Securities Enforcement Alert
January 2008
Authors:
Dick Thornburgh
+1.202.778.9080
dick.thornburgh@klgates.com
www.klgates.com
U.S. Supreme Court Rejects “Scheme
Liability” Claims by Securities Class
Action Plaintiffs
Paul Gonson
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paul.gonson@klgates.com
Glenn R. Reichardt
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glenn.reichardt@klgates.com
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On Tuesday, January 15, 2008, in one of its most important securities law decisions
in recent years, the U.S. Supreme Court rejected efforts by plaintiffs’ class action
lawyers to expand dramatically the range of defendants they can sue under the federal
securities laws.
In Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (No. 06-43), the
Court, in a five-to-three decision, held that class action plaintiffs cannot bring federal
securities fraud claims against businesses that never made a false or misleading statement
to them or to the public, even if those businesses allegedly entered into transactions
of no economic substance that they knew would allow a public company to fool its
auditors into approving false and misleading financial statements that overstated the
public company’s earnings in an effort to meet Wall Street expectations. According
to Justice Kennedy, who wrote the majority opinion, such conduct (which allegedly
included bogus contracts and backdated documents) may give rise to potential criminal
penalties or to civil enforcement action by the SEC. But, the Court held, such conduct
cannot provide the basis for a private cause of action for damages under Section 10(b)
of the Securities Exchange Act of 1934 because Section 10(b) requires that a plaintiff
prove that: (1) it relied upon a material misstatement by the defendant it seeks to sue
when the plaintiff made a decision to buy or sell securities, or (2) the defendant failed
to disclose a material fact it had a duty to disclose—a duty that rarely applies to third
parties that deal with public companies.
According to the Court’s majority, which also included Chief Justice Roberts and
Justices Scalia, Thomas and Alito, deceptive conduct by a third party that facilitates
a fraud by a public company does not provide a basis for an investor suit unless
the third party’s deception was communicated to the public because, absent such a
communication, investors cannot show that they relied upon the third party’s statements
or representations when making their investment decisions, and without such reliance,
there is an insufficient causal connection between the defendant’s alleged deception
and the plaintiff’s alleged injury.
The Court’s decision in Stoneridge represents an affirmation and expansion of the
Court’s 1994 decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver,
N.A., in which the Court held that private securities law damages claims could not be
brought against defendants that merely “aided and abetted” the misrepresentations of
others. Ever since the Central Bank decision, plaintiffs’ lawyers have been trying to
overturn its result, first by lobbying Congress to create an express right to sue aiders
and abettors. In 1995, Congress rejected those lobbying efforts when it enacted the
Private Securities Litigation Reform Act of 1995, and authorized the SEC, but not
private parties, to bring “aiding and abetting” claims.
Securities Enforcement Alert
More recently, plaintiffs’ lawyers have tried to
avoid the reasoning of Central Bank by alleging
that third parties who dealt with public companies
had engaged in “schemes to defraud” that subjected
them to liability as primary violators of Section
10(b). Although many courts rejected this end-run
around Central Bank, a few courts—including the
U.S. Court of Appeals for the Ninth Circuit—had
held that third parties could be liable for securities
fraud if they engaged in a scheme whose purpose
and effect was to create a false appearance of
material fact. On the basis of such a “scheme
liability” theory, the district judge in the Enron case
denied motions to dismiss class action securities
fraud claims against many banks and vendors that
allegedly facilitated Enron’s fraud—precipitating
multi-billion dollar settlements by some Enron
defendants and contentious, high-stakes litigation
by others.
In Stoneridge, the Court’s majority, referring to
the district judge’s opinion in Enron, squarely
rejected such “scheme liability” claims, holding
that, like “aiding and abetting claims,” they cannot
survive absent proof that the plaintiffs relied upon
individual deceptive conduct on the part of each
defendant who allegedly engaged in the scheme.
According to the Court, deceptive acts by alleged
participants in the scheme that are not disclosed
to the investing public are “too remote” to satisfy
the requirement of reliance and, therefore, cannot
trigger Section 10(b) liability.
For example,
as applied to the facts in Stoneridge, the Court
reasoned that, even if Scientific-Atlanta, Inc.
and Motorola, Inc. (two equipment suppliers)
knowingly entered into suspicious transactions that
allowed Charter Communications, Inc. (a cable
operator) to book bogus profits, it was Charter that
misled its auditor and filed fraudulent financial
statements, and nothing that Scientific-Atlanta or
Motorola did “made it necessary or inevitable for
Charter to record the transactions as it did” so as to
mislead investors.
In writing the majority opinion in Stoneridge, Justice
Kennedy (who also wrote the majority opinion in
Central Bank) expressed concern that the plaintiffs’
bar was seeking to expand private securities claims
“beyond the securities markets” and into “the realm
of ordinary business operations” that are generally
governed by state law.
In addition, the Court’s majority clearly was
troubled about the practical implications of “scheme
liability” claims, which, the Court suggested, could
expose a new class of defendants to litigation costs
and risks that “allow plaintiffs with weak claims
to extort settlements from innocent companies.”
Indeed, because of such fears, the Solicitor General
(on behalf of the Government of the United States)
and dozens of other amicus curiae—including
the National Association of Manufacturers, the
New York Stock Exchange, the U.S. Chamber of
Commerce, the Business Roundtable, international
business organizations, the AICPA, insurance
companies, prominent transactional lawyers and
law professors, and former SEC chairmen and
commissioners—filed briefs with the Supreme
Court in Stoneridge, urging the Court to reject the
plaintiffs’ efforts to expand the scope of Section
10(b) liability. Had the Court’s decision gone the
other way, a wide range of individuals and firms that
deal with public companies as suppliers, customers,
contractors, bankers, attorneys, consultants and
accountants might have faced much greater risks
of becoming embroiled in expensive and uncertain
securities class action litigation. In the majority
opinion, Justice Kennedy specifically referenced
the possibility that these litigation risks could
deter overseas firms from doing business with U.S.
companies and might encourage publicly traded
companies to shift their securities offerings away
from U.S. capital markets.
The Court’s majority left little doubt that its view
of implied rights of action is considerably more
“careful” than may have been true decades ago
when the implied right of action under Section
10(b) was first recognized. According to Justice
Kennedy’s opinion, the Congress, and not the
courts, should determine whether there should be
any expansion of the right to bring private securities
fraud claims under Section 10(b), particularly given
that Congress has, in recent years, enacted various
legislative measures to stiffen the requirements
for securities class action claims and specifically
rejected efforts to create an express right to sue
aiders and abettors.
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Securities Enforcement Alert
Justice Kennedy cautioned that the Court’s decision
in Stoneridge does not immunize deceptive conduct
that might be subject to criminal penalties or to
civil enforcement action by the SEC. The Court’s
majority limited the reach of its decision to an
interpretation of Section 10(b) of the Securities
Exchange Act, acknowledging that some conduct
that might not give rise to a Section 10(b) claim
might instead give rise to actions under state
law. The Stoneridge decision also does not affect
express private rights of action that can be brought
against accountants and underwriters under federal
securities laws other than Section 10(b).
The Supreme Court’s decision in Stoneridge
is likely to have several immediate and longterm consequences. In the short run, the Court’s
reasoning probably will put an end to the remaining
Enron-related claims against investment banks and
others who were accused of engaging in a scheme
to defraud Enron investors. The Supreme Court
should rule shortly on the petition for certiorari
challenging the Fifth Circuit’s dismissal of such
claims, which has been pending before the Supreme
Court for many months while briefing and argument
in Stoneridge proceeded. Similarly, the Supreme
Court’s reasoning should encourage the dismissal
of many other “scheme to defraud” claims that
are now pending against securities defendants
throughout the federal court system.
In the years ahead, the Stoneridge decision should
discourage, if not end, further efforts by plaintiffs’
lawyers to expand the range of securities fraud
actions they can bring under Section 10(b) of the
Securities Exchange Act against third parties.
More likely, the plaintiffs will turn their attention
to Congress, in the hope that a future Congress may
be more inclined to expand express rights of action
under the securities laws. This may be a faint hope,
however, because the general difficulty of enacting
such legislation will be compounded by the recent
criminal indictments and guilty pleas of several of
the nation’s most prominent securities class action
plaintiffs’ lawyers.
More generally, the Court’s decision in Stoneridge
reinforces a message that the Roberts Court has
been communicating in several of its most recent
business decisions, which is that the federal courts
should generally be wary of private class action
claims that often may coerce settlements whether
or not the claims have merit—particularly when
Government enforcement mechanisms exist to
protect the public interest and punish wrongdoers.
_____________________
Dick Thornburgh, a former Attorney General of the United States,
and Paul Gonson, a former Solicitor of the Securities and Exchange
Commission, are counsel in our Washington, D.C. office. Glenn
Reichardt, a partner in our Washington, D.C. office, is a member of
our securities enforcement and class action practice groups. They
filed an amicus brief before the Supreme Court in the Stoneridge
case on behalf of Merrill Lynch & Co., Inc.
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