Alert: Supreme Court Limits the Reach of Private Federal Securities Law Actions, Rejecting Claims of Liability Based Upon a “Scheme to Defraud”
In an eagerly anticipated decision, the 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., -- S. Ct. --, 2008 Westlaw 123801 (Jan. 15, 2008).
The plaintiffs in Stoneridge brought a class action alleging that defendants participated in Charter Communications' scheme to defraud its investors. 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 back date 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 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). Because defendants had not "affirmatively cause[d] to be made a fraudulent statement or omission," the Eighth Circuit found that defendants were "at most guilty of aiding and abetting" and, under the Supreme Court's Central Bank decision, could not be liable for violating § 10(b). Id. at 992.
In its 5-3 decision authored by Justice 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.
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 (9th Cir. 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 Act after Central Bank to extend the SEC enforcement power - but not the private right of action -- to reach such third party actors.
The Supreme Court's decision should come as a welcome relief to third parties such as accountants, business partners and attorneys, who will no longer be subject to liability solely on remote allegations of participation in a fraudulent securities "scheme".