Stoneridge: The Supreme Court’s Ruling and Its Impact – Part 2: The Roots of Scheme Liability

The origins of scheme liability and Stoneridge Investment Partners, LLC v. Scientific Atlanta, Inc., No. 06-43, slip op. (Jan. 15, 2008) trace to 1994, when the Supreme Court decided Central Bank of Denver v. First Interstate, 511 U.S. 164 (1994). There, the Court held that liability under Section 10(b) cannot be premised on a theory of aiding and abetting. The decision was based largely on a literal reading of the text of the statute and a record where the it was agreed there was no deception and the plaintiff based the claim solely on a theory of aiding and abetting. The Central Bank Court emphasized the fact that anyone can be liable under Section 10(b) if each element of a private cause of action is established:

The absence of Section 10(b) aiding and abetting liability does not mean that secondary actors in the securities markets are always free from liability under the Securities Acts. Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5, assuming all of the requirements for primary liability under Rule 10b-5 are met … in any complex securities fraud, moreover, there are likely to be multiple violators. …

Id. at 191 (emphasis original).

The decision touched off a debate about who could be held liable under Section 10(b) as primary violator and a debate over how to draw the line between primary and secondary liability. This was a critical issue following Central Bank, not only in private damage cases, but also in SEC enforcement actions. Since the Court based its decision on the text of the statute and not one of the court crafted elements of the implied Section 10(b) private right of action, the ruling applied to both private damage cases and SEC enforcement actions.

The year after the Court’s Central Bank decision, Congress took up the issue in the context of considering what became the Private Securities Reform Act of 1995 (“PSLRA”). That Act placed procedural and substantive limitation on private securities damage actions based on repeated testimony about abusive actions, frivolous suits and huge settlements all out of proportion to the merits of the case. The SEC urged Congress to restore aiding and abetting liability for its actions, as well as in private damage cases. In passing the PSLRA, however, Congress chose only to add Section 20(e) to the Exchange Act, which gave the SEC the right to bring actions based on aiding and abetting. Congress did not extend the same right to private damage actions.

The decision by Congress when enacting the PSLRA set the stage for a years long struggle in the courts over the dividing line between primary and secondary liability. That debate spawned the theory of “scheme liability” to define who might be held liable in a Section 10(b) private damage action. Although this issue did not impact SEC enforcement actions in the wake of Section 20(e), the Commission crafted the theory of scheme liability in amicus briefs filed in some of the largest securities class actions which arose out of corporate debacles such as Enron (Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. 2007) and Homestore (Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th Cir. 2006)) (both discussed here). This is consistent with the SEC’s long-held view that private securities damage actions are necessary adjunct to its enforcement program.

Next: The evolution of primary and secondary liability and the rise of scheme liability.

Trends In Securities Enforcement: FCPA and Insider Trading

Key trends in securities enforcement include increased emphasis in FCPA enforcement, as well as the growing global war on insider trading. Cameron International disclosed yesterday, for example, that the SEC is investigating whether the company may have violated the anti-bribery provisions of the FCPA. This inquiry follows the initiation of a DOJ probe into that issue and an internal investigation by the company.

While the SEC has long emphasized the books and records provisions of the FCPA, in recent years, the agency has also focused on the anti-bribery provisions. That trend continues. Recently, the SEC and DOJ have aggressively pursued investigations and enforcement actions in this area. These efforts are part of an important trend in this area of securities enforcement which will be the subject of a series later this year which will review the provisions of both the anti-bribery sections of the statutes as well as the books and records and internal control provisions. The series will analyze recent enforcement trends in this area. These trends are important to any issuer in view of the broad reach of the books and records and internal control provisions of the FCPA. Similarly, trends in the enforcement of the anti-bribery sections are of critical importance to companies operating abroad.

Another key enforcement trend deals with the world–wide emphasis on insider trading. Last year, the SEC brought a number of important cases, some of which may be the most significant since the late 1980’s and many of which are still in litigation. Those cases have been analyzed in our series which began here.

Issuers doing business abroad should also be aware of increased enforcement in this area in other countries. Recent enforcement activity abroad includes the following overseas cases.

U.K. The Financial Services Authority in the U.K., for example, recently brought its first criminal insider trading case. The defendants are Christopher McQuoid, former general counsel of TTP Communications, a telecom company, and his father-in-law, James William Melbourne. The charges allege that the defendants used inside information to trade prior to the announcement of a bid by Motorola for TTP in June 2006. Both men appeared at the City of London magistrates Court. The case has been adjourned until February 19, 2008.

Chile. Chile’s SVS securities regulator is charging nine people for insider trading. The charges are based on trading in advance of the merger of grocer Distribucion y Servicio D&S S.A. (DYS) and department store retailer SACI Falabella (FALABELLA.SN). D&S shares rose 7% the day before the announcement of the transaction and another 8.2% following the press release about the transaction.

Sweden. In 2007, the Swedish Financial Supervisory Authority received 170 reports of suspected insider trading. The prior, year the regulator only received 79 reports. This trend may stem in part from the fact that since 2005 businesses have been obligated to report any suspected cases of insider trading and market abuse.

Germany. Prosecutors are investigating whether insiders were selling when shares in Gildemeister plunged by 25% last week. The probe reportedly focuses on sales made on Tuesday during police raids the company during an inquiry of the Chief Executive on suspicion of breach of trust, bribery and tax evasion. Company shares reportedly sold off rapidly and in high volume during the non-public raid according to a Reuters report.

Japan. Three NHK employees are under investigation by the Securities and Exchange Surveillance Commission on suspicion of insider trading. Although two of the three men have admitted obtaining confidential company information from an internal news editing system prior to its release, all three have denied engaging in insider trading.

Australia. According to a study done by Keith Neilsen of The Insider Trader, directors of listed companies have significantly out-performed the market when trading shares of their own companies. Mr. Neilsen reportedly analyzed 6,837 trades over four years from September 2003 to September 2007. According to his finding, the overall performance of the trades was 100% bigger than the gain on the All Ordinaries Index. Directors out -erformed the market by a factor of two. Directors of small cap companies had the highest returns. Mr. Neilsen’s study is reminiscent of academic studies which touched off the option backdating probes in this country, as well as the current scrutiny being given Rule 10b5-1 plans by the SEC enforcement staff.