The Supreme Court decision in Stoneridge Investment Partners v. Scientific-Atlanta will not be the panacea some believe; nor necessarily reduce substantially the amount of private securities litigation nor enforcement actions by governmental agencies
In Stoneridge Investment Partners v. Scientific-Atlanta, the United States Supreme Court recently decided that investors could not sue under so-called "scheme liability," a theory under which those who knowingly assist corporations in committing fraudulent acts may be subject to liability. The rejection of scheme liability in investor lawsuits is a major victory for those who are concerned with being dragged into securities litigation even though they do not engage in securities transactions or otherwise participate in the dissemination of materially false information to the investing public. However, it is still important for businesses and other so-called "gatekeepers" to remain vigilant about ways questionable activities could drag them into costly and damaging securities litigation.
The defendants were suppliers and customers of Charter Communications, a cable operator. According to the plaintiffs' allegations, Charter and the defendants entered into agreements intended to misrepresent Charter's financial position. Specifically, Charter agreed to buy converter boxes at an excessive cost in exchange for the defendants purchasing advertising from Charter at an inflated price. According to generally accepted accounting principles, this transaction had no economic substance and should not have been recognized as revenue by Charter. However, Charter recorded $17 million in advertising revenues and improperly capitalized the increased costs of the converter boxes. Accordingly, it met Wall Street's expectations for its operating cash flow. After Charter's stock declined in value, plaintiffs sued defendants under Section 10(b) of the Securities Exchange Act.
Writing for the Court, Justice Anthony M. Kennedy held that the plaintiffs could not establish that they relied on the defendants' conduct. Defendants did not omit a material fact they were under a duty to disclose, nor were their deceptive acts communicated to the public. Either of these circumstances would presumptively have created reliance. Thus, the majority rejected plaintiffs' so-called "scheme liability," under which it would be enough that defendants acted to further Charter's misstatement of its revenues while they knew or recklessly ignored that Charter would use the sham transactions to misstate its financials and defraud investors. What in essence the plaintiffs had alleged was a form of "aider and abettor" liability, something the Supreme Court had rejected for private plaintiffs over a decade earlier in Central Bank of Denver v. First Interstate Bank of Denver (1994).
The majority opinion expresses concern about extending the private cause of action implied under Section 10(b) to reach all transactions that a public company might make. It distinguishes between the securities market and the world of ordinary commercial contracts. The latter, it noted, is covered by "functioning and effective state-law guarantees." The Court clearly desires to curtail the ability of plaintiffs with meritless claims to extract sizable settlements from corporations. Internationally, the majority is concerned that overly broad exposure to U.S. securities laws could deter foreign firms from conducting business in the United States and could "shift securities offerings away from domestic capital markets."
But Justice Kennedy's opinion may not be the crippling blow to the plaintiffs' bar that one might initially think. The opinion emphasizes that the defendants' conduct was within the ordinary commercial realm, not the world of the securities markets. Those who are more directly connected with securities offerings-so-called "gatekeepers" like financial advisors, lawyers and accountants-might not be so classified. Gatekeepers who participate in sham transactions or otherwise facilitate them could still be held liable as primary violators under the traditional anti-fraud theories of Section 10(b).
Although a securities class action is less likely to succeed against secondary actors, companies should remain vigilant in avoiding fraudulent conduct that has the effect of assisting another company in misleading its investors and making fraudulent disclosures. The SEC still has the authority to charge secondary actors with aiding and abetting violations of primary wrongdoers like Charter. As SEC Commissioner Paul Atkins pointed out in the wake of Stoneridge, "[t]he SEC is well positioned to hold responsible individuals accountable by imposing injunctions, officer and director bars, disgorgement, and civil penalties." It is quite possible that the agency will respond to the blow to the private plaintiffs' bar in Stoneridge by stepping up its own enforcement activities to fill the gap left by the rejection of scheme liability. Furthermore, some state securities regulators are authorized to bring enforcement actions also for aiding and abetting violative activity.
Criminal penalties for fraudulent conduct also remain a strong deterrent. Underscoring this point, four executives from reinsurer General Re were convicted last week of engaging in accounting fraud to bolster the financials of AIG. The executives developed and executed a plan to artificially raise AIG's reserves with a sham transaction, similar to what the Stoneridge defendants were alleged to have done. The executives face long prison terms and hefty fines when they are sentenced on May 15.
It is difficult to overestimate the resourcefulness of the plaintiffs' bar in developing new theories of liability. Even if those theories ultimately fail, they may be enough to cause a significant headache to corporations engaged in questionable conduct. Companies, gatekeepers in particular, should continue to strengthen their compliance programs and monitor for the type of conduct described above. Although the Stoneridge decision provides some comfort for those who have feared being dragged into tenuous investor lawsuits, there is still good reason to be cautious.