May 2008

U.S. Supreme Court Rejects “Scheme Liability”

By Steven J. Mintz, LITIGATION NEWS Associate Editor

Long-awaited decision reaffirms reliance as essential for securities fraud claims

The U.S. Supreme Court has dealt a potentially fatal blow to class action plaintiffs’ attempts to use the securities laws as a means of holding secondary actors liability when such defendants do not themselves mislead investors but whose conduct facilitates fraud by the securities issuer. Stoneridge Investment Partners v. Scientific-Atlanta, Inc. Business defendants, law firms, accountants, and bankers portrayed the case as critical to blocking plaintiffs’ search for deep pockets when the company that issued the stock is insolvent.

In an action against Charter Communications, a cable operator, the plaintiffs alleged that Scientific-Atlanta and Motorola, which were suppliers and later customers of Charter, engaged in sham transactions that enabled Charter to materially misstate its financial statements, and thereby artificially inflate its stock price. In 1994, in Central Bank of Denver v. First Interstate Bank of Denver, the Supreme Court held the Securities Exchange Act does not permit an implied private right of action for secondary, aiding and abetting liability. To overcome this hurdle, the plaintiffs alleged that Scientific-Atlanta and Motorola directly participated in a scheme with Charter and therefore could be held liable as primary violators.

The Court, by a 5-3 vote, rejected the concept of scheme liability and reaffirmed that “[r]eliance by the plaintiff upon the defendant’s deceptive acts is an essential element of the § 10(b) private cause of action.” The Court held that, absent actual reliance, reliance may be presumed only “if there is an omission of a material fact by one with a duty to disclose,” or, “under the fraud-on-the-market doctrine, reliance is presumed when the statements at issue become public.” Neither presumption applied here because Scientific-Atlanta and Motorola had no duty to disclose their deceptive acts, which never became public. Therefore, plaintiffs “cannot show reliance upon any of [the defendants’] actions except in an indirect chain that we find too remote for liability.”

The most significant immediate impact of Stoneridge is on the investment banks sued in the Enron litigation, says John R. Bielema, Atlanta, Cochair of the Securities and Corporate Litigation Subcommittee of the Section of Litigation’s Commercial and Business Litigation Committee. Those secondary actors “got out of jail free” when the Court denied certiorari in the Enron case, presumably on the basis of the Stoneridge reasoning, he says.

Longer term, while Stoneridge “has to be considered a big win for corporate defendants, its precise impact is likely to be the subject of some debate,” says Susan L. Saltzstein, New York City, Cochair of the Section’s Securities Litigation Committee, which has published an article on the case in its Securities Litigation Journal. One question is whether Stoneridge benefits all secondary actors equally. “From the defense perspective, the holding should apply to all secondary actors. The distinction that some plaintiffs are trying to draw between the realm of ordinary business and the realm of financing is not a persuasive reading of the decision, which is based on the importance of reliance as an element of the cause of action,” Saltzstein says.

A second issue will be whether Stoneridge’s bar on secondary actor liability will apply to deceptive acts that go beyond seemingly legitimate business transactions or the “but for” causal relationship to fraud that the Court found insufficient. Section leaders specializing in professional liability see Stoneridge as “overall a positive decision for professionals, but it won’t deprive plaintiffs of talking points in future securities cases, depending on their particular facts,” says Amelia T. Rudolph, Atlanta, Cochair of the Accountants’ Liability Subcommittee of the Professional Liability Litigation Committee.

The decision “should curb litigation against lawyers back to the Central Bank levels,” says Carol C. Payne, Dallas, Cochair of the Professional Liability Litigation Committee, and it reinforces the idea that “lawyers cannot be the guarantors of good outcomes.” “The only thin reed of hope for plaintiffs is that third parties could be held liable for deceptive conduct on which investors relied; it doesn’t have to be a representation,” says Bielema.

Stoneridge also continues a trend, seen in Dura Pharmaceuticals, Inc. v. Broudo and other recent cases, of the Court limiting the scope of private securities actions. The Court “is attuned to the power of class actions to be brought as strike suits,” says Bielema. “One takeaway is that there are at least five justices on the Supreme Court who are ambivalent about the implied right of action under Section 10(b), and reluctant to expand it without explicit Congressional direction,” says Saltzstein.

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