In a much anticipated decision that restricts the reach of securities fraud liability under Section 10(b) of the Securities Exchange Act of 1934, the Supreme Court ruled on Tuesday that secondary actors—such an issuer's suppliers, customers, auditors or underwriters—can be liable only if investors specifically relied on their statements or representations.

In Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., a shareholder of Charter Communications, Inc., claimed that Charter, a cable company, misled investors about its financial performance by engaging in a fraudulent scheme with the suppliers of digital cable boxes. Scientific-Atlanta and Motorola allegedly agreed to let Charter overpay $20 for each box they supplied with the understanding that they would return the overpayment by purchasing advertising from Charter at above-market rates. According to the plaintiff, this allowed Charter to record the advertising buys as revenue while capitalizing the box purchases in violation of GAAP. To mislead Charter’s auditor, Scientific-Atlanta allegedly sent Charter false documents stating that it was raising the price of its boxes $20 due to increased production costs, while Motorola revised its contract with Charter to require Charter to pay a $20 per-box penalty if it did not purchase a number of boxes it knew it would not purchase. The supplier agreements assertedly were backdated so that it would appear they were negotiated a month before the above-market-rate advertising agreements. As a result of the scheme, Charter allegedly inflated its revenue and operating income on its financial statements by $17 million.

Although the plaintiff did not allege that the vendors had any role in drafting Charter's financial statements, it claimed that they nevertheless violated Section 10(b) because they knew or recklessly disregarded that Charter intended to use the sham transactions to misstate its financial results. The United States District Court for the Eastern District of Missouri granted the vendors' motions to dismiss, and the United States Court of Appeals for the Eighth Circuit affirmed, based on the Supreme Court's prior holding in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), that Section 10(b) liability does not apply to aiders and abettors of securities fraud, but only to primary violators. Allowing aiding and abetting liability, the Court held in Central Bank, would ignore the longstanding requirement that Section 10(b) plaintiffs prove that that they relied to their detriment on a material misrepresentation or omission by the defendant in connection with the purchase or sale of a security. Although in this case the vendors allegedly engaged in deceptive conduct, the acts were not communicated to the public and thus investors could not have relied on them.

The Charter shareholder nevertheless argued that the vendors should be liable for securities fraud because they intended to further a scheme to misrepresent Charter's financial results and, had they not done so, Charter's auditor and investors would not have been fooled. In its 5-3 majority opinion, the Supreme Court rejected this theory of scheme liability because adopting such an attenuated concept of reliance would expose "the whole marketplace in which the issuing company does business" to securities fraud liability. The Court reasoned that it was Charter—not the vendors—that misled its investors, and nothing the vendors did made it inevitable that Charter would do so. Thus, the Court refused to extend the sphere of securities fraud to the realm of ordinary fraudulent business operations that can be addressed by state law fraud claims.

The Court recognized the business friendly impact of its holding—which follows on the heels of two 2007 decisions that curtailed shareholder claims against companies—noting that the opposite decision could have raised the cost of doing business in the United States and driven the securities markets overseas. Nevertheless, secondary actors still may be liable for securities fraud if they directly mislead investors, and they remain subject to criminal or civil actions by the SEC even for aiding and abetting securities fraud. In addition, the Securities Act of 1933 provides an explicit private right of action against accountants and underwriters, among others, for false statements contained in a registration statement issued under the 1933 Act.

Please click here to read the Court's opinion.

If you wish to speak to someone at Ballard Spahr regarding the implications of Stoneridge or the Supreme Court's other recent decisions limiting shareholder suits, or have any other business litigation or securities law question, please contact William A. Slaughter at 215.864.8114 or Stephen J. Kastenberg at 215.864.8122 with respect to business litigation, or Justin P. Klein at 215.864.8606 with respect to securities law.

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