Enron, the Supreme Court and Shareholders on the Brink

By BEN STEIN, New York Times, Sunday, April 29, 2007:
LONG ago and far away, when I was a little tyke studying economics under the tutelage of C. Lowell Harriss at Columbia, and finance under Jan Ginter Deutsch and Henry Wallich at Yale, we were taught that the stockholder was the ultimate owner of a public company, the ultimate boss, the ultimate trustor to whom the highest standards of fiduciary duty were owed.
These included the duty to put the interests of the stockholder ahead of the interests of the managers and their agents in each and every situation, to avoid even the appearance of a conflict of interest, to disclose each and every material fact and to avoid any subterfuge that would operate to conceal a material fact.
These duties were common-law obligations, but some of them had also been codified in federal and state law. Federal law, in particular, enacted after the disclosure of huge securities fraud surrounding the 1929 stock market crash that started the Great Depression, prohibited the use of any artifice or device to conceal material facts or to keep them from being disclosed to the investing public.
Section 10(b) of the Securities Exchange Act of 1934 specifically barred the use of any manipulative device or contrivance that would defraud or mislead. A rule adopted by the Securities and Exchange Commission under that act, the famous Rule 10b-5 said that it would be unlawful for any person “directly or indirectly” to “engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”
That, you would think, would have special relevance to the huge scandal at Enron. In that sad story, managers of the company used various devices to conceal from the markets and the investing public that the company was essentially a huge fraud.
In that effort, the managers were helped considerably by a number of very large investment banks. These banks and brokerages used complex transactions that made it look as if Enron were making money when in fact it was insolvent. Andrew S. Fastow, the former finance boss at Enron, testified during legal proceedings about Enron that he saw the large banks as “problem solvers” who would come up with these schemes and thus help the company conceal the reality of its dire situation.
Now, you would think that if this were true, Merrill Lynch, Credit Suisse and Barclays — named in an investor lawsuit — might possibly be liable to the defrauded stockholders, whose losses were in the tens of billions of dollars, and might owe some little pittance to them. (Banks including Citigroup, JPMorgan Chase and CIBC have already paid more than $7.3 billion to settle with Enron shareholders.) You would think that there would at least be a trial about it.
Ah, but then you would be missing the point that the law is a wily, cunning beast of utter unpredictability. Some years ago, in 1994, after a series of disastrous missteps by accounting firms in connection with an earlier series of securities frauds, the Supreme Court brought out an opinion in the case called Central Bank of Denver v. First Interstate Bank of Denver.
In this long and incomprehensible case, the high court basically said that there would be no 10(b) liability for players who “merely” aided and betted securities fraud.
Just as an opinion, by little me, this was done to save the accounting firms from completely immolating themselves by their misconduct. However, the facts of that case were somewhat limited. The defendant, Central Bank, had been the trustee for $26 million in defaulted bonds issued by a local public building authority. But Central was not its investment bank and did not issue investment analysis and, moreover, the securities in question were not publicly traded.
The Enron fraud involved a public company and had a much wider scope. In a huge class-action case where millions of documents had been collected in a federal district court, and in which many witnesses had been deposed, a jury trial was headed to daylight. But suddenly last month, something happened. A three-judge panel of the Fifth Circuit United States Court of Appeals in New Orleans ruled that the class-action suit against investment banks over Enron could not proceed. (Individuals’ ability to pursue claims was not affected.)
The panel held that although its ruling might prevent justice from being done and satisfaction from being had, the acts of the investment bankers were at most aiding and abetting, not direct acts, and therefore not actionable under 10(b) as construed in the Central Bank case.
Ouch. Yes, the defendant banks are accused of concealing the true facts about Enron and likely led investors to buy when they should have sold. Yes (and this is a beauty), at the same time the investment banks were helping Enron with its questionable financials, their “analysts” were praising Enron. (As the petitioners’ brief notes in an appeal to the Supreme Court to overturn the Fifth Circuit decision, these were “full service” banks.)
But, according to the Fifth Circuit panel, this was not enough. This was not a scheme or contrivance to defraud, they said. Yes, the facts were completely different from those of the Central Bank case, but the banks were to be let off the hook. This was in the name of offering predictability in these cases (apparently the predictability that the stockholders would be mistreated).
But not all hope is lost. A tasty appeal has been filed, which is a little masterpiece of legal argumentation.
Now, the Supreme Court can have another look at this case. It can return some dignity and rights to Enron stockholders and send up a warning flare to investment banks to avoid helping out with financial fraud. It can let this case go forward to trial.
This is a potential golden moment for the stockholders — or another step down the dreary alley toward extinction of the rights of those poor whipped dogs: the actual owners of America’s public companies. It is up to the Supreme Court to right the ship.
Ben Stein is a lawyer, writer, actor and economist. E-mail: ebiz@nytimes.com.