Court limits securities fraud lawsuits
UPDATED to 11:20 a.m.
The Supreme Court, in one of the most important securities law rulings in years, decided Tuesday that fraud claims are not allowed against third parties that did not directly mislead investors but were business partners with those who did. The 5-3 ruling came in Stoneridge Investment Partners v. Scientific-Atlanta (06-43).
Investors, the Court said, may only sue those who issued statements or otherwise took direct action that the investors had relied upon in buying or selling stock — whether that involved public statements, omissions of key facts, manipulative trading, or conduct that was itself deceptive. One impact of the decision is likely to be the scuttling of a massive $40 billion lawsuit against financial institutions growing out of the Enron scandal. The Court has a case on its docket involving that very dispute, and Tuesday’s ruling will be followed up soon, perhaps by next week, with action on that case — California Regents v. Merrill Lynch, et al. (06-1341).
The Stoneridge decision was the only one the Court released. Other opinions are expected Wednesday.
Justice Anthony M. Kennedy, who wrote the Stoneridge ruling, said the private right to sue for securities fraud “does not reach the customer/companies because the investors did not rely upon their statements or misrepresentations.” The ruling upheld a decision by the Eighth Circuit Court rejecting claims against Scientific Atlanta, Inc., and Motorola, Inc. The investors contended that those two companies helped a giant cable TV firm, Charter Communications, inflate artificially its financial staements in order to bolster its stock’s price. The investors contended that the two companies should be treated as “primary violators,” even though they had not themselves issued any public statements to advance the alleged manipulation plot.
The scheme challenged in the case was carried out in the fall of 2000. Investors claimed that the plot was designed to improve the public appearance of an adequate opeating cash flow for Charter by getting its business partners in TV set-top boxes to engage in “sham” deals under which Charter paid extra for the boxes, but the companies simply turned around and paid that money to Charter in advertising at above-market rates on its cable TV outlets. The result, the lawsuit contended, was to generate some $17 million in phony revenues, so that Charter’s cash position – in reality, a shortfall of $15 to $20 million — did not appear to be below the amount projected by the company and by stock analysts. After losing in the Eighth Circuit, the investors took the case to the Supreme Court, arguing that “the simplicity of the scheme was trumped only by its brazenness.”
The plot led to a federal indictment against two of Charter’s officers, and a cease and desist order against that company by the Securities and Exchange Commission. The Stoneridge investors’ lawsuit was also aimed at Charter and some of its officers. The appeal to the Supreme Court, however, only involved the dismissal of their claims against the vendors, Scientific Atlanta and Motorola. Also sued in the case was the now-defunct accounting firm, Arthur Andersen (which went under after its role in the Enron scandal), but it, like Charter, was not involved in the case before the Supreme Court.
The case involved what has been called “scheme liability,” in which everyone involved in a plot to deceive securities investors would be legally at fault, whether or not each of them had issued any public statements. The Securities and Exchange Commission had previously supported such liability, and wanted to enter the Stoneridge case to say so, but its participation was vetoed by the Bush Administration, with President Bush and Treasury Secretary Henry Paulson directly involved in the decision to keep the SEC out of the case. The Court took the case apparently to resolve a dispute among federal appeals courts on the issue.
The private right to sue at issue is one that has been created by court decisions, not by a direct federal statute. Justice Kennedy said that Tuesday’s ruling limiting the range of such a lawsuit was “consistent with the narrow dimenions we must give to a right of action Congress did not authorize when it first enacted the [Securities Exchange Act of 1934] and did not expand when it revisited the law.”
In ruling Tuesday that Scientific Atlanta and Motorola could not be sued, Kennedy wrote that the two outside companies “had no duty to disclose; and their deceptive acts were not communicated to the public. No member of the investing public had knowledge, either actual or presumed, of [the two companies'] deceptive acts during the relevant times. [Stoneridge], as a result, cannot show reliance upon any of [the companies'] actions except in an indirect chain that we find too remote for liability.”
Noting that the investors had argued that Scientific Atlanta and Motorola had done what they did with the aim, and the result, that a false appearance was created about Charter’s revenues, and that what Charter said publicly was “a natural and expected consequence” of the suppliers’ deception, the Court said this was not a sufficient link in the chain toward liability.
“In effect,” Kennedy wrote, Stoneridge “contends that in an efficient market investors rely not only upon the public statements relating to a security but also upon the transactions those statements reflect. Were this concept of reliance to be adopted, the implied cause of action would reach the whole marketplace in which the issuing company does business; and there is no authority for this rule.”
The Court said that “secondary actors,” like the two outside companies in this case, are subject to criminal penalties under a specific federal law, and civil enforcement action by the SEC. “The enforcement power is not toothless,” Kennedy wrote, attempting to direct dispute a suggestion by the dissent.
The Kennedy opinion was supported by Chief Justice John G. Roberts, Jr., and by Justices Samuel A. Alito, Jr., Antonin Scalia and Clarence Thomas. Justice John Paul Stevens dissented, joined by Justices Ruth Bader Ginsburg and David H. Souter. Justice Stephen G. Breyer took no part in the ruling; he reportedly owns stock in Cisco Systems, Inc., the parent company of Scientific Atlanta. The Chief Justice also was out of the case when the Court granted review on March 26, but got back into the case in September, presumably after selling stock — reportedly, he, too, owed stock in Cisco.
Justice Stevens, in dissent, argued that Charter could not have inflated its revenues to cover up a cash flow shortfall “absent the knowingly fraudulent actions of Scientific-Atlanta and Motorola.” Investors, he wrote, relied upon Charter’s revenue statements in deciding whether to buy its stock, and “in doing so relied on [the two companies'] fraud, which was itself a ‘deceptive device’ ” under securities law. “This is enough,” he concluded, to show a violation of the law against stock fraud.
Congress passed that law, Stevens argued, “with the understanding that federal courts respected the principle that every wrong should have a remedy. Today’s decision simply cuts back further on Congress’ intended remedy.” Citing the Supreme Court’s 5-4 decision in 1994 (Central Bank v. First Interstate Bank), ruling over Stevens’ dissent that private securities lawsuits could not be filed against those who only “aided or abetted” those who committed fraud, Stevens wrote on Tuesday: “I respectfully dissent from the Court’s continuing campaign to render the private cause of action under [the fraud law] toothless.”