THE RECENT OPINION IN THE ENRON SHAREHOLDERS' SUIT:
Will It Redefine Lawyers' Duties When It Comes to Securities Fraud?

The Enron scandal did not produce a great popular backlash against America's corporate class, as some pundits had predicted. Nonetheless, Enron's demise has had at least one seismic impact: It is redefining the way in which courts define the responsibility not only of corporate officers, but also of the high-paid professionals who serve them, such as accountants and lawyers.

Already the criminal case against Arthur Andersen has sent shock waves through the accounting world. In this two-part series of columns, I will examine how another important case - the massive federal securities lawsuit that has been brought by Enron's aggrieved shareholders - may send shock waves through the tight-knit world of big corporate law firms.

Judge Harmon's Opinion and Its Holding

On December 20, 2002, Judge Melinda Harmon, the federal district judge in Houston who is overseeing the consolidated Enron securities actions, issued a 305-page opinion in the suits. (The opinion is extraordinarily long both because the applicable law is very complex and hotly contested, and because it affected a very wide range of actors, some of whom were much more intimately involved with Enron than others.)

The motion that prompted the opinion was filed by the so-called "secondary" defendants, which include the eight banks, two law firms and one accountancy group that are alleged to have committed securities fraud. (The "primary" defendants, of course, are Enron and its officers.)

The motion asked the judge to dismiss the claims against the secondary defendants, on the ground that what they were alleged to have done did not violate the laws invoked in the complaint. Regardless of what Enron may have done, the motion argued, these defendants could not be held liable under either state or federal securities law. They themselves, it argued, were not alleged to have performed conduct that constituted fraud with regard to the purchasers of Enron securities.

In her opinion, among other holdings the judge granted the motion on behalf of one law firm, Kirkland & Ellis, and dismissed the claims against that firm. However, she also allowed the plaintiffs to maintain their federal securities fraud claims against another law firm, Vinson & Elkins.

The opinion's reasoning is interesting in part because it raises this question: Is the distinction between Kirkland & Ellis, on the one hand, and Vinson & Elkins, on the other, principled or ad hoc? The answer to that question, it turns out, is itself complex.

To begin, it's important to realize that the law firms are being sued only under federal - not Texas - securities law. And that means that for the claims against them to survive, they must pass a demanding test. (Over the past ten years, Congress, under the pressure of intense lobbying by corporate America, has the federal securities statute to make it harder for "frivolous" securities claims to be brought; companies had been complaining that they'd had to settle even such claims to avoid the cost of litigation.)

As of today, then, a federal securities fraud plaintiff must allege that the defendant made a misstatement or omission of a material fact, and did so intentionally (in legal parlance, with "scienter"); that the plaintiff relied on the misstatement or omission; and that the misstatement or omission direct (in legal parlance, "proximately") caused the plaintiff injury.

What counts as a "misstatement or omission"? According to Supreme Court precedent, not only a statement or silence, but also a contrivance to achieve a fraudulent end (such as market manipulation), can qualify. That may matter quite a bit in the Enron case, where the structures including offshore entities are a major issue; these seem more like "contrivances" than misstatements to me.

The Allegations of "Aiding and Abetting" By the Law Firms

So what were the law firms' alleged misstatements, omissions, or contrivances? The plaintiffs did not, in their pleadings, identify any. Instead, they alleged, in essence, that the secondary defendants, including the law firms, aided and abetted fraud by Enron and its officers.

What counts as "aiding and abetting"? The question arises in many different areas of law, civil as well as criminal. For instance, as I discussed in a recent column, the issue arises in the context of corporate violations of the Alien Tort Claims Act. (For example, when a company provides material to a government in order to facilitate security around a worksite, and knows the government will use slave labor, rape, and other such actions while trying to "maintain" security, is the corporation aiding and abetting these human rights violations?)

What about in the securities fraud context? The fact is that federal securities laws do not prohibit the aiding and abetting of securities fraud.

Why not? As the Supreme Court said in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., Congress intended to use the laws to regulate primary fraudulent actors, who actually make the misrepresentations - not the secondary actors who, at most, have knowingly help them do so.

So why didn't Judge Harmon dismiss all the claims against the secondary defendants? After all, weren't they just that type of secondary actor? That's where it gets complicated.

Under the case law, professionals such as law firms and accountants need not always be secondary actors; they can sometimes be primary actors, too. As Judge Harmon noted, since 1993 a number of federal appeals courts have so held.

In the U.S. Court of Appeals for the Ninth Circuit, for example, accountants have been found liable as primary actors where there was "substantial participation" by accountant in the preparation of fraudulent statements which were then presented to the public by another primary actor.

Under the "substantial participation" rule, an accountant or a lawyer can be a primary actor even if he or she (or, in the case of a firm, it) did not directly make a statement to the plaintiff. Indeed, the plaintiff need not even know the accountant's or lawyer's name (at the time of the fraud).

However, some federal appellate courts, most notably the U.S. Court of Appeals for the Second Circuit, have rejected the "substantial participation" rule. They have adopted, instead, much more restrictive "bright line" rule. Under the bright line rule, the professional itself must make a misrepresentation and the plaintiff, at the moment of the fraud, must know the professional's identity as the "author" of the misrepresentation.

Judge Harmon - a district judge in a Circuit that has not yet chosen between these tests - needed to choose one herself. The Securities Exchange Commission, in a "friend of the court" brief, urged her to adopt the substantial participation rule. She did.

Her reasoning was that Central Bank may have properly excluded actors who may have conspired to defraud others, but that there is a difference between helping another commit fraud and "making" a fraud, even if one makes the fraud (by necessity) by working with others who are also making the fraud.

The Duty to Report Versus the Duty to Refrain From Fraud

So how did the "substantial participation" rule apply to the law firms? Again, the issue gets a bit complicated.

The law firms first argued that - regardless of whether or not the allegations of substantial participation were sufficient - they could not be held as primary actors in securities fraud because that would impose on them two conflicting duties. On the one hand, they were obliged to maintain their clients' confidences under the ABA's Model Rules of Professional Conduct (as adopted by Texas). On the other hand, "substantial participation" liability would impose on them a duty to disclose these very confidences.

This approach makes some sense: After all, the firms could have withdrawn from the representation without also reporting Enron; the two decisions were separate.

Looking at the Allegations Against V&E, and K&E, Respectively

Next, Judge Harmon looked carefully at the allegations against each of the two firms, respectively: Vinson & Elkins ("V&E"), and then Kirkland & Ellis ("K&E").

V&E, she noted, had become deeply dependent on Enron's business (Enron comprised 7% of its revenues). In addition, she ruled, the facts alleged by the plaintiff suggest that V&E was essentially "a participant making material misrepresentations . . . in order to establish and perpetuate a Ponzi scheme that was making them all very rich."

V&E, according to the allegations, made its own misrepresentations to the buyers of securities, the judge ruled. Specifically, it drafted "true sales" opinions for Enron that it knew were false; prepared disclosures for Enron to sign that it knew were false; and gave advice about how Enron should perform certain fraudulent acts.

Had V&E been alleged merely to have witnessed the misconduct by Enron, Judge Harmon ruled, she would have had to dismiss them from the suit. But, she held, the allegations said V&E did more: When Enron spoke to the public using documents V&E had helped prepare, V&E made false statements to the public too. It didn't matter that V&E had not signed those documents; under the substantial participation rule, it was still "essentially a co-author."

What about K&E? It, too, was alleged to have known perfectly well what Enron was doing, and to have actively assisted Enron's fraudulent activities. But there was a difference in the allegations, the judge held. V&E was alleged to have helped Enron prepare documents relating to publicly traded securities. In contrast, K&E "merely" helped structure Enron's subsidiaries (the famous special partnerships with Star Wars and Jurassic Park-derived names like "Chewco" and the "Raptors").

Why the V&E/K&E Distinction Judge Harmon Made, May Not Hold Water

In the end, this may be - as lawyers often say, a distinction without a difference. As Judge Harmon notes in her opinion, these private Enron-controlled entities were necessary to Enron's "Ponzi scheme"; only because of them could Enron "hide its debt and record its sham profits." In working for these entities, K&E thus allegedly aided fraud. It also allegedly created fraudulent documents - though, like V&E, it may not have signed them.

The difference, then, is this: K&E's documents, even if fraudulent, never saw the light of day. K&E allegedly worked on the secret part of the alleged fraud; V&E allegedly worked on the public part.

Of course, none - or only some - of the allegations against K&E and V&E may be true. But when deciding a motion to dismiss, judges must assume they are. The very purpose of such a motion is to ask: If these facts are true, would they describe a law violation? It is hard to see how this question could be answered differently for K&E and V&E, as Judge Harmon answered it.

Indeed, the ruling seems somewhat ironic: V&E allegedly worked directly for Enron, a publicly traded company that committed fraud. K&E allegedly worked for Enron's non-publicly traded fraudulent subsidiaries. If creating Chewco, the Raptors, and so on wasn't fraudulent, it's hard to see how anything else could be either.