Stoneridge v. Scientific-Atlanta

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Authorship: This page is maintained by Ben Winograd.

[edit] Briefs and Documents

Docket: 06-43

Oral Argument: Transcript

Judgment: AFFIRMED and REMANDED in an opinion by Justice Kennedy.

[edit] Pre-Argument Articles

[edit] Argument Preview

[edit] Background

Widely hailed as the most important securities law case in a generation, Stoneridge Investment Partners, LLP v. Scientific-Atlanta, et al. asks under what (if any) circumstances private investors can sue actors – whether accountants, lawyers, financial advisors or other businesses – that allegedly participate in a scheme to violate Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5.

The case stems from a series of transactions between Charter Communications, a nationwide cable television provider, and Scientific-Atlanta and Motorola, producers of the cable boxes consumers typically rest on top of their television. According to the plaintiff, Stoneridge Investment Partners, Charter executives realized in August 2000 that the company’s year-end cash flow would fall short of analysts’ projection, which would likely cause a drop in the company’s share price. To help cover the shortfall, Charter allegedly entered into a series of “sham” transactions with Scientific-Atlanta and Motorola to create the appearance of additional revenues. While details of the agreements differed slightly, in each case Charter offered to pay Scientific-Atlanta and Motorola $20 more for each of hundreds of thousands of cable boxes they had already agreed to buy. Scientific-Atlanta and Motorola would then return the excess payments by buying large chunks of advertising from Charter, at rates far above those Charter normally charged advertisers. To create the impression the transactions were unrelated, the parties backdated the contract increasing the price of the cable boxes. The transactions ultimately had no impact on Charter’s bottom line, but Charter accounted for them in such a way as to make its balance sheet appear more attractive to investors, according to the complaint. As the plaintiffs would later put it in their petition for certiorari, “The simplicity of the scheme was trumped only by its brazenness.”

Once Charter disclosed its financial improprieties, the value of the plaintiff’s shares fell from a high of $26.31 per share to a low of $0.76 per share in October 2002. In addition to filing claims for securities fraud against Charter and its accountant, Arthur Andersen, Stoneridge also filed suit against Scientific-Atlanta and Motorola for the vendors’ alleged role in the scandal. The plaintiffs alleged that Scientific-Atlanta and Motorola not only 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. In so doing, 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 making in unlawful to engage in ay “act, practice or course of business which operated or would operate as a fraud or deceit upon any person.”

[edit] Opinions Below

In late 2004, U.S. District Judge Charles A. Shaw dismissed the plaintiffs’ complaint under Rule 12(b)(6) of the Federal Rules of Civil Procedure, for failure to state a claim upon which relief could be granted. The court found that even assuming the truth of the complaint, the plaintiffs claims against Scientific-Atlanta and Motorola did not state a valid cause of action under Central Bank Of Denver, N. A. v. First Interstate Bank Of Denver, N. A., a 1994 case in which the Court found Section 10(b) did not permit private investor suits against defendants alleged to have merely “aided and abetted” another company’s securities fraud. Citing a number of circuit court opinions handed down after Central Bank, the district judge found that under Section 10(b) private investors could only sue actors who had themselves made false or misleading statements. The judge found the plaintiffs had not accused Scientific-Atlanta or Motorola of making any such statements, nor of being responsible for the preparation of Charter’s financial statements, its internal accounting practices, or the public statements made by its executives. In April 2006, the U.S. Court of Appeals for the Eighth Circuit upheld the District Court’s dismissal of the complaint. In a unanimous decision, a three-judge panel wrote that “[A]ny defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under $10(b) or any subpart of Rule 10b-5.”

[edit] Grant of certiorari

The Supreme Court granted certiorari on March 26, 2007. The question presented is:

“Whether this Court’s decision in Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), forecloses claims for deceptive conduct under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5(a) and (c), 17 C.F.R. 240.l0b-5(a) and (c), where Respondents engaged in transactions with a public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where Respondents themselves made no public statements concerning those transactions.”

[edit] Petitioner’s brief

In its merits brief, Stoneridge contends that Scientific-Atlanta and Motorola were themselves primary violators of section 10(b) of the Act and sections (a) and (c) of SEC Rule 10b-5, as the transactions in question served no purpose other than to artificially inflate Charter’s balance sheet. Contrary to the Eighth Circuit’s opinion below, the dealings at issue did not involve arm’s length business transactions, the brief says. As evidence, it points to the fact that Scientific-Atlanta and Motorola themselves falsified documents to help complete the transaction. In fact, “[it] is impossible to see how Respondents’ scheme with Charter can be described as anything other than a ‘deceptive device or contrivance’,” the brief says, citing the language of section 10(b) of the Act. Stoneridge also argues that the Eighth Circuit “rewrote the statute” in requiring a defendant to have made a fraudulent misstatement or omission to qualify as primary violator of Section 10(b) of the Act. The brief says that unlike other sections of the Act, Section 10(b) did not limit liability to instances of “misstatements.” In support of this proposition, the brief argues that unlike section (b) of SEC Rule 10b-5, neither section (a) nor section (c) is limited to “false statements.” Going forward, the petitioner’s brief suggests the following test to determine whether participation in fraud amounts to a primary violation of the securities laws in question:

[A] person engages in a deceptive act as part of a scheme to defraud investors, and violates Section 10(b) and Rule 10b-5(a) and/or (c), if the purpose and effect of his conduct is to create a false appearance of material fact in furtherance of that scheme.

[edit] Respondents’ brief

The principle contention of the respondents’ brief is that the theory of “scheme liability” advanced by the plaintiffs is no different than the “aiding and abetting” liability rejected in Central Bank. The brief lists four reasons why the Court’s holding in Central Bank applies equally to the plaintiff’s claim in Stoneridge. First, the respondents’ argue that the whole notion of scheme liability conflicts with Central Bank’s requirement that shareholders must specifically rely on a company’s actions to maintain a private suit against it for securities fraud. Second and relatedly, it was Charter – not Scientific-Atlanta or Motorola – that misled analysts and the investing public. According to the brief, if the Court were to overturn the Eight Circuit decision, the result would be that “Motorola and Scientific-Atlanta shareholders would have to compensate Charter shareholders for a fraud committed by Charter’s own management” (emphasis in original). Third, other provisions of the Securities and Exchange Act that provide express causes of action specifically exclude scheme liability. And fourth, permitting scheme liability – especially under the plaintiff’s “purpose and effects” test – would harm the economy at large, and make public companies settle even meritless claims to avoid the cost of lengthy litigation. Scientific-Atlanta and Motorola further argue that Congress specifically rejected creating private rights of action for “aiding and abetting” securities fraud when it enacted legislation to reduce securities litigation in 1995, a year after the Court’s decision in Central Bank.

[edit] Oral Argument Recap

Oral argument transcript

This recap originally appeared as a post on SCOTUSblog by Lyle Denniston.

If some of Wall Street’s major players — the giant invesment houses — were looking nervously toward the Supreme Court on Tuesday morning, as they reportedly were, by midday they were entitled to take a breath and relax. As the Court concluded an hourlong hearing in a vitally important securities case, there seemed hardly a chance — even a remote one — that federal law against stock fraud would be read to give investors a significant new tool to go after stock fraud themselves. With the seeming exception of only Justice Ruth Bader Ginsburg, and the possible added exception of Justice David H. Souter, members of the Court showed little to no sympathy for opening up a broad new category of liability to investors.

The case was Stoneridge Investment Partners v. Scientific-Atlanta (06-43), but looming ominously in the background is another case involving a $40 billion claim by investors aimed at investment bankers and other business partners who allegedly played roles in the Enron scandal.

Stoneridge was heard Tuesday by an eight-member Court; Justice Stephen G. Breyer disqualified himself. But as the argument unfolded, the private attorney arguing for so-called “third party liability” to investor lawsuits seemed notably short of the five notes needed to establish that principle. Chief Justice John G. Roberts, Jr., who previously had taken himself out of the case and then took steps to get back in, made it clear early on that he was firmly opposed to the Court using its own powers to add liability where Congress had not done so explicitly.

“Congress has kind of taken over for us….They picked up the ball and are running with it….My suggestion is that we should get out of the business of expanding [the key securities fraud section]; Congress has taken over,” the Chief Justice told New York attorney Stanley M. Grossman, who was arguing for investors who seek the right to file private lawsuits to reach business partners of those who directly engage in securities fraud, on a theory that the partners were critical to making the deception work.

Justice Antonin Scalia suggested that, since it was the Court’s own creation to allow private lawsuits by investors for fraud, “why couldn’t we limit it so that schemes, such as that alleged here, can be attacked by the SEC [Securities and Exchange Commission] but not by ‘private attorneys general’?”

Grossman did not appear to make much headway with the argument that Congress had already indicated that it favored exactly the kind of lawsuit undertaken in this case. The law, he said, applies to “any deceptive device” used by “any person, directly or indirectly” to influence stock prices. “This case involves conduct that is squarely covered by the statute.” The business partners sued here, Grossman said, “were not passive bystanders. Their conduct was integral to the scheme” to mislead investors by falsely inflating the revenues of a cable communications company whose stock investors had bought.

Grossman, tested by the Chief Justice and others on how far his argument would take third-party liability, tried to keep it within limits by saying that liability would require proof that the partners acted “for the purpose of furthering the scheme.” Justice Anthony M. Kennedy bluntly told Grossman: “I see no limitation to your proposal for liability.” Kennedy suggested that, in the real world of investing, most people know that if someone engages in fraud, it is going to have an effect on stock market prices, so anyone who had a knowledge of a fraudulent scheme would become liable, under what he took to be Grossman’s theory.

With Justice Samual A. Alito, Jr., Grossman appeared to be having difficulty showing that the lawsuit he was pressing was anything more than a claim that the business partners had “aided and abetted” the securities fraud — aiding-and-abetting claims have already been put beyond the reach of private investor lawsuits by the Supreme Court in a 1994 decision (Central Bank v. First Interstate Bank).

With eight Justices, even if it turned out that the Court was split 4-4, the suing investors would lose in this case, because the Eighth Circuit Court here rejected the claim of third-party liability. It thus would take five votes to reverse that ruling. (Justice Clarence M. Thomas said nothing during the hearing and Justice John Paul Stevens said very little, bugt there is little reason to doubt that, at most, their votes in the case would offset each other — Thomas possibly against further business party liability, Stevens possibly in favor.)

Chicago lawyer Stephen M. Shapiro, representing the business partners sued by the Stoneridge investors, encountered difficulty at various points in his argument — but almost entirely with Justice Ginsburg alone. Otherwise, he was left quite free to make what essentially was his preferred key point: that Congress wanted “cases like this to be handled by an expert agency” — the SEC. Congress, in fact, has legislated precisely for such cases — in a statute “that fits this case like a glove.” For private investors to be abled to sue, they must be able to show that there was “a communication to the market,” that they relied directly upon that communication, and their stocks declined as a direct result.

Ginsburg, however, suggested there must be a “middle category” — between primary liability for the party that directly deceived the market, and aid-or-abet conduct that is not liable to private lawsuits. That middle zone, she suggested, would apply to “a company that made it possible for deception to happen.”

If the deception at work in this case were actually shared with investors, Ginsburg contended, “the whole thing would fail. This can work only if the vendors [the business partners] are silent…Silence, not speech, is what counts.” Thus, arguing to her approach, the fact that the business partners themselves did not communicate to the market what was going on should not absolve them. “The essence of the scheme,” she suggested, was that the business partners “set up” the company to make the fraudulent statements it did make to the investing public.

Justice Souter, in a few remarks, appeared to find some significance in Ginsburg’s approach, but he was nowhere nearly as energetic in pressing the investors’ liability argument.

Shapiro countered almost all comments from the bench with the suggestion that this should be a matter for the SEC. “Congress has said it twice,” he said, making it clear that it felt lawsuits like this one were “hurting our economy.” The SEC’s “panoply of remedies,” the lawyer argued, “is the better mousetrap.”

Deputy Solicitor General Thomas G. Hungar, representing the government position that appears to be an attempt to straddle the opposing arguments, suggested that the ultimate test to be used for such investor lawsuits was whether they could show “reliance” on a deception. Here, he said, “the only deceptive conduct was never disclosed to the market.” Like Shaprio, Hungar noted that Congress had “looked twice” at the kind of liability advanced in Stoneridge, and has declined to provide it.

The Court is expected to issue a final decision this winter or next spring.

[edit] Opinion Analysis

The following entry by Lyle Denniston first appeared on SCOTUSblog.

The Supreme Court, in one of the most important securities law rulings in years, decided Tuesday that fraud claims are not allowed against third parties that did not directly mislead investors but were business partners with those who did. The 5-3 ruling came in Stoneridge Investment Partners v. Scientific-Atlanta (06-43).

Investors, the Court said, may only sue those who issued statements or otherwise took direct action that the investors had relied upon in buying or selling stock — whether that involved public statements, omissions of key facts, manipulative trading, or conduct that was itself deceptive. One impact of the decision is likely to be the scuttling of a massive $40 billion lawsuit against financial institutions growing out of the Enron scandal. The Court has a case on its docket involving that very dispute, and Tuesday’s ruling will be followed up soon, perhaps by next week, with action on that case — California Regents v. Merrill Lynch, et al. (06-1341).

The Stoneridge decision was the only one the Court released. Other opinions are expected Wednesday.

Justice Anthony M. Kennedy, who wrote the Stoneridge ruling, said the private right to sue for securities fraud “does not reach the customer/companies because the investors did not rely upon their statements or misrepresentations.” The ruling upheld a decision by the Eighth Circuit Court rejecting claims against Scientific Atlanta, Inc., and Motorola, Inc. The investors contended that those two companies helped a giant cable TV firm, Charter Communications, inflate artificially its financial staements in order to bolster its stock’s price. The investors contended that the two companies should be treated as “primary violators,” even though they had not themselves issued any public statements to advance the alleged manipulation plot.

The scheme challenged in the case was carried out in the fall of 2000. Investors claimed that the plot was designed to improve the public appearance of an adequate opeating cash flow for Charter by getting its business partners in TV set-top boxes to engage in “sham” deals under which Charter paid extra for the boxes, but the companies simply turned around and paid that money to Charter in advertising at above-market rates on its cable TV outlets. The result, the lawsuit contended, was to generate some $17 million in phony revenues, so that Charter’s cash position – in reality, a shortfall of $15 to $20 million — did not appear to be below the amount projected by the company and by stock analysts. After losing in the Eighth Circuit, the investors took the case to the Supreme Court, arguing that “the simplicity of the scheme was trumped only by its brazenness.”

The plot led to a federal indictment against two of Charter’s officers, and a cease and desist order against that company by the Securities and Exchange Commission. The Stoneridge investors’ lawsuit was also aimed at Charter and some of its officers. The appeal to the Supreme Court, however, only involved the dismissal of their claims against the vendors, Scientific Atlanta and Motorola. Also sued in the case was the now-defunct accounting firm, Arthur Andersen (which went under after its role in the Enron scandal), but it, like Charter, was not involved in the case before the Supreme Court.

The case involved what has been called “scheme liability,” in which everyone involved in a plot to deceive securities investors would be legally at fault, whether or not each of them had issued any public statements. The Securities and Exchange Commission had previously supported such liability, and wanted to enter the Stoneridge case to say so, but its participation was vetoed by the Bush Administration, with President Bush and Treasury Secretary Henry Paulson directly involved in the decision to keep the SEC out of the case. The Court took the case apparently to resolve a dispute among federal appeals courts on the issue.

The private right to sue at issue is one that has been created by court decisions, not by a direct federal statute. Justice Kennedy said that Tuesday’s ruling limiting the range of such a lawsuit was “consistent with the narrow dimenions we must give to a right of action Congress did not authorize when it first enacted the [Securities Exchange Act of 1934] and did not expand when it revisited the law.”

In ruling Tuesday that Scientific Atlanta and Motorola could not be sued, Kennedy wrote that the two outside companies “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 [the two companies’] deceptive acts during the relevant times. [Stoneridge], as a result, cannot show reliance upon any of [the companies’] actions except in an indirect chain that we find too remote for liability.”

Noting that the investors had argued that Scientific Atlanta and Motorola had done what they did with the aim, and the result, that a false appearance was created about Charter’s revenues, and that what Charter said publicly was “a natural and expected consequence” of the suppliers’ deception, the Court said this was not a sufficient link in the chain toward liability.

“In effect,” Kennedy wrote, Stoneridge “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. Were this concept of reliance to be adopted, the implied cause of action would reach the whole marketplace in which the issuing company does business; and there is no authority for this rule.”

The Court said that “secondary actors,” like the two outside companies in this case, are subject to criminal penalties under a specific federal law, and civil enforcement action by the SEC. “The enforcement power is not toothless,” Kennedy wrote, attempting to direct dispute a suggestion by the dissent.

The Kennedy opinion was supported by Chief Justice John G. Roberts, Jr., and by Justices Samuel A. Alito, Jr., Antonin Scalia and Clarence Thomas. Justice John Paul Stevens dissented, joined by Justices Ruth Bader Ginsburg and David H. Souter. Justice Stephen G. Breyer took no part in the ruling; he reportedly owns stock in Cisco Systems, Inc., the parent company of Scientific Atlanta. The Chief Justice also was out of the case when the Court granted review on March 26, but got back into the case in September, presumably after selling stock — reportedly, he, too, owed stock in Cisco.

Justice Stevens, in dissent, argued that Charter could not have inflated its revenues to cover up a cash flow shortfall “absent the knowingly fraudulent actions of Scientific-Atlanta and Motorola.” Investors, he wrote, relied upon Charter’s revenue statements in deciding whether to buy its stock, and “in doing so relied on [the two companies’] fraud, which was itself a ‘deceptive device’ ” under securities law. “This is enough,” he concluded, to show a violation of the law against stock fraud.

Congress passed that law, Stevens argued, “with the understanding that federal courts respected the principle that every wrong should have a remedy. Today’s decision simply cuts back further on Congress’ intended remedy.” Citing the Supreme Court’s 5-4 decision in 1994 (Central Bank v. First Interstate Bank), ruling over Stevens’ dissent that private securities lawsuits could not be filed against those who only “aided or abetted” those who committed fraud, Stevens wrote on Tuesday: “I respectfully dissent from the Court’s continuing campaign to render the private cause of action under [the fraud law] toothless.”