Stoneridge: Pro-Business, Pro-SEC Enforcement, Not The “Decision of the Century”
In its decision in Stoneridge yesterday, the Supreme Court handed down a decidedly pro-business decision, rejecting the notion of “scheme liability.” At the same time, the Court rejected an opportunity to dramatically narrow the scope of liability under the securities laws. Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., Case No. 06-43 (January 15, 2008).
At stake in Stoneridge was the scope of liability under Section 10(b). Under scheme liability, as initially crafted by the SEC and argued by plaintiffs, a third-party vendor alleged to have contributed to a scheme that resulted in the falsification of an issuer’s financial statements could be liable to the company’s shareholders without making any express representation to those shareholders. By ruling in favor of the Respondent-Defendants who were third-party vendors of Charter Communications and against Charter’s shareholders, the Court rendered a decidedly pro-business decision: extending the implied cause of action under Section 10(b) would hinder business. At the same time, Justice Kennedy’s opinion for five members of the Court rejected the constricted reading of antifraud Section 10(b) adopted by the lower court. Upholding that ruling would have significantly narrowed the weapon of choice in most securities class actions and resulted in the blockbuster ruling many sought.
Justice Stevens, in a dissent joined by Justices Souter and Ginsburg, argued that the imposition of liability for the type of sham transactions involved here would be well within the scope of Section 10(b) and would not hinder ordinary business transactions.
The Majority Opinion
Justice Kennedy’ opinion stuck familiar themes: statutory language, Central Bank, congressional action in the PSLRA, not extending an implied cause of action and the impact of liability on business. The opinion begins with basic principles: a citation to the statutory text of Section 10(b) and a reminder that the implied cause of action has six elements, as explicated in Dura Pharmaceuticals. v. Broudo, 544 U.S. 336 (2005). These points are followed by noting that the Court rejected aiding and abetting liability under Section 10(b) in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, 511 U.S. 164 (1994) because it would undercut the key element of reliance. This fact was confirmed by the passage of the Private Securities Litigation Reform Act (PSLRA) in 1995, which only granted the SEC authority to bring such cases.
Adopting a position argued by the Solicitor General, the Court rejected an opportunity to significantly narrow the scope of Section 10(b). The circuit court held that Section 10(b) only proscribes misstatements, omissions by one who has a duty to disclose or manipulative trading, and not the kind of conduct involved in by the third-party vendors here – allegedly a sham transaction. If the court of appeals’ “conclusion were read to suggest there must be a specific oral or written statement before either could be liability under Section 10(b) or Rule 10b-5, it would be erroneous” Justice Kennedy wrote. Rather, “[c[onduct itself can be deceptive, as respondents concede” and thus “respondent’s course of conduct [which] included both oral and written statements, such as the backdated contracts agreed to by Charter and respondents” is deceptive and proscribed by Section 10(b).
Justice Kennedy then reinterpreted the decision of the court of appeals to squarely present the reliance issue the Court wanted to decide: “A different interpretation of the holding from the Court of Appeals opinion is that the court was stating only that any deceptive statement or act respondents made was not actionable because it did not have the requisite proximate relation to the investors harm. That conclusion is consistent with our own determination … that respondents’ acts or statements were not relied upon by the investors ….” This reading is at odds with the comments of Chief Justice Roberts, joined by Justice Ginsburg, at oral argument, noting that the reliance issue was not squarely before the Court.
Reliance can be established through a rebuttable presumption in two instances. First, where a material fact is omitted and there is a duty to disclose, and second, under the fraud on the market doctrine. The Court concludes that neither applies here because respondents had no duty to disclose; and their deceptive acts were not communicated to the public. No member of the investing public had knowledge, either actual or presumed, of respondents’ deceptive acts during the relevant times. Scheme liability, which would find reliance here, is at odds with this point. Indeed, since under this theory “petitioner contends that in an efficient market investors rely not only upon the public statements relating to a security but also upon the transactions those statements reflect … and there is no authority for this rule [of reliance] ….”
Justice Kennedy concludes with three points. First, he cites policy: “Were the implied cause of action to be extended to the practices described here, however, there would be a risk that the federal power would be used to invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees.” Second, adoption of petitioner’s theory is contrary to Central Bank and the PSLRA. Finally, the day is long past when the Court will expand an implied cause of action such as the one involved here in view of separation of powers concerns.
Justice Stevens begins by agreeing with the majority that the narrow construction of Section 10(b) adopted by the court of appeals is wrong – the section clearly covers the conduct at issue here because it is deceptive within the meaning of the statute. This distinguishes the case from Central Bank in which it was agreed that the defendant had not engaged in Section 10(b) deception. Accordingly, the reliance of the majority on that decision is misplaced.
Justice Stevens concludes that the Court’s opinion also misreads and misapplies the fraud on the market theory of Basic Inc. v. Levinson, 485 U. S. 224 (1988). There, the Court “held that the ‘fraud-on-the-market’ theory provides adequate support for a presumption in private securities actions that shareholders … in publicly traded companies rely on public material misstatements that affect the price of the company’s stock. … The holding in Basic is surely a sufficient response to the argument that a complaint alleging that deceptive acts which had a material effect on the price of a listed stock should be dismissed because the plaintiffs were not subjectively aware of the deception at the time of the securities’ purchase or sale. This Court has not held that investors must be aware of the specific deceptive act which violates Section 10(b) to demonstrate reliance.” Here, according to Justice Stevens, the sham transaction alleged in the complaint had the same effect on Charter’s profits as a false entry and is more than sufficient. And, permitting an action to proceed based on this kind of sham transaction will not inhibit business because it is an isolated departure from ordinary transactions. In any event, since the question of reliance was not squarely ruled on below, the case should be reversed and remanded for reconsideration.
After refuting policy points raised by the majority, Justice Stevens concludes his dissent with what might be viewed as an ode to the implied cause of action. While it is clear that Justice Stevens views himself neither as a liberal or an activist judge, the closing paragraphs of his opinion chide the majority for their swipes at implied causes of action. These causes of action are based on “A basic principle animating our jurisprudence … [that was] enshrined in state constitution provisions guaranteeing, in substance, that ‘every wrong shall have a remedy.’ Fashioning appropriate remedies for the violation of rules of law designed to protect a class of citizens was the routine business of judges …,” citing Justice Marshall’s seminal opinion in Marbury v. Madison, 1 Cranch 137, 166 (1903).
Stoneridge is decidedly pro-business as expected, but hardly the ruling of the century. The decision gives business the certainty it sought, but perhaps not the ruling. Under an open-ended version of scheme liability, issuers and their vendors faced the prospect of huge liability in securities fraud suits. Such liability raised the specter of issuers and vendors having their securities lawyers comb every transaction before closing in an effort to avoid liability. This theme threads through the Court’s opinion and no doubt had a significant impact on the decision.
At the same time, the Court declined the opportunity to narrow the scope of Section 10(b) and delimit the reach of the anti-fraud weapon typically invoked in class actions against issuers and others. Affirming the court of appeals on the scope Section 10(b) could have been the “decision of the century,” severely delimiting the scope of the antifraud section. Since the reliance issue had not been squarely raised, as Chief Justice Roberts noted at oral argument and Justice Stevens confirmed in his dissent, the Court could have simply remanded the case for further consideration. This ruling would have been consistent with Court precedent and the dictum of deciding cases on the narrowest grounds.
However, the Court avoided the “blockbuster decision” decision, resolving the case on narrower more conservative grounds. Only by “construing” and “interpreting” – otherwise known as rewriting – the decision of the court of appeals did the Court reach the issue for decision. Clearly, there is a reason the Court sought to resolve this issue.
No doubt the business reasons cited in the opinion played a significant role in the scope of the decision. That rationale, however, does not fully support the Court’s decision.
Constricting the scope of Section 10(b) would not only narrow private damage actions, but also constrict the SEC’s favorite weapon and thus its ability to police the markets. Yet, the Court repeatedly cited the ability of the agency to bring not only Section 10(b) suits, but also fraud claims based on aiding and abetting as a reason not to extend liability in private damage actions.
At the same time, narrowing the reliance element to undercut the efficient market theory and eliminate scheme liability has no impact on the SEC since the agency does not have to prove reliance in its enforcement actions. Thus, while the Court’s decision is pro-business, it is also pro-enforcement, but through SEC actions, not class actions.
Finally, Justice Stevens is no doubt correct in his lament: the days when the federal courts could be viewed as the protectors of all those whose rights have been violated have passed.