LIABILITY IN SECURITIES FRAUD DAMAGE ACTIONS: Part V – The Path to Stoneridge and the Rise of Scheme Liability

In earlier parts of this series, we discussed two approaches used by the Circuit Courts to address the question of primary vs. secondary liability under Section 10(b) and Rule 10b-5.  This is part of the struggle the circuit courts have had with this issue that is the prelude to the Supreme Court’s decision in Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc.,  next term.  Some have termed that decision the most important in years.  See, e.g., John Engler, Washington’s Biggest Decision, Washington Post at D 3 ( July 2, 2007).  

Another approached to this issue advocated by the SEC and some plaintiffs and adopted by the Ninth Circuit and a few District Courts is “scheme liability.”  This theory is based on the language of Rule 10b-5(a) which makes it unlawful to “employ any device, scheme or artifice to defraud …” and (c) which prohibits “any act, practice, or course of business which operates or would operate as a fraud.”  While these terms are not in the statute – the rule cannot be construed in a manner which is broader than its enabling section – the Supreme Court defined the Section 10(b) term “device” to include “scheme” in Ernst & Ernst v. Hochfelder, 425 U.S 185, 199 n. 20 (1976).  In addition, the Supreme Court has repeatedly used the word “scheme” in discussing the statute.  See, e.g., SEC v. Zandford, 535 U.S. 813, 821-22 (2002). 

Last year in Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th Cir. 2006), the Ninth Circuit appeared to have transmuted its “substantial participation” test into scheme liability.  The securities class action in Simpson arose out of the financial fraud at  There, the company engaged in “round trip” barter transactions with certain third-party vendors to inflate its financial statements, according to plaintiffs.  A key question in the case was whether the third-party vendors could be held liable under Section 10(b).  

In an amicus brief, the SEC argued that a person can be held liable under the section “for engaging in scheme to defraud … [if he] directly or indirectly, engages in a manipulative or deceptive act as part of a scheme.”  The Commission defined “deceptive act” as engaging “in a transaction whose principle purpose and effect is to create a false appearance of corporate revenue ….”  The Ninth Circuit did not adopt the SEC’s test. 

The Simpson court did, however, adopt scheme liability and a variation of the SEC’s proposed test.  In doing so the court held that a person is liable for “participation in a ‘scheme to defraud,’ [if he] engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme.”  Substantial participation is enough, “even though that participation might not lead to … [making] actual statements.”  The key, according to the Court, is that the defendants’ “own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect.”  (emphasis original).  This purpose and effect test differentiates conduct and scienter, the Court noted.  Reliance can be established through the fraud on the market theory.  The case was remanded for reconsideration in view of the ruling. 

The ruling in Simpson clearly differs significantly from both the bright line and the substantial participation test and potentially broadens the reach of Section 10(b).  The SEC’s version of scheme liability was adopted in the Credit Suisse case by the District Court, but was rejected at the Circuit Court level.  Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. 2007); Pet. For Cert. filed, 75 U.S.L.W. 3557 (March 5, 2007) (No. 06-13).  See Part IV of this series –  In seeking certiorari in that case, Petitioners have, however, relied on scheme liability.  The Supreme Court has not ruled on that petition.  Granting that petition could have a significant impact on the decision in Stoneridge, as will be discussed in later parts of this series.  

Next: Tests of primary liability used by various District Courts