Oral argument: October 9, 2007
Appealed from: United States Court of Appeals, 8th Circuit (April 11, 2006)
SECURITIES, FRAUD, RULE 10b-5, AIDING AND ABETTING, SECURITIES AND EXCHANGE COMMISSION, SCHEME TO DEFRAUD
Stoneridge Investment Partners, LLC, brought a securities fraud class action against Charter Communications' vendors Scientific Atlanta and Motorola, alleging a scheme in which Charter contracted with the vendors to purchase set-top cable boxes at higher-than-normal prices and sell advertising at higher-than-normal rates. These transactions served to artificially inflate Charter's stock price. The United States District Court for the Eastern District of Missouri held that Stoneridge's claim was foreclosed by the Supreme Court's decision in Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), in which the Court determined that mere "aiders and abettors" of fraud cannot be held liable. The Eighth Circuit affirmed. Thus, the issue before the Supreme Court is whether a party may be held liable for fraud where it made no misleading public statements (or omissions), and had no duty to do make disclosures, but engaged in transactions with a public corporation designed to artificially enhance the public corporation's financial statements. How the Supreme Court decides this case may set a new standard for determining whether third-parties can be held liable for investor-related fraud.
Question presented
Does the Supreme Court's decision in Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), foreclose claims for deceptive conduct under section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, 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?
Issue
Can a party be held liable for fraud where it made no misleading public statements (or omissions), and had no duty to disclose, but engaged in transactions with a public corporation designed to artificially inflate the public corporation's financial statements?
Facts
Charter Communications is a publicly traded cable company that provides digital services to millions of personal and business customers throughout the country. Brief for Petitioner at 4. In order to provide these services, Charter contracts with vendors, such as Respondents Scientific-Atlanta and Motorola, who provide set-top boxes and other equipment that Charter offers to its customers. Id. at 4-5.
According to Stoneridge, in August 2000, Charter determined that it would not meet stock analysts' revenue and cash flow projections and became worried that the company's stock price would suffer as a result. Id. at 5. Stoneridge claims that Charter subsequently requested that Scientific-Atlanta and Motorola purchase advertising on its networks in order to boost its revenue. Id. at 5-6. When Scientific-Atlanta and Motorola refused to purchase the advertising with their own funds, Stoneridge alleges, Charter executives "devised a scheme" in which the company would purchase digital set-top boxes for $20 in excess of the normal price, so long as Scientific-Atlanta and Motorola used the extra $20 paid by Charter to purchase advertising on Charter's cable networks. Id. at 6. Scientific-Atlanta and Motorola agreed, although they dispute their level of knowledge of the scheme.
According to Stoneridge, the rate at which Scientific-Atlanta and Motorola purchased the advertising on Charter's networks was four to five times higher than normal advertising rates. Id. at 8. In addition, Charter recorded the outgoing money (with which Charter purchased the equipment) as capital expenditures, but the incoming money (with which the vendors "purchased" the advertising) as revenue. Id. at 7. These accounting measures falsely inflated Charter's operating cash flow. Id. According to Stoneridge, Charter, Scientific-Atlanta, and Motorola fabricated reasons for the price increases of the equipment and Scientific-Atlanta and Motorola helped document the changes in price and the advertising purchases to make it seem as if the two transactions were unrelated. Id. at 6-7. Scientific-Atlanta and Motorola, however, have replied that they did not know how Charter was documenting the transactions and never mislead Charter, Charter's advisors, or any of Charter's shareholders. Brief for Respondent at 8-9.
Stoneridge Investment Partners, representing the class of investors who held Charter stock at the time of the scheme, brought a securities fraud class action against Charter, some Charter executives, Charter's independent auditors and the vendors. The claims against all defendants other than Scientific-Atlanta and Motorola have since been settled. Brief for Petitioner at 37.
The United States District Court for the Eastern District of Missouri dismissed the claims against Scientific-Atlanta and Motorola, holding that they were not "primary violators" of the relevant statutes, but rather were merely "aiders and abettors" of the fraud. As a result, the claims against Scientific-Atlanta and Motorola were barred by the decision in Central Bank N.A. v. First Interstate Bank N.A., 511 U.S. 164 (1994) in which the Supreme Court held that aiders and abettors of violations of section 10(b) of the Securities and Exchange Act cannot be held liable under SEC Rule 10b-5. The United States Court of Appeals for the Eighth Circuit affirmed the District Court's decision, likewise holding that claims such as these are barred by Central Bank unless there is a "misstatement or a failure to disclose by one who has a duty to disclose." Stoneridge v. Scientific-Atlanta, 443 F.3d 987, 992 (8th Cir. 2006). The United States Supreme Court granted certiorari on March 26, 2007.
Discussion
Background
This case arises under the Securities and Exchange Act of 1934, codified at 15 U.S.C. § 78j(b), and Securities and Exchange Commission Rule 10b-5, codified at 17 C.F.R. § 240.10b-5, which outlaw the use of "manipulative or deceptive devices" to alter the apparent value of a security. The Supreme Court interpreted Rule 10b-5 in Central Bank N.A. v. First Interstate Bank N.A., 511 U.S. 164, holding that it "prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act" and that mere "aiders and abettors" of fraud cannot be held liable. Id. at 177. Stoneridge argues that the vendors' agreeing to and documenting legitimate reasons for illegitimate transactions qualifies as a "manipulative act". See Brief for Petitioner at 17-29. Respondent vendors Scientific-Atlanta and Motorola ("Vendors") argue that Charter investors could not have relied upon any of their internal documentation, and they conclude that their conduct could at most qualify as "merely aiding and abetting". See Brief for Respondent at 17.
Practical Significance
The stakes are high, and this case has attracted the attention of federal lawmakers, business groups, investor-rights activists, labor unions, and others.
Investors'-rights groups point to the parallel policy interests in providing restitution to fraud victims and in holding accountable fraud perpetrators. Noting the impact on similarly situated investors, the University of California (the lead plaintiff in the Enron litigation), argues that "[t]he decision in this case is apt to be critical to claims of . . . victims of the Enron fraud." Amicus Brief by the Regents of the University of California in Support of Petitioner, at 4. The AARP focuses on practical impediments to restitution: "[o]utside actors are often the only culpable defendants with assets sufficient to satisfy a judgment or fund a settlement that secures any real measure of relief for defrauded investors." Amicus Brief by AARP in Support of Petitioner at 5. The Council of Institutional Investors goes a step further and argues that dismissal of the investors' claim "would give accountants, investment bankers, lawyers, and other third parties a safe harbor for fraud so long as they do not publicly announce their involvement with an issuer's misstatements." Amicus Brief by the Council of Institutional Investors in Support of Petitioner at 3.
On the other side, groups—including the Executive Branch of the United States, through the solicitor general—warn that primary liability for Scientific-Atlanta and Motorola could lead to increased litigation, higher transaction costs, and decreased foreign investment, all in the name of "captur[ing] deep-pocketed third parties." "Blow for investors over US securities litigation," MSNBC.com, Aug. 16, 2007. For instance, Mark Lackritz, chief executive of the Securities Industry and Financial Markets Association (SIFMA) said, "[t]he wrong ruling could unleash a cascade of damaging side effects that could infect the entire U.S. economy and harm investors." SIFMA Press Release, Aug. 15, 2007. Similarly, the Defense Research Institute warns that an "expansion of liability to private plaintiffs under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 . . . poses a distinct threat to the efficient and fair administration of justice." Amicus Brief by the Defense Research Institute in Support of Respondents at 2. The Eighth Circuit, in affirming the District Court's dismissal, agreed with these arguments, explaining that to impose liability on the Vendors would "introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings." Stoneridge v. Scientific-Atlanta, 443 F.3d at 994.
In a brief filed by the Solicitor General, the United States government has taken a unique position, ultimately supporting dismissal of the claim, but disagreeing with the reasoning of the Eighth Circuit. In a complicated twist, the Securities and Exchange Commission had voted to support the investors, but it could not file its own brief because the Bush administration "speaks with one voice," through the Solicitor General. See "In High Court Filing, It's U.S. vs. Investors," The Washington Post, Aug. 16, 2007 at D1. (The controversy over the Solicitor General's brief was widely reported in the media. See, e.g. Forbes, The Houston Chronicle, The Wall Street Journal, The Washington Post.)
Analysis
The Central Bank Decision
In 1994, the United States Supreme Court decided Central Bank N.A. v. First Interstate Bank N.A., 511 U.S. 164 (1994). In holding that SEC Rule 10b-5 "prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act," the Court continued, "[t]he proscription does not include giving aid to a person who commits a manipulative or deceptive act. We cannot amend the statute to create liability for acts that are not themselves manipulative or deceptive within the meaning of the statute." Id. at 177-78. Yet, the Court qualified its holding with an important caveat: "Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5, assuming all of the requirements for primary liability under Rule 10b-5 are met." Id. at 191. In the aftermath of Central Bank, there is still considerable confusion over the meaning of the securities laws related to this area. As such, "plaintiffs in recent years have turned to 'scheme' liability, to expand the range of potential defendants." Gregory Markel & Gregory Ballard, "Securities Law: 10b-5 'Scheme Liability,'" Nat'l L. J., Nov. 13, 2006, at 1.
The Ninth Circuit's Rule: Simpson v. AOL
In 2006, the United States Court of Appeals for the Ninth Circuit confronted the issue of scheme liability in Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th Cir. 2006). In Simpson, the plaintiffs alleged that "multiple actors engaged in a scheme to commit securities fraud by overstating the reported revenues of an Internet company, Homestore.com" in violation of SEC accounting rules. Id. at 1042. The allegations stem from a "series of sham transactions" that Homestore entered into with "'Third Party Vendors' who then returned the money to Homestore through contracts with AOL [and the other defendants]." Id. Specifically, the vendors contracted with AOL "for advertising on Homestore's website and AOL would give this money back to Homestore." Id. at 1044.
Plaintiff investors argued that defendants were "primary violators under §10(b) for engaging in a 'scheme to defraud.'" Id. at 1043. Defendants, in response, argued that Central Bank limited primary liability to those "who personally made a public misstatement, violated a duty to disclose or engaged in manipulative trading activity"-not to those engaged in a broader scheme to defraud. Id. Although the Ninth Circuit found the plaintiffs' allegations insufficient in this case, the Circuit did recognize scheme liability. The Court opined, "[w]e hold that to be liable as a primary violator of §10(b) for participation in a 'scheme to defraud,' the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme." Id. at 1048. The Court continued, "It is not enough that a transaction in which a defendant was involved had a deceptive purpose and effect; the defendant's own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect." Id. Yet, the Court did make clear that it is "constrained [by Central Bank] to reject" any claim that includes "aiding and abetting or coconspirator liability." Id.
The District Court and Eighth Circuit Opinions
In the Stoneridge litigation, the United States District Court for the Eastern District of Missouri dismissed the claims against Scientific-Atlanta and Motorola, applying Central Bank and holding that the vendors were merely "aiders and abettors" of the fraud perpetrated by Charter. See In re Charter Communications Inc. Securities Litigation, Consolidated Case No. 4:02-CV-1186 (E.D.Miss 2004). In so holding, the court found that Scientific-Atlanta and Motorola did not make any "statement, omission or action at issue" and that Stoneridge did not "rel[y] on any statement, omission or action made by either of [the vendors]." Id. In addition, according to the court, there is "no precedent for the conclusion that business partners, such as Motorola and Scientific-Atlanta, made false and misleading statements by virtue of engaging in a business enterprise with a company such as Charter." Id.
The United States Court of Appeals for the Eighth Circuit agreed with the District Court's analysis, "reject[ing] Stoneridge's narrow interpretation of Central Bank," and outlining the "three governing principles" that Central Bank "stand[s] for." Stoneridge v. Scientific-Atlanta, 443 F.3d 987, 992 (8th Cir. 2006). These principles include: [1] a plaintiff cannot bring a 10b-5 suit against a defendant for acts not prohibited by §10(b), including claims under Rule 10b-5(a) and (c) as well as 10b-5(b); [2] under §10(b), a "device or contrivance" can only be deceptive if there is a "misstatement or a failure to disclose by one who has a duty to disclose"; [3] a defendant is only taking "manipulative" action if that person makes a fraudulent misstatement or omission or "directly engages in manipulative securities trading practices." Id. Because, according to the Court, neither vendor made a misstatement or engaged in a manipulative act, the claims were properly dismissed by the District Court because the vendors, at most, aided and abetted Charter's fraud. See id. at 7-8. In coming to this conclusion, the Court added, "[t]o impose liability for securities fraud on one party to an arm's length business transaction in goods or services other than securities because that party knew or should have known that the other party would use the transaction to mislead investors in its stock would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings. Decisions of this magnitude should be made by Congress." Id. at 8.
Stoneridge: Scientific-Atlanta and Motorola should be held liable
Stoneridge argues that its claim falls within the scope of "primary liability" as established in Central Bank. See Brief for Petitioner at 17-29. Specifically, Stoneridge argues that liability under Rules 10b-5(a) and (c) is not limited to misleading statements, as it is under Rule 10b-5(b). Application of Rules 10b-5(a) and (c), Stroneridge argues, requires a "broad and flexible interpretation of the statutory scheme such that wrongdoers are not provided immunity merely because they engage in novel, unique, or atypical fraudulent schemes." Petitioner's Opening Brief in Eighth Circuit Case at 14. Similarly, Stoneridge cautioned the Court that dismissing its claim "creates a moral hazard that is deleterious to investors . . . companies will quickly learn that they can get away with fraud by compartmentalizing the creation of a false appearance from the ultimate reporting of false information to investors." Brief for Petitioner at 35.
Scientific Atlanta and Motorola: Central Bank forecloses Stoneridge's claims
Scientific-Atlanta and Motorola argue that Central Bank bars Stoneridge's claim because Stoneridge did not establish the elements of primary liability in addition to the requirement of reliance. See Brief for Respondent at 17. According to Scientific-Atlanta and Motorola, Stoneridge concedes that Scientific-Atlanta and Motorola did not make any statements to Charter investors and had no duty to do so. Thus, according to Scientific-Atlanta and Motorola, Stoneridge cannot maintain an action for a primary violation of the securities law. Brief of Scientific-Atlanta in Eighth Circuit Case at 8; Brief of Motorola in Eighth Circuit Case at 10-11. Scientific-Atlanta and Motorola further argue that they cannot be liable even if they knew of Charter's fraud because "[w]hether the defendant was a primary violator rather than an aider and abettor turns on the nature of his acts, not on his state of mind when he performed them." Brief of Scientific-Atlanta in Eighth Circuit Case at 22. Finally, Scientific-Atlanta and Motorola contend that "private suits are unnecessary to deter secondary actors from participating in a public company's fraud" because of the authority of both the SEC to impose civil penalties and the Department of Justice to commence criminal prosecution. See Brief for Respondent at 15.
The United States' Position
In its amicus brief, the Executive Branch of the United States, through the solicitor general, citing its "strong interest in seeing that the principles applied in private actions promote the purposes of the securities laws and other important federal laws," seemed to apply a two-question test. Amicus Brief by United States Supporting Affirmance at 1-2. First: was the defendant's conduct deceptive? Second: if so, did the plaintiffs rely on the defendant's deception? Although the United States, in contrast to the Eighth Circuit, views the defendants' conduct as deceptive, it argues that the "petitioner did not sufficiently plead reliance. . . ." Id. at 10. Further, the United States observed that extending liability here to third-parties would "potentially expos[e] customers, vendors, and other actors far removed from the market to billions of dollars in liability when issuers of securities make misstatements to the market." Id. at 27.
Conclusion
This case will have important implications for investors and public companies alike, and it is being closely watched by government officials, interest groups, and the media. The Supreme Court's decision may set a new standard for determining who can be held responsible for investor-related fraud. In addition, the plaintiffs involved in the Enron litigation are closely watching this case because the outcome may affect their ability to recover from the third-parties implicated in those actions.
Authors
Prepared by: Eric Finkelstein and Michael Zuckerman
Edited by: Tim Birnbaum