Stoneridge and Securities Violations for Aiders and Abettors

This is a case about alleged securities fraud. It comes alive as I go through the facts. What I want you do to as you read the facts is to ask yourself whether you think this should be illegal. The two federal courts below declared that it was not. I will get to all of that below.

First, a context-giving word. Stoneridge invests money of moms and pops and others in the securities markets. Scientific-Atlanta and the other defendant (Motorola) make "set-top" boxes which you place on top of your TV to get television programming for cable and non-cable stations. S-A and Motorola sell these boxes to cable companies. In this suit the buyer of these boxes was Charter Communications. Charter then sends out its guys in uniforms to put the boxes on your television before overcharging you for cable services. The case has to do with how Stoneridge investors got hurt because of a purportedly deceptive deal between Charter and S-A/Motorola relating to these set-top boxes.

Second, you need to understand one other thing. The time in which these alleged deceptive transactions between Charter and S-A or Motorola took place was the last four months of 2000. Anyone in the financial know knows that these were the months just before the "bottom fell out" in the securities' markets. By Spring 2001 we had a stock market crash on our hands. Thus, the pressure was on companies late in 2000 to do everything they could to make sure that rosy revenue pictures continued through the end of the year. Maybe that would include some manipulations....

Facts of the Case

Here is what Stoneridge alleged that Charter did with S-A and Motorola in Summer/Fall 2000. First, Charter realized in August 2000 that its 2000 net revenue, which is a very important figure for market analysts (their views on this subject affect stock prices), would be lower than projections by $17,000,000. Oops. Big shortfall. So, Charter, being the enterprising business that it is, told one of its execs to approach S-A and Motorola, Charter's supplier of "set-boxes" you put on top of your TV, and ask them to take out millions more in ads on Charter's programming. Both of them respectfully declined. They probably felt the financial pinch, too.

Not deterred by rejection (indeed, to be a big exec. in the world today, you have to, like many inept guys, live with rejection), Charter then cooked up a scheme the simplicity of which, the Stoneridge attorneys say, was "only trumped by its brazenness," (Petition for Writ of Certiorari, 4). It decided to send the exec back to S-A and Motorola with the following proposal. Charter would "buy" new set-boxes for $20 more than currently and send the $20 per box to the suppliers if the suppliers would take out advertising in Charter's programming that would exactly pay for the number of new set boxes bought. For S-A that meant that Charter "paid" about $7 million more for the new set-boxes, while S-A "paid" Charter $7 million to advertise more on Charter's programs. For Motorola it meant $10 million. And, what is the sum of $7 and $10 million? Presto. $17,000,000--just the amount that Charter needed to meet projected shortfalls for the rest of the year. And, guess what? Since the boxes were "equipment" and advertising revenue was not equipment, Charter could report the phony advertising income as "revenue" in 2000 while it could "capitalize" expenses for the set-boxes. That means that it could count the set box purchases on its books over a number of years (don't ask me how many). In any case, it would make it look as if Charter had a banner year when, in fact, they were propping up a losing regime.

Well, you say, it is a "win-win" proposition. Who loses? The mom and pop investors with Stoneridge. They think that Charter is having a great year, they invest more money in Charter and then, boom, sometime later the stock collapses. I have a chart here that shows how Charter stock plummeted from more than 20 in 2000 to about 4 or 5 in early 2003. That is, the scheme caught up with them--and especially with the investors. So, you have a big class actions securities lawsuit on your hands--which leads to this case.

The Law At Issue in the Case

The primary legal question the courts had to consider (and which is before the Supreme Court) is whether the agreement between Charter and S-A/Motorola is a violation of the securities law. Or, to make it sound more "legal," is there liability for aiders and abettors who are third parties when the middle party (i.e., Charter) makes deceptive representations based on its contracts with aiders and abettors? The law at issue is one of the most litigated laws in our history: Sec. 10(b) of the Securities Exchange Act of 1934 (15 USC sec. 78j(b)), which is interpreted by regulations called the "10-b(5)" regulations (17 CFR 240.10b-5). The first makes it illegal

"to use or employ, in connection with the purchase or sale of any security...any manipulative device or contrivance in contravention of such rules and regulations..."

The "rules and regulations" in view include 10-b(5), which reads in part:

"It shall be unlawful....(a) to employ any device, scheme, or artifice to defraud.... (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit on any person, in connection with the purchase or sale of any security."

S-A and Motorola argued that by the wording of the law and a crucial Supreme Court case (Central Bank v. First Interstate Bank, 511 US 164 (1994)), no liability can be placed on them here for the simple reason that they didn't employ a manipulative device in connection with the sale or purchase of securities. They just supplied boxes.

Conclusion

Both lower courts agreed with S-A and Motorola (Circuit Court decision is at 443 F3d 987 (8th Cir 2006)). They felt that the 1994 Supreme Court decision precluded them from stretching the meaning of the securities law to include third-party aiders and abettors. The question here is whether the Supreme Court will do so. Certainly some hanky-panky went on here, and the investors were the big losers. But, an argument can be made that the investors would have been the big losers in 2001 if this deal hadn't been made. The pain was just put off a few years. Welcome to the murky world of securities law!

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