Stoneridge Roundup:

Today the Supreme Court heard oral argument in Stoneridge Investment Partners v. Scientific-Atlanta, arguably the most important securities law case before the Supreme Court in at least a decade. At issue is whether third parties may be held liable under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5 for engaging in transactions that enabled a corporation to misrepresent its earnings to shareholders. In the case at hand, shareholders of Charter Communications are suing Scientific-Atlanta and Motorola for their participation in allegedly fraudulent contracts for cable set-top boxes that enabled Charter to defraud its earnings by overstating its earnings. The implications of the case are potentially far broader, however. A decision for the petitioners (the plaintiff shareholders) could ease the way for lawsuits against bankers, accountants, and perhaps even lawyers who provide services to firms that misstate their earnings or otherwise defraud their investors.

Fortunately for the corporate defendants, most observers believe the Court is leaning against allowing suits against third parties without explicit Congressional authorization. As Lyle Denniston reported for SCOTUSBlog:

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.
University of Denver law professor and "Race to the Bottom" blogger Jay Brown likewise thinks that the corporate defendants have at least five votes (of eight, as Justice Breyer is recused). UCLA's Professor Bainbridge rounds up more of the news coverage and analysis here. The oral argument transcript is available here.

Last Friday, the Center for Business Law & Regulation at the Case Western Reserve University School of Law hosted a conference previewing the case. Panelists included Professors Stephen Bainbridge (UCLA), Barbara Black (Cincinnati), Richard Painter (Minnesota), Jay Brown (Denver), Ohio AAG Andrea Seidt, and the Manhattan Institute's James Copland. The capstone of the day was a debate on the merits of the case between two attorneys who contributed to amicus briefs in the case: Eric Isaacson (Coughlin Stoia) and Ashley Parrish (Kirkland & Ellis). An archived webcast of the conference, co-sponsored by the Federalist Society's Corporate Law practice group, is available here. The conference was very interesting and informative. Those interested in learning more about the issues underlying the case should check it out.

I am no expert in securities law but as I understand the case, the petitioners don't want to open up liability to any third-party that aided and abetted a securities fraud. Rather, they want to open up liability to third parties who undertook a deceptive act which they, at the time, knew would likely be used to further or committ securities fraud. Is this an acurate statement of their contentions? Is that a legitimate distinction? Or would that merely open up all third parties regardless of how they aided and abetted a fraud?
10.9.2007 10:50pm
Elliot Reed:
Is that a legitimate distinction? Or would that merely open up all third parties regardless of how they aided and abetted a fraud?
Well, that depends. If you believe the petitioners, it's a completely legitimate distinction with absolutely no potential for abuse whatsoever. If you believe the respondents, it will cause flocks of trial lawyers to descend on everyone who has ever come within fifty miles of an alleged securities fraud.
10.9.2007 11:17pm
frankcross (mail):
I think it's for respondents, the die was cast with Central Bank.

But I think it's really sad for free market defenders to be saying, "we can rely on SEC action," we don't need private enforcement. It is very clear that private enforcement of the laws is more effective than government enforcement. As I would think a free marketeer would expect.
10.9.2007 11:45pm
Tony Tutins (mail):
The implications of the case are potentially far broader, however. A decision for the petitioners (the plaintiff shareholders) could ease the way for lawsuits against bankers, accountants, and perhaps even lawyers who provide services to firms that misstate their earnings or otherwise defraud their investors.

The broad implications are not that investors might sue companies' advisors, but that investors might sue anyone who does business with the defrauding company, alleging that the customer or vendor should have known by the way their contract was structured that some kind of fraud was going on. This would be a full-employment act for accountants and lawyers, because of the amount of due diligence that would need to be done for all but the simplest transactions.
10.10.2007 12:04am
Christopher Cooke (mail):
Well, I am an expert in securities laws, or at least have pretty good credentials (I worked at the SEC for 7 years in Enforcement, and tried a "scheme" case; I represented companies and others in class action cases before that for several years, and now I represent individuals in SEC investigations), and I think that "scheme" liability is a very amphorous concept, which is like Justice Stewart's definition of obscenity, "I know it when I see it" but otherwise hard to pin down.

First, I agree with Frank, Central Bank largely decided this issue, but it shouldn't be the last word. Here is the issue in a nutshell: Section 10(b) outlaws manipulative or deceptive acts that the SEC, by rule, chooses to outlaw. The SEC issued several rules under this grant, including Rule 10b-5, which has three parts, one of which outlaws material misstatements or omissions, and the other two which outlaw, any person from "directly or indirectly" engaging in any schemes or artifices to defraud or from employing any deceptive acts or practices which "operate" as a fraud.

The Supreme Court in Central Bank overturned Circuit court precedent in virtually every circuit in 1994 when it said that the literal language of the statute, Section 10(b), did not encompass aiding and abetting liability, which had been allowed for 30 years. It rejected the SEC's contention that 'directly or indirectly' might be construed to encompass that type of liability, and said that Congress knew how to include aiders and abettors and didn't do it with Section 10(b). The Supreme Court didn't address the broad "scheme" language in the SEC Rule, 10b-5. After Central Bank, the Circuits agreed that conspiracy liability was out. But, prompted by a few egregious frauds (ZZZ Best, the SEC case against Brennan, First Jersey Securities), the lower courts started saying "well, what about "scheme" liability in SEC Rule 10b-5? That is broader than the material misstatements or omissions portion (10b-5(2))?) and shouldn't the kingpins (Brennan) or really culpable participants whose names are not attributed to the public statements be held accountable? These theories largely died down, though, until Enron, when "scheme" liability became very popular, primarily because the issuer was defunct and unable to pay the large judgment that the plaintiffs wanted. So, the search for deep pockets was on, and an old theory was revived.

My own take is that, assuming there is a private right of action under SEC Rule 10b-5 (an decision that I think was highly questionable when decided), I read Section 10(b) as delegating the authority to the SEC to define what is illegal. Thus, the SEC, by outlawing "schemes" in Rule 10b-5, should have the final word. Of course, no one but the SEC likes that theory, which is why Bush et al refused to let the SEC file an amicus brief in this case on the side of the plaintiffs, and instead weighed in on the other side. My prediction: 5-3 or 6-2, in favor of the corporate defendants.
10.10.2007 12:14am
Houston Lawyer:
As someone who represents companies in corporate transactions, I hope that the Supreme Court rules for the defendants. Otherwise, I will have to consult with accountants prior to closing transactions. The accountants on both sides will have to agree in advance how any significant transaction will be accounted for by both sides. Then the attorneys will have to draft provisions to agreements agreeing in advance to the accounting treatment.

All of this will be on top of management's sworn statements that their accounting is correct.

This would all be at least as useful and costly as all the Y2K crap we put into contracts and SEC filings.
10.10.2007 12:38am
Given the incredible barriers that the courts and Congress have erected for plaintiffs seeking to allege securities fraud--barriers that are higher than in any other area of civil law that I know of--the concern that recognition of scheme liability will lead to an avalanche of litigation is nonsense pure and simple. Even courts recognizing scheme liability have given plaintiffs a very hard time and permitted few claims to proceed past the pleading stage. Nobody seems to be able to point to this glut of scheme cases--on the contrary, securities filings have declined during the recent period in which the scheme theory has been developed in the lower courts.

If the Court restricts 10(b) liability only to those who make misleading public statemsnts (as the Stoneridge defendants argue) it will do so in face of the plain language of both the statute and Rule 10b-5, neither of which can be reasonably interpreted so restrictively. So much for textualism.

Finally, you can argue that the private right of action should not have been inferred from section 10(b), but that is water long under the bridge. And anyway, it seems that Congress pretty much accepted a right of action when it adopted a complex set of rules for it in 1995.
10.10.2007 2:22am
Thanks for the responses. Another question I have about the case is, more specifically, ignoring the possible precedential value of any given decision, do you think the plaintiffs deserve relief in this case given that the "aiding and abetting" alleged in this circumstance occurred with clear knowledge of the fraud and, in fact, made the fraud possible through specific deceptive acts (backdating of contracts and other shady actions)?
10.10.2007 9:46am
Bill Hobbs (mail) (www):
A ruling for the defendants in Stoneridge would leave current law unchanged, while a ruling for the plaintiffs would radically alter current law.

The Court and every federal circuit court but one have made secondary liability (the plaintiffs call it "scheme" liability) off limits for private suits.

However, neither the Court nor Congress have set prosecution of accomplices off bounds in securities
cases - they have simply left that task solely to the SEC and the Justice Department.

This balances the need for justice in such cases with the need to protect the economy from being hamstrung and hog-tied by an avalanche of lawsuits.

The blog "10b-5 Daily" had an interesting post recently headlined "NERA Releases Study on Recent Trends In Shareholder Class Action Litigation."

The gist of it is that the NERA Economic Consulting study, included the following info:

The number of such filings has increased, with 76 new filings through the first half of 2007. The projected annual total of 152 would be a 12% increase over last year.

The average settlement value during the first half of 2007 (excluding settlements over $1 billion) hit a new high of $30 million. There is evidence, however, that this trend may reverse direction based on a decline: (i) in the investor losses associated with recent filings; and (ii) in the prevalence of accounting allegations in recent filings.

Eight of the top ten settlements of all time have resolved in 2006 or 2007, or are pending. Tyco's announced preliminary settlement of $2.975 billion would be the largest amount ever paid by a single settling defendant.

Here's the link.

If the Stoneridge case is decided for the plaintiffs, the number of such lawsuits would skyrocket, putting a huge "scheme liability" tax on the economy.

And the economic costs of our out-of-control legal system are already huge:

According to the Pacific Research Institute's study Jackpot Justice: The True Cost of America's Tort System , America's out-of-control legal system imposes a staggering economic cost of over $865 billion every year calculated that the nation's tort system imposes a yearly "tort tax" of $9,827 for a family of four and raises health care spending in the U.S. by $124 billion.

In addition, according to the PRI study, the impact of America's overly expensive liability system on the health care industry costs lives because it "increases the cost of many risk-reducing products and services and health care services, making them less accessible, and in some cases unavailable to consumers.

From "Jackpot Justice":

PRI estimates that more than 114,000 people would be alive and working today, but are not due to inefficiencies in the tort system over the last two decades.

The practice of "defensive medicine" by litigation-fearing physicians increases American health care costs by $124 billion per year and adds 3.4 million Americans to the rolls of the uninsured.

PRI estimates that American companies suffer more than $367 billion per year in lost product sales because spending on litigation curtails investment in research and development, and lawsuits against American corporations generate an annual loss of $684 billion in shareholder value.

You can read the PRI study at this link..
10.10.2007 11:54am
frankcross (mail):
I think people are vastly underestimating the difficulty of pleading scienter in these cases. And that's for primary violators, third parties shouldn't have that much to fear, given particularity requirements and scienter.

And I don't think PRI is a very good source on tort liability costs but that's another debate. In the securities field, private litigation is very beneficial, with both statistical and substantive significance
10.10.2007 12:56pm
byomtov (mail):
I will have to consult with accountants prior to closing transactions. The accountants on both sides will have to agree in advance how any significant transaction will be accounted for by both sides. Then the attorneys will have to draft provisions to agreements agreeing in advance to the accounting treatment.

I have a question. What exactly did the Motorola and S-A people think was going on when Charter asked to overpay for the equipment if those vendors would spend the extra money to buy ads from Charter?

I mean, let's step back a bit from precedents and fine distinctions, and at least recognize that the odor from this particular rat was pretty strong.
10.10.2007 1:59pm
Christopher Cooke (mail):
There is one difference between scheme liability and conspiracy liability, which I heard articulated by a former federal prosecutor, Geoffrey Lawrence, who now works for the Coughlin Stoia (formerly the Lerach Couglin Stoia firm), is that, in a conspiracy everyone is liable even if no member of the public has been defrauded or otherwise harmed, because the conspiracy imposes liability once the unlawful agreement is reached. In a scheme to defraud, there must be harm caused by the conspiracy. And, under the gloss that the plaintiffs argued for, and that the Ninth Circuit has adopted, each scheme participant must have engaged in a deceptive act to be liable.

NOTE: the Bush Administration partially accepts the "scheme" and Ninth Circuit view, but adds that the plaintiffs must show reliance on the "deceptive act" engaged in by the third party in order to bring a claim against them as scheme participants. The trouble with that view, as noted by Justice Ginsburg, is that you are essentially requiring plaintiffs to plead reliance on an omission (the scheme participant's silence), which is (1) hard to do and (2) contrary to the Supreme Court's venerable case Affiliated Utes, which held that a plaintiff does not have to prove reliance on an omission in a pure "omissions" case.

I think that, if you parse the statute and rule, the "directly or indirectly" language provides a decent argument that a plaintiff should be allowed to reach beyond the persons who directly speak to the public, to those who are indirectly speaking to the public.

As far as Frank Cross' comments on the difficulty of pleading these cases, he is right. I won a dismissal under 12(b)(6), with prejudice, of the first consolidated complaint against a client who was named as a "scheme participant." And that was in the Ninth Circuit, applying its law (which allows for scheme liability). So, I think the "floodgates" argument is a bit exaggerated.

But, I see no way to uphold "scheme" liability, which really is akin to conspiracy liability, consistent with Central Bank's holding. Thus, I think the Supreme Court will not permit this type of liability theory either.
10.10.2007 2:03pm
Joe Jackson:
The question is not whether "the odor" was strong. The question is whether Section 10(b) and Rule 10b-5 reach these transactions as "securities fraud." Those are very different.

It's not like secondary actors can magically escape all other civil and criminal liability. As some of the amici in Stoneridge pointed out, the defendants there are still potentially on the hook for various types of fraud, as well as conspiracy claims. Their profits can be disgorged by the government. Depending upon the proof, they could be criminally prosecuted. Thus, the question is not "Should there be any cause of action against the defendants?" The question is "Should these particular plaintiffs be allowed to pursue a claim against these defendants for securities fraud?" You could obviously answer "yes" to the former while answering "no" to the latter.
10.10.2007 2:17pm
byomtov (mail):
Joe Jackson,

Yes. I understand that they get off on a technicality. OK.

As to other forms of liability, I don't think the SEC or DOJ will pursue this matter. Do you? Further, if all these civil liabilities exist, I wonder why the plaintiffs aren't pursuing them. So I'm not as sanguine as you about the defendants being held accountable.
10.10.2007 2:27pm
Tony Tutins (mail):
I mean, let's step back a bit from precedents and fine distinctions, and at least recognize that the odor from this particular rat was pretty strong.

How strong was the odor, really? Without the benefit of hindsight, Charter simply told GI: we will pay you more per digital cable settop box if you rebate the difference in proportion to our advertising for digital cable. All this does is provide Charter with a motivation to advertise for the new digital cable -- to get its money back. Charter benefits by getting its customers to pay more for what they are getting already -- TV is TV regardless if it's delivered via digital or analog. GI benefits because they sell more settop boxes the more digital customers Charter has. The rebate seems odd, but no odder than a dieter increasing his motivation to lose weight by setting the scale to read 5 pounds heavier, or a chronic late-arriver increasing his motivation to get to appointments on time by setting his watch to read ten minutes later.
10.10.2007 3:00pm
jallgor (mail):
First, yes I think the SEC and DOJ will go after them. They very likely already are after them. Why do you assume they won't pursue it? Do you know how many enforcement actions the SEC brings every year? Go to: and you'll get a flavor.

Second, the issue is not whether the defendants will be held accountable, which I'll note assumes they have something to be accountable for. Recall that, at this point all the plaintiffs' allegations are presumed to be true. They could be flat out lying for all you know.

The issue is WHERE will they be held accountable. These very same plaintiffs can bring a fraud action in state court against these very same defendants. For various strategic reasons, their lawyers have decided not to do that (the common list of reasons are too long to get into but many of them have to do with how much the plaintiffs' lawyers hope to get paid and nothing to do with recovery for the alleged victims).

This is not about whether these defendants did something wrong. It doesn't even decide if they "get off."
This case is about what private rights of action Congress intended to give people under the FEDERAL securities laws. The answer is usually not very many. They were generally not written for private litigants.
10.10.2007 3:14pm
Joe Jackson:

If you agree with the respondents -- and from the looks of all the commentary, a majority of the Court -- the plaintiffs are pursuing a cause of action that does not exist. That is not a "technicality."

To answer your questions, I can think of several reasons why the plaintiffs would not pursue the other forms of civil liability. The most likely, I suspect, is that back-dooring a securities claim allows them to seek staggering damages that bear no relation to the secondary actors' actions. I doubt the courts would let you get away with bringing a common law fraud claim for billions of dollars, where the transactions in question were worth less than 4 million dollars. This was just a clever attempt to force a settlement.

I see no reason to believe that the SEC or DOJ would not pursue this matter. The SEC launches more than 900 investigations and 500 civil or administrative proceedings each year. The DOJ gets roughly 150 corporate fraud convictions per year. Plaintiffs' firms generally piggy-back their claims on government action, and not the other way around.

More fundamentally, though, it is legally irrelevant whether you or I am right about the SEC and DOJ. The plaintiffs have either stated a cause of action or they have not. Policy arguments -- e.g., "plaintiffs should be able to bring these actions because we think the SEC is sleeping on the job" -- belong in Congress, not the courts.
10.10.2007 3:21pm
frankcross (mail):
No they can't bring a fraud action in state court, at least not a class action, that's preempted by SLUSA.

And it is not true that plaintiffs' firms generally piggyback on government actions. They do when they can, but many frauds are not pursued by the government. The government has limited resources, and private investors are much more incentivized to try to sniff out fraud.
10.10.2007 5:52pm
Christopher Cooke (mail):
Frank is right about the inability of plaintiffs to bring this case in state court. After the Private Securities Litigation Reform Act of 1995, many plaintiffs filed class action suits against public companies in state courts. Congress responded by preempting such actions, at least when they involved a public company, with SLUSA.

And, while I agree with Joe Jackson about the irrelevance of policy arguments to the legal statutory question in this case, it is not clear to me that the plaintiffs are the ones relying on policy arguments. Rather, the tenor of the arguments suggests that the corporate defendants are relying on the consequences of allowing the suit to go forward, plus the Central Bank decision, in arguing against a result that would seem to be allowed by the literal language of Section 10(b) and Rule 10b-5 (1), and (3), once you assume that there is a private right of action under the statute and rule (which Congress has expressly affirmed in the PSLRA, among other places). The "directly or indirectly" language of Section 10(b) and the "scheme, artifices, or devices to defraud" language in Rule 10b-5 would seem to prohibit this conduct. If a private litigant has the ability to bring a claim against someone who violates Rule 10b-5, I see no basis for rejecting scheme liability that is consistent with the language of the Rule.
10.11.2007 2:37am