The United States Supreme Court heard oral argument yesterday in a case that presents the Court with the opportunity to broaden the class of potential defendants in private securities class actions, which would substantially increase litigation exposure for corporate America. The questions and comments of the Justices suggest that the majority of the Court is not prepared to alter the current securities class action landscape.
The issue before the Court is whether an entity that has not made any public misrepresentations may be sued in a private securities class action for assisting a public corporation in making public misrepresentations. Specifically, the Supreme Court certified the question of whether “engag[ing] in transactions with a public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements” can create Section 10(b) and Rule 10b-5 liability even if the defendant “made no public statements concerning those transactions.” The case concerns only the right of investors to bring such actions; the SEC's right to bring an action against those entities is not at issue.
Section 10(b) of the Securities and Exchange Act of 1934 and Rule 10b-5 promulgated thereunder grant a private right of action to investors against those corporations for securities fraud. When investors bring securities class actions, public companies can face millions, and even billions, of dollars of exposure.
Plaintiffs’ attorneys have attempted to broaden the scope of Section 10(b) and Rule 10b-5 in securities class actions to include individuals and entities who merely assisted public corporations in committing securities fraud.
In 1994, the Supreme Court, in Central Bank v. First Interstate Bank, held that an individual or entity that merely aids and abets the securities fraud of another public company could not be the subject of a securities class action.
This issue was considered recently by the Court of Appeals for the Fifth Circuit in connection with the alleged Enron fraud where plaintiffs brought litigation against certain investment banks. On March 29, 2007, the Fifth Circuit ruled in Regents of California v. Credit Suisse First Boston that unless a secondary actor (i.e., an entity other than the entity that committed the securties fraud) either makes public misrepresentations or owes investors a duty to disclose, that secondary actor cannot be the subject of a private securities class action. Plaintiffs have filed a petition for a writ of certiorari to the U.S. Supreme Court.
Stoneridge v. Scientific-Atlanta
This case arose out of an allegedly sham transaction between a cable television provider, Charter Communications, and Scientific-Atlanta and Motorola, producers of cable boxes. Charter allegedly conspired with Scientific-Atlanta and Motorola to overpay for hundreds of thousands of cable boxes, and in return, Scientific-Atlanta and Motorola overpaid for advertising they purchased from Charter. This allegedly permitted Charter to falsely inflate its publicly reported revenue.
The Eighth Circuit came to the same conclusion as the Fifth Circuit in Regents of California v. Credit Suisse First Boston and held that a secondary actor must “affirmatively” make a fraudulent misstatement or omission in order to be liable as a primary violator under Section 10(b) and Rule 10b-5, and subject to securities class actions.
The Supreme Court granted certiorari on March 26, 2007. Notably, because Justice Breyer recused himself from this case, five of the eight remaining votes are required to reverse the Eighth Circuit’s decision. (A 4-4 decision would not reverse the underlying court’s decision.) Based on the questions and comments made by Chief Justice Roberts and Justices Scalia and Alito, and the voting histories of the remaining Justices, it appears unlikely that the Supreme Court will overrule the Eighth Circuit’s decision.
At oral argument yesterday, a number of Justices grappled with the question of how to make a practical distinction among companies (that had not made any public misrepresentations) that would face aider and abetter liability (not subject to securities class actions) and those that would face primary violator liability (subject to securities class actions). It appears that the unstated concern was that expanding primary violator liability to those who have not made any public misrepresentations could have the practical effect of eliminating the aider and abetter and primary violator distinction.
Counsel representing the investors argued that the proper distinction turns on whether the defendants made any deceptive acts that further a scheme to commit securities fraud: “If you facilitate with a deceptive act, then you’re a primary violator. That’s what Section 10(b) prohibits. If you facilitate without a deceptive act, then you are an aider and abetter."
Justice Souter was skeptical that any legitimate distinction could be made: “Are you making a distinction that in the real world is not a distinction? That, in reality, no one is going to do what these Respondents did without the kind of knowledge or intent that makes them, on your theory, principals rather than aiders or abetters?"
Chief Justice Roberts also explored an additional concern - namely, that it may be practically impossible to only partially open the door to primary violator liability for entities that have not made public disclosures, because an entity even indirectly involved in the securities fraud could become subject to securities class actions. Chief Justice Roberts cited a hypothetical example of one private company that enters into a scheme with another private company that makes the latter a more attractive takeover target for a public company, and asked counsel for the investors if the first private company would also have primary violator liaibility.
Justice Scalia and Chief Justice Roberts expressed trepidation in broadening the scope of Section 10(b) without the express direction of Congress. During oral argument, Chief Justice Roberts stated that:
[w]e 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? … My suggestion is that we should get out of the business of expanding it, because Congress has taken over and is legislating in the are in the way they weren’t back when we implied the right of action under 10(b).
On the other hand, Justice Ginsburg expressed apparent sympathy with the investors’ position and explored the issue of whether there could be a middle category of liability for companies that have not made public mistatements, but whose conduct was more severe than simply aiding and abetting.
Finally, Chief Justice Roberts appeared to express a fundamental conceptual disagreement with imposing Section 10(b) liability on a secondary actor where the secondary actor had not made a public fraudulent statement, stating:
But that’s … not the fraud that was imposed upon the market. The fraud imposed upon the market was Charter’s accounting for the transaction on its books. Nobody bought or sold stocks in the reliance upon the way that Scientific-Atlantic and Charter structured their deal. They did so in reliance upon the way Charter comunicated its accounting to the marketplace.
The Court will likely issue its decision in the winter or spring.