On January 15, 2008, the United States Supreme Court issued its much-anticipated decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., No. 06-43, concerning the availability of “scheme” liability under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The Court rejected, as legally insufficient, a complaint alleging that the defendants had engaged in transactions with an issuer that, the defendants knew, were designed to permit the issuer to report artificially inflated revenue and earnings figures. In particular, the Court noted that, in the absence of allegations that the investing public was aware of the defendants’ transactions with the issuer, plaintiff had failed to plead reliance — a critical element of the federal securities fraud cause of action. As a result, the Court concluded plaintiff’s allegations established, at best, that the defendants had “aided and abetted” in a fraud by the issuer. That form of liability, however, is unavailable in private actions under Section 10(b) and Rule 10b-5. See Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994).

By holding that Section 10(b) and Rule 10b-5 generally do not permit imposition of “scheme” liability, the Stoneridge ruling significantly limits the group of parties who may become defendants in federal securities fraud actions. In so doing, the Court restricted class plaintiffs’ search for secondary, deep pocket defendants in fraud actions when, as is frequently the case, the principal wrongdoers have become impecunious or bankrupt. Moreover, the opinion strongly signals the Court’s reluctance to extend the implied private right of action under Section 10(b) and Rule 10b-5. Thus, while Stoneridge itself involved claims against an issuer’s suppliers and customers, the Court’s decision also bodes well for other secondary actors — such as auditors, bankers and lawyers — who are frequently targets of the securities plaintiff bar.

The Case Before the Court

Petitioner represented a purported class of investors in Charter Communications, Inc., a cable television operator. Charter, fearful of missing its projected operating cash flow numbers by as much as $15 to $20 million, sought to avoid the shortfall by entering into a series of round trip transactions with Scientific- Atlanta and Motorola — the respondents in the litigation — companies that supplied Charter with digital cable converter (set top) boxes. According to petitioner, Scientific-Atlanta and Motorola agreed to a scheme under which Charter would pay a $20 premium on each set top box and respondents would return this overpayment by buying advertising from Charter that they never actually used. In contravention of Generally Accepted Accounting Principles, Charter recorded these advertising purchases as revenue and capitalized its purchase of the set top boxes. The net effect of these accounting entries was to inflate Charter’s revenue and operating cash flow by about $17 million.

Petitioner asserted that Charter misled its outside auditor into issuing an unqualified opinion with respect to financial statements that included the improper entries relating to the Scientific-Atlanta and Motorola transactions. At Charter’s request, Scientific-Atlanta and Motorola allegedly created false documents to prevent the auditor from detecting a connection between the set top box and advertising transactions. For example, both companies allegedly backdated their set top box agreements so it appeared that they had been negotiated a month before the advertising agreements. To explain the increase in set top box price, Scientific-Atlanta allegedly furnished Charter with a letter that falsely stating production costs had increased. Likewise, a contract between Motorola and Charter allegedly required that, if Charter did not purchase a particular number of set top boxes, Charter would pay Motorola liquidated damages of $20 for each unit it failed to buy.

The inflated revenue and cash flow from the Scientific-Atlanta and Motorola transactions appeared on the financial statements that Charter filed with the SEC.1 When Charter’s true financial situation came to light, its stock plummeted. Petitioner filed a purported class action, alleging that Motorola’s and Scientific-Atlanta’s participation in the scheme to skew Charter’s financials amounted to a violation of Section 10(b) and Rule 10b-5.

The Supreme Court’s Decision

Writing for the majority, Justice Kennedy, joined by Chief Justice Roberts and Justices Scalia, Thomas and Alito, held that the private right of action implied in Section 10(b) does not reach parties that facilitate a corporation’s effort to issue misleading financial statements, ultimately inflating the corporation’s stock price, but themselves make no misstatements upon which investors relied and who had no independent duty to disclose the misconduct.

In Central Bank, the Court ruled that the private right of action under Section 10(b) does not extend to aiders and abettors. Thus, the Stoneridge investors’ success depended on whether they could assert that respondents engaged in a primary securities fraud violation, satisfying each of the elements required for Section 10(b) liability. This, the Court held, petitioner failed to do.

The Court explained that plaintiff’s reliance on the defendant’s deceptive act is a crucial element of a Section 10(b) private cause of action. Reliance, the Court reasoned, provides the necessary causal connection between a defendant’s misrepresentation and a plaintiff’s injury. While a rebuttable presumption of reliance exists when there is “an omission of a material fact by one with a duty to disclose” or when “statements at issue become public,” the Court found that petitioner had failed to allege adequately that either presumption applied. It concluded that Scientific-Atlanta and Motorola had no duty to disclose and that their deceptive acts had not been communicated to the public: “No member of the investing public had knowledge, either actual or presumed, of respondents deceptive acts during the relevant times.” As a result, the petitioner managed only to show reliance “in an indirect chain that we find too remote for liability.”

In so holding, the Court dismissed petitioner’s causation argument that respondents’ conduct created a false appearance of material fact that furthered Charter’s plan to misrepresent its revenue. Without respondents’ help, petitioner argued Charter’s auditor would have learned the corporation’s true financial position and the publicly filed financial statement would have reflected reality. The Court drew a distinction, finding that investors had relied on the publicly filed financial statements, not upon the transactions reflected therein. It explained that “[i]t was Charter, not respondents, that misled its auditor and filed fraudulent financial statements; nothing respondents did made it necessary or inevitable for Charter to record the transactions as it did.”

The Court also noted other grounds supporting its decision. For example, it added that state law generally governs the “world” of Motorola and Scientific-Atlanta, that of purchase and supply contracts. Thus, “[w]ere the implied cause of action to be extended to the practices described here … there would be a risk that the federal power would be used to invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees.” The Court also acknowledged its historically cautious approach to implying a private right of action. It highlighted that despite the new limits on private litigants, however, the actions of secondary actors like those in Stoneridge were not without consequence — they could be subject to criminal or civil proceedings by the Department of Justice or the SEC.

Going Forward

Continuing the trend set by the Private Securities Litigation Reform Act and other recent Supreme Court decisions — including Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007) and Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005) — Stoneridge has narrowed the securities laws typically employed in shareholder class actions, this time rejecting scheme liability so that third-parties are at significantly less risk of being found liable. A private litigant’s success will now hinge on showing any secondary actor’s misconduct amounting to a direct Section 10(b) violation by (1) having an obligation to disclose misconduct and failing to do so, or (2) by engaging in conduct that investors were aware of and relied on. A secondary actor’s undisclosed participation in a transaction resulting in false financials will not alone give rise to private civil liability under Section 10(b) and Rule 10b-5.

More broadly, the Court remains hostile to attempts to expand the implied private cause of action under Section 10(b) and, generally, to the implication of private enforcement rights, not explicity provided for by Congress. The majority also seemed persuaded that Stoneridge’s barriers to securities fraud liability have positive implications for the United States’ position in the global marketplace. Were the Court to have held that the private right of action in Section 10(b) covers suits for aiding and abetting fraud, “[i]t would also expose to such risks a new class of defendants — overseas firms with no other exposure to U.S. securities laws — thereby deterring them from doing business here, raising the cost of being a publicly traded company under U.S. law, and shifting securities offerings away from domestic markets.”

However, it is important to note that while Stoneridge may hamper a private litigant, neither the SEC, nor the Department of Justice is so limited. The SEC has the authority to seek civil recovery, and the Department of Justice may proceed criminally, against aiders and abettors of securities fraud. Furthermore, local laws in many jurisdictions authorize state regulators to seek sanctions against aiders and abettors.