Stoneridge Investment Partners v. Scientific-Atlanta was one of the most consequential securities cases to come before the Supreme Court in recent years.
The claim was that Charter engaged in a scheme involving sham transactions designed to inflate Charter's cash flow by $17 million in one quarter in order to meet the expectations of Wall Street analysts. The alleged scheme was to pay equipment vendors additional moneys in exchange for the vendors returning the moneys to Charter in the form of advertising fees. The vendors named in the case were Scientific-Atlanta, Inc. and Motorola, Inc.
The vendors' position was that they could not be held liable because they were alleged to be only aiding and abetting. The 8th Circuit agreed, holding that one who does not make a fraudulent misstatement or omission, and does not directly engage in manipulative securities practices cannot be guilty of anything more than aiding and abetting - and thus cannot be held liable under Securities and Exchange Act Section 10(b) or SEC Rule 10b-5. (Source)
These facts raised an important issue about the scope of liability under SEC Rule 10b-5. As I explain in the section on 10b-5 in my Corporation Law and Economics text, the Supreme Court held Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), that there was no implied private right of action against those who aid and abet violations of Rule 10b-5. Central Bank thus substantially limited the scope of secondary liability under the rule, at least insofar as private party causes of action are concerned.
Stoneridge required the SCOTUS to delineate what causes of action arise out of secondary violations of Rule 10b-5 from those that arise from primary violations. I signed onto an amici curiae brief, which argued that:
Both the text of Section 10(b) and the structure of the Exchange Act preclude judicial implication of a private right of action against a non-trading, non-speaking entity that merely “enables” the commission of an alleged fraud by a public company on its shareholders.
Petitioner’s “scheme liability” theory is simply a semantic ploy designed to recast secondary conduct as a primary violation. The conduct at issue in Central Bank fits squarely within petitioner’s definition of “scheme liability,” but this Court has already held such conduct to be secondary to a primary violation and, thus, not actionable under Section 10(b). Mere knowing participation in another’s alleged fraud is not sufficient for liability to attach under that provision, as Central Bank makes clear, and petitioner has not alleged that respondents did anything more than that.
I also did a podcast on the case before it was argued before the Court.
The SCOTUS took an unexpected turn in its decision: In Central Bank of Denver v. First Interstate Bank of Denver, the Court held that there was no implied private right of action against those who aid and abet violations of Rule 10b-5. Some read Central Bank broadly to hold that liability under Rule 10b-5 was limited to primary rather than secondary actors. In Stoneridge, however, the Court stepped back from that broad reading of the case, holding that secondary actors can be held liable in cases in which all the elements of Rule 10b-5 are satisfied.
Reliance proved to be the critical element of the 10b-5 cause of action in Stoneridge. Reliance ensures that the “requisite causal connection” between a defendant’s misrepresentation or omission, or deceptive or manipulative conduct, and the plaintiff’s injury is present. The Court held that, on the facts of this case, reliance could not be proven.
Plaintiffs in the case were shareholders of Charter Communications—one of the nation’s largest cable television providers. They alleged that Charter engaged in a “pervasive and continuous fraudulent scheme intended to artificially boost the Company’s reported financial results” by, among other things, entering into sham transactions with two equipment vendors that improperly inflated Charter’s reported operating revenues and cash flow. In addition to various other parties, including Charter, plaintiffs sued Scientific-Atlanta and Motorola (collectively, “the Vendors”).
At the time in question, Charter delivered cable services through set-top boxes. Charter purchased the boxes from third-parties, including the Vendors. In August 2000, although Charter had firm contracts with the Vendors to purchase set-top boxes at a set price, Charter agreed to pay the Vendors an additional $20 per set-top box in exchange for the Vendors returning the additional payments to Charter in the form of advertising fees.
Plaintiffs alleged that these were sham or wash transactions with no economic substance, contrived to inflate Charter’s operating cash flow by some $17,000,000 in the fourth quarter of 2000.
Plaintiffs alleged that the Vendors entered into these sham transactions knowing that Charter intended to account for them improperly and that analysts would rely on the inflated revenues and operating cash flow in making stock recommendations.
The Court held that there need not “be a specific oral or written statement before there could be liability under Sec. 10(b) or Rule 10b-5." Instead, "[c]onduct itself can be deceptive" and provide the basis for liability. At least in theory, the Vendors conduct thus could constitute fraud in connection with a purchase or sale of a security.
Even so, however, the Court concluded that the plaintiffs could not satisfy the reliance element, The Vendors did not – and had no duty to – disclose their conduct to Charter's investors. Accordingly, plaintiffs could not prove that they relied “upon any of respondents’ actions except in an indirect chain that we find too remote for liability.”
Plaintiffs argued that they need not prove reliance, because reliance should be presumed under the fraud on the market theory. The Court rejected that argument because the Vendor’s conduct was “not communicated to the public.”
A number of contributing factors are cited by the proponents of this view, such as the Sarbanes-Oxley legislation, the inconsistencies between US GAAP and IFRS, and so on. The liability exposure created by US securities laws, however, has come under especially close scrutiny. Indeed, Treasury Secretary Henry Paulson has called securities litigation the "Achilles heel" of the US economy. Likewise, the Schumer-Bloomberg report argued that "the highly complex and fragmented nature of our legal system has led to a perception that penalties are arbitrary and unfair."
Despite the active debate, there has been little legislative or regulatory progress in addressing these concerns.
In Stoneridge, however, the Supreme Court stepped into the debate, coming down hard on the side of promoting American competitiveness. The majority opined:
The practical consequences of an expansion [of the Rule 10b-5 cause of action], which the Court has considered appropriate to examine in circumstances like these, provide a further reason to reject petitioner's approach. In Blue Chip, the Court noted that extensive discovery and the potential for uncertainty and disruption in a lawsuit allow plaintiffs with weak claims to extort settlements from innocent companies. Adoption of petitioner's approach would expose a new class of defendants to these risks. As noted in Central Bank, contracting parties might find it necessary to protect against these threats, raising the costs of doing business. Overseas firms with no other exposure to our securities laws could be deterred from doing business here. This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.
I defended the SCOTUS reliance on these policy concerns from those who attacked the court's use of policy-based analysis and/or the policies themselves in this space when the decision came down (here).
The key issue today, however, is that Stoneridge got the policy right. Specter's bill would once again throw American business to the trial lawyer wolves, weakening our competitive position, at a time when our economy needs all the help it can get.
Update: Jonathan Adler has put up a post with links to lots of Stoneridge resources.
