In Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 2008 WL 123801 (U.S. Jan. 15, 2008) (Kennedy, J.), the Supreme Court rejected an attempt by a class action plaintiff to assert securities fraud claims against suppliers and customers of an issuer in whose stock the plaintiff invested. Those suppliers and customers, it was alleged, knowingly agreed to sham contracts with the issuer that the issuer improperly accounted for in its financial statements. Because the suppliers and customers (as distinct from the issuer) made no public statements and owed no disclosure duties to the issuer’s investors, the investors could not state a claim against them on the ground that the plaintiff could not plead or prove reliance on the secondary actors’ conduct. This decision reflects the Supreme Court’s intent to limit exposure to private securities fraud class action litigation to those who are directly responsible for making false or misleading statements to the investing public.

The suit was filed by investors of Charter Communications, Inc. Charter, a cable operator, allegedly engaged in a variety of fraudulent practices so its quarterly financial statements would meet Wall Street expectations for cable subscriber growth and operating cash flow. In late 2000, Charter executives realized that the company would miss projected operating cash flow numbers by $15 to $20 million. To help meet the shortfall, Charter decided to alter its existing arrangements with two of its suppliers, Scientific-Atlanta, Inc. and Motorola, Inc. These companies supplied Charter with the set top boxes that Charter furnished to its customers. Charter arranged to overpay Scientific-Atlanta and Motorola $20 for each set top box it purchased until the end of the year, with the understanding that respondents would return the overpayment by purchasing advertising from Charter. Because Charter would record the advertising purchases as revenue and capitalize its purchase of the set top boxes in violation of generally accepted accounting principles, the transactions would enable Charter to fool its auditor into approving a financial statement showing it met projected revenue and operating cash flow numbers. Scientific-Atlanta and Motorola allegedly agreed to this arrangement, as well as to the documentation of the arrangement in a manner that would persuade Charter’s auditors, Arthur Andersen, to approve Charter’s allegedly improper accounting treatment. The two suppliers (who were by now also customers) had no role in preparing or disseminating Charter's financial statements, and allegedly accounted for the transactions on their own financial statements properly (as a wash).

Charter ultimately was forced to restate its financial statements to reflect the proper accounting for these transactions. Investors sued Charter, certain of its management, its auditors and the two suppliers and customers who agreed to the allegedly sham transactions with Charter. The lower courts dismissed the claims against Scientific-Atlanta and Motorola, holding that the Supreme Court’s prior decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), precluded liability against secondary actors who, like Scientific-Atlanta and Motorola, allegedly only aided and abetted another’s primary violation of the securities laws.

In a five-to-three decision, the Supreme Court affirmed the dismissal of the Rule 10b-5 claims against Scientific-Atlanta and Motorola. Justice Kennedy, writing for the majority, held that the main flaw of the plaintiff’s claim was the absence of reliance by the investors on the conduct of the suppliers and customers:

Reliance by the plaintiff upon the defendant’s deceptive acts is an essential element of the § 10(b) private cause of action. It ensures that, for liability to arise, the “requisite causal connection between a defendant’s misrepresentation and a plaintiff’s injury” exists as a predicate for liability.

. . .[Scientific-Atlanta and Motorola] 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 [their] deceptive acts during the relevant times. [Investors], as a result, cannot show reliance upon any of [the suppliers’ and customers’] actions except in an indirect chain that we find too remote for liability.

Stoneridge, 2008 WL 123801, at *6. The Court went on to discuss the policy reasons supporting its judgment that the “indirect chain” of causation and reliance was too remote. The investors, the Court observed, were contending that in an efficient market investors rely not only upon the public statements relating to a security but also upon the integrity of the underlying transactions those statements reflect. While the Court did not disagree with that concept, it nevertheless rejected it as a basis for federal securities fraud liability because it would expand the scope of such liability to “the whole marketplace in which the issuing company does business.” Id. at *7. This proposed expansion of federal securities liability, the Court held, was not supported (and in some instances contradicted) by existing legal authority, Congressional intent, practical economic considerations and public policy. Finally, the Court noted that abuses by secondary actors in these instances can be remedied through state law claims and enforcement actions by the Securities & Exchange Commission. Justice Stevens dissented, largely on the ground that he disagreed with the policy rationales cited by the majority to limit the scope of federal securities fraud liability.

The decision in Stoneridge reflects the Supreme Court’s willingness to reach judgments regarding securities litigation issues by invoking economic theory, Congressional intent and public policy considerations, not just strict legal analysis. As we have noted in prior posts (see, e.g., here), the Court has issued a flurry of important securities law decisions in the past several years after a decade-long drought, and in each has made reference to these types of considerations in deciding whether to expand or limit the scope of federal securities litigation. It is fair to expect that the Court will decline to take more securities cases in the next several years to allow the lower courts to digest and apply its recent decisions.