Supreme Court Limits Securities Fraud Liability for Secondary Actors

On January 15, 2008, the U.S. Supreme Court decided a major securities case that gives businesses some guidance about which members of a fraudulent scheme may be held liable for violating federal securities laws. By a 5-3 decision, the court held that "secondary actors" (such as investment banks, vendors, and law firms) who help publicly-held companies commit securities fraud cannot themselves be liable under federal securities laws unless investors actually rely on the secondary parties’ actions.

The case, Stoneridge Investment Partners v. Scientific-Atlanta (No. 06-43), involved a cable TV company, Charter Communications, that engaged in a sham accounting scheme with two of its vendors. Under the scheme, which enabled Charter to meet Wall Street expectations, the vendors agreed to increase the price of cable boxes that they sold to Charter, and then to use the additional money to buy advertising on Charter’s television stations. This generated artificial cash flow for Charter and allowed it to falsely report its financial condition. Charter’s investors sued the vendors under Section 10(b) of the Securities Exchange Act of 1934, alleging that without the vendors’ participation, the fraudulent scheme could not have occurred, and the investors would not have been misled by Charter’s false financial reports.

The Supreme Court’s decision turned on the concept of the investors’ "reliance," which is a requirement for liability under Section 10(b). The investors argued that even though the vendors did not make public statements about Charter or its stock, their actions allowed Charter to issue fraudulent financial statements, which in turn affected Charter’s stock price. As a result, the investors claimed, their purchase or sale of Charter stock at artificially-influenced prices meant that they "relied" on the vendors’ deception.

The Supreme Court found this chain of events to be "too remote for liability." The court stated that federal securities fraud liability "does not reach all commercial transactions that are fraudulent and affect the price of a security in some attenuated way." Instead, the court found that because no member of the investing public knew about the vendors’ deceptive transactions, the investors could not have relied upon them. The court also held that the vendors owed no duties to Charter’s investors, so they were not required to disclose their sham transactions to the investors.

The court held that that, at most, the vendors might be liable for aiding and abetting Charter’s securities fraud. But this did not save the investors’ claims because, under Supreme Court precedents, private plaintiffs cannot bring actions for aiding and abetting under Section 10(b). The court noted, however, that parties who aid and abet securities fraud are subject to criminal penalties and civil enforcement by the Securities and Exchange Commission.

Justice Stevens dissented, stating that the vendors in Stoneridge did not simply aid and abet Charter’s fraud, but actually committed fraudulent acts that violate Section 10(b). Justice Stevens, joined by Justices Souter and Ginsburg, argued that the vendors could therefore be sued under Section 10(b).

The court’s Stoneridge opinion showed that, consistent with other decisions issued in recent years, the majority of justices are opposed to judicial expansion of liability under Section 10(b). The court noted that Congress, not the judiciary, should make any decisions to expand such liability. If courts are free to expand liability for securities fraud, the majority stated, "the cost of being a publicly held company under [U.S.] law" may increase, and would harm the economy by deterring overseas firms from doing business in the United States.

Although Stoneridge resulted in shielding parties that committed deceptive acts from private civil liability, the decision is also important to firms that conduct legitimate transactions with publicly-held companies. The court’s decision provides some measure of comfort that business conducting proper, non-fraudulent transactions with publicly-held companies are less likely to be subject to baseless lawsuits if the publicly-held companies later use those proper transactions to commit fraud.