Why Stoneridge Matters

Pundits struggling to portray the significance of the Stoneridge v. Scientific Atlantic case, to be argued before the U.S. Supreme Court on Tuesday October 9, have asserted that it may be the most important business case of the generation. I am more comfortable with the more restrained assessment of the October 6, 2007 Wall Street Journal editorial (here) that it is "the business case of the year." But even if it is not a potentially epoch defining case, it is still nonetheless important, and it could, regardless of outcome, have ramifications for the potential liability exposures of prospective securities lawsuit defendants, including accountants, lawyers, investment banks, and arguably any publicly traded company.

The case arises out of events that took place in 2000. Apparently fearing a revenue shortfall and missing analyst estimates, Charter Communications reached an agreement with two vendors, Scientific Atlanta and Motorola, to sell the vendors cable set-top boxes at a premium price. The premium was returned to Charter as a "marketing expense." Charter immediately booked the return funds as revenue. On April 1, 2003, Charter announced (here) that it was restating its financial statements for a variety of reasons, including the reclassification of the revenue from the set-top deal with the vendors.

Investors quickly filed securities class action lawsuits against Charter, its directors and officers, its former auditor (Arthur Anderson) and the vendors. According the petitioners’ opening brief (here) the claims against all the defendants other than the vendors ultimately settled for $146.5 million. The claims against the vendors included allegations that the set-top deal had no business purpose and was intended solely to create a desired accounting outcome. The investors further alleged that the vendors were aware of the desired outcome, and not only helped structure the deal to accomplish the outcome, but affirmatively helped facilitate the outcome, among other things, allegedly backdating documents and issuing other false documents. (The Race to the Bottom blog has a detailed summary of the active misconduct alleged against the vendors, here.)

The district court granted the vendors' motion to dismiss the Charter shareholders' claims, and the Eighth Circuit affirmed (here). In ruling in the vendors' favour, the Eighth Circuit relied on the Supreme Court’s decision in the Central Bank of Denver case (here). Central Bank held that there is no private cause of action for aiding and abetting under Section 10(b). The Eighth Circuit stated that

any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under Section 10(b).

The investor plaintiffs (who are the petitioners before the Supreme Court) argue that the Eighth Circuit erred in holding that because the vendors themselves did not make any misstatements or omissions, they cannot be held liable under Section10(b). The petitioners argue that because the vendors engaged in deceptive conduct as part of a scheme to defraud, they can be subject to Section 10(b) liability. The respondents also argue that this case is different from Central Bank, because here the defendants are alleged to have actively engaged in the fraud.

The respondents and the various parties that have filed amicus briefs urging affirmance of the Eighth Circuit argue that petitioners are trying to overthrow Central Bank, and that if the Eighth Circuit's decision is overturned, the litigation floodgates will be opened, which it is urged will further erode the competitiveness of U.S. financial markets.

Looking at the composition of the current court would as an initial matter suggest that the petitioners prospects appear difficult. Of the current justices who will be hearing the case (Justice Breyer having recused himself) that were on the court at the time of Central Bank, three were part of the Central Bank majority (Scalia, Thomas and Kennedy) and three were in dissent (Ginsberg, Souter and Stevens). The two newest Justices (Roberts and Alito) would seem more likely to vote with the conservative group, seemingly providing the respondents’ with a strong prospective 5-3 majority.

But there is a lot more to prognosticating this case than just dividing the justices into seemingly congenial groups. In fact, there may be reasons to suppose that even this Supreme Court might reverse the Eighth Circuit. As the Solicitor General noted in the amicus brief he filed on behalf of the Department of Justice (here) , the Eighth Circuit concededly erred in concluding that the petitioners had failed to satisfy the deception requirement, and indeed conduct other than making statements or omissions can be deceptive within the meaning of Section 10(b). A group of justices looking for a narrow ground on which to reverse might be able to build a majority around this issue.

There are also narrow grounds on which the Supreme Court might affirm as well, without foreclosing the possibility that there might be other "scheme liability" cases that might satisfy Section 10(b)'s requirements. For example, the Central Bank case did not hold that that secondary actors were immune from liability under the securities laws. Central Bank in fact held that any person who employs a manipulative device "may be held liable as a primary violator" assuming all the requirements of Section 10 are met. So in order for the vendors here to be held liable, all of the Section 10 requirements would need to be established.

The court could affirm the Eighth Circuit on the grounds that the claims against the vendors do not satisfy all of the Section 10(b) requirements, and in particular cannot satisfy either the reliance requirements or the that the deceptive acts were made in connection with the purchase or sale of a security. Indeed, the ground on which the Solicitor General urges affirmance of the Eighth Circuit is that the petitioners had not show that the Charter investors detrimentally relied on the vendors' alleged deceptive acts, and in fact were completely unaware of the conduct constituting the alleged deception. By the same token, the respondents argue that even if the alleged conduct were fraudulent, it did not involve nor was it involved in the purchase or sale of a security.

While the Court might well affirm this case on one or more of these narrow grounds, the kinetic potential of the case is the possibility that the court takes the occasion of having the Stoneridge case before it to further define the possibility of a scheme liability case under Section 10. We can never be too sure of what the court might do. The Court's relative restraint in the recent Tellabs case (refer here) leads me to believe that the Court may not reach beyond a narrow ground here, particularly since it apparently does not need to do so to resolve the case. But if the Court does go further and seeks to provide further definition to a theory of scheme liability under the securities laws, it seems to me that given the composition of the current Court, it is unlikely to come up with an expansive definition for scheme liability.

Nevertheless, there is the perhaps incalculable possibility that the Court might well be affected by the alleged fraudulent conduct in which the vendors are alleged to have engaged , and it is possible that the Court could conclude that the securities laws were intended to reach the kind of conduct of which the vendors stand accused, in which case there could be a decision that provides an expansive allowance for scheme liability claims. Were the Court to do so, the potential liability of many third parties could be expanded enormously, with significant ramifications for accountants, lawyers, investment bankers and basically any firm that does business with a reporting company.

In the event that the Supreme Court were to rule for the petitioners and reverse the Eighth Circuit, the outcome could have immediate practical consequences for those of us in the D & O industry, particularly if the outcome of the case is an expansive recognition of the viability of the kinds of claims raised against the vendors here. If vendors, professionals or investment banks can be held liable under the securities laws for the statements of others, the challenge of underwriting potential securities risk escalates enormously. Professional liability underwriters are long accustomed to underwriting their applicants' prospective legal exposures by reviewing the applicants conduct; in the case of prospective public company accounts, underwriters are accustomed to reviewing the company's own public statements. But if a company potentially can be held liable based on the alleged statements of others with whom the company does business, the universe of potential sources of exposure multiplies exponentially, as does the job of underwriting the risk.

And by the same token, policy wordings may have to be adjusted as well. For example, it may no longer be sufficient for policy definitions to target claims by a company's own securities holders, as the claim could come from another company's securities holders. The definitions must be adjusted to reflect the possibility of any claim under the securities laws, rather than just a securities claim by a company's own investors.

An expansive recognition of scheme liability also could have a potentially significant impact on claim frequency, and by extension, upon pricing. But at this point the extent of these potential effects is uncertain and it would be speculation to try to provide any estimation of the effects, until the outcome of the case is better known.

If, as seems like the likelier outcome, the Supreme Court sides with the respondents and affirms the Eighth Circuit, the case could also have some very significant effects. If Supreme Court seizes on the occasion of this case to rule out any type of secondary liability, the case would significantly reduce the liability exposure of third party professionals. But this possibility is unlikely. Even if the Court simply reaffirms the Central Bank of Denver case and holds that the petitioners have not met the requirements for primary liability, the impact could be more nuanced. The specific contours will define the practical effects. If the Court decides the case based on narrow grounds of the type supposed above, the may well be little categorical impact on the potential liability exposure.

What makes this case interesting is the potential that arises any time the Supreme Court accepts jurisdiction of a securities case. The possibility that the Court will use the occasion to rewrite some well established part of securities liability exposure creates a dramatic tension that makes this case worth watching closely --whether or not it is the most important case of the generation.