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January 22, 2008
Supreme Court Rules on Naming Secondary Actors in Fraud Cases
    by Anne Moore Odell

In a ruling last week, the Supreme Court laid out what businesses can be held liable under current securities fraud laws.


In a five-to-three decision on Stoneridge Investment Partners v. Scientific-Atlanta and Motorola (No. 06-43), the Supreme Court justices voted against investors and for business through a strict interpretation of current anti-fraud laws. The majority ruled that secondary actors that made it possible for a business to commit fraud are not liable under current laws unless the secondary actors actually gave investors false information.

Stoneridge Investments was a shareholder in Charter Communications, a cable television company. Stoneridge sued Charter's executives for inflating its earnings in 2000. Executives at Charter artificially inflated the Cable Company's earnings when they found themselves $15 million short of projected cash flows. Scientific-Atlanta and Motorola, suppliers of cable boxes to Charter, increased the price of their cable boxes to Charter $20 over their regular sale price. The cable box suppliers then used the money gained from this increased price, around $17 million, to turn around and buy advertising on Charter's television stations. This artificially created cash flow for the cable television company.

Charter as a company was never accused of wrong doing, After investors settled their suit against Charter executives out of court, investors then also sued Scientific-Atlanta and Motorola as secondary actors, under Section 10(b) of the Securities Exchange Act of 1934.

The court's verdict hinged on if investors in Charter relied on information from the suppliers, as "reliance" is necessary for liability under the 1934 Act. Although the plaintiffs said that the vendors never made public statements about Charter, their actions did exaggerate Charter's worth and stock prices.

The chain of events from cable box sales to Charter's investors was "too remote for liability," the five majority justices found. The five voting in favor of the suppliers were Justices Alito, Kennedy, Roberts, Scalia, and Thomas.

Although the majority did agree that these secondary actors might be liable for aiding in Charter's fraud, they found that investors couldn't sue these secondary actors under Section 10(b). The Securities and Exchange Commission (SEC) can, however, punish secondary parties who help commit frauds under a 1994 Supreme Court decision in the Central Bank v. First Interstate Bank case, which upheld investors can only ask state or federal prosecutors, or the SEC for enforcing action of those aiding and abetting with fraud.

Interestingly, the SEC found itself on the side of investors and opposing the Bush administration, which supported the businesses.

The majority also wrote that if liability for securities increased, the US economy as a whole could suffer with overseas businesses shying away from US companies.

"The determination of who can seek a remedy has significant consequences for the reach of federal power," wrote Justice Kennedy for the majority. "The decision to extend the cause of action is for Congress, not for us."

Justices Stevens, Souter, and Ginsburg founded the dissention, and stated that the suppliers did in fact violate Section 10(b) and could be sued.

Stevens wrote in the dissent, "the court is simply wrong when it states that Congress did not impliedly authorize this private cause of action when it first enacted the statute."

Justice Breyer, who owns Cisco stock, recused himself. Cisco bought Scientific-Atlanta in 2005.

The US District Court for the Eastern District of Missouri and the 8th Circuit Court of Appeals had dismissed the suit against Scientific-Atlanta and Motorola in 2006.

Some are seeing the ruling as an impediment for shareholders holding accountable all those involved with securities fraud. The ruling, too, raises questions to how the court will come down in the Enron fraud case.

"Although the Supreme Court today ruled against the plaintiffs in the Stoneridge case, its opinion rejected the rationale relied on by the 5th Circuit in its Enron decision," said Trey Davis, University of California's Director of Special Projects. "In the coming days, we will be analyzing the Stoneridge decision to determine its impact on the Enron case."

Others in the business community are hailing the ruling a victory, protecting businesses from unnecessary litigations.

"In this common-sense and balanced ruling, the court said that investors may only sue those who issued statements or otherwise took direct action that the investors had relied upon in buying or selling stock,'' said Richard I. Miller, American Institute of Certified Public Accountants (AICPA) General Counsel.

Given the Supreme Court's ruling on this case, shareholders interested in strengthening anti-fraud laws need to shift their attention to pressuring Congress to rewrite current laws.

"Allowing those who conspire to defraud is antithetical to the whole concept of 'social responsibility,'" said James McRitchie, Publisher of Corporate Governance. "Shareholders will be bringing attention to both primary and secondary actors involved in the subprime debacle during the 2008 proxy season. As the country digs itself out of a recession, election of a Democratic president is likely to lead to restoring liability for aiding and abetting in 2009," McRitchie continued.

 

 
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