The Supreme Court’s opinion in Stoneridge Investment Partners v. Scientific-Atlanta was issued today. This case involved investors in Charter Communications’ common stock who sued under Section 10(b) of the Securities Exchange Act of 1934. The investors sued Charter’s SUPPLIERS AND CUSTOMERS, including Scientific-Atlanta and Motorola, who had entered into essentially “wash†contracts with Charter for purposes of allowing Charter to inflate its earnings and mislead investors. The contracts involving Scientific-Atlanta and Motorola obligated Charter to buy set top boxes from Scientific-Atlanta and Motorola, and, in return, both parties would buy advertising from Charter. The effect of these agreements was technically a wash for Charter, but Charter was using these agreements – specifically the advertising agreements – to inflate its revenues and bolster its financial statements. Both Scientific-Atlanta and Motorola knew, it is alleged, why Charter wanted to enter into these wash transactions with them.
The trial court, with the 8th Circuit affirming, dismissed this lawsuit in favor of the defendants. The Supreme Court today affirmed, finding that the complaining Charter investors failed to adequately plead the “reliance†element of a Section 10(b) claim. (In order to sue in a private action under Section 10(b), a complaining party (other than the SEC) must establish that the defendant (a) made a material misstatement or omission, (b) in connection with the purchase or sale of securities, (c) with the intent to deceive, manipulate or defraud, (d) and the investor relied on this misstatement or omission, and (e)  the investor suffered losses from the misstatement or omission.)
Unfortunately, today is a double teaching day for me (M&A and Business Enterprises II), so I cannot spend a whole lot of time blogging on this case. But I have several points to make quickly:
1. Some of the media blurbs I have seen today warn that the Supreme Court’s holding in Stoneridge bodes ill for private securities fraud suits against secondary actors (such as lawyers, bankers, auditors, underwriters). That is NOT true. The media folks writing those inflammatory headlines either (a) have not read the Stoneridge opinion, (b) are not familiar with the Stoneridge facts, or (c) are only discussing the case with the corporate defense bar who, I am sure, will likely try to sell the Stoneridge holding as ringing the death knell for any securities fraud cases against anyone other than an issuer. As a fan of the broad interpretation of Section 10(b), allow me to say that the facts of this case (the facts pertaining to the involvement of Scientific-Atlanta and Motorola in Charter’s securities fraud) troubled even me. This case – Stoneridge – involved suppliers and customers of an issuer. Those parties are even further removed from investors and the actual securities market than traditional “secondary actors†such as an issuer’s lawyers, auditors, etc. Even with my propensity to broadly interpret and apply the elements of a 10(b) cause of action, I might have had a hard time holding S-A and Motorola liable thereunder. So the Supreme Court opinion in Stoneridge, if anything, should stand for the notion that, the further down the fraud actor chain we go, the harder it is to pull in defendants.
2. In a related vein, I am stunned that the Supreme Court treated this case as a “reliance†case. Basically the Court said that the investors could not have relied on Scientific-Atlanta and Motorola b/c those parties had no “duty†to make disclosure to the investors. Huh? As I understand the reliance argument that could be made by the investors in this case, it is that the investors relied on the fact that the contracts with Scientific-Atlanta and Motorola were legitimate, business-justified, economically defensible contracts. Which wasn’t true –they were wash contracts, designed to be wash contracts. If an investor walked into court and could prove that she bought stock in Charter because she saw on Charter’s books the contracts with S-A and Motorola, and she relied on the economic value of those contracts (that they were positive contracts benefiting Charter), why *couldn’t* the investor establish reliance as it pertains to S-A and Motorola? The fact that S-A and Motorola had no “duty†to the Charter investors is irrelevant. “Duty†is not an element to a Section 10(b) violation. Reliance is, and if an investor could prove that she “relied†on the true economic value of those contracts (to wit, that they weren’t sham “wash†contracts), why couldn’t she prove reliance?
3. To that end, this opinion re-affirms that the Supreme Court is often totally confused when it tries to discuss securities fraud. First Dura, now Stoneridge. With due respect to the Justices who signed on to the majority opinion in this case, the law isn’t particularly challenging in this area– either a plaintiff establishes the five/six elements necessary to prove securities fraud or she does not. Were I writing the Stoneridge opinion, and I wanted, for policy reasons, to affirm dismissal of the suit, I would have done it on the “in connection with†element. One could argue with a straight face that S-A’s and Motorola’s “lies†(to wit, the fraudulent wash contracts) were not lies told “in connection with the purchase or sale of securities.â€Â Reliance, not so much.
4. Justice Kennedy, in his majority opinion, made clear that he really *wanted* to cut off investors at the knees in terms of their ability to sue “secondary actors.â€Â His opinion gave us a stream of dicta regarding aiding and abetting and federalism and the problem with expansive interpretations of 10(b). At the end of the day, he didn’t *need* to give us that monologue in order to decide the case, but he clearly wanted us to know that he’s not a big fan of broadly interpreting Section 10(b). Duly noted.
5. To that end, Kennedy includes some ramblings about common law fraud in his majority opinion, but he gets the story wrong. (See point “3,†above.) Section 10(b) was adopted on the heels of the stock market collapse in the 1920’s, and Section 10(b) was therefore specifically designed to address fraud in the securities markets that the common law was insufficient to reach. Common law fraud doctrine was viewed as not broad enough – that’s why we needed an expansive federal scheme. So, if anything, as we look at the elements of a 10(b) claim, we need to interpret these elements more BROADLY than they have been interpreted at common law. With due respect to Justice Kennedy, when he says “Section 10(b) does not incorporate common-law fraud into federal law,†he should have been using that as his launching point to justify interpreting “reliance†in the 10(b) context more broadly than reliance in the plain vanilla common law context. Instead, he used that as his launching point to have a discussion about the need to limit who we can reach under a Section 10(b) private action. (How could Kennedy’s law clerk have missed this point about common law fraud and the history of 10(b)’s adoption?)
6. The majority opinion makes clear that the SEC can go after S-A and Motorola for aiding and abetting securities fraud. I have no idea if the SEC has already undertaken to so do. If they have not, I would urge the SEC to get on that task now. The last thing the investing public needs is an invitation like that from the Supreme Court to be ignored.
7. One more thing: Justice Kennedy writes in his opinion that, if the Court is too broad with its interpretation of Section 10(b), “[o]verseas firms with no other exposure to our securities laws could be deterred from doing business here.â€Â In the margin of the opinion next to that language, I wrote “huh?â€Â For the love of all things good and holy, why would Kennedy include that kind of needless hyperbolic dicta in an opinion that is already anti-investor? I will bet you $12 that that line becomes one of the most-quoted Stoneridge lines within the next two years. The reality is that overseas firms aren’t going to be deterred from doing business here, because they KNOW that the sort of facts we see in Stoneridge usually don’t make it to court due to problems with the “in connection with†element of Section 10(b). Kennedy’s “overseas firms†comment strikes me as a bizarre attempt to get on the “capital is going overseas†band wagon some anti-regulation wonks have recently been driving around blindly. The “capital is going overseas†cry, even if we assume its truth, is not a reason to stop enforcing Section 10(b). Reading Justice Kennedy’s nod to the overseas market hysteria made me feel so… cheap and dirty. Trendy doomsday rhetoric from the Supreme Court is, in my mind, equivalent to the Justices ending an opinion with “woot†or something.
