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Judge Melinda Harmon referred to the pending Enron private action over which she presides as “probably the largest and most complex [litigation] of its kind in the history of this country.”[1] We have considered the race to the courthouse, the selection of lead plaintiff, and the selection of lead counsel part of that story in an earlier hypothetical. There are several ways you can follow that story in these materials. First, you can use the Enron_Story Table of Contents (see above) that includes links to various facets of the litigation. Second, you can use the Table of Contents (see above) and the links to different portions of Judge Harmon's decision in In re Enron, in which she ruled on the motion of the so-called secondary actors to dismiss the complaint. You can also use the link on the top of the page to the Amended Complaint to get plaintiff's version of what went on. We are going to be focusing on Judge Harmon's opinion relating to the secondary actors in this hypothetical and will attempt to guide you in selection of relevant parts of the opinion. Her opinion does not focus on any of the principal characters that we have included in the Hall of Fame, as of this writing she has not ruled on the motion to dismiss as to that phase of the case. Although her opinion relates to the secondary actors (the lawyers, the accountants, and the investment banks), it is an extremely important one. The secondary actors allegedly were involved in the complex structures of so-called Special Purpose Entities designed to create phony profits and keep debt off the balance sheet. The opinion is extremely long, includes a primer on securities law that may be a good introduction to those without the basic background; sometimes strays a little from the path, and has to deal with a 500 plus page Milberg Weiss complaint as well as the lengthy briefs filed by the various defendants and the response lengthy brief of Milberg Weiss. She is a bit wary of the Milberg Weiss conclusory and prolix allegations, but at the same time buys into the allegations that it all involved one big Ponzi scheme. This is an unnecessary characterization, but the concept of scheme (Ponzi or otherwise) may be very real and played an important role in her decision. The opinion is noteworthy for a number of reasons, including that Judge Harmon may be the first judge to recognize that pleading after Enron/WorldCom to some degree is a different ball game. Click HERE.
We are ahead of ourselves. To start at the beginning you can use the chronology from the Wall Street Journal relating to the accounting misdeeds and the investigation. Click HERE (use the bookmarks to start then read pages in descending order. Do not click on the internal links unless you subscribe to Wall Street Journa online). You can also go to Sections 1:1, 1:5, and 1:6 to get the broad picture, including in the latter section a brief description of the alleged role of the investment banks named as defendants. We will go to the AMENDED COMPLAINT to feel some of the excitement/anxiety surrounding the case and events. Use Find (ctrl+F) to go to the preamble, quoting from the employee's letter. Come back and go to footnote 92 in the opinion where Judge Harmon quotes at greater length from the letter Sherron Watkins, the employee in question. For comic relief view a picture of Ms. Watkins looking askance at Skilling as he testified to a Congressional Committee he knew nothing incriminating about the special purpose entities. Click HERE. Ms. Watkins, Cynthia Cooper, and Coleen Rowley are shown on the cover of Time, honored as "whistleblowers". Cynthia Cooper is the internal auditor at WorldCom who was the first to detect a simple but huge $7 billion fraud at WorldCom, consisting of capitalizing expenses rather than deducting them from revenue in determining net income. Mr. Myers was one of her "victims". We may get to the WorldCom story eventually in connection with SEC enforcement, but if you are curious click HERE to take a peek.
In the AMENDED COMPLAINT (use ctrl+n) to go to designated pages; use the pages as shown by Adobe Acrobat and not the pages as numbered), go to page 5 and note the Parties listed under Overview. Those under (b) Enron's Accountants, (c) law firms, and (d) Enron's banks are the secondary actors that are the subject of the In re Enron opinion. Then go to page 48 and paragraph 70, where in conclusory fashion the complaint outlines in general terms the case against the secondary actors. There are other sections that detail the involvement of the secondary actors in greater detail, but we are trying to get an overview at this point. With the same view in mind, we will go to that part of Judge Harmon's opinion in which she summarizes the allegations as to the alleged scheme.
Click HERE. Keep in mind she is summarizing the allegations and not necessarily accepting all of them. We are going to have to simplify what is involved with Special Purpose Entities as used by Enron they came in every shape and form imaginable. We saw some of this earlier in its simplest form in Green Tree involving the securitization of mortgages. See § 3.04. Oversimplified, a mortgage company invests $2 billion in mortgages and now has depleted its cash by $2 billion and has mortgage receivables of $2 billion paying an average interest rate of 8%. It probably borrowed a substantial part of the money it used for this purpose, presumably at a somewhat lower interest rate. Now it securitizes the mortgages by selling them to investors in a separate entity, a trust, which holds the mortgages. It uses the proceeds to pay off the money it borrowed in order to make the mortgage loans and has wiped that debt off its balance sheet. Under the securitization arrangement the investors who acquired an interest in the underlying mortgages will receive an average return of 6% and the mortgage company retains the other 2% of interest payable. Instead of reporting income as it receives its share of the mortgage income over a period of years, under accounting rules in place for several years (instead of the old fashion way of reporting income as received) it reports in the year it securitized the loans the present discounted value of the flow of income over the life of the mortgages making provision for estimated defaults and prepayments. This kind of accounting, its critics would say is no better than the reasonableness of the discount rate and the estimates of defaults and prepayments and can readily be tainted by the desire to meet analysts' expectations of accountants. One of the uses Enron made of SPEs was to sell them long term contracts that were designed in theory to produce a revenue flow over several years and allowing Enron in the current year to take the discounted value of the estimated flow into current income and profits. The allegations were to the effect (and the restatement of the financial statements confirmed the allegations to be true in large part) that the income flow estimated was not realistic and that a host of the accounting rules relating to SPEs were not followed both with respect to recognizing income and taking the debt transferred to the SPEs off of Enron's balance sheet . If you go to page 204 of the AMENDED COMPLAINT, you will find at subparagraph (o) allegations relating to the Blockbuster/VOD joint venture under which Blockbuster was to furnish the movie content on a pay for view basis and Enron was to deliver it through its broadband subsidiary. The subsidiary recognized on a present value basis a $11 million profit based on projections of future revenues from the joint venture. Note in passing, the basis for the allegations relating to the Blockbuster/VOD joint venture. Judge Harmon also described and summarized these allegations. Click HERE. She, however, interpreted the complaint as alleging that "Enron abused mark-to-market accounting to claim a profit of over $110 million " rather than the $11 million stated in the complaint. We are not sure which is correct (our version is what appears on the Milberg Weiss web site), but Milberg Weiss is not noted for understating the extent of an alleged fraud.
Before we go much further, we have to deal with one of the principal issues of law facing Judge Harmon and that is the holding in Central Bank that in a private action based on violations of Rule 10b-5 a claim can be asserted only against primary violators and cannot be asserted against aiders and abettors. See § 1.08[1]. In determining who is a primary violator she took two paths; one applicable primarily to the lawyer defendants and in some instances to the accountants, and the other applicable to all three categories of defendants but particularly the investment banks. She was concerned with whether one who is involved in the preparation of a disclosure document (or filing, or press release) can be held as a primary violator, notwithstanding s/he/it did not publish the document in question and the document is not attributed to that person. The defendants most affected in this regard are attorneys who participate in the preparation of the disclosure document released by the issuer. The accountants are also impacted particularly to the extent they may have reviewed a document (e.g. a quarterly earnings report) but the issuer releases it as an unaudited interim report. The accountant is more directly implicated in the annual audited financial statements since the accountant's report represents that the financial statements fairly present the financial condition of the issuer. The second path that she explored relates to the involvement of a defendant in what is alleged to be a scheme to defraud. We are going to direct you to her discussion in these areas and may make some comments, but expect you to be able to respond to the questions posed in the second half of this hypothetical.
Go to her discussion of Central Bank by clicking HERE. Skim as you reach what she has to say about the "bright line" test and the intermediate view until you come to the view of the SEC as expressed amicus in Klein v Boyd and again to Judge Harmon. Take that all in and stop after you reach the point at which she says "the SEC's proposed test is a reasonable interpretation of the text of the statute and serves its underlying policies, the Court adopts and applies it in this litigation to claims under § 10(b) and Rule 10b-5(b)." Click HERE to go to that part of her opinion relating to Professional Conduct/Duty to Nonclient Investors and her discussion of Attorneys in this context. The first part of the discussion at this point relates to the professional responsibility of lawyers. We are not going to get into that area at this point, although we will be discussing it at a later stage in the context of Section 307 of Sarbanes-Oxley requiring attorneys to go up the corporate ladder to prevent clients or employers from violating the securities laws or breaching fiduciary duties. Interestingly, Judge Harmon does not refer to Section 307 or the rules the Commission has proposed implementing Section 307, which has securities practitioners (but not the securities fraud class action lawyers or academia) up in arms. In fact, skip or skim to the last paragraph of the discussion relating to attorneys (beginning "This court concludes") and focus on it and how it differs, if at all, from the conclusion she reached in discussing the Commission's amicus position. This is followed [click HERE] by an extensive discussion of accountants and as to Arthur Andersen the conclusion should not be that difficult with respect to its audited financial statements. The complaint, however, as noted under parties includes a long list of Arthur Andersen partners as defendants. Judge Harmon said it all when referring to her discussion of the responsibility of attorneys noted, "[t]he discussions above regarding liability under § 10(b) and the duty of the professional to nonclients apply to accountants." But she said more referring to and relying on the requirement under Section 10A of the Exchange Act (15 U.S.C. § 78j-1(a)(1)) requiring public accounting firms to have in place procedures to detect illegal acts and to up the ladder and, if necessary, report them to the SEC. Although again not referred to by Judge Harmon, the SEC used the Section 10A model in proposing rules implementing Section 307 of Sarbanes-Oxley. That is another story and we will come back to it in due course.
In the same context and in the same part of her opinion, Judge Harmon referred to the liability of underwriters. Click HERE. After noting that the underwriter is expressly made liable for misrepresentations in a registration statement the court also refers to the fact that an underwriter may be liable under Rule 10b-5 for misrepresentations in a registration statement.
The second path Judge Harmon took down the road of determining whether the secondary actors could be primary violators also is a circuitous one. We start with here extensive discussion of Rule 10b-5 as encompassing more than the making of a false or misleading statement in connection with the purchase or sale of a security. Click HERE. Read the first paragraph carefully and skim the rest of this part of the opinion except for footnote 15 in which Judge Harmon appears to make a significant finding. We looked earlier at what Judge Harmon had to say about Central Bank, but focused only on that aspect of the discussion pitting the "bright line" view against the SEC view. We go back by clicking HERE. to look at that part we skimmed or ignored. Begin with the second paragraph, which begins "[n]evertheless, the Supreme Court did not." and quotes from that part of the decision that specifically refers to the potential liability of "a lawyer, accountant, or bank." Then go all the way down to the paragraph that begins "Central Bank 's holding." Take in and be prepared to discuss her discussion of allegations that a group of defendants participated in a scheme or a course of business to defraud investors under § 10(b) and Rule 10b-5 and distinguishing allegations of a conspiracy. What Judge Harmon has to say here is critical as to her holding with respect to a number of the secondary actors.
Before we can follow her holding with respect to each of the secondary actor defendants we have to become familiar with her view about alleging scienter with particularity and the view of the Fifth Circuit on which she relies. We discussed Zonagen in the pleading context previously, but you may want to review Section 3.09[2]. We have previously noted that the Fifth Circuit in Ace Arbitrage followed Novak in allowing allegations based on information furnished by unnamed sources if sufficiently identified to suggest that the informant was in a position to be credible. Judge Harmon described the Fifth Circuit position with respect to pleading scienter in the context of her discussion of the elements of a Rule 10b-5 claim. Click HERE. Consider also what the court said in discussion primary violations by specific defendants with regard to the scienter requirement in the context of this complaint being satisfied in part by "allegations of a regular pattern of related and repeated conduct" with respect to the special purpose entities. See discussion of Primary Violations by Specific Defendants. Click HERE. For a broad view of Judge Harmon's opinion join the Discussion. See also her subsequent holding relating to the individual Andersen partners part of the Enron engagement team. Click HERE. See also Complaint in SEC v. Kopper. Merrill-Lynch to settle SEC charges? HERE