On January 15, 2008 the Supreme Court decided the Stoneridge Investment v. Scientific Atlanta case. The Court ruled that the implied private right of action in section 10 (b) does not extend to fraud claims against a non-issuer of a security whose allegedly misleading statements and conduct was not directly relied on by investors in making investment decisions. UCLA Law professor Stephen Bainbridge, Denver Sturm College of Law professor Jay Brown, the American Enterprise Institute's Ted Frank, Mayer Brown's Andrew Pincus, University of Texas at Austin - McCombs School of Business professor Robert Prentice, and Ohio Assistant Attorney General Andrea Seidt debate whether the Court decided the Stoneridge case correctly.
Questions and Answers:
Stephen Bainbridge: From the moment the Supreme Court granted cert in Stoneridge Investment Partners v. Scientific-Atlanta, the case was recognized as potentially one of the most significant business cases to come before the SCOTUS in recent years. In this opening post, I’ll tee up the discussion by setting the background.
In Central Bank of Denver v. First Interstate Bank of Denver, the Court held that there was no implied private right of action against those who aid and abet violations of Rule 10b-5. Some read Central Bank broadly to hold that liability under Rule 10b-5 was limited to primary rather than secondary actors. In Stoneridge, however, the Court stepped back from that broad reading of the case, holding that secondary actors can be held liable in cases in which all the elements of Rule 10b-5 are satisfied.
Reliance proved to be the critical element of the 10b-5 cause of action in Stoneridge. Reliance ensures that the “requisite causal connection” between a defendant’s misrepresentation or omission, or deceptive or manipulative conduct, and the plaintiff’s injury is present. The Court held that, on the facts of this case, reliance could not be proven.
Plaintiffs in the case are shareholders of Charter Communications—one of the nation’s largest cable television providers. They allege that Charter engaged in a “pervasive and continuous fraudulent scheme intended to artificially boost the Company’s reported financial results” by, among other things, entering into sham transactions with two equipment vendors that improperly inflated Charter’s reported operating revenues and cash flow. In addition to various other parties, including Charter, plaintiffs sued Scientific-Atlanta and Motorola (collectively, “the Vendors”).
At the time in question, Charter delivered cable services through set-top boxes. Charter purchased the boxes from third-parties, including the Vendors. In August 2000, although Charter had firm contracts with the Vendors to purchase set-top boxes at a set price, Charter agreed to pay the Vendors an additional $20 per set-top box in exchange for the Vendors returning the additional payments to Charter in the form of advertising fees.
Plaintiffs alleged that these were sham or wash transactions with no economic substance, contrived to inflate Charter’s operating cash flow by some $17,000,000 in the fourth quarter of 2000.
Plaintiffs alleged that the Vendors entered into these sham transactions knowing that Charter intended to account for them improperly and that analysts would rely on the inflated revenues and operating cash flow in making stock recommendations.
The Court held that there need not “be a specific oral or written statement before there could be liability under Sec. 10(b) or Rule 10b-5." Instead, "[c]onduct itself can be deceptive" and provide the basis for liability. At least in theory, the Vendors conduct thus could constitute fraud in connection with a purchase or sale of a security.
Even so, however, the Court concluded that the plaintiffs could not satisfy the reliance element, The Vendors did not – and had no duty to – disclose their conduct to Charter's investors. Accordingly, plaintiffs could not prove that they relied “upon any of respondents’ actions except in an indirect chain that we find too remote for liability.”
Plaintiffs argued that they need not prove reliance, because reliance should be presumed under the fraud on the market theory. The Court rejected that argument because the Vendor’s conduct was “not communicated to the public.”
Jay Brown: Most thought Stoneridge would build on Central Bank, helping to determine the distinction between primary and secondary liability. The main issue was whether deceptive conduct rather than false disclosure could constitute primary liability. The decision ultimately found that deceptive conduct could constitute a violation of Rule 10b-5, a victory of sorts for shareholders. But following the lead of the Solicitor General, the Court went on to conclude that shareholders could not rely on fraud on the market but instead had to show actual reliance on the vendors’ behavior.
The Court’s reasoning had nothing to do with the language of the statute or with common law notions of fraud. In fact, the Court made clear that neither controlled. Instead, the decision arose because of the Court’s dislike for the implied right of action under Rule 10b-5. Unwilling to do away with the cause of action, the Court concluded that it would not extend the reach any further than was already the case. To the Court, allowing vendors to be sued was an extension. As a result, the use of reliance was merely an expediency designed to exonerate the vendors in this case (as evidenced by the refusal of the Court to remand on the issue of reliance).
The use of an expediency rather than thoughtful analysis based upon the language of the provision will ultimately be counterproductive. It does not, in fact, result in the exoneration of all vendors. For example, while the Court denied cert in the Enron case, it is back at the District Court (the case was on appeal from the district court’s decision to grant class certification) and the plaintiffs will try to show reliance on the statements of the investment bankers (apparently through reliance on analyst reports and recommendations). In other circumstances, issuers will make disclosure of vendor contracts (see Item 1.01 of Form 8-K, requiring companies to report any “material definitive agreement not made in the ordinary course of business”), presumably creating a strong basis for arguing reliance.
The case is sloppy, not controlled by legal principles, and likely to result in more rather than less litigation.
Robert Prentice: If we truly dislike courts that make law, we cannot be happy withStoneridge, which is an activist, policy-driven decision.
In Central Bank, the Supreme Court on its own motion addressed an issue that the parties had not raised. The Court held that because Congress did not mention “aiding and abetting” when it drafted Sec. 10(b), it did not intend for “secondary” parties to be liable in fraud. This was utterly wrong, because every body of fraud law in existence in 1934 (common law of fraud, blue sky law, mail fraud, etc.) provided that all who knowingly “participated” in another’s fraud were jointly and severally liable. That Congress did not mention aiding and abetting was irrelevant, for it naturally would have expected the universal rule to be applied.
Because Central Bank did not actually involve a defendant that participated in another’s fraud but, instead, involved a mere failure to warn where no duty was owed, it could have been limited to its facts. Instead, Stoneridge cemented the Central Bank error by apparently accepting the interpretation of most lower courts that parties involved in fraud cannot be held liable unless false statements are attributed to them when issued.
Because defendant vendors in Stoneridge did draft, backdate, and transmit false documents, they arguably satisfied even the most aggressively narrow definition of “primary” liability. Therefore, the Court had to completely revise the law of reliance as well.
Over the years, crooks have often used the “A helps B defraud C” style of fraud involved inStoneridge and in the Enron-Merrill Lynch Nigerian barge deal. The common law always held A liable, even if A stayed in the background and had no interaction with C. For example, in a 1928 case, A entrusted bonds to B knowing that B would show them to C to prove creditworthiness to obtain a loan that C would otherwise not have granted. In a 1927 case, A allowed its invoices and check vouchers to be used by B to convince C that B had large numbers of orders from A and was therefore creditworthy. In such cases, A was always held liable to C even though it had no contact with C. Stoneridge changes a couple hundred years of common law in telling fraudsters that if they stay in the shadows, they cannot be held liable.
The Court’s true policy-driven motives shine through clearly in the opinion. After holding in previous cases that policy considerations should be considered only to ensure that a particular statutory interpretation is not “bizarre,” the Stoneridge majority ignored that self-imposed limitation and reached its preferred result with completely one-sided policy analysis. There is certainly a case to be made that private litigation under Sec. 10(b) carries more disadvantages than benefits, but there is also substantial empirical evidence to the contrary. Given the Court’s concession that Congress has approved and ratified the private right to sue, that policy debate should have been left to Congress rather than resolved by the Court.
Ted Frank: Disclaimer: as an investor in the Charter IPO who lost money, I was a member of the putative plaintiff class in Stoneridge. The trial lawyers blamed Scientific-Atlanta and Motorola for billions of dollars of liability for their role in offering a rebate of a few million dollars that Charter executives chose to criminally misreport, so the Court’s opinion perhaps cost me the opportunity to benefit from an extortionate settlement.
Nevertheless, as an investor in many other stocks, and as someone who cares about judicial restraint, I am happy that the Court ruled against the plaintiffs.
Professor Prentice’s statement that Stoneridge is judicial “activism” turns that word upside-down. The majority opinion simply refused to create a cause of action that Congress explicitly rejected when crafting the Private Securities Litigation Reform Act. Any other result would have been judicial activism.
We can see this quite plainly in Justice Stevens’s dissent, where he justifies creating a cause of action that Congress rejected by claiming that it is within the judicial power to enforce the principle that “Every wrong shall have a remedy.” This is a noble sentiment, but utterly disingenuous on Stevens’s part. Stevens surely does not believe that “Every wrong shall have a remedy.” After all, he wrote the opinion in Kalina v. Fletcher, 522 U.S. 118 (1997), where he recognized an absolute immunity for prosecutors to create charging documents in their role as an advocate, even if it results in a wrongful deprivation of liberty. Accord Imbler v. Pachtman, 424 U.S. 409 (1976) (majority opinion joined by Stevens, J.). Justice Stevens has never rejected the doctrine of qualified immunity, whereby government officials are not subject to damages liability for performance of their discretionary functions when their conduct does not violate clearly established statutory or constitutional rights. E.g., Buckley v. Fitzsimmons, 509 U.S. 259 (1993) (Stevens, J.). So it is not the case that every wrong shall have a remedy. Some remedies have costs that exceed the benefits. Imagine if every exonerated criminal defendant could sue the prosecutor.
If some wrongs do not have civil remedies, the question then becomes who shall decide which wrongs will have civil remedies and which do not? This is a public-policy question of balancing costs and benefits. In a democracy, it is the legislature that typically makes, or at least delegates, these choices. Justice Stevens has announced that it is the role of an unelected judiciary to perform that legislative public-policy decision. And that aggrandizement, dear colleagues, is precisely what it means to be a judicial activist. Congress has decided that, because of the well-documented downsides of private civil enforcement, “aiding and abetting” liability should be a question of public enforcement. This case, where a $17 million transaction by a third party led to a lawsuit alleging $7 billion in consequential damages because of Charter’s wrongful acts, illustrates why Congress made the correct call. The Supreme Court doesn’t get to second-guess that decision.
Robert Prentice: Here are three true things: 1. The common law would have imposed liability on Charter’s vendors. 2. Section 10(b) was enacted to strengthen investor protections beyond what the common law provided. 3. Congress has adopted and ratified the private right to sue.
So, how did we get to a point where Stoneridge holds that shareholders have substantially less, not more, protection than at common law?
The only plausible argument that the Supreme Court raised inStoneridge is embraced by Frank. In passing the PSLRA, Congress failed to override Central Bank’s activist and erroneous decision regarding the private right to sue. However, the Court itself has said that legislative inaction is a “poor beacon to follow in discerning the proper statutory route,” for such “inaction frequently betokens unawareness, preoccupation, or paralysis.”
In 1995, many lower courts across the country had defined “primary” liability to include “substantial participation,” “direct participation ”and“ intricate involvement” in frauds. In other words, they were still holding that those who knowingly participated in a fraud were liable as joint tortfeasors, which had been the law from 1613 in Heydon’s case to 1994. A perfectly rational reason for Congress not to act was that it appeared the courts were going to minimize the adverse impact of Central Bank’s erroneous ruling by defining primary liability broadly and perhaps limiting Central Bank to its facts, which involved merely a failure to warn in a situation where no fiduciary duty was owed. Limited to its facts, Central Bankprovided no precedent at all for the Stoneridge holding.
Only because of Central Bank’s error did Congress have to address the issue at all. To me, it seems like a couple of N.F.L. referees’ on-field calls that were reviewed in the booth. The call regarding SEC action was reversed. The call regarding private suits was allowed to stand, but not confirmed. Given that Members of Congress in passing the PSLRA expressly noted that “[t]he success of the U.S. securities markets is largely the result of a high level of investor confidence in the integrity and efficiency of our markets” and that “[t]he SEC enforcement program and the availability of private rights of action together provide a means for defrauded investors to recover damages and a powerful deterrent against violations of the securities laws,” it seems dangerous to place too much emphasis on Congress’s decision not to expressly reverse Central Bank regarding private rights to sue.
I understand Frank’s $17 million vs. $7 billion argument, but fraudsters’ liability has always been measured by the damage they caused, not the profit they made. With a lie that costs nothing to tell, an actor in today’s economy can cause millions of dollars of damage. It should be up to the legislature, not the Supreme Court, to change that long-standing rule.
Stephen Bainbridge: There was a time, not so very long ago, when the Supreme Court quite explicitly took public policy concerns into account in deciding securities cases. Ironically, however, in Central Bank—Stoneridge’s direct antecedent, written by the very same Justice Anthony Kennedy who penned Stoneridge—the Court denied the propriety of doing so:
“Policy considerations cannot override our interpretation of the text and structure of the Act, except to the extent that they may help to show that adherence to the text and structure would lead to a result ‘so bizarre’ that Congress could not have intended it.”
We are dealing here with an implied private right of action. Public policy considerations weighed heavily in the creation of the implied private rights of action. In J. I. Case v. Borak, for example, in which the Supreme Court created the analogous implied private right of action under Section 14(a)’s proxy rules, the Court expressly relied on the need for private attorneys general, opining that “Private enforcement of the proxy rules provides a necessary supplement to Commission action.”
The Court has repeatedly quoted that passage favorably in cases arising under Rule 10b-5.
Public policy concerns also were repeatedly invoked as the Rule 10b-5 cause of action evolved. This should not be surprising.
In Stoneridge, we are dealing with a species of federal common law. As Justice Rehnquist famously quipped, Rule 10b-5 is “a judicial oak which has grown from little more than a legislative acorn.” Hence, as Judge Winter explained in Chestman, the text of Section 10(b) can be seen as “a general authorization to the SEC and to the courts to fashion rules founded largely on those tribunals’ judgments as to why insider trading is or is not fraudulent, deceptive, or manipulative.” The same holds true for the rest of Rule 10b-5 jurisprudence.
More important folk than I have been of the same opinion. As Law Professor Adam Pritchard has written, Justice Lewis Powell “considered the judge-made remedy under Rule 10b-5 to be a species of federal common law, and thus appropriate for judges to consider policy in defining its limits. Second, Powell understood, based on experience counseling corporate clients, the consequences that the phenomenon of class action lawsuits had for corporations and their officers and directors. Finally, Powell was profoundly suspicious of judicially created private causes of action not specifically authorized by Congress. From Powell’s perspective, the expansion of securities fraud lawsuits based on implied rights of action was creating a litigation crisis. That perception of crisis would influence the outcome in a number of cases that came to the Supreme Court.”
Indeed, as Pritchard further observes, Powell thought policy considerations “particularly relevant in ‘a private cause of action . . . wholly of judicial creation.’”
The proper question thus is not whether Stoneridge is an example of judicial legislation, but rather whether the SCOTUS improperly deployed the tools of common law adjudication so as to reach an erroneous result.
Jay Brown: It seems as if there is broad agreement that the majority in Stoneridgeengaged in a policy endeavor rather than a more traditional search for the legal meaning of a provision. Many have justified this by arguing that in the case of implied rights of action, the Court essentially has a right to restrict the scope of a provision, even if not justified by the language of the statute itself.
I want to challenge this proposition directly. The justification, as Steve Bainbridge notes, tends to arise from the belief that Section 10(b) and Rule 10b-5 are really matters of common law and can be changed or reinterpreted accordingly.
The problem with this approach is that it attempts to divorce the analysis from an actual statute that Congress adopted. The only portion of Section 10(b) that is truly common law is the implied right of action (and any elements of fraud applicable only to private parties).
The difficulty in treating this area as one of common law can be seen from the approach taken by Congress. While not contemplating a private right of action, Congress did contemplate that the Securities and Exchange Commission would have the authority to enforce the provision. By reading additional restrictions into the language of Section 10(b) and Rule 10b-5 in an effort to limit private parties, the Court likewise limits the enforcement scope of the Securities and Exchange Commission.
Some may argue that the SEC is not harmed because of the authority to bring cases for aiding and abetting. First, the authority tells us nothing about the meaning of Section 10(b) since it was only adopted in 1995. Second, and more importantly, aiding and abetting requires proof of actual intent, recklessness will not suffice. To the extent Stoneridge applies to the SEC (reliance is generally not an element the Commission needs to prove), it will be prevented from bringing cases against vendors that engage in reckless behavior. In other words, Stoneridge may well prevent the SEC from brining cases that Congress intended it should bring.
There was never much doubt (at least after oral argument) that the Court in Stoneridgewould dismiss the case against the vendors. We are merely discussing the particular method used in this case. The Court could have picked any number of ways that would have been more consistent with the language of Section 10(b). Instead, it chose to legislate based on no other guiding principle than it didn’t like the private right of action, proposing no guiding principles or limits. Moreover, it did so without apparent concern over the impact on the one agency assigned by Congress to enforce the provision. This, it seems to me, is a dangerous and unsettling approach to jurisprudence.
Andrea Seidt: While none of us seems too surprised by the result in Stoneridge, I was surprised by the majority's view of the "practical consequences" of "expanding" Section 10(b) liability to corporate defendants like Motorola and Scientific-Atlanta. On pages 12-13 of the opinion, the majority indicated that holding these types of vendor companies liable under Section 10(b) would expose a new class of defendants to extensive discovery and extortionate settlements. The practical consequence of this, the majority believes, would be an increased cost of doing business here in the United States that would potentially shift securities offerings away from our domestic markets. The majority cited briefs submitted by investor Amici Curiae to support this view, which I am guessing both Bainbridge and Frank each share. We should all seriously question this view. As we all know, there are already tools in place to prevent needless discovery and extortionate settlements for all defendants facing PSLRA actions. There is no discovery unless a plaintiff successfully passes a Rule 12(b)(6) motion to dismiss and there is no settlement until a federal district court rules on its fairness. If frivolous claims are indeed earning extortionate settlements, that is more reflective of a problem with our federal courts rather than a problem with the federal statute and regulations. Moreover, the real practical consequences of letting companies like Motorola and Scientific-Atlanta go if could have been shown that they falsified documents to defraud Charter Communication's auditors and investors are less transparency, less accountability in our capital markets. Like Prentice, I believe our capital markets are strong because they demand full disclosure and because our federal securities laws empower both the SEC and private litigants to police the markets for fraudulent schemes and abuses like those allegedly orchestrated by Charter Communications, Motorola, and Scientific-Atlanta. Insulating one class of culpable defendants (whether they be of the vendor or other non-duty variety) who engage in sham transactions with the singular goal of deceiving investors will weaken, not strengthen, our markets. If the goals of the federal securities laws are to provide compensation to defrauded investors, deter future fraudulent conduct, and promote efficient, transparent markets, I do not see how Stoneridge furthers any of those goals.
Robert Prentice: First, it is unfortunate that Stoneridge leaves unresolved the basic issue of whether there is such a thing as "scheme liability" under Section 10(b). I believe that there is....although it's viability as a cause of action for plaintiffs is clearly limited. But clear resolution of that issue awaits.
Second, a very important question going forward is whether the "attribution rule" is the law of the land. Can a plaintiff rely only upon statements (or actions) labeled as the defendant's at the time they were made (or taken)? Can the prime mover in a fraud truly avoid liability by the simple expedient of ensuring that statements are issued in others' names? I hope not, but again, this issue awaits clarification.
Finally, the Court has stated repeatedly in many context that interpretation of the meaning of a statute must start with its words. Here, the majority made absolutely no effort to reason from the language of Section 10(b), or to ground its decision in that language. The language of the statute outlawing use or employment of any "deceptive device or contrivance" clearly authorizes the SEC to outlaw employment of "any device, scheme or artifice to defraud." It is a shame that the Court was too busy listing NASDAQ's policy objections to private lawsuits to spend time on the language of the law.
Andrew Pincus: Policy-driven judicial activism? Far from it. Stoneridge rests firmly on precedent and long-established principles of statutory interpretation.
Rather like the child who murdered his parents and then sought mercy as an orphan, critics of Stoneridge attack the Court for failing to focus on the language of Section 10(b) and for allegedly ignoring the common law. Congress created several express private actions in the Securities Exchange Act, but did not include a cause of action for private parties in 10(b). Invocations of statutory text ring hollow when the cause of action itself was created by courts without any basis in the statutory text. The guidance found in 10(b)’s text is that the cause of action should never have been created in the first place; its language cannot help in determining who is entitled to sue, what plaintiffs must prove, how to calculate damages, etc.
The Court has not eliminated the cause of action. Instead, it seeks guidance in the express causes of action that Congress did create. Because none of them authorize aiding and abetting liability, the Court in Central Bank held that aiding and abetting claims are not cognizable under Section 10(b). And because scheme liability was invented solely for the purpose of circumventing Central Bank (it appeared after that decision as a basis for the very same claims that previously had been framed as aiding and abetting), the Court applied similar reasoning to reject that new form of liability.
One last point about statutory language – the language enacted in 1995, after Central Bank, which authorized only the SEC to bring aiding and abetting claims, even though the SEC and others argued that private parties too should be permitted to sue. The creation of scheme liability was an obvious attempt to circumvent that congressional determination, and therefore properly rejected by the Court on that ground as well.
The critics’ arguments based on common law follow the same pattern. Common law in 1934 required proof of reliance to recover damages for fraud. Advocates of broad 10(b) liability in 1988 convinced the Supreme Court to replace this long-established common law requirement with imputed reliance based on the fraud on the market theory. In arguing that the common law would recognize scheme liability, the critics entirely ignore this huge expansion in liability (which is what makes securities class actions possible). By imposing liability on third parties without requiring proof of reliance, the scheme theory would have created a species of liability that simply did not exist at common law.
Finally, a word about the decision’s practical effect. The SEC has full authority to bring enforcement actions against third parties such as the Stoneridge defendants and – using its “fair funds” authority – to use those actions to obtain funds for investors. Deterrence, punishment and compensation all are effected through these actions. What Stoneridge prevents is a vast expansion of liability in a class action system that increasingly is seen by academics across the ideological spectrum as disserving investors because it simply transfers funds from one set of investors (the owners of the company) to another (the class), with huge transaction costs in the form of fees to lawyers (both plaintiff and defense).
Jay Brown: So where does Stoneridge leave us? The inadequacy of the decision can be seen from the impact on the other cases addressing the same issue. Stoneridge was one of three cases raising the issue of liability for tertiary actors such vendors and investment banking firms. The Supreme Court's decision in Stoneridge put an end to any chance of liability for the vendors in that particular case. In the other two cases, however, the Supreme Court's decision resolved little.
In Simpson v. AOL/Time Warner, the Supreme Court granted certiorari, vacated the decision, and returned it to the 9th Circuit for reconsideration in light of Stoneridge. 2008 U.S. LEXIS 1170 (U.S., Jan. 22, 2008). The plaintiffs in the case will be able to do what the Supreme Court denied the plaintiffs in Stoneridge - the right to marshal facts to present evidence that would meet the reliance requirements.
In Regents v. Merrill Lynch, the case involving investment banking firms employed by Enron, the Court denied certiorari. 2008 U.S. LEXIS 1120 (U.S., Jan. 22, 2008). Ordinarily, that would have been the end of the case but for the odd procedural posture. The case was an appeal from the district court's decision on class certification, not from a dispositive motion. The cert denial, therefore, was not a final resolution of the matter. Jurisdiction remained and continues to remain in the district court.
When the petition for certiorari was denied, lead plaintiff filed a motion for a status conference which was held on Feb. 1. The trial judge issued an order setting out a briefing schedule with the plaintiff set to provide its views on the "effect" of Stoneridge on the pending motions for summary judgment. Based upon a currently pending motion, plaintiff will file this brief on March 28.
In other words, both cases are very much alive and both cases provide plaintiffs with some opportunity to present evidence of reliance. In the case of Regents v. Merrill Lynch, a glimpse of plaintiffs arguments can be seen from the supplemental brief filed before the Supreme Court after Stoneridge came down (but before certiorari was denied). In addition to arguing that investment banking firms are in a different position than vendors, the plaintiffs contended that the reliance element has been met. As the brief notes:
Having spoken through analyst reports, and indeed, having touted Enron's false results, which their transactions created while recommending purchase of Enron stock (clearly satisfying the "in connection with" requirement) unlike the defendants in Stoneridge, the banks in this case had a duty to disclose what each knew about those false results. This alone raises a presumption of reliance based on "an omission of material fact by one with a duty to disclose."
The majority in Stoneridge was determined to exonerate the vendor defendants and not "expand" the scope of the private right of action under Rule 10b-5. Because of this motive, the Court did not feel compelled to rely on any guiding legal principles, whether statutory interpretation or common law principles. As a result, the holding had its intended effect but in a way that leaves more questions than answers. It does not exonerate all vendors but only imposes one additional hurdle on plaintiffs, the need to meet the reliance requirement. It contains no explanation of what will meet the reliance requirement, leaving it to disparate courts to decide in a fact intensive way which vendors can be sued and which cannot.