Third Parties Catch a Break in 'Stoneridge'
This article first appeared in the February 27, 2008 issue of The Recorder.
Last month, the U.S. Supreme Court handed down a victory for third parties accused of securities fraud violations under §10(b) of the Securities Exchange Act of 1934, holding that §10(b) does not extend to secondary actors based solely on their participation in a public company's "scheme to defraud." Stoneridge Investment Partners, LLC v. Scientific-Atlantic, Inc., 128 S.Ct. 761.
The plaintiffs in Stoneridge brought a class action alleging that defendants participated in Charter Communications' scheme to defraud its investors in violation of §10(b). Section 10(b) prohibits "any person, directly or indirectly, ... [from] us[ing] or employ[ing], in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe." 15 U.S.C. §78j(b).
Defendants were vendors of set top cable boxes who had agreed to sell their boxes to Charter at inflated prices and then return the excess payments to Charter through the purchase of advertising from Charter. This allowed Charter to capitalize the purchase of the cable boxes and record the advertising as revenue, defrauding investors into believing Charter had met revenue and cash flow projections. Plaintiffs alleged the defendant vendors knew of the fraud and even agreed to backdate the cable box contracts to make them appear unrelated to the advertising purchases.
The trial court dismissed the action against the vendors, and the Eighth Circuit U.S. Court of Appeals affirmed, concluding that defendants had not engaged in a "deceptive act" within the meaning of §10(b), which extends only to "conduct [that] involves either a misstatement or a failure to disclose by one who has a duty to disclose." In re Charter Communications, Inc., Securities Litigation, 443 F.3d 987, 990 (2006). Relying on the Supreme Court's decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 191 (1994), which held that there is no private right of action for aiding and abetting a §10(b)(5) violation, the Eighth Circuit held that defendants had not "affirmatively cause[d] to be made a fraudulent statement or omission" and, thus, were "at most guilty of aiding and abetting" Charter's §10(b)(5) violation. Id. at 992.
REQUIREMENT OF RELIANCE
In its 5-3 decision authored by Justice Anthony Kennedy, the Supreme Court rejected the Eighth Circuit's definition of deceptive acts as overly narrow, but agreed that the third-party vendor defendants could not be liable even if they were alleged to have participated in Charter's scheme to defraud because the plaintiffs could not establish reliance on defendants' allegedly deceptive acts. In addition to reliance, a private plaintiff in a §10(b) action must prove (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) economic loss; and (5) loss causation.
The court noted that to establish a private right of action under §10(b), investors must prove not only that the defendant engaged in a deceptive act in connection with the purchase or sale of a security, but also that the investor relied on the deceptive conduct. The element of reliance ensures that "'the requisite causal connection between a defendant's misrepresentation and plaintiff's injury' exists as a predicate for liability."
In the absence of specific proof of reliance, plaintiffs may generally rely on one of two rebuttable presumptions. First, reliance is presumed if an investor establishes that there was an omission of a material fact by a party with a duty to disclose that fact. Second, reliance may also be presumed if a party's misrepresentation is made public, because it is assumed that the investor relied on the information being reflected in the market price of the security.
Here, however, the Supreme Court found that plaintiffs could not avail themselves of either presumption. Even if the vendor defendants' conduct amounted to an omission of material information, they owed no duty to the investors of Charter. Nor was there any allegation that the vendors' deceptive acts had been communicated to the public, giving rise to a presumption of reliance from an alleged fraud on the market. The court thus held that plaintiffs could not establish reliance on the vendors' actions "except in an indirect chain that we find too remote for liability."
The court went on to expressly reject plaintiffs' argument that, even in the absence of a public misstatement, defendants should be held liable for their participation in the overall fraudulent scheme, a theory previously accepted by the Ninth Circuit in Simpson v. AOL Time Warner Inc., 452 F.3d 1040 (2006). If scheme liability were adopted, the court noted, "it would revive in substance the implied cause of action against all aiders and abettors" that was rejected in Central Bank and undermine Congress' amendment of the Securities Exchange Act after Central Bank to extend the enforcement power of the Securities and Exchange Commission - but not the private right of action - to reach such third-party actors.
IMPACT OF 'STONERIDGE'
The Supreme Court's decision in Stoneridge narrowly curtails the ability of private plaintiffs to impose liability for securities fraud on secondary actors such as accountants, financial institutions, vendors and attorneys. Allegations of participation in a fraudulent securities "scheme" are no longer sufficient to state a claim for securities fraud under the federal act. After Stoneridge, a third party's deceptive acts which are merely reflected in a public statement - by influencing the company's financial condition, for instance - are too remote to establish the necessary element of reliance. Thus, a private plaintiff will now have to demonstrate that (1) the plaintiff relied on the third party's misstatement, (2) that the third party omitted a material fact which it had a duty to disclose to the plaintiff, or (3) that it made a direct misrepresentation to the public.
The impact of the Stoneridge decision is already being felt. One week after it issued the opinion, the Supreme Court took steps to cement the reach of the case's holding by issuing rulings on two securities fraud class actions seeking certiorari. The court denied certiorari in the Enron case, Regents of the Univ. of California v. Merrill Lynch, 482 F.3d 372 (2007), where plaintiffs had tried to appeal the Fifth Circuit's decision rejecting "scheme" liability against a number of banks that had allegedly participated in "contrived, deceptive deals" that helped Enron show profits that were not real. On the same day, the court granted certiorari, vacated and remanded the Ninth Circuit's Simpson decision, in which the Ninth Circuit had concluded that "scheme" liability was adequate to establish a §10(b) cause of action. Both rulings confirm that a private cause of action for securities fraud can no longer be premised solely on a third party's alleged participation in a so-called "scheme" to defraud.
Stoneridge should come as a welcome relief to third parties such as accountants, banks, attorneys and business partners who will no longer be subject to private federal securities liability based solely on allegations of participation in an alleged fraudulent securities scheme. The court's recent certiorari decisions also give comfort that the Stoneridge decision will not be limited to certain categories of defendants, but will be applied broadly to attempts by private plaintiffs to bring federal claims against third-party defendants.