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In Stoneridge, the Supreme Court ruled that businesses may not be sued in private securities fraud lawsuits unless they themselves make deceptive statements or acts directly relied on by investors.
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The Court sought to shield parties in "the realm of ordinary business operations" who do not attempt to "affect securities markets" from the risks and costs associated with private shareholder litigation.
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The SEC and Justice Department may still proceed against businesses that participate in fraudulent schemes or otherwise "aid and abet" fraud.
On January 15, 2007, in Stoneridge Investment Partners v. Scientific-Atlanta, a 5-3 ruling, the U.S. Supreme Court sharply limited the ability of investors to sue companies doing business with the public company in which they invested – i.e., customers or suppliers – for securities fraud. While they may still be subject to criminal penalties or civil enforcement action by the SEC, these “ordinary businesses” may be sued by investors only if they themselves make deceptive statements or acts that the investors directly relied on, as opposed to simply knowing about or even participating in the public company’s underlying fraudulent scheme.
Stoneridge involved an alleged scheme by a publicly-held cable television company, Charter Communications, to inflate its reported revenues with the alleged assistance of two of its vendors, Scientific-Atlanta and Motorola. According to the plaintiffs, Charter agreed to pay Scientific-Atlanta and Motorola inflated prices for set-top cable boxes in exchange for the vendors agreeing to buy advertising from Charter at far higher rates than usual. The vendors allegedly backdated contracts and falsified other documents to help Charter improperly book the advertising “purchases” as revenue. The price of Charter’s stock ultimately collapsed after a series of fraudulent accounting practices came to light.
The plaintiffs in Stoneridge sought to hold Scientific-Atlanta and Motorola liable as participants in Charter’s fraud under § 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. (Neither vendor had misrepresented its finances to its own shareholders, and neither had made any misrepresentations directly to Charter’s shareholders.) Section 10(b) and Rule 10b-5 make it unlawful to commit a manipulative or deceptive act in connection with the purchase or sale of securities, and for decades courts have recognized an implied private right of action for damages under these provisions.
However, in its 1994 ruling in Central Bank of Denver v. First Interstate Bank of Denver, the Supreme Court rejected § 10(b) liability for actors who “aid and abet” fraud. Congress subsequently authorized “aiding and abetting” liability for actions prosecuted by the SEC, but not for private investor lawsuits.
In Stoneridge, the investors relied on the theory of “scheme liability,” in which participants in a fraudulent scheme may be held responsible even if they did not make any statements to the investing public. The Court, in a 5-3 ruling, first observed that the investors were correct in arguing that that “deceptive conduct” may be sufficient to establish liability; there does not have to be “a specific oral or written statement,” as the court below had suggested.
The Stoneridge investors fell short, however, on another required element for private suits under § 10(b): reliance by the investors on the defendants’ deceptive statement oract. As the Court summarized, the vendors “had no duty to disclose; and their deceptive acts were not communicated to the public. No member of the investing public had knowledge, either actual or presumed, of [the vendors’] deceptive acts during the relevant times.”
The investors argued that there was in fact reliance, since the vendors allegedly knew that their deceptive actswould provide the basis for financial statements releasedby Charter to the public. The Court disagreed. Noting that nothing that the vendors did “made it necessary or inevitable for Charter to record the transactions it did,” it ruled that any reliance by the investors was “too remote for liability” under § 10(b)’s implied private right of action. To allow investors to sue the vendors under § 10(b) under such an attenuated theory of reliance, the Court concluded, would obliterate the distinction between “the securities markets” (governed by § 10(b) and other federal securities law) and “ordinary business operations” (governed mainly by state law) and undermine its earlier ruling in Central Bank.
The Supreme Court’s ruling in Stoneridge providesfurther evidence of the Court’s current distaste for lawyer-driven shareholder litigation. For example, in its 2007 ruling in Tellabs v. Makor Issues & Rights, theCourt cited “nuisance filings, targeting of deep-pocket defendants, vexatious discovery requests and manipulation by class action lawyers” as grounds for setting a high bar for the pleading of scienter. In Stoneridge, the Court similarly reasoned that adoption of the investors’ theory of liability would expose “the entire marketplace” to the costs of discovery, and that the risk that “plaintiffs with weak claims” would try to “extort settlements” – as well as deter overseas firms from doing business in the U.S. (In dissent, by contrast, Justice Stevens contended that by rendering § 10(b)’s private right of action “toothless,” the ruling may weaken “investor faith in the safety and integrity of our markets.”)
Clearly, Stoneridge provides substantial relief for businessesnot directly involved in the securities markets. Even if aclaim could be made that such businesses knowinglyassisted corporate wrongdoers, they may not be sued byprivate investors under § 10(b) unless they directly misled investors. More generally, the Court’s observation that the reach of § 10(b)’s private right of action should not normally extend to “ordinary business operations” may well signal its attitude toward the resolution of § 10(b) claims in other contexts.
The consequences of Stoneridge for other “secondary actors” – such as accounting firms, investment banks, and law firms – are less clear. Because these actors arguably operate in “the investment sphere” (to use the Court’s words) and may participate in the drafting or approval of public statements made by corporate issuers, Stoneridge’s focus on the reliance element may not directly offer them much help. However, Stoneridge continues along the Supreme Court’s current trajectory of curtailing private securities actions and redirecting emphasis toward regulatory enforcement.
In conclusion, while Stoneridge represents the latest in a series of victories for corporate defendants in the Supreme Court, the win was not as big as some businesses had hoped. Deceptive conduct – sham transactions, rigged prices, etc. – remains actionable, even without explicit oral or written statements. And parties that participate in fraudulent schemes, or otherwise “aid and abet” fraud, may be sued in civil enforcement actions by the SEC or prosecuted criminally by the Justice Department. Furthermore, the Supreme Court’s curtailment of the implied right of action may lead Congress to provide additional resources for these agencies to pursue securities fraud – if not amend the underlying law. The scope of liability for securities fraud is likely to remain a hot issue in the years ahead.
Foley Hoag's Business Crimes Perspectives is a regular publication exploring trends and emerging issues in the areas of business crimes, fraud and government investigations. Lawyers in Foley Hoag’s Business Crimes practice represent corporations, officers, directors, and other individuals in criminal, administrative, regulatory and civil proceedings. If you find this update useful, please encourage your colleagues and contacts to visit us at foleyhoag.com.