Stoneridge v. Scientific Atlanta and Securities Fraud

By a 5-3 margin (Opinion Kennedy; Dissent Stevens), the Court held today that sec. 10(b) of the Securities Exchange Act of 1934 does not reach to liability of third parties--in this case customers and suppliers of the "middle-man" (Charter Communications). Thus, as a result, Stoneridge Inv. has no case against either Scientific-Atlanta ("S-A") or Motorola, defendants, even though the two defendants "aided and abetted" Charter's scheme to conceal their financial shakiness from investors, represented by Stoneridge. Stoneridge's case would be against Charter alone. In this essay I will repeat a few salient facts of the case and then give some of the crucial paragraphs from Justice Kennedy's decision.

A Few Facts--as Rehearsed by the Court

"Respondents (S-A and Motorola) supplied Charter with the digital cable converter (set top) boxes that Charter furnished to its customers. Charter arranged to overpay respondents $20 for each set top box it purchased until the end of the year, with the understanding that respondents would return the overpayment by purchasing advertising from Charter. The transactions, it is alleged, had no economic substance; but, because Charter would then record the advertising purchases as revenue and capitalize its purchase of the set top boxes, in violation of generally accepted accounting principles, the transactions would enable Charter to fool its auditor into approving a financial statement showing it met projected revenue and operating cash flow numbers. Respondents agreed to the arrangement."

But, as the Court went on to explain, despite S-A's and Motorola's participation in the scheme to help Charter's revenue look better,

"Respondents had no role in preparing or disseminating Charter's financial statements. And their own financial statements booked the transactions as a wash, under generally accepted accounting principles. It is alleged respondents knew or were in reckless disregard of Charter's intention to use the transactions to inflate its revenues and knew the resulting financial statements issued by Charter would be relied upon by research analysts and investors."

Stoneridge filed a securities class action on behalf of purchasers of Charter common stock and alleged that, by doing this, S-A and Motorola violated sec. 10(b) of the 1934 Act and SEC Rule 10b-5.

Legal Analysis

In Central Bank of Denver, 511 US 164 (1994), the Court "determined that § 10(b) liability did not extend to aiders and abettors. The Court found the scope of § 10(b) to be delimited by the text, which makes no mention of aiding and abetting liability. 511 U.S., at 177. The Court doubted the implied § 10(b) action should extend to aiders and abettors when none of the express causes of action in the securities Acts included that liability. Id., at 180. It added the following: 'Were we to allow the aiding and abetting action proposed in this case, the defendant could be liable without any showing that the plaintiff relied upon the aider and abettor's statements or actions.'"

As a result of this 1994 decision, Congress took up the issue of whether to create an express cause of action for aiding and abetting within the Securities Exchange Act. The Court explained:

"Then-SEC Chairman Arthur Levitt, testifying before the Senate Securities Subcommittee, cited Central Bank and recommended that aiding and abetting liability in private claims be established. S. Hearing No. 103-759, pp. 13-14 (1994). Congress did not follow this course. Instead, in § 104 of the Private Securities Litigation Reform Act of 1995 (PSLRA), 109 Stat. 757, it directed prosecution of aiders and abettors by the SEC. 15 U.S.C. § 78t(e)."

Since a sec. 10(b) right of action doesn't extend against aiders and abettors (S-A and Motorla), the only way to bring successful suit against these defendants would be if the defendants committed deceptive acts themselves on which the investors relied. The Court explained the doctrine of reliance in a 10(b) case:

"Reliance by the plaintiff upon the defendant's deceptive acts is an essential element of the § 10(b) private cause of action. It ensures that, for liability to arise, the “requisite causal connection between a defendant's misrepresentation and a plaintiff's injury” exists as a predicate for liability. Basic Inc. v. Levinson, 485 U.S. 224, 243, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988); see also Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 154, 92 S.Ct. 1456, 31 L.Ed.2d 741 (1972) (requiring “causation in fact”). We have found a rebuttable presumption of reliance in two different circumstances. First, if there is an omission of a material fact by one with a duty to disclose, the investor to whom the duty was owed need not provide specific proof of reliance. Id., at 153-154. Second, under the fraud-on-the-market doctrine, reliance is presumed when the statements at issue become public. The public information is reflected in the market price of the security. Then it can be assumed that an investor who buys or sells stock at the market price relies upon the statement. Basic, supra, at 247."

Conclusion

However, the majority found that neither of these two circumstances applied in our case. S-A and Motorola had no duty to disclose the deceptive relationship with Charter and, in fact, their deceptive acts were not communicated to the public. Therefore, the public couldn't "rely" on their bad acts.

From a technical legal point of view, then, S-A and Motorola have no liability to Stoneridge or its clients, even though it was S-A and Motorola's agreement with Charter which artificially buoyed the stock price of Charter and ultimately led to the collapse a year later of Charter's stock. The dissenters argued, however, that something was deeply "fishy" (my word) in this case. Investors, the ones who were ultimately screwed by corporate shenanigans, have no cause of action against those who planned their demise. The only cause of action, according to the majority, is if the SEC decides to bring suit. Surely various corporate defendants have more room to maneuver now in cooking up schemes that may be fraudulent, unless there is a vigorous federal watchdog to prosecute. Is the SEC up to it?

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