Financial Institutions, Professionals Breathe Sigh of Relief

By: Kevin P. Dwight

Supreme Court Stonewalls Plaintiffs’ Attempt to Expand Liability for Securities Fraud in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., et al.

In what has been billed as the Roe v. Wade of securities law, the U.S. Supreme Court recently decided that secondary actors - including banks, vendors, attorneys, and accountants - cannot be sued for securities fraud merely because they are business partners with a company that committed fraud. Needless to say, Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., et al. is a significant victory for business defendants. By a 5-3 vote, the Court followed its recent trend in favoring corporate defendants over investors, rejecting a theory used by plaintiffs known as "scheme liability." Prior to Stoneridge, professionals and companies could be sued for securities fraud when they did not directly mislead the public, but simply because they allegedly "schemed" with the company primarily responsible for committing the fraud. While an adverse ruling could have opened the door to a flood of investor-driven litigation - and potentially raised the cost of being a publicly traded company in the U.S. - Stoneridge limits investor rights and protects companies and those third parties with whom they do business.

The Stoneridge litigation arose when cable television company Charter Communications tried to boost its revenue by allegedly entering into a fraudulent scheme with its suppliers, Scientific-Atlanta and Motorola. Under the scheme, Charter agreed to purchase its cable boxes from Scientific-Atlanta and Motorola at inflated prices. In return, the suppliers agreed to use the extra money to buy advertising from Charter, which capitalized its purchase of the boxes and recorded the suppliers' advertising purchases as revenue, in violation of generally accepted accounting principles. The scheme worked, generating an additional $17 million in revenue for Charter and allowing the company to hit its expected financial estimates for 2000. Charter then listed the inflated numbers on its financial statements filed with the SEC and reported those numbers to the public. While Scientific-Atlanta and Motorola allegedly knew about and helped facilitate the fraudulent scheme, neither Scientific-Atlanta nor Motorola had any role in preparing or disseminating Charter's financial statements to the public. Nevertheless, Charter's shareholders filed suit against all three parties for violations of the securities laws.

The Supreme Court dismissed the claims against Scientific-Atlanta and Motorola. In doing so, the Court focused on the fact that the suppliers' deceptive acts were never communicated to the public. As such, Charter's investors could not have relied upon any misstatements or misrepresentations by Scientific-Atlanta or Motorola. The only party that misstated its revenues to the public was Charter when it filed its financial statements with the SEC and disseminated them to the public. At most, the suppliers "aided and abetted" Charter's misstatements. The Court has previously ruled that parties who merely "aid and abet" violations of the securities laws are not liable for securities fraud.

After Stoneridge, investors are left with a more limited means of recouping losses due to securities fraud. Notably, plaintiffs have lost a significant weapon in litigation related to the subprime mortgage meltdown. An adverse ruling in Stoneridge would have permitted plaintiffs to file claims against financial institutions that financed troubled subprime entities.

The Stoneridge decision also has had an immediate impact in securities fraud litigation. On January 22 - just one week after Stoneridge was decided - the Supreme Court declined to review the Fifth Circuit's refusal to allow a class action to proceed in the $40 billion lawsuit filed by Enron's shareholders, who alleged that a number of investment banks "schemed" with the energy company to conceal its actual financial condition from the public.

While business defendants can certainly breathe a sigh of relief, the Stoneridge decision by no means relieves businesses and those advising them from their responsibilities to comply with U.S. securities laws and regulations. Although secondary actors cannot be sued by plaintiffs in a civil securities fraud action for participating in a "scheme" to defraud the public, they are still subject to civil enforcement actions conducted by the SEC and possible criminal prosecution by the Department of Justice.