It is a theory that will not die. Fifteen years have passed since the Supreme Court drove a stake through the heart of aiding and abetting securities fraud in Central Bank v. First Interstate Bank (1992). It came back like a zombie half-alive in the Private Securities Litigation Reform Act of 1995 as a concept that only the Securities and Exchange Commission could use (or love).
Now the question before the Supreme Court in Stoneridge Investment Partners v. Charter Communications, with oral argument today, is whether liability under the federal securities laws -- Rule 10b-5 -- extends to silent partners in a fraudulent scheme.
The case involves the alleged overstatement of earnings by Charter, a major cable TV company that filed for bankruptcy in 2003. Among other things, Charter allegedly overpaid for converter boxes it bought from Motorola and Scientific Atlanta (the secondary defendants), which in turn agreed to use the overpayments to buy advertising from Charter, thus artificially raising its reported revenues.
The plaintiff class in Stoneridge filed suit against Charter claiming this misstatement of revenues. It also sued the secondary defendants as alleged participants in the scheme. Simply stated, Charter could not have reported higher revenues from advertising if the box providers had not participated in the scheme. (It does not appear that the scheme affected reported earnings.)
The problem is that, in its 1992 decision in Central Bank, the Supreme Court held that Rule 10b-5 did not extend to claims of aiding and abetting. (The claim was that Central Bank, acting as indenture trustee, had neglected to verify the value of collateral -- a claim that would clearly be barred anyway under standard indenture terms.)
But the Court did allow that liability might nonetheless extend to participants in the primary fraud. The Court stated: "The absence of §10(b) aiding and abetting liability does not mean that secondary actors in the securities markets are always free from liability under the securities Acts. Any person or entity, including a lawyer, accountant, or bank, who employs 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. ... In any complex securities fraud, moreover, there are likely to be multiple violators; in this case, for example, respondents named four defendants as primary violators."
So the question is whether the actions of the secondary defendants in Stoneridge constitute participation or mere aiding and abetting.
The 8th U.S. Circuit Court of Appeals held that because the secondary defendants did not speak to the market, they cannot be held liable under Rule 10b-5.
That simply cannot be an accurate statement of the law. As the quoted passage from Central Bank makes clear, an absence of speech may give rise to liability. And there are many examples of securities fraud that do not involve speaking. A tippee who learns of inside information and knows that the information was disclosed by the tipper in violation of a fiduciary (or similar) duty is liable under Rule 10b-5.
To be sure, an absence of speech is actionable only if one has a duty to speak. In an insider trading case, the tippee inherits that duty from the tipper. In theory, there is no reason that the secondary defendants could not take on the duty that the primary defendants owe to the stockholders.
One does not need to hold the gun to participate in an armed robbery. Just ask O.J. Simpson.
As the Supreme Court has stated repeatedly, federal securities law is about disclosure. It does not give rise to substantive (fiduciary) duties. Unless federal law creates a duty to speak through, say, a reporting requirement, the duty to speak is one that comes from state law. As a result, federal law often depends here on state law.
It happens that the state courts (and federal courts applying state law) have often recognized claims based on a civil conspiracy involving a breach of fiduciary duty or aiding and abetting a breach of fiduciary duty. It is a fine point, but in Central Bank the Supreme Court held that as a matter of federal law there is no cause of action for aiding and abetting securities fraud. That does not mean that a violation of federal law cannot be based on an underlying state law duty not to assist a breach of fiduciary duty by another person. And, indeed, Rule 10b-5 expressly outlaws schemes to defraud. Clearly the long arm of the law reaches more than the trigger man.
On the other hand, as the 8th Circuit itself noted, it would be insane to extend Rule 10b-5 to a third party on the basis of an arm's-length transaction. That would mean that every deal, no matter how unrelated to trading in securities, could potentially become part of a Rule 10b-5 claim. How would we distinguish good-faith bargains from those that form part of a conspiracy?
SHARING THE LOOT?The answer is really quite easy. If the secondary defendants were motivated by the prospect of sharing the loot from the fraud, they may be held to have participated in the fraud.
So the question is: Who shared the loot in the alleged Stoneridge fraud? The answer is that there was no loot.
As in most federal securities fraud class actions, the plaintiff class consists of those who bought at the wrong time, when the stock price was supposedly inflated because of the fraud. In the absence of insider trading or other forms of misappropriation (such as the backdating of options), the gain from the so-called fraud went to those who happened to sell their stock during the fraud period.
If there was no insider gain, there should be no cause of action for fraud.
To be sure, this argument raises the fundamental question of why any action for fraud should exist at all, at least when the perpetrators themselves did not gain directly from the wrongdoing.
The obvious answer to this question is that the stockholders who bought during the fraud period at the wrongfully inflated prices lost money, whether or not insiders gained.
The problem with this answer is that it is the company that pays for successful fraud suits. That means that the stockholders pay. And they pay twice, in the sense that the value of their stock has already fallen as a direct result of the bad news that gave rise to the fraud. And then, when the company pays damages, its stock price falls still further.
In short, buyers are made whole at the expense of holders, and sellers keep their windfall gains. In the absence of insider misappropriation, a securities fraud class action is nothing but a rearrangement of wealth among investors, minus a hefty cut for the lawyers.
Most investors are well-diversified as a result of investing through mutual funds, pension plans, and other institutional vehicles. Indeed, more than three-quarters of all stock (by value) is held by such diversified investors, who effectively own hundreds of different stocks.
Accordingly, a diversified investor is equally likely to be a seller as to be a buyer of any given stock. So losses and gains balance out over time. Moreover, a diversified investor is even more likely to be a nontrading holder in most cases.
So for a diversified investor, securities fraud litigation is a deadweight loss. Only the lawyers win.
If diversified investors could get together to change the law, they would abolish private securities fraud class actions except in cases involving insider trading or other forms of insider misappropriation.
In other words, the only real loss from securities fraud for a diversified investor is the loss that comes from insiders who use the opportunity to extract stockholder wealth from the market. But in such a case, diversified investors can be made whole if the company recovers.
The bottom line is that investors would gain if securities fraud litigation were limited to derivative actions on behalf of the securities issuer, with any damages recovered from the culprits to be paid only to the company. Of course, the SEC would still be free to pursue enforcement actions.
The Stoneridge case offers a rare opportunity for the Supreme Court. By holding that scheme liability depends on sharing the gain from securities fraud -- and not from allegedly selling overpriced converter boxes in exchange for advertising -- the Court could take an important step toward making sense of securities litigation.
Richard A. Booth is the Martin G. McGuinn professor of business law at Villanova University School of Law.