LIABILITY IN SECURITIES FRAUD DAMAGE ACTIONS: Part VII – Stoneridge
The Supreme Court’s decision next term in Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc., No. 06-43, will do more than simply resolve the split in the Circuit Courts over the dividing line between primary and secondary liability. At issue in the case is not only who can be held liable in a private securities fraud damage action – directors, officers, auditors, lawyers, outside vendors and perhaps others – but perhaps the very way in which many companies do business. The potential significance of the decision starts to become apparent when the dichotomy between the issue the Supreme Court agreed to hear and the Eighth Circuit’s decision under consideration is considered. The question presented in the petition for certiorari is: “Whether [Central Bank of Denver, N.A. v. First Interstate Bank of Denver, 511 U.S. 164 (1994)] forecloses claims … under Section 10(b) … where Respondents engaged in transactions with a public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where … [respondents] made no statements concerning the transactions.” Petitioners thus asked, and the Court agreed to resolve, the issue of whether third-party vendors to a public company who engage in sham transactions to permit the public company to falsely inflate earnings are primary violators under Section 10(b). The Eighth Circuit, however, saw the issue differently. In affirming the dismissal of claims against the third-party vendors, the Court noted that it was not aware of any decision imposing liability “[o]n a business that entered into an arm’s length non-securities transaction with an entity that then used the transaction to publish false and misleading statements to its investors … imposing such liability would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings. Decisions of this magnitude should be made by Congress.” In the Circuit Court’s view, the transactions engaged in by the vendors were business deals, not the sham transactions referenced in the question presented in the petition for certiorari. These divergent views are at the core of Stoneridge and suggest the huge implications of the decision next term. Indeed, Stoneridge could potentially require every vendor to re-evaluate the way it does business with a public company in order to avoid liability – the lack of certainty in business transactions that the Supreme Court decried in Central Bank. The backdrop to Stoneridge is straight forward. The case is based on the dismissal of a securities fraud class action complaint brought against Charter Communications and its outside vendors. According to the complaint, Charter and its equipment vendors entered into barter arrangements regarding the sale of television set top cable boxes under which the company agreed to pay the vendors inflated prices for equipment. In the final phase of the barter arrangements, the inflated portion of the price was returned to Charter. The company then recognized the amounts received under the barter arrangements as revenue while capitalizing the equipment costs, thereby improperly inflating revenue.
The Eighth Circuit essentially adopted the bright line test, rejecting a scheme liability argument made by plaintiffs. Following Central Bank, the Court held that “any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission … is at most guilty of aiding and abetting … .” Since the third- party vendors did not make any statement to the shareholders of Charter, all claims were dismissed as to them. Subsequently, the Fifth Circuit Court of Appeals adopted a similar position in 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) (the Enron class action litigation discussed in Part IV of this series on June 28, 2007). There, a group of banks was alleged to have engaged in sham transactions with Enron, knowing that the company intended to defraud its shareholders. The allegations in this case, however, claimed that the third party banks had known for a considerable period of time that Enron was falsifying its financial statements. The Fifth Circuit, like the Eighth, rejected plaintiffs’ claim, refusing to impose liability on third parties for engaging in what it saw as business transactions. The Enron plaintiffs have requested that the Supreme Court review this decision. The solicitor general declined to file a brief supporting the plaintiffs (despite a request by the SEC) reportedly based on the opposition of President Bush and the Treasury Department. If the petition is granted Credit Suisse could be combined with Stoneridge. Credit Suisse presents the Court with the same key issue concerning a transaction used by a public company to falsify its book: are the other parties to the transaction liable for securities fraud to the shareholders of the public company? The answer to this question has potentially huge implications for the way in which business is conducted. Next: Analysis of the issues before the Supreme Court in Stoneridge.