On January 15, 2008, the U.S. Supreme Court issued its eagerly anticipated decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., et al. By a vote of 5-3 (with Justice Breyer abstaining), the Court ruled against the plaintiff investors, holding that the implied private right of action for securities fraud under Section 10(b) of the Securities Exchange Act of 1934 (the “1934 Act”) does not extend to third parties that may have participated in allegedly deceptive business transactions, but that did not make alleged misstatements nor commit any other primary deceptive act on which investors relied. This ruling means that investors cannot bring private lawsuits against third parties in corporate-fraud cases unless they relied on actions by those parties when making investment decisions. The Court’s ruling rejected the plaintiffs theory of “scheme liability” for Section 10(b) and Rule 10b-5 violations, which would have permitted secondary actors (e.g., vendors, accountants, lawyers, etc.) to be held liable for fraud committed by companies with which they do business, even if they did not commit a primary violation.
The Investors’ Claim
In Stoneridge, investors in Charter Communications, Inc. (“Charter”) alleged that Scientific-Atlanta, Inc. and Motorola, Inc. knowingly participated with Charter in a business scheme that allowed Charter to artificially inflate its reported revenues and operating cash flow. The investors alleged that, under the scheme, Charter agreed to pay Scientific-Atlanta and Motorola inflated prices for cable boxes that they sold to Charter, and then Scientific-Atlanta and Motorola used the extra money they received from cable box purchases to buy advertising on Charter’s television stations. While Scientific-Atlanta and Motorola accounted for these transactions as a wash under generally accepted accounting principles (GAAP), Charter capitalized the purchases of the cable boxes while recording the advertising payments separately to artificially inflate Charter’s revenue and operating cash flow. The plaintiffs alleged that contracts, one of which was backdated, were created by the parties as part of the scheme.
The investors argued that Scientific-Atlanta and Motorola violated Section 10(b) and Rule 10b-5 of the 1934 Act by participating in business transactions that they knew were part of a scheme designed to permit Charter to commit fraud. The district court dismissed these claims, and affirmed the U.S. Court of Appeals for the Eighth Circuit affirmed.
The Supreme Court’s Ruling
In upholding the lower court rulings, the Court reviewed the requirements for violations of Section 10(b) and Rule 10b-5: (i) a material misrepresentation or omission by the defendant; (ii) scienter; (iii) a connection between the misrepresentation or omission and the purchase or sale of a security; (iv) reliance upon the misrepresentation or omission; (v) economic loss and (vi) loss causation. The Court then emphasized the importance of reliance as an element of a Section 10(b)/Rule 10b-5 action, and focused on whether the investors could be said to have relied upon deceptive acts of Scientific-Atlanta and Motorola in purchasing their securities.
The Court concluded that there was no basis for finding that the investors relied upon, or could be presumed to have relied upon, the relevant deceptive acts in this case. The Court noted that it has found a rebuttable presumption of reliance in two different circumstances: (i) if there is an omission of a material fact by one with a duty to disclose, the investor to whom the duty was owed need not provide specific proof of reliance, and (ii) under the fraud-on-the-market doctrine, reliance is presumed when the statements at issue become public. However, the Court found that (i) Scientific-Atlanta and Motorola had no duty to disclose their conduct to Charter's investors, and (ii) the fraud-on-the-market doctrine was inapplicable because the conduct was not communicated to the public. Accordingly, the Court held that the investors could not "show reliance upon any of respondents' actions except in an indirect chain that we find too remote for liability."
Ruling Settles Lower Courts’ Split Rulings on Scheme Liability
The Supreme Court’s ruling in Stoneridge has settled the split among various federal courts of appeals as to when a secondary actor commits securities fraud and becomes liable under Section 10(b). Specifically, the Court rejected the “scheme liability” theory, while also extending prior rulings that there is no private right of action under Section 10(b) or Rule 10b-5 for aiding and abetting a securities fraud.
Until 1994, some lower federal courts had allowed private litigants to sue secondary actors for “aiding and abetting” securities fraud when the actors’ conduct itself did not directly violate Section 10(b) or Rule 10b-5, but the actors had assisted others to violate the law. However, in that year, the Supreme Court ruled in Central Bank of Denver v. First Interstate Bank of Denver that private parties could not bring suits under Section 10(b) and Rule 10b-5 of the 1934 Act for aiding and abetting securities fraud. Central Bank held that, to be liable for securities fraud, the defendant must have directly violated Section 10(b) by committing one of the acts prohibited by the statute. In response to Central Bank, Congress, in the Private Securities Litigation Reform Act of 1995, gave the Securities Exchange Commission (SEC) the power to take action against aiders and abettors, but did not create a private right of action for aiding and abetting securities fraud. See 15 U.S.C. § 78t(e).
The Court’s ruling in Stoneridge, reaffirms the Court’s holding in Central Bank that there is no private right of action for aiders and abettors under Section 10(b) and Rule 10b-5. As the Court noted in its opinion, aiders and abettors are still subject to prosecution for criminal violations and civil enforcement by the SEC, and may be subject to state law claims in certain circumstances. However, absent new statutory authority, the Court concluded that even knowing participation in a fraudulent scheme would not be sufficient for liability under Section 10(b) or Rule 10b-5 absent a primary misrepresentation or omission upon which investors relied to their detriment.