Risky Business

Elements of Aiding-and-Abetting Liability

18 U.S.C. ' 2(a) provides that “whoever commits an offense against the United States or aids, abets, counsels, commands, induces or procures its commission, is punishable as a principal.” To “prove the act and intent elements for aiding and abetting the commission of a crime, the evidence must demonstrate that the defendant joined and shared in the underlying criminal endeavor and that his efforts contributed to its success.” United States v. Pipola, 83 F.3d 556, 562 (2d Cir. 1996). “[U]nknowing participation in a criminal enterprise” is not sufficient for conviction. United States v. Pearlstein, 576 F.2d 531, 546 (3d Cir. 1978).

Similarly, ' 20(e) of the Exchange Act states: “Any person that knowingly provides substantial assistance to another person in violation of a provision of this chapter, or of any rule or regulation issued under this chapter, shall be deemed to be in violation of such provision to the same extent as the person to whom such assistance is provided.” Generally, the SEC must prove that the aider and abettor defendant had actual knowledge of the underlying violation at the time the defendant rendered substantial assistance to the primary violator. See, e.g., SEC v. Fehn, 97 F.3d 1276, 1288 (9th Cir. 1995). But see SEC v. Lybrand, 200 F. Supp.2d 384, 400 (S.D.N.Y. 2002) (recklessness may satisfy “knowingly” element for aiding and abetting in Second Circuit.)

Recent Examples

Enron

During 2003, the Department of Justice and the SEC brought a series of aiding-and-abetting cases against financial institutions that engaged in substantial transactions with Enron. Enron later reported those transactions on its financial statements in ways that violated GAAP and distorted Enron's published earnings, cash flow, and liabilities. Two of the financial institutions — Merrill Lynch and Canadian Imperial Bank of Commerce — negotiated deferred prosecution agreements and settled SEC civil actions by each paying $80 million in disgorgement and penalties. Another financial institution — Another financial institution — J.P. Morgan Chase — negotiated simultaneous settlements with the New York County District Attorney and the SEC, paying $160 million in fines and disgorgement. In addition, each of these financial institutions also agreed to implement significant internal reforms that will affect their future structured finance transactions with public companies.

The pleadings filed by the SEC in each of these actions contain allegations that the defendants “knowingly [rendered or provided] substantial assistance” to Enron in financial transactions that Enron later reported fraudulently in its SEC filings. The defendants' alleged level of knowledge concerning Enron's prospective fraudulent reporting varies widely across the complaints. For example, the SEC quoted an internal J.P. Morgan Chase email in which “one of Chase's most senior officers” stated: “We are making disguised loans, usually buried in commodities or equities derivatives (and I'm sure in other areas).” Another J. P. Morgan Chase employee commented that Enron “loved” the transactions because “they are able to hide funded debt from their equity analysts because they (at the very least) book it as deferred [revenue] or (better yet) bury it in their trading liabilities.”

In contrast to J.P. Morgan Chase's apparent direct knowledge of Enron's fraudulent intent, when Merrill Lynch entered into call option contracts with Enron, Merrill Lynch received a “warranty letter” that Enron's outside auditor had approved the transaction and its proposed accounting treatment. Despite that letter, the SEC alleged that Merrill Lynch “fully knew” that the transaction “was a sham … intended to create year-end earnings for Enron.” The SEC imputed knowledge to Merrill Lynch in part because its own employees described the transaction as “delta-neutral” (ie, risk-free) to Merrill Lynch. In addition, the SEC alleged that one Merrill Lynch employee speculated that the transaction appeared to be an attempt by Enron to manipulate its earnings and a “high-level Merrill Lynch executive stated that Merrill Lynch had '17 million reasons' [the amount of Merrill Lynch's fee] for getting the transaction approved.” At a recent CLE seminar, SEC staff attorneys commented that the evidence showed Merrill Lynch's scienter to be so high that Merrill Lynch would have been charged as an aider and abettor even if Merrill Lynch had obtained a written opinion from Enron's auditor vouching for the propriety of the transaction.

Mutual funds

Aiding and abetting was also recently the subject of an SEC enforcement action in the mutual fund area. In December 2003, the SEC instituted and settled an administrative proceeding against FT Interactive Data Corp., an independent bond pricing service. The SEC alleged that FT Interactive supplied inaccurate bond pricing information to an investment adviser so that the prices of certain mutual funds would drop gradually, rather than steeply. The SEC contended that FT Interactive aided and abetted the adviser's violations because it “knew or was reckless in not knowing that the price decrease did not reflect the fair value of the bonds … ” Moreover, the SEC noted that its allegation that the FT Interactive “ willfully” aided and abetted the IA's violations merely meant that FT Interactive intentionally supplied the prices and did not mean that FT Interactive was actually aware of the violations by the IA. At least in this settled administrative proceeding, the SEC has attempted to set a very low knowledge requirement for aiding and abetting.

Intent: Profits vs. Facilitating Fraud

In each of the cases described above, it seems obvious that defendants' primary motive for the transactions underlying the aiding-and-abetting charges was the profit opportunity in the transactions themselves. For example, none of the bank defendants had any identifiable financial interest in, or otherwise directly benefited from, Enron's financial-reporting fraud scheme.

Each of the bank defendants, however, also learned various facts concerning Enron's purpose in entering into the transactions. Sophisticated financial institutions frequently compete for business by developing a detailed understanding of an existing or prospective client's financial needs. When that knowledge includes information about a client's aggressive accounting, it may lead to aiding-and-abetting charges if aggressive” moves over the line into “fraudulent.”

In a letter to banking authorities that was released at the time of the J.P. Morgan Chase settlement, Manhattan District Attorney Robert Morganthau commented: “All financial institutions need to take a broad view of their responsibilities to assess the economic substance and consequences of the transactions they enter into … Bankers — and the lawyers and accountants they employ — all need to take off the blinders and judge the appropriateness of interrelated transactions as a whole.” If the trend of aiding-and-abetting charges continues, the challenge for financial institutions will be managing their exposure to a client's future financial reporting problems.

“Third-party facilitators have played a critical role in allowing corporate misconduct to happen,” according to Deputy Attorney General James B. Comey, Jr., head of the Justice Department's Corporate Fraud Task Force. Stephen Cutler, Director of Enforcement for the SEC, has warned that financial institutions violate the federal securities laws by “contributing to fraudulent accounting and manipulated financial results” of public companies. In a recent report, the Enron bankruptcy examiner described a financial institution as an “enabler” of violations by Enron's officers. In the Sarbanes-Oxley era, the government is not only rounding up the direct violators, but has also brought aiding-and-abetting charges against companies that entered into certain business transactions with other companies accused of securities violations, even though the alleged abettors themselves filed honest reports with the SEC.

The government's trend of charges against secondary actors is not necessarily an attempt to expand the law of aiding and abetting. To date, the SEC complaints have carefully alleged the traditional elements. However, at least some of the recent cases raise issues regarding the level of knowledge and intent required for an aiding-and-abetting charge and the evidence necessary to support it. In announcing one case, the SEC contended that “if you know or have reason to know that you are helping a company mislead investors, you are in violation of the federal securities laws.”

The result is that honest companies may be forced to become their counter-parties' keepers whenever “normal” business transactions may affect public financial reports or otherwise enable the counter-party to violate the federal securities laws. Thus, in addition to analyzing the economic risks of a significant transaction, companies may need to examine the likelihood that their counter-party will fail to report the transaction properly and that the false reporting will materially impact the counter-party's financial statements. Unless the company can prove that it reasonably believed the counter-party would report the transaction honestly, prosecutors with 20-20 hindsight may charge the company as a “facilitator” of the counter-party's subsequent financial reporting fraud.

Elements of Aiding-and-Abetting Liability

18 U.S.C. ' 2(a) provides that “whoever commits an offense against the United States or aids, abets, counsels, commands, induces or procures its commission, is punishable as a principal.” To “prove the act and intent elements for aiding and abetting the commission of a crime, the evidence must demonstrate that the defendant joined and shared in the underlying criminal endeavor and that his efforts contributed to its success.” United States v. Pipola, 83 F.3d 556, 562 (2d Cir. 1996). “[U]nknowing participation in a criminal enterprise” is not sufficient for conviction. United States v. Pearlstein , 576 F.2d 531, 546 (3d Cir. 1978).

Similarly, ' 20(e) of the Exchange Act states: “Any person that knowingly provides substantial assistance to another person in violation of a provision of this chapter, or of any rule or regulation issued under this chapter, shall be deemed to be in violation of such provision to the same extent as the person to whom such assistance is provided.” Generally, the SEC must prove that the aider and abettor defendant had actual knowledge of the underlying violation at the time the defendant rendered substantial assistance to the primary violator. See, e.g., SEC v. Fehn , 97 F.3d 1276, 1288 (9th Cir. 1995). But see SEC v. Lybrand , 200 F. Supp.2d 384, 400 (S.D.N.Y. 2002) (recklessness may satisfy “knowingly” element for aiding and abetting in Second Circuit.)

Recent Examples

Enron

During 2003, the Department of Justice and the SEC brought a series of aiding-and-abetting cases against financial institutions that engaged in substantial transactions with Enron. Enron later reported those transactions on its financial statements in ways that violated GAAP and distorted Enron's published earnings, cash flow, and liabilities. Two of the financial institutions — Merrill Lynch and Canadian Imperial Bank of Commerce — negotiated deferred prosecution agreements and settled SEC civil actions by each paying $80 million in disgorgement and penalties. Another financial institution — Another financial institution — J.P. Morgan Chase — negotiated simultaneous settlements with the New York County District Attorney and the SEC, paying $160 million in fines and disgorgement. In addition, each of these financial institutions also agreed to implement significant internal reforms that will affect their future structured finance transactions with public companies.

The pleadings filed by the SEC in each of these actions contain allegations that the defendants “knowingly [rendered or provided] substantial assistance” to Enron in financial transactions that Enron later reported fraudulently in its SEC filings. The defendants' alleged level of knowledge concerning Enron's prospective fraudulent reporting varies widely across the complaints. For example, the SEC quoted an internal J.P. Morgan Chase email in which “one of Chase's most senior officers” stated: “We are making disguised loans, usually buried in commodities or equities derivatives (and I'm sure in other areas).” Another J. P. Morgan Chase employee commented that Enron “loved” the transactions because “they are able to hide funded debt from their equity analysts because they (at the very least) book it as deferred [revenue] or (better yet) bury it in their trading liabilities.”

In contrast to J.P. Morgan Chase's apparent direct knowledge of Enron's fraudulent intent, when Merrill Lynch entered into call option contracts with Enron, Merrill Lynch received a “warranty letter” that Enron's outside auditor had approved the transaction and its proposed accounting treatment. Despite that letter, the SEC alleged that Merrill Lynch “fully knew” that the transaction “was a sham … intended to create year-end earnings for Enron.” The SEC imputed knowledge to Merrill Lynch in part because its own employees described the transaction as “delta-neutral” (ie, risk-free) to Merrill Lynch. In addition, the SEC alleged that one Merrill Lynch employee speculated that the transaction appeared to be an attempt by Enron to manipulate its earnings and a “high-level Merrill Lynch executive stated that Merrill Lynch had '17 million reasons' [the amount of Merrill Lynch's fee] for getting the transaction approved.” At a recent CLE seminar, SEC staff attorneys commented that the evidence showed Merrill Lynch's scienter to be so high that Merrill Lynch would have been charged as an aider and abettor even if Merrill Lynch had obtained a written opinion from Enron's auditor vouching for the propriety of the transaction.

Mutual funds

Aiding and abetting was also recently the subject of an SEC enforcement action in the mutual fund area. In December 2003, the SEC instituted and settled an administrative proceeding against FT Interactive Data Corp., an independent bond pricing service. The SEC alleged that FT Interactive supplied inaccurate bond pricing information to an investment adviser so that the prices of certain mutual funds would drop gradually, rather than steeply. The SEC contended that FT Interactive aided and abetted the adviser's violations because it “knew or was reckless in not knowing that the price decrease did not reflect the fair value of the bonds … ” Moreover, the SEC noted that its allegation that the FT Interactive “ willfully” aided and abetted the IA's violations merely meant that FT Interactive intentionally supplied the prices and did not mean that FT Interactive was actually aware of the violations by the IA. At least in this settled administrative proceeding, the SEC has attempted to set a very low knowledge requirement for aiding and abetting.

Intent: Profits vs. Facilitating Fraud

In each of the cases described above, it seems obvious that defendants' primary motive for the transactions underlying the aiding-and-abetting charges was the profit opportunity in the transactions themselves. For example, none of the bank defendants had any identifiable financial interest in, or otherwise directly benefited from, Enron's financial-reporting fraud scheme.

Each of the bank defendants, however, also learned various facts concerning Enron's purpose in entering into the transactions. Sophisticated financial institutions frequently compete for business by developing a detailed understanding of an existing or prospective client's financial needs. When that knowledge includes information about a client's aggressive accounting, it may lead to aiding-and-abetting charges if aggressive” moves over the line into “fraudulent.”

In a letter to banking authorities that was released at the time of the J.P. Morgan Chase settlement, Manhattan District Attorney Robert Morganthau commented: “All financial institutions need to take a broad view of their responsibilities to assess the economic substance and consequences of the transactions they enter into … Bankers — and the lawyers and accountants they employ — all need to take off the blinders and judge the appropriateness of interrelated transactions as a whole.” If the trend of aiding-and-abetting charges continues, the challenge for financial institutions will be managing their exposure to a client's future financial reporting problems.