Argument preview: Stoneridge v. Scientific-Atlanta
Widely hailed as the most important securities law case in a generation, Stoneridge Investment Partners, LLP v. Scientific-Atlanta, et al. asks under what (if any) circumstances private investors can sue actors "“ whether accountants, lawyers, financial advisors or other businesses "“ that allegedly participate in a scheme to violate Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5.
The case stems from a series of transactions between Charter Communications, a nationwide cable television provider, and Scientific-Atlanta and Motorola, producers of the cable boxes consumers typically rest on top of their television. According to the plaintiff, Stoneridge Investment Partners, Charter executives realized in August 2000 that the company's year-end cash flow would fall short of analysts' projection, which would likely cause a drop in the company's share price. To help cover the shortfall, Charter allegedly entered into a series of "sham" transactions with Scientific-Atlanta and Motorola to create the appearance of additional revenues. While details of the agreements differed slightly, in each case Charter offered to pay Scientific-Atlanta and Motorola $20 more for each of hundreds of thousands of cable boxes they had already agreed to buy. Scientific-Atlanta and Motorola would then return the excess payments by buying large chunks of advertising from Charter, at rates far above those Charter normally charged advertisers. To create the impression the transactions were unrelated, the parties backdated the contract increasing the price of the cable boxes. The transactions ultimately had no impact on Charter's bottom line, but Charter accounted for them in such a way as to make its balance sheet appear more attractive to investors, according to the complaint. As the plaintiffs would later put it in their petition for certiorari, "The simplicity of the scheme was trumped only by its brazenness."
Once Charter disclosed its financial improprieties, the value of the plaintiff's shares fell from a high of $26.31 per share to a low of $0.76 per share in October 2002. In addition to filing claims for securities fraud against Charter and its accountant, Arthur Andersen, Stoneridge also filed suit against Scientific-Atlanta and Motorola for the vendors' alleged role in the scandal. The plaintiffs alleged that Scientific-Atlanta and Motorola not only knew or recklessly disregarded the possibility that the sham transactions would allow Charter to falsely inflate its revenue figures, but that analysts would rely on such figures in making investment recommendations. In so doing, Scientific-Atlanta and Motorola violated two sections of SEC Rule 10b-5: section (a), which makes it unlawful to employ any "scheme" to defraud investors, and section (c), which making in unlawful to engage in ay "act, practice or course of business which operated or would operate as a fraud or deceit upon any person."
In late 2004, U.S. District Judge Charles A. Shaw dismissed the plaintiffs' complaint under Rule 12(b)(6) of the Federal Rules of Civil Procedure, for failure to state a claim upon which relief could be granted. The court found that even assuming the truth of the complaint, the plaintiffs claims against Scientific-Atlanta and Motorola did not state a valid cause of action under Central Bank Of Denver, N. A. v. First Interstate Bank Of Denver, N. A., a 1994 case in which the Court found Section 10(b) did not permit private investor suits against defendants alleged to have merely "aided and abetted" another company's securities fraud. Citing a number of circuit court opinions handed down after Central Bank, the district judge found that under Section 10(b) private investors could only sue actors who had themselves made false or misleading statements. The judge found the plaintiffs had not accused Scientific-Atlanta or Motorola of making any such statements, nor of being responsible for the preparation of Charter's financial statements, its internal accounting practices, or the public statements made by its executives. In April 2006, the U.S. Court of Appeals for the Eighth Circuit upheld the District Court's dismissal of the complaint. In a unanimous decision, a three-judge panel wrote that "[A]ny defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under $10(b) or any subpart of Rule 10b-5."
Grant of certiorari
The Supreme Court granted certiorari on March 26, 2007. The question presented is:
"Whether this Court's decision in Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), forecloses claims for deceptive conduct under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5(a) and (c), 17 C.F.R. 240.l0b-5(a) and (c), where Respondents engaged in transactions with a public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation's financial statements, but where Respondents themselves made no public statements concerning those transactions."
In its merits brief, Stoneridge contends that Scientific-Atlanta and Motorola were themselves primary violators of section 10(b) of the Act and sections (a) and (c) of SEC Rule 10b-5, as the transactions in question served no purpose other than to artificially inflate Charter's balance sheet. Contrary to the Eighth Circuit's opinion below, the dealings at issue did not involve arm's length business transactions, the brief says. As evidence, it points to the fact that Scientific-Atlanta and Motorola themselves falsified documents to help complete the transaction. In fact, "[it] is impossible to see how Respondents' scheme with Charter can be described as anything other than a "deceptive device or contrivance'," the brief says, citing the language of section 10(b) of the Act. Stoneridge also argues that the Eighth Circuit "rewrote the statute" in requiring a defendant to have made a fraudulent misstatement or omission to qualify as primary violator of Section 10(b) of the Act. The brief says that unlike other sections of the Act, Section 10(b) did not limit liability to instances of "misstatements." In support of this proposition, the brief argues that unlike section (b) of SEC Rule 10b-5, neither section (a) nor section (c) is limited to "false statements." Going forward, the petitioner's brief suggests the following test to determine whether participation in fraud amounts to a primary violation of the securities laws in question:
[A] person engages in a deceptive act as part of a scheme to defraud investors, and violates Section 10(b) and Rule 10b-5(a) and/or (c), if the purpose and effect of his conduct is to create a false appearance of material fact in furtherance of that scheme.
The principle contention of the respondents' brief is that the theory of "scheme liability" advanced by the plaintiffs is no different than the "aiding and abetting" liability rejected in Central Bank. The brief lists four reasons why the Court's holding in Central Bank applies equally to the plaintiff's claim in Stoneridge. First, the respondents' argue that the whole notion of scheme liability conflicts with Central Bank's requirement that shareholders must specifically rely on a company's actions to maintain a private suit against it for securities fraud. Second and relatedly, it was Charter "“ not Scientific-Atlanta or Motorola "“ that misled analysts and the investing public. According to the brief, if the Court were to overturn the Eight Circuit decision, the result would be that "Motorola and Scientific-Atlanta shareholders would have to compensate Charter shareholders for a fraud committed by Charter's own management" (emphasis in original). Third, other provisions of the Securities and Exchange Act that provide express causes of action specifically exclude scheme liability. And fourth, permitting scheme liability "“ especially under the plaintiff's "purpose and effects" test "“ would harm the economy at large, and make public companies settle even meritless claims to avoid the cost of lengthy litigation. Scientific-Atlanta and Motorola further argue that Congress specifically rejected creating private rights of action for "aiding and abetting" securities fraud when it enacted legislation to reduce securities litigation in 1995, a year after the Court's decision in Central Bank.