I. Capital Markets

With "more than half of all U.S. households," previously assessed at $57 million, participating in equity markets through "investments either directly in securities or indirectly in mutual funds" the need to maintain investor confidence is paramount. [1] Ways of maintaining investor confidence include enforcing strict compliance with established auditing, disclosure, and financial reporting requirements. [2] Furthermore, allowing adequate remedies at law for violations of securities law promotes investor confidence in the capital markets. However, investors seeking private class action lawsuits against potential defendants such as lawyers, banks, and accountants alleged to have aided and abetted securities fraud face a substantial impediment.

In a recent 5-3 decision, the United States Supreme Court ruled in the case of Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. [3] Writing for the majority, Justice Anthony Kennedy was joined by Chief Justice John Roberts, Justice Samuel Alito, Justice Antonin Scalia, and Justice Clarence Thomas. While it is clear that the majority affirmed the judgment of the United States Court of Appeals for the Eighth Circuit, the future is unclear for investors wishing to bring class action suits under the theory of so-called "scheme liability."

II. Central Bank and the Impetus for Scheme Liability

In 1994, Justice Kennedy wrote for the majority in the case Central Bank of Denver v. First Interstate Bank of Denver. [4] In Central Bank, the Court faced the issue whether violations of section 10(b) of the Securities Exchange Act of 1934 extended to persons that "do not engage in the manipulative or deceptive practice, but who aid and abet the violation." [5] Central Bank was sued by First Interstate Bank of Denver for being secondarily liable, under the Securities Exchange Act of 1934, for Central Bank's alleged conduct in aiding and abetting fraud by the Colorado Spring Stetson Hills Public Building Authority (Authority).

The Central Bank case was the result of various bond issues from the Authority. In 1986 and 1988, Authority issued "a total of $26 million in bonds to finance public improvements at Stetson Hills" and "petitioner Central Bank of Denver served as indenture trustee for the bond issues." [6] Security for the bonds was maintained by "landowner assessment liens" and the bond covenants required that "the land subject to the liens be worth at least 160% of the bonds' outstanding principal and interest." [7] The developer of Stetson Hills, AmWest Development, was also required by the bond covenants to give an annual report containing evidence to Central Bank that the 160% test was met.

In 1988, AmWest supplied Central Bank with an appraisal of the land securing the 1986 bonds and of the land proposed to secure the 1988 bonds. Central Bank also received a letter "from the senior underwriter for the 1986 bonds," which, "noted that property values were declining in Colorado Springs and that Central Bank was operating on an appraisal over 16 months old." [8] In addition, concern was expressed in the underwriter's letter that the 160% requirement was not being met. Central Bank's in-house appraiser concluded the "values listed in the appraisal appeared optimistic considering the local real estate market" and he suggested Central Bank should "retain an outside appraiser to conduct an independent review of the 1988 appraisal." [9]

Central Bank, after communicating through letters with AmWest, decided to delay the suggested independent review of the appraisal until the end of the year. However, the Authority defaulted on the 1988 bonds before the independent review was complete. First Interstate Bank of Denver and Jack K. Naber were purchasers of $2.1 million of the bonds issued in 1988. As a result of the default, First Interstate Bank of Denver and Jack K. Naber sued various entities, including Central Bank. Following the initial lawsuit filed in the United States District Court for the District of Colorado, summary judgment was entered for Central Bank. The United States Court of Appeals for the Tenth Circuit reversed the District Court's decision, and found that a reasonable trier of fact might conclude that Central Bank, by delaying the independent review of the appraisal, provided substantial assistance to the alleged fraud. [10]

Section 10(b) of the Securities Exchange Act of 1934 expressly prohibits any person "to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe." [11] Furthermore, Rule10b-5, promulgated by the SEC under section 10(b) in 1942, provides it shall be unlawful for any person: "[a] To employ any device, scheme, or artifice to defraud," "[b] To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading," or "[c]To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." [12]

The Supreme Court in Central Bank noted "the language of Section 10(b) does not in terms mention aiding and abetting." [13] Furthermore, the Court added "If . . . Congress intended to impose aiding and abetting liability, we presume it would have used the words 'aid' and 'abet' in the statutory text." [14] As a result, the court held a private plaintiff may not maintain an aiding and abetting suit under section 10(b). Interestingly, the Court mentioned a way secondary actors such as lawyers, accountants, and banks, could be liable as primary violators of securities fraud. Lawyers, accountants, or banks who employ "a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5, assuming all of the requirements for primary liability under Rule 10b-5 are met." [15]

Because the majority in Central Bank did not provide a clear test for analyzing the distinction between "primary violation" and "aiding and abetting" various lower courts have "grappled with Central Bank's ambiguous language, often reaching disagreement about its implications for 10b-5 liability." [16] One response to Central Bank has been the prevalence of claims seeking to establish liability for secondary actors, not the issuer of the securities, by focusing the complaint on Rule 10b-5 sections (a) & (c). Sections (a) & (c) of Rule 10b-5 make it unlawful for any person "to employ any device, scheme, or artifice to defraud" or "to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person." [17] Scheme liability typically involves investors, through class action lawsuits, seeking to use Rule 10b-5(a) & (c) to attach primary liability to secondary actors.

III. Alleged Fraud

Investors brought a securities fraud class action suit against cable television service provider Charter Communications, Inc., in the United State District Court for the Eastern District of Missouri. Charter was named as defendants along with some of its executives, independent auditor, and vendors and customers. The District Court dismissed the claims against the vendors and customers. The investors appealed and The Court of Appeals for the Eighth Circuit affirmed the lower court's decision. The case eventually reached the court on grant of certiorari.

Stoneridge Investment Partners, LLC, is a limited liability company formed under the laws of Delaware, and was the lead plaintiff in the District Court. Stoneridge was the petitioner at the Supreme Court. Stoneridge Investment Partners was the petitioner when the case reached the United States Supreme Court. Furthermore, the Supreme Court was concerned with two defendants, referred as respondents throughout the opinion. Respondents are Scientific-Atlanta, Inc. and Motorola. Respondents were suppliers, and ultimately customers of Charter.

The United States Supreme Court accepted several facts, alleged by Stoneridge, to be true. Facts accepted as true include that Charter, a cable operator, engaged in a "variety of fraudulent practices so its quarterly reports would meet Wall Street expectations for cable subscriber growth and operating cash flow." [18] Furthermore, "the fraud included misclassification f its customer base; delayed reporting of terminated customers; improper capitalization costs that should have been shown as expenses; and manipulation of the company's billing cutoff dates to inflate reported revenues."  [19] It was also alleged that in late 2000, executives of Charter realized despite their fraudulent activities, the company would miss projected operating cash flow number by $15 to $20 million dollars. Respondents alleged Charter engaged in an elaborate scheme with Scientific-Atlanta and Motorola to alter its existing arrangements with respondents to help meet the shortfall.

Charter furnished its customers with digital cable converter (set top) boxes supplied by respondents. Petitioner alleged that Charter "arranged to overpay respondents $20 for each set top box it purchased until the end of the year, with the understanding that respondents would return the overpayment by purchasing advertising from Charter." [20] It is alleged the transactions had no economic substance and that Charter recorded the advertising purchases as revenue.

Respondents agreed to the arrangement and the companies drafted documents to make it appear the transactions were unrelated and conducted in the ordinary course of business. For example Scientific-Atlanta sent documents to Charter falsely stating that it had increased production costs. Scientific-Atlanta then raised the price for set top boxes for the rest of 2000 by $20 per box. Motorola executed a written contract in which Charter agreed to purchase from "Motorola a specific number of set top boxes and pay liquidated damages of $20 for each unit it did not take." [21] The contract was alleged to be a scam where Motorola expected Charter not to purchase all the units and pay Motorola the liquidated damages.

The alleged scheme also involved Scientific-Atlanta and Motorola signing contracts with Charter to purchase advertising time, for a price higher than fair value, as a way to return the additional money from the set top box sales. Subsequently, Charter recorded the advertising payments to inflate revenue and operating cash flow by approximately $17 million. The inflated revenue projection was shown on financial statements Charter filed with the Securities and Exchange Commission and was also reported to the public. Scientific-Atlanta and Motorola did not prepare or disseminate Charter's financial statements. Furthermore, respondents' financial statements showed the transactions as a wash, under generally accepted accounting principles. Allegedly, respondents either knew or recklessly disregarded Charter's clear intention to use the transactions to inflate its Charter's revenues. Petitioners also alleged respondents knew investors and research analysts would rely on the resulting financial statements issued by Charter.

IV. The Majority and Dissenting Opinion

The majority ultimately concluded an implied right of action did not reach Scientific-Atlanta and Motorola because investors never relied on respondents statements or representations. Justice Kennedy was correct to, note "the decision in Central Bank led to calls for Congress to create an express cause of action for aiding and abetting within the Securities Exchange Act." [22] However, in section 104 of the Private Securities Litigation Reform Act of 1995 (PSLRA) Congress directed all prosecutions of aiders and abettors to the SEC. [23]

Interestingly the Court frequently referenced the decision in Central Bank. Justice Stevens, writing a dissenting opinion, wrote the current case, "is critically different from Central Bank because the bank in that case did not engage in any deceptive act, and therefore, did not itself violate section 10(b)." [24] Central Bank's delay in conducting the independent view can be differentiated from the actions the respondents allegedly took. Central Bank acted passively when it did not account for a deception. However, the alleged role of the respondents in Stoneridge was more active. Without the substantial assistance provided by Scientific-Atlanta and Motorola the alleged scheme would not have been possible.

Granted, neither Scientific-Atlanta nor Motorola required Charter to reflect the inflated revenue on its financial statements. Justice Kennedy wrote that the respondents were, "acting in concert with Charter in the ordinary course as suppliers and . . . as customers." [25] However, the majority seemed satisfied that the deceptive acts occurred outside the investment sphere. The actions of respondents, according to the majority, existed in the "marketplace for goods and services." [26] As a result, Justice Kennedy believed, "the investors cannot be said to have relied upon any of respondents' deceptive acts in the decision to purchase or sell securities." [27]

In his dissent, Justice Stevens presented several ways to show that investors detrimentally relied on the conduct of respondents. The majority premised its finding, a lack of reliance, on the difficulty in establishing how investors relied on respondents deceptive acts in the marketplace for goods and services. Justice Stevens argued that reliance can be equated with "transaction causation." [28] Additionally, Justice Stevens defined transaction causation as "requiring an allegation that but for the deceptive act, the plaintiff would not have entered into the securities transaction." [29] Furthermore, Justice Stevens also mentioned that petitioner alleged, "respondents' acts had the foreseeable effect of causing petitioner to engage in the relevant securities transactions." [30] The dissenting opinion presented a myriad of plausible arguments to justify finding respondents liable for primary violations of securities law. In the end, Justice Stevens was not able to convince a majority of the justices to join his opinion.

V. Questionable Rationale

Was petitioner's claim denied purely because Congress did not expressly authorize private litigants to seek aiding and abetting liability under the Securities Exchange Act of 1934, or were there other influences on the majority's opinion? This question is difficult to answer. Granted, Justice Kennedy wrote the Court's conclusion "is consistent with the narrow dimensions we must give to a right of action Congress did not authorize when it first enacted the statute and did not expand when it revisited the law." [31] As a result, some might conclude the majority opinion was based solely on judicial restraint and an intense desire to avoid undermining Congress's decision that the SEC, and not private litigants, may pursue actions alleging aiding and abetting liability. If this conclusion is correct then the Court should be commended for its decision. However, Justice Kennedy's opinion alludes to other potential factors.

Justice Kennedy wrote, "Petitioner invokes the private cause of action under section 10(b) and seeks to apply it beyond the securities markets-the realm of financing business-to purchase and supply contracts-the realm of ordinary business operations." [32] Furthermore, he added if petitioner's concept of reliance was adopted, "the implied cause of action would reach the whole marketplace in which the issuing company does business; and there is no authority for this rule." [33] Apparently, Justice Kennedy was greatly concerned with scheme liability's potential impact on the economy in the aggregate, and not solely on the merits of the claim before the court.

Recent class action statistics appear to bolster Justice Kennedy's concern. Since 1997, the number of class action settlements worth more than $100 million has increased from 0% of all cases to 10% of all cases in 2006. [34] One Wall Street Journal writer, referring to scheme liability, wrote "The costs of these preventative measures would be a hidden tax on the American economy and would affect our global competitiveness." [35] It seems hyperbolic to assume that upholding scheme liability will lead to throngs of lawyers filing frivolous lawsuits, seeking to obtain settlements on weak claims. It is plausible that imposing scheme liability would lead companies to seek ways of preventing litigation that might arise from the fraudulent actions of its suppliers, customers, or clients. Furthermore, it can be argued that the additional burden placed on companies would lead them to pass the litigation costs on to the shareholders as the cost of capital rises.

VI. Conclusion

Balancing the costs and benefits of scheme liability can be problematic. Assessing a lawsuit based on the potential burdens on the entire economy presents an analysis that many might find unfair. If a class of investors has been genuinely harmed by their reliance on the actions of a company they owned stock in, as well as secondary actors, an adequate remedy at law should be available. After the obstacle placed in the path of shareholders after Central Bank, the best way to try attaching primary liability to secondary actors became lawsuits alleging violations of Rule 10b-5(a) & (c). With the ruling in Stoneridge the future of claims alleging scheme liability is uncertain. Some crafty lawyers might try to distinguish the facts of their client's lawsuits from the facts alleged in Stoneridge, but the outcome of such a claim is speculative at best. Justice Kennedy was able to clearly express the reasons he believed the petitioner did not rely on the responents' actions. However, the extent of scheme liability remains unsettled and uncertain. Does every citizen have a right to receive a trial on the merits of their claim, or should their claim be denied if the aggregate effect of potential litigation might be substantial? The answer to that question has not been resolved yet. While the majority opinion in Stoneridge represents a significant loss for proponents of scheme liability, the theory is not obsolete yet.

[1] U.S. Chamber of Commerce, Comm'n on the Regulation of U.S. Capital Markets in the 21st Century, Report and Recommendation (Mar. 2007).                                             

[2] Id. at 31.                                                                                                                               

[3] Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761 (2008).                            

[4] Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994).    

[5] Id. at 167.                                                                                                                         

[6] Id.                                                                                                                                        

[7] Id.                                                                                                                                              

[8] Id.                                                                                                                                             

[9] Id. at 168.                                                                                                          

[10] First Interstate Bank of Denver, N.A. v. Pring, 969 F.2d 891, 904 (10th Cir. 1992).                      

[11] 15 U.S.C. § 78j(b)(2006).                                                                                                               

[12] 17 C.F.R. § 240.10b-5 (1993).                                                                                             

[13] See Central Bankof Denver, 511 U.S. at 175.                                                                                                   

[14] Id. at 177.                                                                                                                     

[15] Id.                                                                                                                                       

[16] Mark S. Pincus, Circuit Split or a Matter of Semantics?, 76 FORDHAM L. REV. 423, 442 (2007).    

[17] 17 C.F.R. § 240.10b-5 (1993).                                                                                             

[18] See Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761 (2008).                                                                                                        

[19] Id.                                                                                                                                       

[20] Id.                                                                                                                                       

[21] Id. at 767.                                                                                                       

[22] Id. at 768.                                                                                                                     

[23] 109 Stat. 757; U.S.C. § 78t(e).                                                                               

[24] Stoneridge, 128 S. Ct. at 775.                                                                                                         

[25] Id. at 774.                                                                                                                           

[26] Id. at 744.                                                                                                       

[27] Id.                                                                                                                                  

[28] Id. at 776.                                                                                                                           

[29] Id.                                                                                                                                              

[30] Id. at 777                                                                                                                            

[31] Id. at 774.                                                                                                                           

[32] Id. at 770.                                                                                                                            

[33] Id.                                                                                                                                       

[34] U.S. Chamber of Commerce, supra note 1, at 30.                                                               

[35] Paul Atkins, Just Say 'No' To the Trial Lawyers, WALL ST. J., Oct. 9, 2007, at A17.