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In Stoneridge Investment Partners LLC v. Scientific-Atlanta, Inc., No. 06-43, Slip Op. (Jan. 15, 2008) and Regents of the Univ. of Calif. v. Merrill Lynch, No. 06-1341 (Jan. 22, 2008) (“Enron Litigation”), the U.S. Supreme Court decided two cases that severely limit the “scheme liability” theory under which investment banks, auditors and other third parties had been charged with securities fraud as a result of their business-related dealings with public companies that had engaged in securities fraud. In Stoneridge, the court affirmed the 8th U.S. Circuit Court of Appeals’ decision rejecting scheme liability. Thereafter, in the Enron Litigation, the court denied certiorari and left in place the 5th Circuits’ even broader rejection of the scheme liability theory.

Plaintiffs developed the scheme liability theory as an end run around the Supreme Court’s 1994 decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, 511 U.S. 164 (1994), in which the court rejected aiding and abetting liability in private securities actions. At issue in Stoneridge and the Enron Litigation was whether secondary actors that had business dealings with a public company that had engaged in securities fraud could themselves be held liable for such involvement under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, where these secondary actors made no public statements themselves to the market but were merely alleged to have knowingly participated in business dealings that were intended to assist the public company in issuing misleading financial statements affecting its share price.

The Supreme Court’s rulings represent yet another victory for defendants in securities fraud actions and a defeat for plaintiffs and their counsel in such actions.

The Stoneridge Decision

In Stoneridge, plaintiffs claimed that Scientific Atlanta and Motorola helped Charter Communications meet its revenue targets through sham transactions whereby Charter overpaid these vendors for set-top cable boxes and the vendors agreed to return the overpayment by buying advertising from Charter. The vendors treated the two transactions as a wash sale, but Charter accounted for the transactions so that they favorably impacted its revenue and permitted the company to meet Wall Street’s expectations. Charter subsequently restated its revenue from the sham deals. Charter investors sued Charter and its accountant in a case that settled. The investors also sued the vendors, alleging that the vendors violated Section 10(b) by knowingly entering into these transactions in order to permit Charter to achieve a desired accounting outcome. The investors also alleged that the vendors falsified documents and backdated contracts in order to facilitate Charter’s desired outcome.

The district court granted the vendors’ motion to dismiss and the 8th Circuit affirmed, holding that “any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission . . . is at most guilty of aiding of abetting and cannot be held liable under section 10(b).”

The Supreme Court affirmed the 8th Circuit’s decision, but it disclaimed the 8th Circuit’s reasoning and rejected an opportunity to significantly narrow the scope of Section 10(b). The 8th Circuit held that Section 10(b) reaches only misstatements or omissions by one who has a duty to disclose, and not the kind of conduct involved in by the vendors in Stoneridge. Adopting a position argued by the solicitor general, Justice Anthony Kennedy wrote that if the 8th Circuit’s “conclusion were read to suggest there must be a specific oral or written statement before either could be liability under Section 10(b) or Rule 10b-5, it would be erroneous.” The court went on to note explicitly that “[c]onduct itself can be deceptive.”

Kennedy then squarely presented the reliance issue that the court would ultimately decide: “A different interpretation of the holding from the court of appeals opinion is that the court was stating only that any deceptive statement or act [defendants] made was not actionable because it did not have the requisite proximate relation to the investors’ harm. That conclusion is consistent with our own determination . . . that [defendants'] acts or statements were not relied upon by the investors. . . . “

The court noted that reliance can be established through a rebuttable presumption under two circumstances: first, where a material fact is omitted and there is a duty to disclose; and second, under the fraud-on-the-market doctrine delineated in the Supreme Court’s decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988). In Stoneridge, however, reliance could not be shown because the vendors had no duty to disclose their actions nor were their alleged deceptive acts communicated to the market. Finally, the plaintiffs’ theory of scheme liability could not save their claims. The plaintiffs argued the vendors were liable under Section 10(b) because Charter Communications could not have made the misstatements without the vendors’ active participation in the transactions. They argued an efficient market relies not only on financial and public statements relating to the issuer but also upon the transactions those statements reflect. The Court disagreed, stating “[w]ere this concept of reliance to be adopted, the implied cause of action would reach the whole market in which the issuing company does business; and there is no authority for this rule.”

The Court concluded, “[i]t was Charter, not [the vendors], that misled its auditor and filed fraudulent financial statements; nothing [the vendors] did made it necessary or inevitable for Charter to record the transactions as it did.”

Denial of Certiorari in the Enron Litigation

On Jan. 22, consistent with the result in Stoneridge and possibly extending its holding, the Supreme Court declined to review a 5th Circuit decision that had reversed a district court order certifying a class of Enron investors which had been based on the scheme liability theory and the fraud-on-the-market theory from Basic. In the Enron Litigation, the plaintiffs asserted federal securities fraud claims against certain investment banks that had engaged in allegedly deceptive partnerships and transactions with Enron that allowed Enron to misstate its financial condition by taking liabilities off the books or by inflating its revenues.

Similar to the 8th Circuit’s decision in Stoneridge, the 5th Circuit concluded in part that the conduct of the investment banks, who were alleged to have structured sham transactions knowing Enron would utilize them to falsify its financial statements, did not violate Section 10(b): “The district court’s conception of ‘deceptive act’ liability is inconsistent with the Supreme Court’s decision that Section 10b does not give rise to aiding and abetting liability.” Regents of the Univ. of Calif. v. Credit Suisse First Boston, 482 F.3d 372, 386 (5th Cir. 2007). The Supreme Court in Stoneridge had concluded the 8th Circuit had been discussing reliance, not deception, and concluded that the shareholders failed to establish that element despite their dependence on Basic and its fraud-on-the-market theory, because the vendors’ actions were unknown to the market. The 5th Circuit reached a similar conclusion on the issue of reliance in the Enron Litigation.

By denying certiorari in the Enron Litigation, the Supreme Court left intact a ruling on deception that is clearly broader than its own. More importantly, however, the court also left standing a ruling on reliance and Basic that is fully consistent with Stoneridge, and a victory for the investment banks. The Enron Litigation may extend the Stoneridge “reliance” limitations on shareholders’ lawsuits to alleged fraudulent transactions in the “investment sphere” as well as traditional contracts for goods and services.

Practical Implications

As a practical matter, the Stoneridge decision represents a significant victory for banks, accountants, lawyers and other third parties that have been increasingly targeted by the plaintiffs’ bar as potential deep pockets in securities fraud lawsuits.

The Enron Litigation, read with Stoneridge, suggests that what constitutes deception is still an open question. Actively participating in a scheme to defraud investors may in fact be sufficient under Stoneridge. A significant issue will be whether the participation of the secondary actor is disclosed to the market. If, for instance, the transactions of the third parties are discussed in the primary violator’s public filings or if the underlying contracts are attached to or discussed in their filings, plaintiffs may argue that the Stoneridge reliance requirements have been met.

We will expect the plaintiffs’ bar to be more creative in pleading to try to plead around Stoneridge‘s holding, such as trying to plead that, in contrast to Stoneridge, the acts or omissions of the secondary actors in their cases did make it “necessary or inevitable for the [primary violator] to record the transactions as it did.”

Although the courts and Congress have limited private actions for secondary liability, public companies and the financial community as a whole must still contend with the SEC and its ability to police the financial markets. The Stoneridge court repeatedly referenced the ability of the SEC to bring fraud-related claims based on aiding and abetting against secondary actors. Indeed, one year after Central Bank, Congress enacted the Private Securities Litigation Reform Act, which included express authority for the SEC to bring aiding and abetting actions.

JAY A. DUBOW is a partner resident in the Philadelphia office of Pepper Hamilton. He focuses his practice on complex business litigation, with a special emphasis on defending against securities class action litigation and representing clients involved in investigations by the U.S. Securities and Exchange Commission, the Pennsylvania Securities Commission and various self-regulatory organizations, including stock exchanges and the National Association of Securities Dealers. He also conducts internal investigations on behalf of clients.

THOMAS T. WATKINSON II is an associate in the Philadelphia office of Pepper Hamilton who concentrates his practice in commercial litigation, with a particular focus in federal securities fraud, contract, antitrust and complex commercial litigation.

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