Putting yourself on the side of anyone who may have helped Enron fleece its investors isn't bound to win you any friends. It could help explain why SEC Chairman Christopher Cox, under fire for being too business-friendly, has decided to side with those who believe that investors can sue third parties, such as investment banks and law firms, for fraud committed by their clients.
At issue is whether a third party that helped a company defraud investors can be sued as a "lead violator." Sounds pretty easy to resolve: If you've knowingly participated in a fraud, you should be held accountable.
The so-called "scheme liability" issue goes back to 1994 when the Supreme Court held that third parties can't be charged with aiding and abetting a fraud because Congress hadn't intended for such acts to be covered when it wrote the law. Securities manipulation, insider trading, making material statements -- these were the types of actions that were covered. A business transaction that leads to fraud was not.
The Supreme Court is going to revisit this issue when it decides whether shareholders of Charter Communications
The problem here is that a third party has no fiduciary responsibility to the company's shareholders. Whatever other crimes such acts may constitute, it's not a violation of the securities laws. I believe that going after third parties because of the acts of a company's managers to defraud its shareholders would create serious competitive issues.
Scheme liability looks to be an invention of trial lawyers. Ever since the Supreme Court ruled that the law did not support charging corporations for aiding and abetting, it seems to me that the trial lawyers have been searching for an alternate theory to pursue. When you enter into an arm's length business transaction, you have no duty to report that a company intends to use that transaction for improper purposes. That's not to say that the vendors, suppliers, lawyers, accountants, and the whole panoply of third parties should engage in such devious transactions, but there are other remedies to penalize them.
I don't think firms that neither trade in the company's stock nor make or take part in any material statements about the actions should be held responsible for a company's decision to defraud its shareholders, even if it helped create the circumstances that led to the fraud.
Frauds perpetrated against shareholders are indeed crimes that ought to be punished. But to the extent that investors are being misled by their companies, they have not been misled by the banks, lawyers, accountants, and other enablers. The securities laws were not designed to address that kind of conduct.
Certainly, laws can be flexible, but the courts cannot simply rewrite the laws to achieve an end that may be desirable, particularly when the law doesn't even address such actions. Even where courts have ruled in favor of scheme liability, they can't clearly delineate what conduct might be proscribed by it in advance. So while third parties should be expected to operate in an above-board manner, we can't expect them to be liable for the crimes committed by their customers and clients.
The SEC drew some criticism earlier this year when it sided with fiber optics maker Tellabs
In an effort to deflect the criticism that it's too pro-business, the SEC has decided to back a theory that may ultimately prove to be a particularly shareholder-hostile action.
The views expressed here are solely those of Fool contributor Rich Duprey and do not necessarily represent those of The Motley Fool. Rich does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.
