In a 5-3 decision, the United States Supreme Court declined to permit investor suits against third parties who engaged in deceptive acts that contributed to another party’s securities fraud, where the third parties had no duty to disclose their acts to the public, and where their deceptive acts were in fact not communicated to the public.

The much-anticipated decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. reaffirmed and strengthened the Court’s prior decisional law that the federal securities laws do not extend a private right of action against secondary actors for securities fraud based upon an aiding and abetting theory. Further, the Court rejected the argument that such secondary actors, whose conduct has the “effect of creating a false appearance of material fact” that is eventually communicated to the marketplace by another party, should be liable for securities fraud under a “scheme liability” theory.

Allegations of Scheme Liability

In Stoneridge, the plaintiff brought a class-action lawsuit on behalf of investors in the cable company Charter Communications, Inc. (“Charter”). They alleged that two suppliers of cable boxes, Scientific-Atlanta and Motorola, entered into contracts with Charter under which Charter overpaid the suppliers for the cable boxes by $20 per box, “with the understanding that [the suppliers] would return the overpayment by purchasing advertising from Charter.” The plaintiff alleged that the transactions “had no economic substance.” Nevertheless, Charter recorded and released financial statements showing the advertising payments as revenue and the costs for the purchases of the cable boxes as capitalized, having the effect of inflating Charter’s revenue and operating cash flow. The plaintiff further alleged that Charter and the suppliers created false paperwork to hide the transactions from Charter’s auditors. The Court’s decision centers around the plaintiff’s theory that Scientific-Atlanta and Motorola should be liable under federal securities laws for their involvement in the “scheme to defraud” Charter’s shareholders.

Investors Cannot Skirt the Reliance Element of Section 10(b)

In order to establish a securities fraud claim under Section 10(b) of the Securities Exchange Act of 1934, a plaintiff needs to establish that the defendant (1) made a material misrepresentation or omission (2) in connection with the purchase or sale of a security, (3) with a wrongful state of mind, (4) that the plaintiff relied upon that statement or omission and (5) that it caused the plaintiff loss. The Supreme Court in Stoneridge reiterated that no liability exists for third parties absent a satisfactory showing of each of the Section 10(b) elements.

The Court held that the plaintiff investor could not sue the suppliers because it had not relied upon statements or misrepresentations by the suppliers when purchasing Charter stock. Nor did the suppliers have a duty to disclose the deceptive conduct to the marketplace – only Charter had a duty to make accurate disclosures to its investors. The majority, stating that “[n]o member of the investing public had knowledge, either actual or presumed, of [the suppliers’] deceptive acts during the relevant times,” concluded that the suppliers’ alleged “deceptive acts, which were not disclosed to the investing public, are too remote to satisfy the requirement of reliance.” The Court was not swayed by the argument that “investors rely not only upon the public statements relating to a security but also upon the transactions those statements reflect.” The Court explained, “[w]ere this concept of reliance to be adopted, the implied cause of action would reach the whole marketplace in which the issuing company does business. . . .” Because the investor could not show direct reliance on any act or statement of the suppliers, the investor could not establish a key element of a securities fraud claim.

Looking Ahead – Impact of Stoneridge

In the end, the Supreme Court’s decision in Stoneridge was not the landmark ruling many in the business and professional world feared. Indeed, the most immediate impact of the decision is that it may undermine a shareholder suit against the Enron underwriters that is currently before the Supreme Court, and may curb the rush of securities litigation against banks that sponsored troubled subprime mortgage entities. It also allows businesses to breathe easier, knowing that they will not be exposed to securities fraud liability based on the wrongful conduct of their customers, suppliers and other business partners, where they themselves have no duty to disclose to the public and do not communicate any alleged wrongful acts to the public.

However, because Stoneridge did not foreclose all claims against third parties, the contours of the case undoubtedly will be examined closely by the plaintiffs’ bar. For example, the Court refused to adopt a broad safe harbor to protect third parties from Section 10(b) liability, as urged by the suppliers. Instead, the Court reaffirmed the right of private litigants to bring action against third parties who satisfy all of the elements for primary violations of Section 10(b). Moreover, the Court specifically noted that the circumstances in Stoneridge arose “in the marketplace for goods and services, not in the investment sphere” and drew a distinction between transactions occurring in the “realm of ordinary business operations” and those in “the realm of financing business.” Thus, under the right circumstances, third parties – such as lawyers, accountants and investment bankers – who participate as secondary actors in deceptive corporate transactions reflected on publicly disclosed financial statements may continue to be within the reach of private litigants.

Likewise, the Court’s criticism of the lower court’s attempt to limit Section 10(b) claims to cases involving only oral or written statements is noteworthy. By holding that “conduct can be deceptive,” the Court has appeared to leave open a new avenue for securities fraud cases. It appears that securities fraud claims premised upon reliance on deceptive conduct by primary or secondary actors in the purchase or sale of securities, even in the absence of alleged misstatements or omission, would pass muster.

By and large, the Stoneridge decision reinforces the status quo. The Court will continue to require plaintiffs in securities fraud actions to show reliance upon the defendants’ material misstatements, omissions or deceptive conduct. The SEC will continue to follow its existing statutory authority to pursue persons that aid and abet securities fraud. And, plaintiffs will continue to seek other avenues to extend private claims of securities fraud liability to secondary actors through openings they can find in the Court’s jurisprudence.