I. Introduction
The idea that by engaging in fraudulent behavior one incurs liability for the foreseeable harm caused by such behavior is a cornerstone of the law. Therefore, it seems reasonable that by engaging in fraudulent transactions designed to manipulate financial statements and market valuations a company should expect to incur liability to investors relying on those statements and valuations. In a 5-3 opinion (Justice Breyer recused himself) authored by Justice Kennedy,the Court, in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., limited such liability in private actions based on SEC Rule 10b-5. [1] In doing so, the Court drastically restricted the types of private actions that are critical to investor confidence and market stability, and to the success of U.S. securities markets.
II. The Facts and the Theory
In the suit, Stoneridge Investment Partners, LLC ("petitioners"), alleged that Scientific-Atlanta, Inc., and Motorola, Inc. (collectively "respondents"), in an alteration of existing agreements, supplied Charter Communications , Inc., with digital converter boxes. [2] Charter allegedly overpaid Scientific by $20 per box, and contracted with Motorola to purchase a set number of the boxes and pay liquidated damages of $20 per box not ultimately purchased, with the expectation that it would not purchase the prescribed number of boxes. [3] In return, respondents allegedly agreed to purchase $17 million in advertising time, creating a wash transaction. [4] Charter then allegedly improperly capitalized the expenses associated with the transaction and recorded the $17 million in advertising revenue to cover a $15 to $20 million shortfall from its projected operating cash flow, using these fraudulent figures in statements reported to the SEC and the public. [5] After dismissal for failure to state a claim by the District Court for the Eastern District of Missouri, the Eighth Circuit Court of Appeals affirmed. [6] In doing so, the Eighth Circuit joined the Fifth Circuit, [7], in rejecting such claims, and placed itself in conflict with the Ninth Circuit, which recognized such actions. [8]
In Stoneridge, the petitioners' asserted cause of action relied on the Securities Exchange Act of 1934 § 10b, [9] and SEC Rule 10b-5 (a) and (c), promulgated under that act, which prohibit the use of "any device, scheme, or artifice to defraud, . . . [and prohibit engaging in] any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." [10] The petitioners argued that the respondents had opened themselves to liability under Rule 10b-5 by knowingly engaging in a scheme allowing Charter to make fraudulent statements to the SEC and the public. [11] Known as "scheme liability" actions, such actions came into use after the Supreme Court, in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., rejected "aiding and abetting liability" under 10b-5 (b). [12, 13] In that 1994 case, the Supreme Court overruled every Circuit Court in finding that no private liability attached to those aiding or abetting violations of Rule 10b-5 (b), which the Court interpreted to require actual misstatements or failure to disclosure coupled with a duty to disclose; that is, there is no secondary liability under 10b-5(b). [14, 15] Parties bringing scheme liability actions argued that Central Bank narrowly targeted actions brought under Rule 10b-5(b), and that Rule 10b-5 (a) and (c) required no such misstatement or failure to disclose, thus attaching primary liability to all parties to a fraudulent securities scheme. [16]
III. The Decision
The Court sidestepped such arguments, however, with the ruling resting primarily on what the Court contended was a lack of reliance. While the respondents' alleged actions were integral to allowing Charter's misstatements, the Court reasoned, the actions were not themselves sufficiently linked to the petitioners' purchase or sale of Charter securities to affix primary liability to the respondents under Rule 10b-5. [17] Essentially, the Court argued that petitioners bought Charter stock based on the strength of Charter's financial statement to the SEC, and not due to direct knowledge of the transactions between Charter and the respondents. [18] Thus, the Court held, while Charter's misstated financial report to the SEC admittedly affected the market for Charter's stock (and petitioners actions regarding that stock), the companies that allegedly knowingly engaged in fraudulent transactions allowing the improper report could not be held accountable in private 10b-5 actions. [19] In this way, the Court re-framed the petitioners' claims in terms of aiding and abetting, and not as primary action on the part of the respondents, and affirmed their dismissal as congruent with the decision in Central Bank. [20]
In addition to relying on Central Bank, the Court supported its decision with numerous policy arguments. Pointing to the Private Securities Litigation Reform Act of 1995 ("PSLRA") § 104 [21], passed in the wake of Central Bank and expressly granting the SEC the power to bring claims against aiders and abettors of fraudulent acts covered by Rule 10b-5, the Court noted that Congress had declined to extend this right to private actors. [22] Thus, the Court argued, it would undermine Congress to interpret Rule 10b-5 to allow private claims against aiders and abettors of 10b-5 violations. [23] Additionally, the Court contended that allowing private aiding and abetting claims under 10b-5 would effectively extend federal causes of action into the traditionally state-governed realm of supply and purchase contracts, since the respondents liability would be arising from their actions concerning such contracts. [24] The Court also suggested that an expansion of the right to private actions under 10b-5 open the floodgates of litigation, swamping courts and allowing plaintiffs to extort settlements from innocent companies with only tangential marketplace connections to 10b-5 violations. [25] The Court even suggests that such actions could increase the cost of operating as a public company within the U.S., harming domestic capital markets and providing an incentive for foreign companies to avoid doing business in the U.S. [26]
IV. An Analysis
While the Court attempted to place the Stoneridge opinion in a line with Central Bank, the decision is actually an expansion of Central Bank. That case involved a bond issue secured with liens on land that were supposed to equal at least %160 of the issue value, with liability allegedly arising in the indentured trustee, Central Bank of Denver, N.A.[27] After an in-house appraisal suggested that the valuation of the land (and subsequently the liens) was "optimistic," Central Bank decided to delay an independent appraisal of the land, but the issuer defaulted on that year's bonds before the appraisal was completed. [28] There were no allegations that Central Bank itself was a primary violator of § 10(b) or Rule 10b-5. [29] In Stoneridge, by contrast, the petitioner alleged that the respondent's themselves had engaged in fraud covered by Rule 10b-5.
The Court's contention that there was no reliance is also mistaken. As part of its claim, Stoneridge alleged both that Scientific and Motorola knowingly engaged in fraudulent behavior and that they knew that behavior would be used by Charter to issue fraudulent statements to the SEC and the public. Given that such statements would obviously have an effect on Charter's market valuation, there is a sufficient connection between the respondents' actions and Charter's stock performance to make the respondents' actions violations of Rule 10b-5. This position is seen in Justice Stevens' dissent (joined in by Justices Souter and Ginsburg) from the Stoneridge majority opinion, asserting that the petitioners claimed that the respondents' actions fulfilled both the but-for and the proximate cause requirements, with the "respondents' acts [having] the foreseeable effect of causing petitioner to engage in the relevant securities transactions." [30]
The policy arguments on which the Court relies are similarly misleading. First, in rearing the specter of federal intrusion on matters of traditionally state concern, the Court fails to acknowledge the fact that even the SEC actions expressly allowed by PSLRA § 104, with which the Court takes no issue, do the same. Second, the legislative actions and history that the Court positions as evidence of Congressional intent to limit private actions under Rule 10b-5 are much more ambiguous than the Court suggests. PSLRA § 104, passed as it was shortly after Central Bank, merely makes explicit the SEC's long-recognized right of action against aiders and abettors and reinforces the notion of private-action liability under §10(b) as to primary violators, and thus seems like an action taken to limit the fallout from Central Bank, and not, as the Court asserts, to implicitly reject the notion of any private 10b-5 actions against secondary parties. In fact, the legislative history surrounding PSLRA includes comments that recognize the importance of private actions in maintaining the integrity and stability of domestic securities markets. [31] Finally, the Court's concerns about opening the floodgates of litigation, thereby causing harm to the U.S. economy and judicial system, are misplaced. While the Court wonders where the boundaries of 10b-5 liability would be drawn if it allows liability to arise from marketplace transactions [32], it supplies an answer: "Petitioner's view of primary liability makes any [party] liable under § 10(b) if he or she committed a deceptive act in the process of providing assistance." [33] The distinction is clear: liability arises only in those assisting parties who themselves engage in fraud. This provides a clear a line as any for establishing the validity of claims under Rule 10b-5, comports with general notions of justice, including the idea that fraudulent activity generally gives rise to liability. Finally, the Court's view disregards the notion, endorsed in an amici curiae brief by former SEC commissioners, that private action liability strengthens securities markets, improving their integrity and safety in a manner that allows for a successful marketplace. [34]
V. The Fallout
The direct effects of Stoneridge are already being felt. In the instant case, of course, those who purchased Charter stock based on its performance reports and corresponding market movements still have a prospective defendant in Charter itself. In other cases, however, such as those involving insolvent primary violators, attempting to collect from secondary violators is sometimes the only option. While it is true that the SEC can still bring actions for secondary liability, it is far from clear that this provides adequate compensation for harmed investors. In the case of Enron, for example, the SEC has collected nearly $440 million in damages from former employees and secondary actors. [35] This, however, pales in comparison to Enron's $65 billion market capitalization just 16 months prior to its bankruptcy. [36] With nearly $40 billion in damage claims from Enron investors, and only $7.3 billion from secondary actors in private settlements (which Stoneridge makes much less likely in future cases) [37], investors are still out more than $32 billion. In the wake of Stoneridge and the Supreme Court's subsequent denial of certiorari in the Enron-related action against secondary actors in Regents of the Uni. of Cal. v Merrill Lynch, Pierce, Fenner & Smith, Inc., [38], investors are unlikely to close the gap.
Stoneridge's indirect effects are likely to be less readily discernible, but are potentially far-reaching. One of the reasons for the success of U.S. markets since the mid-20th century has been their relative stability and integrity. While investing always carries risk, the threat to investors from companies' fraudulent behavior was minimized through a system that allowed both government and private actions against such companies. Stoneridge removes a powerful tool from the private-action arsenal. It would be rash to conclude that Stoneridge will allow rampant fraud; there are, after all, still numerous remedies for defrauded investors, including private primary-actor actions, SEC actions and, in some cases, private secondary-actor actions under state law. It is, however, a step in the wrong direction, especially coming at a time when the reputation of foreign markets for stability and investor protection is improving. Unfortunately, the Court looks unlikely to reverse course in the near future. Justice Breyer, who recused himself from the Stoneridge decision, was a part of the majority in Central Bank, and all of the other veterans of that decision aligned themselves similarly in Stoneridge. Given this, Congress would be well advised to create an explicit private cause of action against secondary actors who commit primary violations of § 10b.
[1] Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761, 767 (2008).
[2] Id.
[3] Id.
[4] Id.
[5] Id.
[6] In re Charter Communications, Inc., Securities Litigation, 443 F.3d 987 (C.A.8 2006).
[7] See Regents of University of California v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (C.A.5 2007).
[8] See Simpson v. AOL Time Warner Inc., 452 F.3d 1040 (C.A.9 2006).
[9]15 U.S.C. § 78j.
[10] 17 C.F.R. § 240.10b-5.
[11] Stoneridge, 128 S. Ct. at 767.
[12] Thomas O. Gorman, Who Does the Catch-All Antifraud Provision Catch? Central Bank, Stoneridge, and Scheme Liability in The Supreme Court, Securities Litigation & Enforcement Institute 2007, PLI, September, 2007. Available at http://www.secactions.com/articles/aiding/Article2.pdf.
[13] Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N. A., 114 S.Ct. 1439 (1994).
[14] Gorman, supra.
[15] Central Bank, 114 S. Ct. at 1448.
[16] Gorman, supra.
[17] Stoneridge, 128 S. Ct. at 770.
[18] Id.
[19] Id.
[20] Id. at 771.
[21]109 Stat. 757, 15 U.S.C. § 78t(e).
[22] Stoneridge, 128 S. Ct. at 771.
[23] Id.
[24] Id. at 770.
[26] Id.
[27] Central Bank, 114 S. Ct. at 1443
[28] Id.
[29] Id.
[30] Stoneridge, 128 S. Ct. at 777.
[31] See S. Rep. No. 104-98, p. 8 (1995), U.S.C.C.A.N., 1995, p. 679, 687
[32] Stoneridge, 128 S. Ct. at 764.
[33] Id. at 771.
[34] Brief for Former SEC Commissioners and Officials and Law and Finance Professors as Amici Curiae Supporting Respondents, Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761 (2008) (No. 06-43), 2007 WL 2329638.
[35] Securities Exchange Commission, Enforcement Division, Enron Claims http://www.sec.gov/divisions/enforce/claims/enron.htm
[36] Bruce Mizrach, The Enron Bankruptcy: When did the options market in Enron lose its smirk?, 27 Rev. of Quantitative Fin. and Accounting, 365, 365, December, 2006. Available at ftp://snde.rutgers.edu/Rutgers/wp/2002-24.pdf
[37] Petition for Writ of Certiorari Volume I of II, 5, n. 8, Regents of the Uni. of Cal. v Merrill Lynch, Pierce, Fenner & Smith, Inc., No. 06-1341, 2007 WL 1059567.
[38] Denial of Writ of Certiorari, Regents of the Uni. of Cal. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., No. 06-1341, 2008 WL 169504.
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Posted by: Considerationfish | December 14, 2009 at 10:54 AM
It`s time we let the free market rules prevail again.
Posted by: Michael L.Weiss | December 07, 2009 at 05:19 PM
Great post. and great info. I hope that I can continue to learn more from this site.
Posted by: VA Refinance | September 14, 2009 at 10:05 PM
I want to say - thank you for this!
Posted by: tramadol dependence | July 30, 2009 at 04:39 PM
It may make an impact on the US market at first, but it should settle down after a while. Thats just my two cents!
Posted by: Acai | July 18, 2009 at 02:41 PM
lTuONB
Posted by: Czkpgixf | July 15, 2009 at 02:28 PM
Was the transaction between respondents and Charter inherently fraudulent or did the fraud consist of Charter's method of accounting for it in its reports to the SEC? If the latter, the respondents woud not have committed fraud, only Charter in reporting the transaction. If the former, you seem to have a good case and one would think that the SEC would be eager to prosecute even if private parties could not.
It is interesting that a part of the Supreme Courts thinking seemed to be the pragmatic view that the potential for excessive litigation was more dangerous to the economic and legal systems than occasional secondary collusion in fraud.
Posted by: Etienne-Sebastian Bufter | March 02, 2008 at 05:23 PM