Supreme Court Rejects "Scheme Theory" of Liability and Curbs Investor Suits Against Secondary Actors
On January 15, 2008, the Supreme Court continued to restrict investors' ability to bring securities fraud lawsuits against secondary actors, and, in so doing, rejected the theory of "scheme liability" as a basis for asserting a securities fraud claim. In Stoneridge Investment Partners LLC v. Scientific Atlanta, Inc., et al., 552 U.S. ___ (2008), the Court resolved a circuit court conflict with respect to when, if ever, an injured investor may rely upon Section 10(b) of the Securities Exchange Act of 1934 to recover from a party that neither makes a public misstatement nor violates a duty to disclose, but does participate in a scheme to violate §10(b). The Court held that injured investors may not maintain a §10(b) claim against such third parties where the third parties do not violate a duty to disclose, do not make any public misstatement, and the deceptive conduct is too attenuated from the primary wrongdoing for the marketplace to rely on such conduct.
In Stoneridge, investors brought a class action suit against Charter Communications, Inc. and its accountant for issuing false and misleading financial statements and joined as additional defendants two customers and suppliers of Charter (the "customer/supplier defendants"), who were accused of knowingly entering into sham transactions with Charter for the purpose of inflating Charter's revenues in order for Charter to meet its operating cash flow projections. The district court dismissed the investors' claims against the customer/supplier defendants for failure to state a claim upon which relief could be granted. The Eighth Circuit affirmed the lower court decision, ruling that the allegations did not show that the customer/supplier defendants made misstatements relied upon by the public or violated a duty to disclose. The Eighth Circuit observed that, at most, the allegations showed that the customer/supplier defendants had aided and abetted Charter's misstatements, but that such conduct was not actionable under §10(b) under the Supreme Court's prior ruling in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994).
The Supreme Court, in a 5-3 decision split along conservative and liberal lines (Justice Breyer recused himself), affirmed the Eighth Circuit's dismissal of the investors' §10(b) claims against the customer/supplier defendants. Justice Kennedy, writing for the majority, explained that while the underlying conduct was deceptive, it was nonetheless not actionable because the investors could not have relied on the defendants' conduct. As the Court noted, reliance by a plaintiff upon a defendant's deceptive acts is an essential element of a §10(b) private cause of action because it supplies the requisite causal connection between the defendant's misrepresentation and the plaintiff's injury. Reliance can only be presumed in two instances: where the defendant omits a material fact and has a duty to disclose, or when the statements at issue are public. Here, neither presumption applied because the customer/supplier defendants had no duty to disclose to the investors and their allegedly deceptive acts were not communicated to the public.
The Court further outright rejected the "scheme liability" approach adopted by other district courts and pressed by plaintiffs, under which liability can be imposed even absent a public statement if the non-speaking defendant participated with the issuer in a scheme to defraud investors. The majority observed that the scheme liability approach fails to answer the objection that the plaintiffs did not, in fact, rely upon the defendants' deceptive conduct. As Justice Kennedy explained, "[w]ere this concept of reliance to be adopted, the implied cause of action [under §10(b)] would reach the whole marketplace in which the issuing company does business; and there is no authority for this rule." Deceptive acts which were not disclosed to the public are too remote to satisfy the requirement of reliance. Justice Kennedy made it clear that, "[i]t was Charter, not [the customer/supplier defendants] that misled its auditor and filed fraudulent financial statements; nothing [the customer/supplier defendants] did made it necessary or inevitable for Charter to record the transactions as it did." This decision reinforces the Court's unwillingness to allow private rights of action under the securities laws against secondary actors, no matter the particular label plaintiffs try to attach to the cause of action.
The Court also held that "scheme liability" would put an unsupportable interpretation on Congress' specific response to Central Bank. There, the Court held that there was no private right of action for aiding and abetting a §10(b) violation. Despite calls for Congress to create an express cause of action for aiding and abetting within the Securities Exchange Act, Congress did not follow this course and instead directed, in Section 104 of the Private Securities Litigation Reform Act of 1995, that aiders and abettors be prosecuted by the SEC. Thus, adopting the plaintiffs' construction of §10(b) would "revive in substance the implied cause of action against all aiders and abettors except those who committed no deceptive act and would undermine Congress' determination that this class of defendants should be pursued by the SEC and not private litigants."
The dissent by Justice Stevens argued that the majority opinion set the liability bar too high and that its view of reliance was unduly stringent, unmoored from authority and was part of the majority's continuing campaign to render the private cause of action under §10(b) "toothless." Furthermore, Justice Stevens argued that the Court's restriction of §10(b) claims went even further than Central Bank because there the defendant engaged in no deceptive conduct and was, at most, an aider and abettor, whereas in Stoneridge, it was alleged, and the court assumed, that the defendants engaged in deceptive conduct.
It is likely that the Court's decision in Stoneridge, which was the fifth consecutive securities matter to be decided in favor of corporate defendants since 2004, will strike a blow to similar pending securities lawsuits, including a case where Enron investors have attempted to sue Wall Street firms that did work for the energy firm when Enron was engaging in massive accounting fraud. The Court, however, did leave itself some wiggle room for further reconsideration of the matter. The Court noted that the conduct at issue in Stoneridge involved the respondents acting in concert with the issuing corporation in the ordinary course as suppliers and, as matters then evolved, in the not so ordinary course as customers. Stating that, "[u]nconventional as the arrangement was, it took place in the marketplace for goods and services, not in the investment sphere," the Court thereby left open the possibility that investor suits against third parties involved in the investment sphere could be subject to a less stringent reliance requirement.
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