After Stoneridge: The Onus is on Congress to Advocate Investors' Interests
| Author | Erica L. Finkelson |
| Pages | 05 |
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When Congress passed the Securities Exchange Act of 1934 ("'34 Act"), it created the U.S. Securities and Exchange Commission ("SEC") to restore investors' faith in U.S. markets by maintaining fair, orderly, and efficient trading, purchasing and selling of securities.1 The '34 Act aimed at protecting investors' interests by mandating companies' honest dealing and disclosure of information to investors.2 Congress incorporated the antifraud provision of Section 10(b) into the '34 Act to deter companies from engaging in conduct that would deceive or mislead investors by subjecting them to private action by investors and the SEC.3 Current securities laws, however, do not allow investors to sue lawyers, accountants, or bankers for facilitating behind-the-scenes transactions that enabled the issuers of the securities to succeed with their fraudulent schemes.4
This article reflects on the need for Congress to pass legislation expanding the scope of liability for secondary actors in order to comport with the goals of the '34 Act and to better serve investors' interests. It may not come as a surprise that the primary actors (the chief perpetrators of) investment schemes, likely end up penniless when the scheme fails thus leaving investors undercompensated and sometimes uncompensated for their losses. For example, one source predicts that an average Bernie Madoff victim, if lucky, might eventually get back 20 cents on the "(fictitious) dollar."5 Moreover, allowing investors to pursue private actions against those who aided and abetted securities fraud would function as a means of restitution to victims and as a deterrent to secondary actors.6
In 1994, the Supreme Court declared in Central Bank of Denver, N.A v. First National Bank of Denver, N.A. ("Central Bank") that Section 10 (b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 afford shareholders the right to bring a private lawsuit against a principal party who committed a securities fraud.7 The Court recognized that empowering shareholders to sue those who defraud them provides investors with recourse to recover as well as deters improper behavior within the securities industry.8 However, the Court in Central Bank held that only the SEC, and not investors, could sue actors whose conduct aided and abetted another party to commit a fraudulent act.9 The Central Bank decision has proved problematic because it did not clearly distinguish a primary violator of securities fraud from an aider and abettor.10
Specifically, Central Bank left unsettled whether an actor who does not make a material misstatement or commit a manipulative act but knowingly engages in a scheme to defraud investors is a primary violator of Section 10 (b) and therefore can be subject to private action.11 This concept is referred to as "scheme liability."12 The federal circuits have applied different tests in deciding when investors have valid claims to sue secondary actors such as law firms, accountants, and investment banks.13 The SEC has consistently voiced its position supporting liability for actors who engage in deceptive conduct as part of a fraudulent scheme.14
On January 15, 2008, in arguably one of the most important securities law cases in years,15 the Supreme Court in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. and Motorola, Inc (Stoneridge) clarified that investors do not have a right to sue third parties who were knowingly involved in sham transactions with a company that deceived investors if the third party did not directly mislead the investors.16
When Charter Communications, Inc. (Charter) realized that it was not on track to meet Wall Street stock analysts' expectations of its revenue and cash flow for 2000, it engaged in fake transactions with its vendors, Scientific-Atlanta and Motorola, in order to inflate its revenue and operating cash flow on its financial statements.17 Charter overpaid these vendorsPage 38for cable boxes, and the vendors used the funds from the extra payments to purchase advertising from Charter.18 Scientific-Atlanta and Motorola knew that their transactions with Charter had no economic substance and that Charter intended to use them to inflate its own revenues and cash flows as shown to investors and analysts.19 Moreover, Scientific-Atlanta and Motorola created the appearance that these transactions were legitimate by falsifying documents to justify the price increase in the cable boxes and backdated contracts to reflect the higher selling price to Charter.20
Investors in common stock issued by Charter filed a class action in Stoneridge against Charter's two equipment suppliers, Scientific-Atlanta and Motorola, alleging not only that they knew or recklessly disregarded the possibility that the sham transactions would allow Charter to falsely inflate its revenue figures, but that analysts would rely on such figures in making investment recommendations.21 The investors argued that Scientific-Atlanta and Motorola violated two sections of SEC Rule 10b-5: section (a), which makes it unlawful to employ any "scheme" to defraud investors, and section (c), which makes it unlawful to engage in any "act, practice or course of business which operated or would operate as a fraud or deceit upon any person."22
In a 5-3 decision, the Supreme Court held that in order to bring a 10(b) lawsuit, plaintiffs have to demonstrate that in deciding whether to purchase or hold stock, they relied on the behind-the-curtain actions of the third parties.23 In his majority opinion, Justice Kennedy explained that the investors in Stoneridge could not have relied on Scientific-Atlanta's and Motorola's deceptive behavior because it was never communicated to the marketplace.24
The Supreme Court articulated that the test for determining liability based on a secondary actor's conduct under Section 10(b) is whether the conduct is "immediate or remote to the injury."25 Even though Scientific-Atlanta and Motorola engaged in behavior with the objective and outcome of creating a false appearance of material fact to further Charter's scheme to misrepresent its revenue, the financial statement that Charter released to the public was "a natural and expected consequence of respondents' deceptive acts," and this was not a sufficient link in the chain of liability.26 Essentially, because Scientific-Atlanta and Motorola's acts were not disclosed to the investing public, they were "too remote to satisfy the requirement of reliance." The Court distinguished the transactions that occurred between Scientific-Atlanta and Motorola and Charter as "[taking] place in a marketplace for goods and services, not in the investment sphere,"27 and emphasized the remoteness of these transactions with Charter from those making decisions to invest in Charter's securities. Ultimately, the Court said it was Charter that misled its auditor and investors. Scientific-Atlanta and Motorola were not involved in preparing or disseminating Charter's fraudulent financial statements, made no statements to Charter shareholders or the investing public, had no contact with investors, and had no duty to disclose their deceptive acts to Charter shareholders.28 Although secondary actors like Scientific-Atlanta and Motorola in Stoneridge do not fully escape liability because they are subject to criminal penalties under federal law and civil enforcement actions by the SEC,29 these penalties do not make injured investors whole. Also, the SEC's limited resources do not always allow it to pursue all aiding and abetting charges.30
Stoneridge called attention to how crucial it is for plaintiffs to prove reliance in order to succeed in bringing a Section 10(b) securities fraud claim. Stoneridge did not foreclose certain plaintiffs in securities fraud cases from pursuing a fraud-on-the-market theory and others from bringing state tort claims (if they are not pre-empted by the Securities Litigation Uniform Standards Act of 1998).
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The Supreme Court in Stoneridge rejected the suggestion by other appellate courts that, "there must be a specific oral or written statement before there could be liability" under federal securities laws.31 The Stoneridge Court acknowledged that it had previously recognized two circumstances for a rebuttable presumption of reliance: (1) in the context of an omission of a material fact by one with a duty to disclose such fact or (2) under the fraud-on-the-market theory, in which the statement or deceptive act at issue became public and that information was reflected in the market price of the security. However, in Stoneridge, neither of these circumstances was met.32
One week later and consistent with its decision in Stoneridge, the Supreme Court refused to review an appellate court decision that reversed a district court order to certify a class of Enron investors.33 Enron...
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