When the U.S. Supreme Court recently gave its decision in the widely anticipated Stoneridge case—ruling that, usually, shareholders cannot sue a third party that abetted a company committing fraud—legal observers rushed to proclaim the death of so-called “scheme liability” lawsuits.
The decision also capped a parade of cases that have increasingly restricted whom investors can sue and how easily they can proceed with a case.
Those notions were reinforced several days later when the High Court refused to hear a case brought by Enron investors against large banks that worked with the one-time energy giant to devise partnerships and transactions that allowed Enron to keep large liabilities off its balance sheet.
And if all that weren’t enough, the High Court also remanded back to the Ninth Circuit Court of Appeals Avis Budget Group v. California State Teachers Retirement, specifically instructing that the shareholder class-action lawsuit should be re-examined “in light of Stoneridge.”
So what’s an upset shareholder to do? Not write off class-action litigation just yet, some say.
“No one can call it a victory for one side or the other,” insists Stuart Grant of the law firm Grant & Eisenhofer, which represents plaintiffs in private securities litigation.
Grossman
Likewise, Stanley Grossman, a lawyer with the firm Pomerantz Haudek Block Grossman & Gross and the one who argued Stoneridge on behalf of the plaintiffs, says, “Stories of champagne popping were premature.”
Here’s the backstory: In Stoneridge Investment Partners v. Scientific-Atlanta, investors in the cable company Charter Communications claimed that Scientific-Atlanta and Motorola helped Charter inflate its revenues by participating in an elaborate scheme based on advertising in the set-top boxes they supplied to Charter. A federal district court and then an appeals court both dismissed Stoneridge Partners’ claim, ruling that Scientific-Atlanta and Motorola did assist in Charter’s fraud but did not violate federal securities law themselves.
The Supreme Court then ruled that when such “secondary actors” do business with a company and their transactions are part of the company’s false financial statements, they may not be held liable for damages in a private securities lawsuit—even if those secondary actors knew that the company intended to defraud investors. Because the actions of those third parties were “not disclosed to the investing public” and “not relied upon by the investors,” the Court ruled that a third party’s conduct is not within the scope of a private lawsuit under Section 10(b) or Rule 10b-5 of the Securities Exchange Act.
“This conclusion is consistent with the narrow dimensions we must give to a right of action Congress did not authorize when it first enacted the statute and did not expand when it revisited the law,” the Court wrote.
The ruling applies to private lawsuits only. The Securities Exchange Commission can, and routinely does, pursue its own enforcement actions against third parties for their role in another company’s fraud.
Capping a String of Rulings
The Stoneridge decision had been looming for more than a decade as a result of prior Supreme Court and congressional action.
For example, in 1994 the Supreme Court ruled that Congress did not intend for secondary actors be held responsible in private suits for “aiding and abetting” the securities fraud of a primary violator under the Securities Exchange Act and Rule 10b-5. And lawyers have repeatedly argued that when Congress passed the Private Securities Litigation Reform Act of 1995, it did not prescribe civil causes of action for aiding and abetting under Rule 10b-5. To the contrary, it set a higher pleading standard for private securities fraud litigation and explicitly said that only the SEC can bring aiding-and-abetting cases.
Hurd
“Congress was asked to create a private cause of action for aiding and abetting liability, but instead chose to amend the securities laws to provide only limited coverage of aiders and abettors through suits brought exclusively by the SEC and not private parties,” says Susan Hurd, of the law firm Alston & Bird.
“Stories of champagne popping were premature.”
— Stanley Grossman,
Senior Partner,
Pomerantz Haudek Block Grossman & Gross
Corporate law specialists also say other recent Supreme Court rulings laid the groundwork—or at least foreshadowed—the Stoneridge decision by interpreting securities law in a very conservative manner. For example, in 2005 the Supreme Court ruled that Dura Pharmaceuticals could not be sued for securities fraud, stressing plaintiffs must prove that a company’s misrepresentation or other fraudulent conduct “proximately caused the plaintiff’s economic loss.”
In 2006, the High Court decided in Merrill Lynch et al v. Dabit that shareholders who claim they held a security—but didn’t purchase or sell it—as a result of a fraudulent statement cannot bring class actions in state court to get around the federal Securities Litigation Uniform Standards Act, which disallows such complaints.
And the more recent Tellabs v. Makor Issues & Rights set a very high standard of what scienter (knowingly wrongful intent) plaintiffs must prove companies had when committing the alleged fraud. (For a related story on scienter, please see “Scienter Standard After Tellabs Ruling” in this week’s edition.)
THE BIG DECISION
Below is an excerpt of the U.S. Supreme Court Decision in Stoneridge Investments vs. Scientific-Atlanta and Motorola.
Affirming the District Court’s dismissal of respondents, the Eighth Circuit
ruled that the allegations did not show that respondents made misstatements relied
upon by the public or violated a duty to disclose. The court observed
that, at most, respondents had aided and abetted Charter’s misstatement, and noted that the private cause of action this Court has
found implied in §10(b) and Rule 10b–5, Superintendent of Ins. of
N. Y. v. Bankers Life & Casualty Co., 404 U. S. 6, 13, n. 9, does not
extend to aiding and abetting a §10(b) violation.
The §10(b) private right of action does not reach respondents because
Charter investors did not rely upon respondents’ statements or
representations. … the §10(b) private right of action does not extend
to aiders and abettors. Because the conduct of a secondary actor
must therefore satisfy each of the elements or preconditions for
§10(b) liability, the plaintiff must prove, as here relevant, reliance
upon a material misrepresentation or omission by the defendant.
The Court has found a rebuttable presumption of reliance in
two circumstances.
First, 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.
Second, under the fraud-on-the-market doctrine, reliance is presumed when the statements at issue become public.
Neither presumption applies here: Respondents had no duty to disclose; and their deceptive acts were not communicated to the investing public during the relevant times. Petitioner, as a result, cannot show reliance upon any of respondents’
actions except in an indirect chain that is too remote for liability.
It was Charter, not respondents, that misled its auditor and filed fraudulent financial statements; nothing respondents did made it necessary or inevitable for Charter
to record the transactions as it did.
The argument that there could be a reliance finding if this were a common-law
fraud action is answered by the fact that §10(b) does not incorporate
common-law fraud into federal law …
Upon full consideration, the history of the §10(b) private right of
action and the careful approach the Court has taken before proceeding without congressional direction provide further reasons to find no
liability here. The §10(b) private cause of action is a judicial construct that Congress did not direct in the text of the relevant statutes… The decision to extend the cause of action is thus for the
Congress, not for this Court.
Source
U.S. Supreme Court (Jan. 15, 2008).
Taken together, the cases “should serve to limit liability” to corporate defendants, says Lisa Wood, a lawyer with the firm Foley Hoag. She notes that in the Dura decision, plaintiffs had to tie their losses to the company’s alleged misstatement. Stoneridge extends that concept, she says, because plaintiffs must show they relied on the defendant (not just the company, but the secondary actor) as well.
Still, Grant and other plaintiff lawyers say Stoneridge won’t change the litigation landscape nearly as much as some initially claimed. First, he says, most private securities lawsuits do target issuers, directors, and auditors rather than secondary actors—and for those cases, Stoneridge “will have no effect.” He insists there will be roughly the same number of lawsuits, just fewer defendants named.
Keep On Going
Others say Stoneridge does not close the door entirely on pursuing secondary actors.
For example, under some circumstances the third parties could be deemed primary actors if their transactions with the defendant are known to the market. This could involve, say, a bank providing financing to a company accused of committing securities fraud.
In fact, the Supreme Court’s decision explicitly says that all secondary actors “are not necessarily immune from private suit.” It adds that securities statutes “provide an express private right of action against accountants and underwriters in certain circumstances” and that “the implied right of action in Rule 10(b) continues to cover secondary actors who commit primary violations.”
That last line refers to the court’s 1994 decision, Central Bank v. First Interstate Bank of Denver, which allowed lawsuits against secondary actors stemming specifically from financial transactions. “So, one of the big issues going forward is whether there is a carve-out for financial transactions,” says Grossman.
He stresses that if the facts of Stoneridge were slightly different, Charter’s business partners could have been liable. For example, if Charter actually had announced that it had entered into an advertising deal with Motorola and Scientific-Atlanta, “then it would be deceptive, phony, disseminated to the public, and investors would have relied on it,” he argues. Or if a merger had been pending and the potential buyer examined Charter’s books and saw the contracts, the suitor could have argued that it relied on those contracts.
Grant
And Grant stresses that while a Supreme Court decision outlines broad legal themes, federal district and appeals courts must still apply that decision to specific cases—including Stoneridge, which was sent back to the Eighth Circuit for a new hearing based on the Supreme Court’s decision.
Some observers also believe legislators could weigh in again if a Democrat wins the White House and Congress becomes even more Democratic, since the party is typically pro-shareholder rights. “Only Congress can expand the boundaries of Rule 10(b),” says John Coffee, a law professor at Columbia University.
Coffee
At least two prominent members of Congress seem to support expanding the definition of aiders and abetters: Rep. Barney Frank, the Massachusetts Democrat who heads the House Financial Services Committee, and House Judiciary Chairman John Conyers (D-Mich.). They had earlier filed an amicus brief in the Stoneridge case in support of the plaintiffs. The pair could try to expand the scope of who can be sued under Rule 10(b).
A spokesperson confirms that Frank plans to hold hearings on the matter sometime this year. Noting that the plaintiff bar is the leading source of contributions to Democrats, Coffee adds: “I think Barney Frank will want to restore some form of aiding and abetting to secondary participants.”
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