Justices Skeptical About Securities Fraud Liability for "Secondary Actors"

On October 9, 2007, the U.S. Supreme Court heard argument in a much-anticipated case that could finally resolve considerable uncertainty about the exact scope of the federal securities laws. Many commentators consider this case, Stoneridge Investment Partners v. Scientific-Atlanta (No. 06-43), the most significant securities-related case in a generation. At issue is whether "secondary actors" such as investment banks, accounting firms, and vendors are liable for securities fraud when they do business with companies that use those transactions to commit securities fraud, even if the secondary actors themselves never communicated with the market or engaged in securities transactions. Based on the justices’ questions at oral argument, it seems unlikely that the Supreme Court will permit such broad liability.

Stoneridge comes to the Supreme Court against a backdrop of cases like those related to the Enron collapse, in which plaintiffs are often unable to collect money judgments from primary wrongdoers, who are frequently bankrupt. Therefore, many plaintiffs have sued banks and other entities that, through relationships with Enron, allegedly enabled that company to defraud its shareholders.

The specific legal issue in Stoneridge is whether the court should interpret Section 10(b) of the Securities Exchange Act of 1934 and its key regulation, Rule 10b-5, to include liability for such secondary actors. Section 10(b) makes it unlawful to directly or indirectly use "any manipulative or deceptive device or contrivance" in connection with the purchase or sale of a security. Rule 10b-5 prohibits the following in connection with the purchase or sale of any security: material misstatements and omissions; employing a scheme to defraud; and engaging in any act or course of business that operates as a fraud.

Until 1994, some lower federal courts allowed private litigants to sue secondary actors for "aiding and abetting" securities fraud when the actors’ conduct itself did not appear to violate Section 10(b) or Rule 10b-5, but the actors helped others to violate the law. But that year, in Central Bank of Denver v. First Interstate Bank of Denver, the Supreme Court held that private parties could not bring suits for aiding and abetting securities fraud. Central Bank held that to be liable for securities fraud, a person must have actually committed one of the acts prohibited by the text of Section 10(b). This significantly limited securities fraud liability for secondary actors.

Since Central Bank, various federal courts of appeals have disagreed on what it takes for a secondary actor to actually commit securities fraud and thereby be liable under Section 10(b), rather than to aid and abet such fraud, which yields no liability. Stoneridge promises to settle this split, which is between courts holding that a secondary actor’s mere participation in a "scheme to defraud" is sufficient, even though the secondary actor never communicated with the investing public, and other courts holding that a party must actually "speak to the market" regarding its deceptive acts.

In Stoneridge , a cable TV company called Charter Communications felt Wall Street pressure to maintain high earnings, so it asked two of its vendors—Scientific-Atlanta and Motorola—to increase their prices for the cable boxes that they sold to Charter, and then to use the additional money to buy advertising on Charter’s television stations. This meant that the vendors were "purchasing" advertising with Charter’s own money, which allowed Charter to artificially increase its reported cash flow. This was part of a larger fraud by Charter, which led to criminal charges against four executives, and a civil suit by Stoneridge (an investor in Charter) that resulted in a $144 million settlement for the investors.

The investors then sued the vendors Scientific-Atlanta and Motorola, alleging that their participation in the "scheme" with Charter made them primary violators of Section 10(b) and Rule 10b-5, even though the vendors themselves never made any misleading statements to the public about their dealings with Charter. The Court of Appeals for the Eighth Circuit rejected this claim, holding that secondary actors such as the vendors are liable only when they actually "speak to the market" by making fraudulent misstatements or omissions, or by directly engaging in manipulative securities trading practices. The investors sought and received Supreme Court review.

At the Supreme Court’s oral argument, much of the discussion centered around whether the vendors—without whose alleged assistance Charter’s fraudulent scheme never could have worked—can escape liability for securities fraud because the vendors themselves never made fraudulent statements to the public or to Charter’s shareholders. The investors argued that Rule 10b-5 makes the vendors liable because they knew about and participated in Charter’s deceptive scheme. Several justices challenged this argument, suggesting that such liability is nothing more than aiding and abetting, which the court rejected in Central Bank.

Most notable among these was Chief Justice Roberts, who challenged the investors’ lawyer to explain why the courts, rather than Congress, should decide that Rule 10b-5 implicitly imposes liability on secondary actors. The chief justice noted that after the court’s Central Bank decision, Congress passed a law that expressly allowed for aiding and abetting liability in a different portion of the securities fraud statute, but limited that provision to government enforcement actions, not private lawsuits. The chief justice stated:

• My suggestion is that we should get out of the business of expanding [Rule 10b-5 liability], because Congress has taken over and is legislating in the area in the way that they weren’t back when we implied the right of action under 10(b).

Justice Souter suggested that under the investors’ theory of liability, there may be a theoretical distinction between aiding and abetting and a primary violation, but in reality the investors’ definition would make almost any secondary party a primary violator. Justice Alito seemed to have similar concerns and invited the investors’ lawyer, Stanley Grossman, to explain the difference between the investors’ theory and simple aiding and abetting:

JUSTICE ALITO: . . . [I]f Charter and Arthur Anderson and Scientific-Atlanta and Motorola all sat down and cooked up this scheme together and they all knew exactly what was going on, would you have a claim against the [vendors] here?

MR. GROSSMAN: Yes. And the reason for that . . . is because the advertising contract was a sham . . . because Charter was giving the [vendors] money to buy the advertising.

JUSTICE ALITO: Then I see absolutely no difference between your test and the elements of aiding and abetting.

The investors’ lawyer argued that the vendors are liable under Section 10(b) simply because their transaction—the sham advertising contract with Charter—was a deception. But Chief Justice Roberts responded by reiterating the heart of the Eighth Circuit’s ruling against the investors: that the sham advertising contract is "not the fraud that was imposed upon the market." The chief justice continued:

• The fraud imposed upon the market was Charter’s accounting for the [sham] transaction on its books. Nobody bought or sold stocks in . . . reliance upon the way that [the vendors] and Charter structured their deal. They did so in reliance upon the way Charter communicated its accounting to the marketplace.

These questions suggest that several justices believe that the investors’ case amounts to little more than trying to find a way around Central Bank’s proscription of liability for aiding and abetting. But Justice Ginsburg said that this framework—which envisions only primary violators like Charter who are liable, and aiders-and-abettors who are not liable—fails to punish parties that are integral to a deceptive scheme. Through her questioning of the vendors’ lawyer, Justice Ginsburg suggested that there should be a "middle category" of liability for "people who, while not . . . the company that’s trying to achieve the deception[,] . . . made it possible for that . . . deception to happen." Without such a middle category of liability, Justice Ginsburg suggested that parties like the vendors are home free because they didn’t themselves make any statement to investors. But they set up Charter to make those [fraudulent] statements, to swell its revenues—revenues that it in fact didn’t have.

Counsel for the investors did not take up Justice Ginsburg’s suggestion that there might be such a middle category.

These are just a few highlights of the exchanges at the Stoneridge hearing. Trying to determine the outcome of a court’s decision by studying judges’ questions is an uncertain science at best, but in this case several justices apparently made little effort to hide their views. From the questioning of Chief Justice Roberts and others, many commentators find it unlikely that the court will agree with the Stoneridge investors that Rule 10(b) imposes full liability on parties that do not communicate any fraud to the public.

Even if this holds true, the ultimate impact of the decision will depend on whether the court dictates a pure, "bright line" rule establishing that anything other than fraudulent statements to the public or manipulative trading constitutes aiding and abetting that has no private remedy under Section 10(b), or whether the justices craft a narrow ruling that leaves room for some "middle ground" to be defined in a later case that has different facts. The answer to this question will determine whether Stoneridge marks the end of certain "scheme liability" lawsuits, or simply a new beginning. A decision is expected in 2008.