Davis Polk & Wardwell Newsflash

U.S. Supreme Court Issues Decision in Stoneridge Investment Partners LLC v. Scientific-Atlanta

January 15, 2008

On January 15, 2008, the U.S. Supreme Court issued its decision in Stoneridge Investment Partners LLC v. Scientific-Atlanta [“Stoneridge”], No. 06-43, resolving whether there can be private civil liability under section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), 15 U.S.C. § 78j(b), for actors who do not make misstatements or omissions or engage in manipulative securities transactions, but instead are alleged to have participated in a “scheme” to defraud in which another actor has made misleading statements to investors.  In a 5-3 decision (with Justice Breyer recusing himself), the Supreme Court answered this question in the negative, holding that there is no private civil liability for a secondary actor who did not speak to the market, and whose allegedly deceptive conduct is not disclosed to the market, because the reliance element of a section 10(b) claim cannot be satisfied. 

In Stoneridge, Charter Communications (“Charter”), a cable company, allegedly entered into fraudulent transactions with two suppliers of set-top boxes, Scientific-Atlanta and Motorola, to inflate Charter’s reported revenues in 2000.  According to the complaint, Scientific-Atlanta and Motorola essentially agreed to overcharge Charter for set-top boxes, on the understanding that they would then buy an equivalent amount of advertising from Charter at inflated rates.  It was alleged that as part of this arrangement, the defendants made misrepresentations to Charter’s auditor and backdated documents to hide the relationship between the inflated hardware sales and the inflated advertising purchases.  It was further alleged that the defendants knew or recklessly disregarded that Charter intended to use the transactions to inflate revenues and knew that the resulting financials would be relied upon by analysts and investors.  The defendants, however, were not alleged to have made any false statements to the market themselves, and the public was not aware that Scientific-Atlanta or Motorola played any role in these transactions.  The Eighth Circuit affirmed dismissal of the complaint against Scientific-Atlanta and Motorola, holding that defendants’ conduct was not deceptive in the absence of any misstatement or omission (where there is a duty to disclose) by them.  In re Charter Commc’ns, Inc. Sec. Litig., 443 F.3d 987, 992 (8th Cir. 2006).  The Eighth Circuit relied on Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. [“Central Bank”], 511 U.S. 164 (1994), in which the Supreme Court held that section 10(b) did not authorize private damages suits for aiding and abetting a violation by another.

The Supreme Court granted certiorari in Stoneridge to resolve a circuit split between the Eighth and Fifth Circuits, which held that scheme liability does not exist under section 10(b), see Regents of the University of California v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372, 390, 392 (5th Cir. 2007), and the Ninth Circuit, which held that claims for scheme liability are actionable if the principal purpose and effect of a business transaction is to mislead, Simpson v. AOL Time Warner, Inc., 452 F.3d 1040, 1050 (9th Cir. 2006).

In the majority opinion, Justice Kennedy (joined by Chief Justice Roberts, and Justices Scalia, Thomas and Alito), affirmed, but on different reasoning from the Eighth Circuit.  The Court held that non-verbal conduct could be deceptive for purposes of section 10(b), but that on the facts alleged, plaintiffs had not established the reliance element necessary to sustain a section 10(b) claim.  In doing so, the majority adopted the principal argument advanced by the United States as amicus curiae.  The majority explained that because Scientific-Atlanta and Motorola made no statements to the public relating to their transactions with Charter, and the public was not aware of their role in the transactions, plaintiffs could not allege reliance directly and neither of the presumptions of reliance under prior Supreme Court precedent (omissions where a duty to speak exists and fraud on the market) was available.  The majority rejected the argument that the market had relied on the underlying transactions themselves, even though Charter had reported the revenue from those transactions in its financial statements.  The majority held that such a causal chain was “too remote” because “[i]t was Charter, not respondents, that misled its auditor and filed fraudulent financial statements; nothing respondents did made it necessary or inevitable for Charter to record the transactions as it did.”  (Id. at 10.) 

The majority referenced several policy considerations in support of its decision.  First, it observed that recognizing scheme liability would unnecessarily extend the implied private right of action under section 10(b) beyond the securities markets to cover run-of-the-mill business relationships, an area historically governed by state law.  (Id. at 11.)  Additionally, the majority concluded that Congress’s decision when enacting the Private Securities Litigation Reform Act (“PSLRA”) in the wake of Central Bank to authorize aiding and abetting claims by the Securities and Exchange Commission reflected Congress’s determination not to permit such claims in private damages litigation.  (Id. at 11-12.)  Permitting private scheme liability claims to proceed—which the Court viewed essentially as a form of aiding and abetting—would thus frustrate congressional intent.  Finally, the majority believed that exposing contracting parties to securities law liability for non-financing related transactions would potentially raise the costs of doing business generally and might deter overseas firms from dealing with U.S. issuers.  (Id. at 13.)

In dissent, Justice Stevens (joined by Justices Souter and Ginsburg) argued that the majority decision misinterpreted Central Bank and adopted too stringent a standard for pleading reliance.  (Separate op. of Stevens, J., dissenting, at 2-6.) 

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Stoneridge should end the attempt by the plaintiffs’ bar to circumvent Central Bank’s flat prohibition against section 10(b) private damages claims for aiding and abetting an issuer’s misrepresentation or omission by recharacterizing them as claims for participation in a scheme to defraud.  Plaintiffs will need to show that the market was aware of and relied upon defendant’s deceptive conduct or statements.  Fraud on the market, standing alone, will not be enough to satisfy the reliance requirement in such situations.  Stoneridge effectively insulates trade customers and suppliers, and probably others, who do not have any direct involvement in the preparation or issuance of financial statements or other disclosures to investors, from exposure to securities litigation for misstatements by the issuer.  That said, Stoneridge leaves open the possibility that secondary actors could be liable where they have engaged in deceptive conduct relating to transactions with an issuer and the issuer has disclosed those transactions to the market.

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