A federal district court in Washington, D.C. has held that the Securities and Exchange Commission adequately pled that the owner of a company that sold certain products to a corporate subsidiary aided and abetted the subsidiary’s violations of the Securities Exchange Act of 1934 by signing and returning audit confirmation letters that he knew, or was reckless in not knowing, were materially false by understating promotional allowances. This holding reminds us that while a private lawsuit may not be brought on an aiding and abetting theory against a vendor who sells to the primary violating company, the SEC may bring such claims. In Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., et al., 128 S. Ct. 761 (2008), corporate investors could not maintain a Section 10(b) securities fraud action against corporation’s vendors and customers for allegedly entering into a sham transaction with the corporation that inflated corporation’s reported revenues and cash flow when vendors and customers did not directly mislead plaintiffs.
In its complaint, the SEC noted that the parent company of U.S. Foodservice (USF) had restated its income for fiscal years 1998 through 2002 due to its overstating of its income and sales in its original SEC filings and other public statements. The SEC alleged that the erroneous filings were facilitated by the scheme undertaken by USF’s executives to inflate the value of “promotional allowances” received from USF’s vendors by urging them to sign and return false audit confirmation letters that included fictitious or inflated promotional monies earned, paid, or received by the vendors. These false amounts were included in USF parent company’s SEC filings and other public statements. The complaint alleged that defendant, an owner of one of the vendors, aided and abetted the fraud perpetrated by USF’s executives by signing and sending an audit confirmation letter that contained materially false information to USF’s auditors. Moreover, the complaint alleged that on the same day that he sent the allegedly false confirmation letter, defendant obtained a side letter from USF, which explained that the information in the confirmation letter was inaccurate.
In rejecting defendant’s motion to dismiss the complaint, the court noted that the SEC can plead a claim for aiding and abetting by alleging that defendant had a “general awareness that his role was part of an overall activity that was improper,” and that such “general awareness” can be established through a showing of “extreme recklessness,” such as defendant’s encountering of “red flags” or “suspicious events creating reasons for doubt.” Emphasizing defendant’s alleged awareness of the discrepancy of information contained in the audit confirmation letter and the side letter and the close temporal proximity between the two letters, the court concluded that the SEC satisfied its pleading burden. (SEC v. Grendys et al., 2008 WL 4377450 (D. D.C. Sept. 29, 2008))