Part II: Securities Class Actions: Current And Emerging Trends
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