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.
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
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
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
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
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.