On Jan. 15, 2008, the U.S. Supreme Court reaffirmed the limited reach of private securities fraud actions. The Court held that securities purchasers do not have an implied private right of action for federal securities fraud claims against secondary actors who neither speak nor have a duty to speak because such investor plaintiffs cannot rely upon the defendants’ alleged deceptive conduct. Importantly, the Court’s decision in Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc. rejected the theory of “scheme liability” that had recently found favor with some lower courts, and took a pragmatic approach in limiting the reach of private-plaintiff federal securities fraud litigation. The Court found that those who transact business with a public company will not be subject to private securities fraud liability—even if such transactions lead to the deception of the investing public—unless such persons speak or act in connection with a securities purchase or sale. This clear statement limiting secondary liability under the federal securities laws bodes well for the banks, professionals and others who daily transact with public companies.
In this case, Stoneridge Investment Partners LLC, a hedge fund that purchased shares of Charter Communications, Inc., alleged violations of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, against Charter, its auditor, and, importantly, two of Charter’s suppliers on behalf of a class of investors who purchased common stock of Charter. Stoneridge alleged that Charter and the two suppliers knowingly participated in sham transactions that generated $17 million in additional, but bogus, revenue that Charter reported on its publicly issued financial statements as part of a scheme to hide Charter’s revenue shortfall. While neither Stoneridge nor any “member of the investing public had knowledge, either actual or presumed,” of the transactions between the suppliers and Charter, Stoneridge sought to hold the suppliers liable for securities fraud because the misstatements in Charter’s financial statements that resulted from the sham transactions were “a natural and expected consequence” of the suppliers’ actions.
In affirming a decision of the Eighth Circuit Court of Appeals’ dismissal of Stoneridge’s claims against the suppliers, the Court relied extensively on its 1995 decision Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. In that case, the Court established limits on a private plaintiff’s ability to bring a federal securities fraud action against “secondary actors” by holding that the Securities Exchange Act did not imply a private right of action for aiding and abetting a federal securities violation. Later that same year, Congress passed the Private Securities Litigation Reform Act of 1995, and seemingly approved of this Court-imposed limitation by permitting only the SEC to pursue an aiding and abetting theory. With the Stoneridge opinion, the Court thus reaffirms Central Bank’s limitation—that private securities fraud plaintiffs cannot expand the limited reach of the federal securities laws to secondary actors whose alleged misconduct did not influence plaintiffs’ investment decisions.
As its primary justification for this result, the Court looked to the reliance prong of a §10(b) claim. Although Stoneridge argued that its reliance on Charter’s financial statements meant it relied on a misstatement that was “a natural and expected consequence” of its suppliers’ actions, the Court found this connection between the suppliers’ conduct and the plaintiffs’ alleged injuries too remote. Instead, the Court reaffirmed that Stoneridge had to show reliance, either actual, presumed or indirect, on some statement made or act done by those suppliers.
Since Stoneridge did not claim that it, or the market, actually knew of the suppliers’ allegedly deceptive conduct, the Court concluded there was no actual reliance. The Court further concluded that there was no presumed reliance because the suppliers had no duty to disclose their allegedly deceptive conduct to a securities purchaser like Stoneridge. This left Stoneridge with only its theory of “indirect” reliance, namely, that the Court should hold the suppliers liable for the false financial statements on which Stoneridge relied, because the suppliers knowingly participated in the alleged scheme leading to Charter’s misstated financial statements. This, the Court held, took indirect reliance too far, as that liability theory would open up the entire marketplace to causes of actions otherwise outside the reach of the federal securities laws. After all, the Court noted, it was Charter, and not the suppliers, “that misled its auditor and filed fraudulent financial statements.”
Particularly telling is the Court’s additional analysis of the “practical consequences of an expansion” of secondary liability under §10(b). Employing a pragmatic approach, the Court articulated a need to strike a balance between the orderly conduct of the securities markets and the desire to give businesses the freedom to conduct their ordinary business operations without fear that the ripple effects of those operations on the securities markets will result in liability. The Court concluded that adopting Stoneridge’s theory would expose a “new class of defendants” to risks of liability including “settlements from innocent companies,” and increased cost of doing business as contracting parties found it necessary to insulate themselves from potential litigation. The Court also cited its concern that such expanded liability could deter foreign businesses from doing business in the United States, leading to a shifting of securities offerings away from the public markets.
One possible crack in the Court’s wall against secondary actions may be in the Court’s attempt to distinguish “the realm of financing business” from “the realm of ordinary business operations.” While it is clear that the latter cannot be the basis for private liability against defendants who do not themselves commit primary violations of the securities laws, the opinion can be read to suggest that the former—meaning those operating in the realm of financing business—might yet be subject to some form of secondary liability. What this distinction means is still unclear, as the Court did not offer any further explanation.
As a result, the line between these two realms will likely have to be determined through future litigation. One case that may yet clarify exactly where the Court believes this line should be drawn is the class action suit brought by Enron Corporation shareholders against Enron’s investment banks, currently before the Supreme Court on a petition. Indeed, some members of the securities plaintiffs’ bar have already suggested that the Enron claims will survive the Stoneridge opinion, noting the contrast between suppliers who contract to supply parts and investment banks that design financing mechanisms. Asserting that this difference demonstrates that the bank defendants in the Enron litigation were involved in the financing of business, and not simply its ordinary operations, these commentators have suggested the Enron plaintiffs’ claims should survive even after Stoneridge. Not surprisingly, others have disagreed, noting that those claims clearly relied on the very same scheme liability that the Court rejected in Stoneridge.
Finally, the Court specifically noted that its decision does not result in defendants like Charter’s suppliers getting a free pass for allegedly wrongful conduct, pointing that such conduct is not without possible consequences. As the Court highlights, in any instance where “business operations” are used to “affect securities markets,” the SEC’s enforcement power may be in play. Further, in the securities realm, secondary actors remain exposed to criminal penalties, state securities laws (albeit in very limited circumstances), and for primary violations of the securities laws. Finally, and perhaps most importantly for the Court’s purposes, acts like those alleged to have been carried out by the suppliers in Stoneridge remain subject to state laws governing ordinary business operations.
In the end, and notwithstanding the dissent’s protest that the majority’s opinion not only fails to follow Central Bank but also is part of “the Court’s continuing campaign to render the private cause of action under §10(b) toothless,” what may make the Stoneridge opinion so significant is its effort to present itself as simply an adherence to the Court’s prior precedent. In the name of adherence to that precedent, the Court confirmed that the limits of private securities liability remain where the majority believed Central Bank put them. The result, once more, is a rejection of private causes of action for aiding and abetting liability, irrespective of the name used to describe it.