1. 19 th Annual Plus International Conference Primary Liability for Secondary Actors David H. Kistenbroker Katten Muchin Rosenman, LLP 525 West Monroe Street Suite 1900 Chicago, Illinois 60661 312.902.5200

2. 2 Primary Liability for Secondary Actors  Civil liability for banks, issuers, broker-dealers and other “secondary” actors. –Primary liability under the evolving theory of “scheme” liability.  Liability under SEC enforcement provisions –Primary liability under securities laws –Secondary liability under traditional theories of aiding and abetting and “causing” primary violations. –Liability under the USA Patriot Act

3. 3 Primary Liability for Secondary Actors  Civil liability under § 10b for financial institutions and other secondary actors –Traditional Rule 10b-5 claim requires a material misstatement or omission –“Speaker” faces primary liability for a primary violation  Historically, financial institutions faced only secondary liability –aiding and abetting the fraudulent statements of others

4. 4 Primary Liability for Secondary Actors  Central Bank of Denver (1994) –No private action for aiding and abetting –A financial institution may still face potential liability as a “primary violator” The Battle Line: Primary liability versus non-actionable secondary actions –Courts have utilized three tests “Bright Line” test – secondary actor must directly or indirectly make fraudulent statement: Wright v. Ernst & Young, LLP (2d Cir. 1998) “Substantial Participation” test – significant role in preparing fraudulent statements: In re Software Toolworks, Inc. Sec. Litig. (9 th Cir. 1994)

5. 5 Primary Liability for Secondary Actors  “Creation of Misrepresentation” test –First advocated by SEC in 1998 in amicus brief in Klein v. Boyd (3d Cir. 1998) –Focus is on secondary actors’ conduct rather than actual misstatements –Relies on 10(b)-5(a) and (c) “device, scheme or artifice to defraud” –First adopted in In Re Enron Corp. (2002) Lawyers drafted/approved false SEC filings intimate involvement with transactions supported allegation they “created” the misstatements

6. 6 Developments in Secondary Actor Liability  “Scheme” liability and the courts  Appellate courts reject “scheme” liability: –8 th Circuit – In re Charter Communications, Inc. –9th Circuit – In re Homestore.com, Inc. Third party vendors/arm’s length transactions – no other role Primary defendants failed to properly account for transactions No misstatements, “deceptive” device or “manipulative” conduct

7. 7 Developments in Secondary Actor Liability  District courts mixed on “scheme” liability –In re Dynegy (S.D. Texas 2004) - claim rejected Bank set up, executed two loans disguised as investment and cash flow No role in accounting/reporting transactions No allegations deceptive acts “coincided with sales of Dynegy securities.” –Quaak v. Dexia, S.A. (D.Mass 2005) – claim survives Bank financed “sham” entities used to record fictitious revenue “Substantial participation” -- bank a ‘primary architect’ of the scheme. Plaintiff subsequently filed amended complaint alleging direct liability; First Circuit vacated leave to appeal

8. 8 Developments in Secondary Actor Liability  District courts mixed on “scheme” liability –In re Parmalat (SDNY 2005) – mixed outcome Sham versus legitimate transactions –The securitization and factoring of duplicate invoices for same goods was “deceptive device” –Loans disguised as investments; deception resulted from company’s description, therefore Citigroup/BoA’s conduct not actionable – No showing of reliance required in actionable transaction – no direct reliance is needed

9. 9 Developments in Secondary Actor Liability  District courts mixed on “scheme” liability –In re Mutual Fund Investment Litig. (D. Md. 2005) – mixed outcome Broker-dealers facilitated market-timed transactions No liability for knowingly financing or clearing late trading Liability for providing after-hours trading system, disabling time-stamp function

10. 10 Developments in Secondary Actor Liability  Line between primary and secondary liability remains undefined –Legitimacy of underlying transaction Transaction has true business purpose Fraud is in accounting/reporting –Direct or substantial participation in deceptive acts “substantial participation” in Quaak “orchestrating” in Mutual Fund Litig. –SEC Liability for “aiding and abetting” remains

11. 11 Developments in Secondary Actor Liability  31 C.F.R. 103.122 Implements § 326 of the USA PATRIOT Act –Final rule took effect on June 9, 2003, although broker-dealers had until October 1, 2003, to implement –The rules seek to protect the U.S. financial system from money laundering and terrorist financing. –Parallel rules exist for banks under § 103.121 and futures commission merchants and introducing brokers under § 103.123.

12. 12 Developments in Secondary Actor Liability  Requires Customer Identification Program (CIP) that, at a minimum, includes: –Identity verification procedures –Recordkeeping –Comparison with government lists –Customer notice –Reliance on another financial institution

13. 13 Developments in Secondary Actor Liability  On May 22, 2006, the SEC announced its first-ever enforcement action under the USA PATRIOT Act –Action was brought against Crowell, Weedon, a broker- dealer. From 10/03 to 4/04, Crowell opened approximately 2,900 accounts. In verifying customer’s identities, Crowell relied on its registered reps’ attestations that they had personal knowledge of the customers opening the accounts The practice not documented in the firm’s written customer identification program (CIP). Rather, the CIP stated the firm would verify the identity of new customers using certain non-documentary and documentary procedures, such as public data base searches and reviewing government issued identification.

14. 14 Developments in Secondary Actor Liability  Violation –By failing to accurately document its CIP, Crowell violated the record-keeping and record retention requirements under the rule. –Crowell consented to the issuance of an order that it cease and desist from committing or causing any violations and any future violations of Section 17(a) of the Securities Exchange Act and Rule 17a-8 thereunder.