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Enron Class Action Defense Case-Regents v. Credit Suisse: Certification Of Securities Class Action Seeking $40 Billion Overturned By Fifth Circuit Because Classwide Presumption Of Reliance Did Not Apply

Fifth Circuit Holds that District Court’s Erroneous Definition of “Deceptive Acts” Resulted in Mistaken Application of Presumption of Reliance in Certifying Class Action Against Banks, Necessitating Reversal of Class Certification Order

After Enron’s collapse in 2001, dozens of class action and individual lawsuits were filed against numerous defendants for violations of Section 10(b) of the Securities Exchange Act of 1924 and Rule 10b-5; more than 30 of these actions were consolidated in the district court for the Southern District of Texas and Regents of the University of California was named lead plaintiff. Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. 2007) [Slip Opn., at 3]. “Years of discovery have ensued, and tens of millions of documents have been produced.” Id. In 2006, the district court granted plaintiff’s motion to certify the litigation as a class action, id., at 3-4. Defense attorneys sought and received permission from the Fifth Circuit to file an interlocutory appeal, id., at 2; the Circuit Court reversed.

As the Circuit Court admitted, the facts of this case are “difficult to detail” so we simply quote the Court’s broad summary: “Plaintiffs allege that defendants Credit Suisse First Boston (“Credit Suisse”), Merrill Lynch & Company, Inc. (“Merrill Lynch”), and Barclays Bank PLC (“Barclays Bank”) (collectively “the banks”) entered into partnerships and transactions that allowed Enron Corporation (“Enron”) to take liabilities off of its books temporarily and to book revenue from the transactions when it was actually incurring debt. The common feature of these transactions is that they allowed Enron to misstate its financial condition; there is no allegation that the banks were fiduciaries of the plaintiffs, that they improperly filed financial reports on Enron’s behalf, or that they engaged in wash sales or other manipulative activities directly in the market for Enron securities.” Slip Opn., at 2. In essence, the class actions alleged that the banks knew Enron executives were manipulating financial information to inflate the company’s stock price to maximize their personal compensation. Id.

In certifying the class action, the district court concluded that a “deceptive act” under Rule 10b-5(c)3 includes participation in a “transaction whose principal purpose and effect is to create a false appearance of revenues,” and that Rule 10b-5(a)’s prohibition of any “scheme . . . to defraud” creates joint and several liability for individuals who commit deceptive acts in furtherance of such a scheme. Slip Opn., at 3. At the Fifth Circuit explained, “The court’s theory of scheme liability considerably simplified finding commonality among the plaintiffs with respect to loss causation. The court stated that ‘a reasonable argument can be made that where a defendant knowingly engaged in a primary violation of the federal securities laws that was in furtherance of a larger scheme, it should be jointly and severally liable for the loss caused by the entire overarching scheme, including conduct of other scheme participants about which it knew nothing.’” Id., at 3-4. The district court also concluded that plaintiffs could rely on “classwide presumptions of reliance for omissions and fraud on the market” because it believed the banks breached a “duty not to engage in a fraudulent ‘scheme,’” and concluded that plaintiffs need not demonstrate market efficiency or reliance to invoke the fraud-on-the market presumption of reliance under Rule 10-5(a) or (c), believing this to be required only for claims under Rule 10-5(b). Id.

Ultimately, the district court certified a class action on behalf of all persons who bought Enron securities between October 19, 1998, and November 27, 2001, and suffered a loss – a class that includes an estimated $40 billion in damages. The lower court recognized that the “proportionate liability provisions” of the Private Securities Litigation Reform Act (PSLRA) would be problematic, but addressed this issue by instructing the banks “to prepare a list of non-parties to whom they intend to assign responsibility and declared that defendants will bear the burden to prove nonparties’ responsibility by a preponderance of the evidence.” Slip Opn., at 4. The Fifth Circuit reversed.

Preliminarily, the Circuit Court held that under a Rule 23(f) appeal “this court can, and in fact must, review the merits of the district court’s theory of liability insofar as they also concern issues relevant to class certification.” Slip Opn., at 7. In this regard, the district court’s conclusion as to what constitutes a “deceptive act” was “integral” to its class certification ruling, bearing directly on the predominance and superiority tests under Rule 23(b)(3). Id. As the Fifth Circuit explained at pages 7 and 8, “The district court’s theory of liability implicates primarily the predominance requirement. To succeed on a claim of securities fraud, a plaintiff must prove ‘(1) a material misrepresentation or omission by the defendant, (2) scienter on the part of the defendant, (3) reliance, and (4) due diligence by the plaintiff to pursue his or her own interest with care and good faith.’ [Citation.] A plaintiff must prove not only that the fraud occurred but that it proximately caused his losses.”

As a general rule, a fraud class action fails if proof of individual reliance is required. See, Castano c. American Tobacco, 84 F.3d 734, 745 (5th Cir. 1996). The district court, however, permitted a “classwide presumption of reliance,” thus obviating the need for such individual proof. “Without its broad conception of liability for ‘deceptive acts,’ the district court could not have found that the entire class was entitled to rely on [the] fraud-on-the-market theory, because the market may not be presumed to rely on an omission or misrepresentation in a disclosure to which it was not legally entitled.” Slip Opn., at 8 (footnote omitted). In holding that the district court misapplied the presumption of reliance in this case, the Fifth Circuit explained that the banks were under no duty, fiduciary or otherwise, to disclose the nature of Enron’s transactions to the plaintiffs, id., at 9, and that “[t]he banks’ participation in the transactions, regardless of the purpose or effect of those transactions, did not give rise to primary liability under § 10(b),” id., at 16. Because the district court erred in applying a classwide presumption of reliance, and because a class action may not be certified in a § 10(b) case absent such a presumption, the Fifth Circuit reversed the class certification order. Id., at 19.

NOTE: The Fifth Circuit rejected plaintiff’s arguments that leave to appeal had been improvidently granted: “This is a legally and practically significant class certification decision, and the motions panel properly allowed the appeal. The commentary to rule 23(f) indicates that it is appropriate to grant leave to appeal an adverse determination where (1) a ‘certification decision turns on a novel or unsettled question of law’ or (2) ‘[a]n order granting certification . . . may force a defendant to settle rather than incur the costs of defending a class action and run the risk of potentially ruinous liability.’” Slip Opn., at 4 (citations omitted).

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