion, as well as a potential expansion of primary liability in private actions through the back door of SEC precedents, we hope the courts will opt for uniformity.


1. Now Rule 10b-5(1) and (3).

2. Late trading is the practice of placing orders to buy, redeem, or exchange mutual fund shares after the 4:00 p.m. (EST) market close while still receiving the current day's mutual fund price. Late trading allegedly harms shareholders in mutual funds by diluting the value of their shares.

3. See, e.g., Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 119 (2d Cir. 1982) (aiding and abetting a violation of §10(b) requires knowledge of the violation and "substantial assistance in the accomplishment of the violation").


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