January 16, 2008

SUPREME COURT LIMITS “SCHEME” LIABILITY

IN PRIVATE SECURITIES FRAUD ACTIONS

In an eagerly anticipated ruling, the Supreme Court held that so-called “scheme” liability cannot be used to reach defendants who did not commit a primary violation of the federal securities laws. See Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., et al., 2008 WL 123801. Writing for a 5-3 majority, Justice Anthony Kennedy delivered the Court’s opinion, which affirmed the dismissal of securities fraud claims brought against an issuer’s customers and suppliers.1

The plaintiffs in Stoneridge alleged that certain customers and suppliers engaged in fraudulent reciprocal transactions with the issuer that were devised solely to allow the issuer to record improper revenue and disseminate false financial statements to investors. Because the customers and suppliers had not made any statements to the public, they contended that they could not be liable in a private lawsuit as direct violators of Section 10(b) and Rule 10b-5. Rather, the customers and suppliers characterized the claims against them as aiding and abetting securities fraud, which the Court’s 1994 decision in Central Bank v. First Interstate Bank2 barred.

In response, the plaintiffs claimed that the customers’ and suppliers’ conduct was deceptive within the meaning of Section 10(b) and could give rise to liability notwithstanding Central Bank, pursuant to the language of Rule 10b-5, which prohibits a “scheme” to defraud.

The Court held that Section 10(b) liability did not extend to the defendant customers and suppliers “because investors did not rely upon their statements or representations,” whether or not the alleged misconduct was characterized as a scheme.

Stoneridge makes clear not only that Central Bank remains good law, but also that the scheme liability theory arguably left open by that case is now closed. In its ruling, the Court recognized the difficulties and cost of imposing private securities fraud liability on parties other than issuers and their officers and directors – such as an issuer’s banks, auditors, attorneys, advisors, or customers – who do not themselves make statements to investors. As the opinion notes, however, such third parties remain subject to action by the Securities and Exchange Commission (SEC) as aiders and abettors to an issuer’s securities fraud and even to criminal prosecution.

By extinguishing the prospect of private Section 10(b) claims based on scheme liability, Stoneridge makes explicit the limits upon the reach of investor claims and has important implications for the direction of private securities fraud suits. With respect to aiding and abetting liability, Stoneridge appears to establish unequivocally that the onus will be on the SEC to bring these actions, under statutory authority enacted in the Private Securities Litigation Reform Act of 1995.

Stoneridge and Central Bank

In Central Bank, the Court rejected claims seeking to impose aiding and abetting liability on secondary actors under Section 10(b). Plaintiffs have tested the boundaries of Central Bank, attempting to assert claims of primary liability against third parties who engage in allegedly fraudulent “schemes” with a public corporation.

Stoneridge is a prime example of this strategy. In that case, the plaintiffs alleged that the issuer, a cable television company, entered into sham transactions with two equipment customers and suppliers that improperly inflated the issuer’s reported operating revenues and cash flow. The cable company agreed to pay the customers and suppliers inflated prices for set-top boxes used by the company, and the customers and suppliers in turn agreed to pay inflated prices for advertising sold by the company. The inflated portion of the price later was returned to the cable company, who recognized the amounts received as revenue while capitalizing the equipment costs, thereby improperly inflating revenue.3

The customers and suppliers allegedly knew that the purpose of the transactions was to allow the cable company to inflate its financial results, and they allegedly engaged in some deception (such as backdating documents and falsely claiming that higher production costs justified the increased prices for set-top boxes) in connection with the transactions. The customers and suppliers, for their part, properly accounted for the transactions in their own financial statements.

Plaintiffs argued that they alleged a primary violation of the securities laws in accordance with Central Bank because the customers and suppliers violated Rule 10b-5(a) and (c) by participating in a “scheme or artifice to defraud” and by engaging in a “course of business which operates... as a fraud or deceit.”4 In its opinion, the Eighth Circuit expressly rejected this argument. Following Central Bank, the circuit court held that “any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission... is at most guilty of aiding and abetting.”5

Prior to the Supreme Court’s decision, the circuit courts had split on this issue of potential “scheme liability,” with the Second and Ninth Circuits accepting some form of a scheme liability theory and the Fifth and Eighth Circuits rejecting it. To resolve the split concerning scheme liability, the Supreme Court granted certiorari.6

No Primary Violation

In affirming the Eighth Circuit’s decision, the Supreme Court relied upon its Central Bank decision, which barred aiding and abetting liability because it was not included in Section 10(b)’s statutory language. Allowing aiding and abetting liability, concluded the Central Bank Court, would effectively eviscerate the requirement that a 10(b) plaintiff allege and prove reliance.

In Stoneridge, the Court took note of Congress’ refusal to create an express private cause of action for aiding and abetting liability following the Central Bank decision. Indeed, Congress addressed the issue of aiding and abetting liability by providing in 1995’s PSLRA that the SEC could prosecute aiders and abettors. 15 U.S.C. § 78t(e). Accordingly, a plaintiff attempting to assert a private claim for aiding and abetting a violation of Section 10(b) or Rule 10b-5 must plead each element as if the defendant were a primary violator. Considering whether the Stoneridge investors properly alleged the elements of a Section 10(b) claim, the Court concluded that they had not.

Plaintiffs Did Not Rely on Third Parties’ Conduct

The Court premised its decision on the fact that the investor plaintiffs had not alleged—and could not allege—that they relied on the customers’ and suppliers’ conduct. As a practical matter, the investors lacked “knowledge, either actual or presumed, of respondents’ deceptive acts during the relevant times.”

Although there are two circumstances where a plaintiff may be entitled to a presumption of reliance–either when a defendant has a duty to disclose and does not or under a fraud-on-the-market theory–neither of these circumstances was present in Stoneridge. Instead, under the circumstances presented, the Court found that the plaintiff failed to “show reliance on any of respondents’ actions except in an indirect chain that we find too remote for liability.”

“Scheme Liability” Rejected

The Court then explicitly rejected the concept of “scheme liability.” The plaintiffs argued that, although they were not aware at the time of the customers’ and suppliers’ bad acts, investors necessarily rely on the legitimacy of the transactions underlying an issuer’s financial statements and the integrity of the process through which those financial statements were generated. The plaintiffs also argued that the intention of the customers’ and suppliers’ conduct was to create a false impression and that a false financial statement was a “natural and expected consequence.”

The Court rejected the liability theory urged by the plaintiffs, finding it would be so broad that it would be meaningless and would “reach the whole marketplace in which the issuing company does business.” The Court found “no authority for this rule.”

The Court premised its decision on a number of crucial factors, including the following:

  • The customers’ and suppliers’ actions, even if deceptive, “were too remote to be actionable” because the issuer—and not the customers and suppliers—“misled its auditor and filed fraudulent financial statements.”
  • Plaintiffs’ theory would extend Section 10(b) liability beyond the realm of the securities markets and onto supply agreements or other conduct traditionally governed by state law, creating the “risk that the federal power would be used to invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees.” The Court further emphasized that the federal securities laws are not intended to “reach all commercial transactions that are fraudulent and affect the price of a security in some attenuated way.”
  • Plaintiffs’ theory “would put an insupportable interpretation on Congress’ specific response to Central Bank in § 104 of the PSLRA,” through which Congress allowed aiding and abetting claims to be “brought by the SEC but not by private parties.”
  • An expansion of the universe of potentially liable entities would increase the risk of litigation abuses against an entirely new category of defendants, “and could allow plaintiffs with weak claims to extort settlements from innocent companies,” which would increase the costs of doing business, and “shift securities offerings away from domestic capital markets.”
  • Finally, the Court noted that the “§ 10(b) private cause of action is a judicial construct that Congress did not enact in the text of the relevant statute,” and that “[c]oncerns with the judicial creation of a private cause of action caution against its expansion.”

Stevens Dissent Asserts Flaws in Majority Opinion

In a sharply worded dissent, Justice John Paul Stevens identified what he believed to be three major flaws with the majority’s opinion.

First, he wrote that the majority misapprehended and misapplied Central Bank. In Central Bank, the defendant did not engage in any deceptive conduct and could not have been anything more than an aider or abettor, whereas, Justice Stevens stated, in Stoneridge the customers’ and suppliers’ conduct could be regarded as deceptive. Second, Justice Stevens opined that the majority applied an overly formal and counterproductive view of reliance. According to Justice Stevens, the facts alleged made plain that the customers and suppliers knew that the issuer would rely on their deceptive acts to make misstatements that would affect the market price of the issuers’ stock. And third, according to Justice Stevens, it violated the fundamental principle of American jurisprudence that “every wrong shall have a remedy.”

Plaintiffs Now Must Plead and Prove That Third Parties’ Involvement Is a Primary Violation

Read broadly, the Southridge opinion answers many of the questions left open by Central Bank and effectively ends the prospect of private 10(b) claims based on scheme liability. Instead, plaintiffs must allege and then prove direct, culpable involvement of third parties that rises to the level of a primary violation. As the opinion notes, third parties remain subject to SEC action as aiders and abettors to an issuer’s securities fraud and even to criminal prosecution.

1 Justices John Roberts, Samuel Alito, Clarence Thomas, and Antonin Scalia were also in the majority. Justice Stephen Breyer recused himself from the case.
2 511 U.S. 164 (1994).
3 Id. at 989-990.
4 Id. at 991.
5 443 F.3d at 990.
6 127 S. Ct. 1873 (2007).