Yesterday, the Supreme Court reiterated its holding in Stoneridge Investment Partners LLC v. Scientific-Atlanta, Inc., Case No. 06-43, Slip Op. (Jan. 15, 2008) (discussed here) by issuing rulings in two huge class actions that had been waiting in the wings, Regents of the Univ. of Calif. v. Merrill Lynch, Case No. 06-1341 (the “Enron Litigation”) and Avis Budget Group, Inc. v. Calif. State Teachers’ Retirement, No. 06-560 (addressing the Ninth Circuit’s decision in Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th Cir. 2006)). The Court entered an order denying certiorari in the former, while granting the petition for in the latter and then remanding the case to the Ninth Circuit Court of Appeals for further consideration in view of its Stoneridge opinion.
While the disposition of the Enron Litigation and Simpson would ordinarily not be of particular interest, here, the rulings are instructive. In the Enron Litigation, the Fifth Circuit reversed a class certification order of the District Court which had been based on the scheme liability theory created by the SEC (and discussed here) and the fraud on the market theory from the Supreme Court’s decision in Basic, Inc. v. Levinson, 485 U.S. 224 (1988). The Fifth Circuit concluded in part that the conduct of the investment bank defendants who were alleged to have structured sham transactions knowing Enron would used them to falsify its financial statements and defraud its shareholders did not violate Section 10(b): “The district court’s conception of ‘deceptive act’ liability is inconsistent with the Supreme Court’s decision that Section 10 does not give rise to aiding and abetting liability.” Regents of the Univ. of Calif., v. Credit Suisse First Boston, 482 F.3d 372, 386 (5th Cir. 2007).
The ruling of the court in the Enron Litigation is not significantly different from that of the Eighth Circuit in Stoneridge. Consider the description of that ruling by the Supreme Court: “The Court of Appeals concluded petitioner had not alleged that respondents engaged in a deceptive act within the reach of the Section 10(b) private right of action … If this conclusion were read to suggest there must be a specific oral or written statement before there could be liability under Section 10(b) … it would be erroneous.” Slip Op. at 7. The Supreme Court went on of course to conclude that the Eighth Circuit had been talking about reliance, not deception. The Stoneridge Court concluded plaintiffs failed to establish that element despite their reliance on Basic and its fraud on the market theory, because their acts were unknown to the investors. The Fifth Circuit came to a similar conclusion as to reliance and Basic in the Enron Litigation. By denying certiorari, the Supreme Court left standing a ruling on deception that is clearly narrower that its own. At the same time, however, the Court also left standing a ruling on reliance and Basic that is fully consistent with Stoneridge – and an ultimate ruling for defendants.
The Supreme Court’s ruling in Simpson reaches a similar result – ultimately it reaffirms the narrowly drawn Stoneridge reliance element. The Simpson court concluded that scheme liability and the Basic fraud on the market presumption were adequate to establish a Section 10(b) cause of action. After adopting a modified version of the SEC’s scheme liability theory to establish Section 10(b) deception, the court held that “[a] plaintiff may be presumed to have relied on a misrepresentation if the misleading or false information was injected into an efficient market. … The fraud-on-the-market presumption requires the dissemination of the misrepresentation into an efficient market, but not personal involvement by the defendant in disseminating this statement.” Simpson v. AOL Time Warner, 452 F. 3d 1040, 1051 (9th Cir. 2006).
By granting certiorari and remanding Simpson to the Ninth Circuit to reconsider its decision, it seems clear that the Supreme Court is reinforcing the key portion of its opinion – a narrowly drawn definition of reliance under the fraud on the market theory. While it may be argued that the remand suggests a rejection of the Ninth Circuit’s “scheme liability” theory, a close reading of Stoneridge suggests otherwise. The Supreme Court did not specifically rule on that theory. Indeed, its ruling on deception is an awkward reconfiguration of the Eighth Circuit’s decision which permitted the Court to reach the reliance issue that had not been squarely presented in the lower court. At the same time, the narrow reading of Basic and its fraud on the market theory in Stoneridge is unmistakable. As the Court stated: “In all events we conclude respondents’ deceptive acts, which were not disclosed to the investing public, are too remote to satisfy the requirement of reliance.” Slip Op. at 10. Stated differently, to establish reliance, the deceptive acts of the defendant must be disclosed to the investors – it is not enough that they may be incorporated into the price of the security through the efficient market theory.
These rulings, read in conjunction with Stoneridge, clearly suggest that the scope of Section 10(b) and precisely what constitutes deception is still an open question. Participating in a scheme to defraud many in fact be sufficient deception under Stoneridge despite the fact that the narrower circuit court decision in the Enron Litigation still remains. The key, however, is whether the participation of the defendant is disclosed to investors. Accordingly, in the future a key issue may be disclosure requirements such as MD&A or others. If, for example, the transactions of the Stoneridge third party-vendors or the Enron investment banks had been discussed in the MD&A section of a Form 10K because they were important to the issuer’s cash flow, the reliance element of Stoneridge might be met. Similarly, if the contracts or transaction documents were appended to or discussed in other filings again, the Stoneridge reliance requirements might be met. All of this is to say that while Stoneridge is clearly an important ruling, it clearly is not the last chapter in third party liability.