On Tuesday, the Supreme Court ruled in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. that private plaintiffs may not bring fraud claims under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) against persons or entities that allegedly assisted or participated in a company’s misrepresentations to the investing public, but that did not themselves make the misstatements or engage in conduct on which investors relied. Thus, as a practical matter, the Supreme Court has put an end to socalled “scheme liability” claims by investors against secondary actors—such as investment banks, accountants, lawyers, commercial counterparties and officers, directors and employees of companies who did not personally make the statements or sign the public filings that were allegedly fraudulent.
Prior to the Stoneridge decision, plaintiffs’ lawyers sometimes succeeded in circumventing the Supreme Court’s prior ruling in Central Bank of Denver, N.A., v. First Interstate Bank of Denver, 511 U.S. 164 (1994). In Central Bank, the Court noted that there are two alternative theories of liability under Section 10(b): “the making of a material misstatement (or omission) or the commission of a manipulative act.” Material misstatements are addressed by Rule 10b-5(b), while manipulative acts are addressed by Rules 10b-5(a) and (c).1 The Court in Central Bank made clear that, to state a claim for violating Section 10(b) based on misstatements, the defendant must have actually made the material misrepresentations or omissions, not merely aided and abetted them. As an end-run around Central Bank, however, securities plaintiffs increasingly advanced the argument that secondary actors in misrepresentation cases could nevertheless be liable for engaging in a fraudulent “scheme” under Rules 10b-5(a) and (c)—hence, the advent of “scheme liability.”
That is what the investor plaintiffs argued in Stoneridge in support of their Section 10(b) claims against customers and suppliers of Charter Communications, Inc. that allegedly had engaged in sham transactions with Charter for the specific purpose of helping Charter inflate its revenue and meet its cash flow targets in Charter’s financial statements. In rejecting this argument, the Supreme Court reasoned that plaintiffs could not establish reliance on these customers/suppliers’ own fraudulent statements or acts—one of the essential elements of a private Section 10(b) claim. Noting that Section 10(b) requires deceptive acts—just like misrepresentations—to have been “in connection with the purchase or sale of any security,” the Court ruled that the defendant customers/suppliers’ alleged deceptive acts, which were not disclosed to the public, were “too remote” to satisfy the element of reliance. It was only Charter’s ensuing misstatements in its publiclyissued financial statements on which investors could have relied.
In reaching its decision, the Supreme Court also reasoned that adoption of the plaintiffs’ theory “would put an unsupportable interpretation on Congress’ specific response to Central Bank” in enacting Section 104 of the Private Securities Litigation Reform Act of 1995 (“PSLRA”), which restored the ability of the Securities and Exchange Commission—but not private plaintiffs—to bring aiding and abetting claims against those who “knowingly” provide substantial assistance to another in violating the Exchange Act. See Section 20(e) of the Exchange Act (codified at 15 U.S.C. § 78t(e)).
Interestingly, however, the SEC also has embraced “scheme liability” in its own efforts to evade both Central Bank and Section 104. This is because several courts ruled that, whereas the separate scienter element of Section 10(b) may be satisfied with proof of mere recklessness for primary violators, the SEC must meet the “knowingly” requirement of Section 104 by proving that the aider and abettor had “actual knowledge” of the falsity of the alleged misstatement. Thus, to avoid this higher scienter standard where a defendant did not actually “make” the alleged misstatement and is therefore an aider and abettor, the SEC often brought claims for primary liability under Rules 10b-5(a) and (c) for “scheme liability.” While the Supreme Court in Stoneridge did not directly address the SEC’s use of “scheme liability,” the fact that the Court discussed the SEC’s ability to pursue secondary actors only in the context of the SEC’s power to bring aiding and abetting claims under Section 104 of the PSLRA should help defeat the SEC’s own attempts to use “scheme liability” to thwart Central Bank.