Skip to main content
Find a Lawyer

Why Claims Alleging Negligence Or Fraud Might, Or Might Not, Work

Monday, Mar. 04, 2002

This is Part Two of a two-part series by Professor Sebok on tort litigation, bankruptcy, and Enron. Part One of this series can be found in the archive of Professor Sebok's columns on this site. - Ed.

The shareholders who held Enron stock - many of whom were or are Enron employees - have suffered serious economic injuries. Their pensions were basically tied up in a stock whose value has plummeted. Moreover, they have apparently suffered these injuries as a result of wrongdoing. Do they have legal recourse?

In a previous column, I explored the reasons why the former shareholders would have little or no chance to recover against the bankrupt company itself. Fortunately, however, a suit against Enron itself is not the only remedy tort law may afford them.

Depending on the facts, shareholders may also be able to bring negligence claims, and claims of fraud or other intentional torts, against other defendants, such as Enron's lawyers and accountants. However, under Texas law, which would apply, bringing such claims would still be rough going. Indeed, some of the claims might well be dismissed on legal motions even before discovery is conducted.

Tort Law Claims for Economic Harms Alone

When a plaintiff's economic interests have been harmed, but the plaintiff has not suffered any accompanying physical injury, tort law offers two remedies: negligence claims and fraud (or other intentional tort) claims.

To establish a negligence claim, the plaintiff must show that the defendant owed them a duty, acted unreasonably, and caused them an economic injury. To establish a fraud claim, the plaintiff must show that the defendant intentionally communicated a misrepresentation upon which they relied. Finally, the plaintiff can also bring another type of intentional tort claim - a claim for "tortious interference" - if they can show the defendant intentionally interfered with their economic activity.

Why An Attorney Malpractice Suit By Shareholders Would Fail

If the shareholders sued the lawyers and accountants, would they win? Right now, it is impossible to tell. Obviously, whether either group of professionals could be held liable after a trial depends on the development of facts available only through discovery. But there may also be legal obstacles to contend with. One of these obstacles relates to the negligence plaintiffs' need to prove that the professionals had a duty not only to Enron, but to them.

When accountants and lawyers injure their clients through negligence, the tort remedy is relatively straightforward: a suit in professional malpractice, with each professional measured against the commonly accepted standards of their profession. But when professionals injure third parties (parties other than their clients), the story gets a little more complicated.

In Texas (and many other states), it is near impossible for a non-client (such as a company shareholder) to sue a lawyer for injuries resulting from malpractice to a client (such as a company), except in a narrow set of cases involving wills. Courts hold the attorney's duty is to the client, not to third parties.

Thus, in a malpractice case, Enron's attorneys' duty would be held to be a duty to Enron, not its shareholders. The rationale behind this rule is that if lawyers were held to have duties in malpractice to anyone but their clients, they would not be able to represent their clients faithfully.

Why A Negligent Misrepresentation Suit Would Probably Fail, Too

The Texas Supreme Court does, however, offer a possible remedy to third parties that is not based in malpractice law, but in the tort of negligently supplying information for the guidance of others.

In McCamish, Martin, Brown & Loeffler v. V. F. E. Appling Interests, a law firm negligently told its client that the client could enter into a settlement agreement with another party, Appling, without getting the consent of the Texas Savings and Loan Commissioner. Both the client and Appling were harmed by the lawyer's mistake. The Texas Supreme Court allowed Appling to sue the law firm for negligence, even though it was not the firm's client.

In support of its holding, the court cited the Restatement (Second) of Torts S 552, which concerns "information negligently supplied for the guidance of other." This section creates what lawyers term a negligent misrepresentation claim. In Texas, this section applies to lawyers, accountants, doctors, title insurers, and real estate agents in pretty much the same way; all can be defendants in a negligent misrepresentation suit.

Moreover, the court held that, to sue on a Section 552 theory, Appling did not have to have directly received the information from the law firm. Instead, Appling could recover if it could show that it was a member of a "limited group of persons" to whom the law firm knew or should have known its client would give the information.

Initially, this holding sounds very promising for Enron shareholders. After all, one would think Enron's accountants and lawyers probably knew or should have known that the information they provided to Enron (such as a favorable audit, or a legal blessing for unusual accounting practices) could be passed on to its shareholders. But there's a catch: Texas follows the view that a shareholder is not a party to whom a duty may be owed either in malpractice or a negligent misrepresentation such as a Section 552 claim.

The theory behind this bright line rule is that a shareholder is merely a part-owner of the corporation, and so any duty owed to the shareholder is really owed to Enron. If the managers or board of trustees fail to protect the corporation's interests, then the shareholder can bring a derivative action.

This logic may make some sense when a company is solvent, and the shareholders' derivative suit can be used to bring money back into the corporation -money that then can be used for dividends, or that simply may increase the company's stock price, to shareholders' benefit. However, the problem with using a derivative action in the Enron case is that, as I discussed in my previous column, any recovery from the lawyers or accountants that Enron receives will go into the pool of money for the ongoing bankruptcy proceedings-and shareholders are in a terrible position compared to other creditors in bankruptcy.

Nevertheless, the Texas rule applies regardless of whether a company is in bankruptcy - suggesting shareholders may be out of luck with a Texas negligent misrepresentation claim.

Why A Fraud Claim By Shareholders Might Possibly Succeed

Fortunately for shareholders, under Texas law, the situation changes when fraud is involved. Texas courts hold that, if a professional engages in fraud, they may be sued for fraudulent misrepresentation as defined in the Restatement (Second) of Torts S 531.

Under Section 531, a party making a misrepresentation will be held liable for the economic damages she causes if the parties injured reasonably relied on the misrepresentations. and if the parties who reasonably relied belong "to a class of persons" whom the defendant "had reason to expect" would rely on the misrepresentation.

Just like with negligent misrepresentation, fraudulent misrepresentation raises issues of scope of reliance - that is, of who is the "class of persons" to which Section 531 refers. If I lie to a potential customer about the wholesale price of a television in my store, suggesting he is getting a great bargain because the retail price is close to wholesale, I know he may well rely on my lie. But what if that customer goes home and repeats my lie to his cousin, who then runs out to buy a TV from my store too? And then the cousin tells her best friend? Is one liable in fraud for knowing misrepresentations that could affect anyone in the world?

In federal securities law, the problem of scope of reliance is solved through a fiction called "fraud on the market." When a company lies to an analyst or lies on its annual report, the lie is presumed to affect the price of the stock, because some buyers or sellers will have read the lie, and directly relied on it. Moreover, once the stock is mispriced, based on false information, everyone else who buys or sells is thought to have relied, too - regardless of whether they actually read or heard of the lie. That obviates the need for each individual buyer or seller to individually prove reliance by showing up in court with the report and testifying that he or she read it and relied on it.

But fraud on the market is a legal fiction, and it is a fiction confined to federal securities law. It has not been extended to state common law fraud claims such as Texas' Section 531 fraudulent misrepresentation claim, which still require individualized proof of reliance. (That is why, even in the recent tobacco litigation, in which the plaintiffs argued that they were lied to by cigarette company press releases, courts have been careful to ask the plaintiffs to state with particularity when they read newspaper articles that restated the alleged lies. Since the tobacco litigation claims are state law fraud claims, reliance must be individually proven)

How would shareholders fare in a suit for fraudulent misrepresentation against Enron's lawyers and accountants? Probably not too well, according to a recent Texas Supreme Court holding. Nevertheless, this type of claim may be the shareholders' last, best hope.

In Ernst & Young, LLP v. Pacific Mutual Life Insurance Company, the Texas Supreme Court held that a purchaser of shares who relied upon a fraudulent misrepresentation contained in an accountant's report did not fall under Section 531. The court noted that "reason to expect" is not the same thing as "foreseeability." Thus, while it may be foreseeable that a purchaser of shares may rely on misrepresentation concerning a company's financial situation, that alone would not satisfy the test for common law fraud - which requires, as mentioned above that the shareholder belong to a "class of persons" whom the defendant had "reason to expect" would rely.

One could try to distinguish this decision by arguing that an employee who is a current shareholder is very different from a prospective stock purchaser. Anyone in the world might be a prospective stock purchaser, whereas the employees of Enron who held stock in the company as a result of their pension plan constituted a discrete "class of persons" - a class whose members had a finite number, and could be listed by name.

Moreover, Enron higher-ups reportedly spoke with employees frequently about their stockholdings and the pension plan. If this is true, then Enron's accountants and lawyers might well have had "reason to expect" that employee-stockholders, as a class, would rely on what the accountants and lawyers said to Enron, and what Enron then repeated to the employee-stockholders.

Nevertheless, Texas courts' resistance to allowing shareholders negligent representation suits does not bode well for the same courts' inclination to allow such suits in cases of fraudulent misrepresentation. The courts may well reason again that the proper remedy for shareholders should be found in a derivative suit, not a shareholders' fraudulent misrepresentation suit.

To prevent such as ruling, attorneys for the plaintiffs should invite the court to carve out an exception to the bar against shareholder fraudulent misrepresentation suits when a corporation is in bankruptcy, and the derivative suit alternative therefore will be fruitless.

A Final Issue: The Goal of the Alleged Fraud

One final issue may hinder the shareholders' recovery - the issue of the goal of the alleged fraud. If fraud was committed by Enron's accountants and lawyers (and no one has yet established that it was, for the facts are not yet known), then it was likely fraud designed to help Enron and its shareholders, not hurt them.

Had the tricks kept working indefinitely, Enron's shareholders would have profited mightily (indeed, some did). This point may jeopardize the stockholders' chances of success as plaintiffs; a court may feel more comfortable turning away plaintiffs who seek to remedy an alleged fraud that was arguably intended to benefit them.

On the other hand, if it was clear that the Enron cover-up would not last forever, it may be that stockholders stuck in a pension plan were not among the intended beneficiaries of the alleged fraud. In that event, the goal of the alleged fraud would have been to help those who could afford to sell, and had the freedom to do so, to profit in the short term - at the cost of employees' suffering in the long term.

Anthony J. Sebok, a FindLaw columnist, is a Professor of Law at Brooklyn Law School, where he teaches Torts, among other subjects. Professor Sebok has written several columns on mass tort litigation for FindLaw; they can be located in the archive of his columns on the site.

Was this helpful?

Copied to clipboard