At what point does a third party's involvement with a company that is engaged in fraudulent activities in violation of Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 10b-5 result in primary liability for the third party? In Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. and Motorola, Inc., 552 U.S. ___ (2008), the U.S. Supreme Court revisited and, in a five-to-three decision, substantially reaffirmed its earlier holding in Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), which barred suits for aiding and abetting a violation of Section 10(b) and Rule 10b-5. Writing for the majority, Justice Anthony Kennedy reasoned that, when it enacted the Private Securities Litigation Reform Act of 1995 ("PSLRA"), Congress narrowly tailored its response to Central Bank to authorize the Securities and Exchange Commission ("SEC") to bring aiding and abetting actions against third parties, but deliberately did not authorize a similar private right of action. The Court concluded that investors cannot bring actions for aiding and abetting violations of Section 10(b) against third parties, such as a company's customers or suppliers, where those third parties have not made public statements or representations that the investors relied upon in making their decision to purchase shares of the company's stock.
Section 10(b), the Exchange Act's general anti-fraud provision, prohibits the use, "directly or indirectly," of "any manipulative or deceptive device or contrivance in contravention" of rules promulgated by the SEC pursuant to that section. In Stoneridge, Stoneridge Investment Partners, LLC brought a securities fraud class action on behalf of purchasers of securities of Charter Communications, Inc. ("Charter"), which action included claims against Scientific-Atlanta, Inc. ("Scientific-Atlanta") and Motorola, Inc. ("Motorola" and, together with Scientific-Atlanta, the "Vendors"). Arguing that Central Bank only precluded third party liability under Rule 10b-5(b), which requires proof of a fraudulent misrepresentation or a failure to disclose, Stoneridge asserted fraudulent "scheme liability" claims, alleging the Vendors engaged in a primary violation of Rules 10b-5(a) and (c).1 The U.S. District Court for the Eastern District of Missouri dismissed the claims against the Vendors, holding that they were at most merely aiders and abettors of Charter in its primary violation. Accordingly, the District Court held that Central Bank barred the claims against the Vendors.
The U.S. Court of Appeals for the Eighth Circuit affirmed the District Court's dismissal of the claims, holding that the language of Section 10(b) was constrained by Central Bank to prohibit "only the making of a misstatement or a failure to disclose by one who has a duty to disclose" and that the Vendors' conduct was nothing more than aiding and abetting Charter's violation, and was not itself a violation of Section 10(b) or Rule 10b-5.
Charter is one of the nation's largest providers of cable services. In 2000, recognizing that it would fail to meet its anticipated revenue and cash flow, Charter approached Scientific-Atlanta and Motorola, proposing an arrangement whereby Charter would pay the Vendors significantly more than their existing contract rates for set-top cable boxes the company had already agreed to purchase, provided that the Vendors in turn would use the funds from the increased purchase price to purchase advertising from Charter. In addition to the new agreements for the set-top boxes, Charter, Scientific-Atlanta and Motorola entered into advertising agreements under which the Vendors agreed to pay advertising rates that equaled the above-contract-rate payments Charter made to them. Neither Scientific-Atlanta nor Motorola had ever before purchased advertising from Charter, and the advertising rates reflected were four to five times higher than the rates each would normally have paid for similar advertising elsewhere.
As a result of the increased advertising revenue Charter was able to book from the Scientific-Atlanta and Motorola transactions, the company met analysts' expectations. However, when the nature of transactions was subsequently revealed, Charter was forced to restate its financials, and the company's stock price declined.
Prior to Central Bank, aiding and abetting liability under Section 10(b) required proof of three elements: (i) a primary violation of Section 10(b); (ii) the aider and abettor's reckless actions with knowledge of the primary violation; and (iii) the aider and abettor's provision of "substantial assistance" toward the accomplishment of the primary violation. However, in Central Bank, the Court rejected aiding and abetting liability, reasoning that the language of Section 10(b) did not support such liability. "We . . . conclude," the Court wrote, "that the statute prohibits only the making of a material misstatement (or omission) or the commission of a manipulative or deceptive act. We cannot amend the statute to create liability for acts that are not themselves manipulative or deceptive within the meaning of the statute." The Court declined to impose Section 10(b) liability on a third party that did not itself commit a deceptive act, but who took part (knowingly or unknowingly) in the transaction that gave rise to a primary violation. Knowledge of a primary violation alone was insufficient to turn a party engaging in a legitimate deal into a primary violator.
Stoneridge and Aiding and Abetting Liability
Acknowledging that Congress by the PSLRA limited enforcement actions against aiders and abettors to the SEC, the Court emphasized that in a private action under Section 10(b), an investor must establish each element of a primary violation, including that the investor relied upon the defendant's statements or misrepresentations in making his decision to invest in the company. In its analysis, the Court noted that conduct itself can be deceptive, in addition to written or oral statements being deceptive. The Court concluded that Stoneridge was unable to show that it relied upon any statement or deceptive conduct by either Vendor. Moreover, the Court found that the Vendors had no duty to disclose information to Stoneridge and that the Vendors' acts were not communicated to the market and were not reflected in Charter's stock price, what is known as the "fraud-on-the-market presumption." Absent a public statement by either of the Vendors, the Court found the linkage between the Vendors' transactions and Charter's decision to file false financial statements too remote to impose liability on the Vendors. "[Stoneridge] contends," Justice Kennedy wrote, "that in an efficient market investors rely not only upon the public statements relating to a security but also upon the transactions those statements reflect. Were this concept of reliance to be adopted, the implied cause of action would reach the whole marketplace in which the issuing company does business."
Causation and Reliance
In a dissent joined by Justices Ginsburg and Souter, Justice John Paul Stevens rejected the majority's conclusion that Stoneridge could not show reliance upon the Vendors' statements and actions with respect to the wash transactions. The fraud-on-the-market presumption, Justice Stevens urged, "says nothing about . . . what an individual or corporation must do in order to have 'caused' the misleading information that reached the market." The Vendors' actions, then, should be the focus of a discussion of causation and reliance. In the dissent's view, the Vendors knew that "their deceptive acts would be the basis for statements that would influence the market price of Charter's stock on which shareholders would rely." The dissent concluded that "a correct view of causation coupled with the presumption would allow [Stoneridge] to plead reliance."
Signposts to Future Actions and Jurisprudence
The Court also engaged in a lengthy discussion of the negative practical implications of expanding the reach of Section 10(b)'s implied private right of action. The Court described certain potential adverse consequences of such an expansion as including increased "costs of doing business," the deterrence of "[o]verseas firms with no other exposure to our securities laws . . . from doing business here" and an ultimate shifting of "securities offerings away from domestic capital markets." The Stoneridge decision is consistent with the Court's recent decisions in the securities litigation context, and is a clear indication that the present Court will continue to construe the federal securities laws narrowly.
Although Stoneridge cast the Vendors' actions as fraudulent scheme liability, the Court did not present any holding on that theory, instead deciding the case on the basis of Congressional intent and an absence of reliance. In our view, it would be incorrect to regard the Court's holding in Stoneridge as a rejection of fraudulent scheme liability.
In the wake of Stoneridge, companies should anticipate a more rigorous SEC enforcement effort against aiders and abettors, including fines that will go into the Fair Funds account for ultimate distribution to injured parties. Companies should pay special attention in SEC reports to statements made about other companies - particularly publicly traded companies - in order to assure the accuracy of factual statements or the reasonableness of opinion or belief (which must be made in good faith).