Since antifraud Section 10(b) is the weapon of choice in many securities class actions, a key question is the reach of the statute – just who can be held liable under Section 10(b) and Rule 10b-5?

The Supreme Court’s decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (Jan. 15, 2008) earlier this year could have expanded the reach of the statute. It did not. Stoneridge rejected scheme liability theory under which business partners of defendant Charter Communications could have been held liable for allegedly participating in a fraud Charter perpetrated on its shareholders by falsifying its financial statements.

Stoneridge traces its roots to the Supreme Court’s 1994 decision in Central Bank of Denver N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). In that case the Court concluded that there is no liability for aiding and abetting under Section 10(b). The decision is based largely on the literal language of the Section, which does not mention aiding and abetting.

Following Central Bank, the circuit courts struggled to determine who could be held liable under Section 10(b). Essentially two tests evolved, although there are variations. The Ninth Circuit created the “substantial participation” test. That test focused on the conduct of the potential defendant, keying on whether the person substantially contributed to the claimed fraud. Virtually no reference is made to the other elements of a Section 10(b) claim in the Ninth Circuit decisions discussing this test. In re Software Toolworks, Inc., 50 F.3d 615 (9th Cir. 1995); see also Howard v. Everex Systems, Inc., 228 F.3d 1057, 1061 (9th Cir. 2000).

In contrast, the Second and Tenth Circuits developed the “bright line” test. Under this test, the defendant must have made a misrepresentation which he or she knew or should have known would reach investors, essentially keyed to the fraudulent conduct and reliance elements of a claim. Shapiro v. Cantor, 123 F.3d 717 (2nd Cir. 1997); Anixter v. Home-Stake Production Co., 77 F.3d 1215 (1996). These circuits rejected the Ninth Circuit test.

The SEC crafted a different approach called “scheme liability.” Under this theory, a securities law plaintiff must prove three key elements to sustain a Section 10(b) claim: 1) the person must directly or indirectly engage in deceptive or manipulate conduct as part of a scheme; 2) there is a deceptive act whose principle purpose or effect is to create a false appearance; and 3) the plaintiff relies on a material deception flowing from defendant’s deceptive act. A variation of this theory was adopted by the Ninth Circuit in the Simpson/Homestore case, Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th Cir. 2006). The Fifth and Eighth Circuits rejected it in, respectively the Enron and Charter Communications (later Stoneridge) cases. Regents of the Univ. of Calif. v. Credit Suisse First Boston (USA), 482 F.3d 372 (5th Cir. 2007), cert. denied, 128 S.Ct. 1120 (2008); In re Charter Communications, Inc., Sec. Litig., 443 F.3d 987 (8th Cir. 2006), reversed Stoneridge Investment Partners, LLC. V. Scientific-Atlanta, Inc., 128 S.Ct. 761 (2008).

Stoneridge considered the question of scheme liability under a fact pattern similar to those in Enron and Homestore. Each case, in essence, involved round trip barter transactions which allegedly were used by the issuer to falsify its financial statements and defraud its shareholders. Noting that scheme liability obviates the key element of reliance, the Stoneridge Court rejected the theory.

In support of its conclusion the Supreme Court cited five policy reasons: 1) the theory is too broad; 2) the acts of the defendants were too remote; 3) the transactions involving the third-party defendants were not securities transactions; 4) the deals plaintiffs sought to reach with their “scheme liability” theory were covered by state law; and 5) the cause of action for damages under Section 10(b) has been implied by the courts and not enacted by Congress, suggesting caution in expanding its reach. In many ways, the opinion is reminiscent of classic tort law foreseeability concepts.

The implications of Stoneridge are just beginning to emerge. The initial impact of the decision can be seen in Enron and Simpson. At the time Stoneridge was decided, petitions for certiorari had been filed in both cases. Following its decision in Stoneridge, the Supreme Court denied the petition in Enron, ending that litigation. The petition in Simpson was granted and the case was remanded to the Ninth Circuit which, in turn, sent the case back to the district court.

Another indication is the ruling in Grossman v. Merrill Lynch & Co., Civ. Action No. 2:03-cv-05336 (E.D. Pa. filed Sep. 23, 2003). There, claims against a law firm alleged to have participated in the fraud of a client company were dismissed based on Stoneridge. These early rulings clearly suggest that Stoneridge will in fact have a significant impact on the reach of Section 10(b).

Next: A new pleading standard

Last week, the Commission filed a settled administrative proceeding based on alleged violations of the FCPA. It named Faro Technologies, Inc. as a Respondent. In the Matter of Faro Technologies, Inc., Adm. File No. 3-13059 (June 5, 2008). One more settled FCPA bribery case might seem relatively routine at a time when the SEC and DOJ are focusing on enforcement in this area. There is more to this case however, than might first appear.

The facts are straightforward. According to the Order, Faro Technologies is a software development and manufacturing company based in Florida. In early 2003, the company established Faro-China, a wholly owned subsidiary, to sell its products in China. Previously, the company had sold products in China through a distributor. Sales in the subsidiary were directed by the Sales Director. The Sales Director hired a former employee of the company’s Chinese distributor as the Country Sales Manager.

Subsequently, the Country Sales Manager communicated to three Faro officers, including the Sales Director, a request to do business the “Chinese way,” that is, to pay kickbacks to potential customers. The Faro officers consulted with their Chinese counsel who informed them that such payments may well violate China’s anti-bribery laws. Accordingly, the Faro officers told the Sales Director and Country Manager not to make the payments.

Nevertheless, between 2004 and 2005, the Sales Director authorized the Country manager to make the illegal payments. The Sales Director also instructed Faro’s China sub staff to alter account entries in an effort to cover up the payments.

In February 2005, a new Faro officer e-mailed a news article to all of the international business units. The article described the prosecution of another U.S. company for paying bribes in China. The e-mail noted that they should take appropriate precautions to comply with U.S. law. The clipping was specifically directed to the Sales Director with instructions to have it translated and distributed to the staff at the Chinese subsidiary. After the dissemination of the article, the Sales Director reiterated his authorization for the payments.

Based on these facts, the SEC filed a cease and desist proceeding against the company. That action was resolved with the entry of an order directing that the company cease and desist from violations of the anti-bribery sections and requiring the payment of disgorgement, prejudgment interest and compliance with its undertakings regarding retention of a monitor.

Clearly Faro initially took the right steps. They obtained a legal opinion from local counsel and, when it appeared the payments were illegal under local law, directed that they not be made. Later, the company reinforced its instruction with the circulation of the news clip.

Nevertheless, the Commission exercised its discretion to charge the company, concluding that its agents had in fact paid the bribes and that the company had inadequate internal controls and books and records. No doubt the bribes were paid, although one might question the prosecutorial decision here.

Even more suspect is the internal controls conclusion. The company had rogue agents that disregarded repeated directives and concealed the bookkeeping entries. The Commission’s conclusion here seems like little more than fraud by hindsight, which is no fraud at all. See, e.g., Denny v. Barber, 575 F.2d 465, 470 (2nd Cir. 1978) (classic statement of Judge Friendly rejecting fraud by hindsight); see also Higginbotham v. Baxter International, Inc., 495 F.3d 753, 760 (7th Cir. 2007) (“That’s no news [that the controls cannot prevent fraud]; by definition, all fraud demonstrate the ‘inadequacy’ of existing controls, just as all bank robberies demonstrate the failure of bank security and all burglaries demonstrate the failure of locks and alarm systems”). So too, the payment of the bribes at the China sub – covered by phony entries – standing alone says little about the adequacy of the internal controls and the books and records.

There is more, however. The SEC also concluded that Faro simply had not done enough to prevent FCPA violations: “During the period of the improper payments described above, Faro provided no training or education to any of its employees, agents, or subsidiaries regarding the requirements of the FCPA. Faro also failed to establish a program to monitor its employees, agents, and subsidiaries for compliance with the FCPA.” This finding can only be viewed as critical to the prosecutorial decision making process here. This is particularly true in view of the fact that the company was doing business in a high risk country such as China and its employees had raised the issue of doing business “the Chinese way.” See also SEC v. Lucent Technologies, Civil Action No. 07-092301 (D.D.C. Dec. 21, 2007) (settled FCPA action in which SEC noted lack of training).

Any issuer reading this opinion should look beyond the booking findings and focus on the clear message: FCPA training and compliance programs are essential for those doing business overseas, particularly in areas of high risk.