On October 9, 2007, the Supreme Court heard oral argument in what commentators believe may be the most important securities law case in years. Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., S.Ct. No. 06-43, could decide whether business partners of a public company may be held liable in a securities fraud damage suit. The legal question in Stoneridge is: who can be held liable under catch-all antifraud provision, Section 10(b)? Plaintiffs rely on a theory of “scheme liability,” developed initially by the SEC, to try to hold liable business partners who engage in transactions with a public company when the latter records the deal in a fraudulent manner. Defendants counter this theory by arguing that scheme liability is outside the statute and contrary to an earlier Supreme Court decision.

Comments by the Justices at the oral argument, coupled with the Court’s approach in a recent key securities case, suggest that the Court may hand down a more limited decision focused on the scope of Section 10(b) and give district courts directed discretion to continue developing Section 10(b) liability. Such a decision could be viewed as a win for plaintiffs — for now. On the one hand, it would allow some of the huge class actions, such as the one arising out of Enron Corporation’s financial difficulties, to continue. On the other hand, it would also give defendants new arguments with which to seek dismissal. Whether the Court decides the broad issue of third-party liability posed by the parties or resolves the case on a more limited issue, the decision will be important for everyone.

Was it an Everyday Business Transaction or a Scheme to Defraud?

The fact pattern in Stoneridge illustrates the potential ramifications of the Court’s decision. The case centers on a deal involving Charter Communications, Inc. (“Charter”), a large, publicly-traded cable company, and two of its vendors, Scientific-Atlanta, Inc. (“Scientific-Atlanta”) and Motorola, Inc. (“Motorola”). In a threeway barter deal, Charter acquired TV set-top cable boxes in exchange for advertising. As part of the transaction, Charter paid an additional $20 per box. That sum was returned to the company as advertising revenue. Charter capitalized the cost of the boxes, while recognizing the revenue from the advertising, thus deferring expenses while adding to income. According to the complaint, Charter improperly booked the barter deal, thereby falsifying its financial statements that were disseminated to the market and its shareholders — securities fraud.

Shareholders filed suit against not only Charter, but against the two vendors, Scientific-Atlanta and Motorola for their participation in the transaction, as well as others. The district court and the Eighth Circuit Court of Appeals rejected plaintiffs’ claims against the vendors as being outside the scope of Section 10(b). In re Charter Commc’n, Inc., Sec. Litig., 443 F.3d 987, 992 (8th Cir. 2006) (holding that liability could not be imposed on businesses who merely engage in “an arms length non-securities transaction with an entity that then used the transaction to publish false and misleading statements to its investors and analysts”). The Supreme Court agreed to review the dismissal of the action as to the third-party vendors.

What are the Arguments?

The plaintiffs in Stoneridge call the barter transaction fraudulent. Plaintiffs rely on a “scheme liability” theory to argue a Section 10(b) violation by the vendors. Under this theory, a party who participates in a fraud committed by a public company may, under certain circumstances, be held liable when the fraudulent information is given to the securities markets and relied on by investors. This theory was initially advocated by the SEC in an amicus brief in a case before the Ninth Circuit, arguing that a third-party vendor is liable “for engaging in a scheme to defraud … [if it] directly or indirectly, engages in a manipulative or deceptive act as part of a scheme” whose purpose and effect is to create a false appearance of revenue. The Ninth Circuit adopted a variation of this theory. Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th Cir. 2006). The same theory was rejected by the Fifth Circuit in a case involving Enron. Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. 2007); Pet. For Cert. filed, sub nom Regents of the Univ. of Cal. v. Merrill Lynch Pierce Fenner & Smith, Inc., 75 U.S.L.W. 3557 (March 5, 2007) (No. 06-1341) (“Enron”). The Supreme Court has not ruled on petitions for certiorari in either Simpson and Enron, yet.

The defendants in Stoneridge argue that the barter deal is merely a business transaction, and that how Charter booked the transaction and what it told the market is between the company and its shareholders. Defendants further argue that scheme liability is outside the scope of Section 10(b) and contrary to the Court’s 1994 decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, 511 U.S. 164 (1994). That decision concluded that aiding and abetting — liability based on rendering substantial assistance to a primary fraudster who violated Section 10(b) — is outside the scope of Section 10(b). According to defendants, Congress resolved the issue of secondary liability with the passage of the Private Securities Litigation Reform Act of 1995 (“PSLRA”). By reforming the pleading and substantive requirements for private securities fraud suits, Congress gave the SEC authority to bring fraud suits on an aiding and abetting theory, but did not extend the same right to private plaintiffs. According to defendants, this congressional action suggests that the Court should not expand the judicially created remedy under Section 10(b). Defendants also contend that plaintiffs have failed to plead reliance, a key element of a Section 10(b) private damage action.

Comments by the Justices: Is There a Middle Ground?

A ruling by the Court adopting the position of either party would have a significant impact on Section 10(b) liability and could change the way business is conducted. Adoption of plaintiffs’ scheme liability theory would allow not only Stoneridge, but also Enron, Simpson and other class actions to proceed, potentially imposing securities fraud liability and damage awards on a host of companies, banks, investment banks, and other unsuspecting business partners of public companies. Conversely, a ruling for defendants would end these class actions and could potentially leave many shareholders claiming huge losses without a remedy. A decision on this basis would also significantly alter the scope of future securities damage actions and the right of shareholders to pursue securities fraud claims. During the October 9, 2007 oral argument in Stoneridge, the Supreme Court Justices raised significant questions about the positions advanced by both sides.

Chief Justice Roberts, for example, suggested that adopting plaintiffs’ scheme liability theory would be inconsistent with congressional action in the PSLRA: “I mean, we don’t get in this business of implying private rights of action any more. And isn’t the effort by Congress to legislate a good signal that they have kind of picked up the ball and they are running with it and we shouldn’t? … [M]y suggestion is not that we should go back and say that there is no private right of action. My suggestion is that we should get out of the business of expanding it, because Congress has taken over and is legislating in the area in the way they weren’t back when we implied the right of action under 10(b).”

The Chief Justice, along with Justices Scalia, Kennedy, and Alito, also pointed out that plaintiffs’ position was inconsistent with the Court’s decision in Central Bank. In this regard, Justice Alito pointed out to plaintiffs’ counsel that he saw “absolutely no difference between your test and the elements of aiding and abetting.” Justice Kennedy warned of the danger of plaintiffs’ scheme liability argument being effectively limitless, encompassing every minor act that could affect share price: “there are any number of kickbacks and mismanagements and petty fraud that go on in the business, and business people know that any publicly held company’s shares are going to be affected by its profits, so I see no limitation” to plaintiffs’ theory of scheme liability.

However, the Court also criticized defendants’ assertion that they did not make any misstatement to Charter’s shareholders, when Justice Ginsburg pointed out that the lack of a statement (or silence) was the key to the fraudulent scheme: “[T]hat’s the essence of the scheme. You said that they — they are home free because they didn’t themselves make any statement to investors. But they set up Charter to make those statements, to swell its revenues — revenues that it in fact didn’t have.”

As the arguments progressed, the questions and comments from the Court focused on a middle ground — somewhere between plaintiffs’ scheme liability theory and defendants’ argument that there is no secondary liability.

  • Justice Ginsburg began the search for a middle ground when she asked: “[T]hat’s if [defendants] are aiders and abettors, which is what Congress covered [in Section 20(e) of the Exchange Act]. And I again go back to see if there is another category or is everyone — either Charter, the person whose stock is at stake, the company whose stock is at stake and everyone else is an aider?”
  • Justice Kennedy continued the search for middle ground by asking defense counsel if, under the common law of torts, there was a category between primary violator and aider and abettor. Justice Souter echoed this theme by inquiring if there was “overlap” between the two categories — that is, some kind of common ground which would in fact be a third category. The Court has previously used common law fraud theory to limit the scope of Section 10(b) when defining the elements of a claim for damages. Dura Pharmaceuticals, Inc., v. Broude, 544 U.S. 336, 344-46 (2005).
  • Justice Stevens asked defense counsel whether reliance — a key defense argument — is an element of a private cause of action or of a statutory violation. Defense counsel responded that it is an element of a private action — a response drawn straight out of the Court’s decision in Dura, decided two years ago. The Chief Justice, in a comment echoed by Justice Ginsburg, followed up on this point by noting that the question of reliance had not been squarely ruled on by the lower courts. Since the Court frequently declines to decide issues not addressed by the lower courts, these questions suggest the Court may not resolve the reliance issue. If so, the remaining issue would be the scope of Section 10(b).

Analysis and Conclusion

In the Court’s most recent securities fraud case, Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007), an eight-Justice majority held that the goals of the PSLRA are to permit meritorious private damage actions to proceed and eliminate those that are frivolous. Justice Ginsburg, writing for the Court in Tellabs, crafted a standard for pleading a “strong inference” of scienter under the PSLRA and the Court remanded the case to the district court for further proceedings. The consensus approach of Tellabs, based on a focused point, coupled with a vesting of broad discretion in the district court, appears to be the formula that drew together eight votes on the Court, which is frequently fractionalized along ideological lines.

The “all or nothing” approach inherent in the arguments advanced by the Stoneridge parties is inconsistent with the focused, consensus approach of Tellabs. Plaintiffs’ “scheme liability” theory may, as the Chief Justice suggested, be viewed as an expansion of Section 10(b) liability at a time when the Court is trying to circumscribe the implied cause of action it created in a manner which is consistent with the PSLRA. Defendants’ “business as usual” approach may be viewed as leaving shareholders alleged to have suffered huge losses in well-publicized financial fraud cases such as Enron without a remedy, a result that might also be viewed as contrary to the PSLRA.

A decision limited to a construction of Section 10(b), however, with a remand to the lower courts, may create a Tellabs-type consensus. Under this approach, the Court could give definition to what constitutes a primary violation of Section 10(b) in a manner consistent with its restrictive view of interpreting the Section. Since the question of reliance deals with an element of a claim, not statutory construction, the Court may leave this issue to another day. The case could then be remanded for further proceedings in view of the opinion. This would give the lower courts discretion to continue developing the notion of Section 10(b) liability under instructions from the High Court.

A Tellabs-style a middle ground consensus approach would permit all sides to declare victory — for now. Plaintiffs’ case — and those in the wings, such as Enron — could go forward. Defendants would have new arguments for dismissal. The lower courts would have new guidance on the question left open by Central Bank years ago — who is liable under Section 10(b)?

In any event, no matter what the Court does — adopt the scheme liability theory argued by plaintiffs, accept the argument by defendants that such vendors fall outside the scope of the PSLRA, or find some middle ground — the decision in Stoneridge should be watched closely by counsel for publicly-traded companies, as well as those who do business with those companies.