Stoneridge Securities Fraud Opinion from the Supreme Court

Elizabeth Nowicki —  15 January 2008

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.”  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.”  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.”  In the margin of the opinion next to that language, I wrote “huh?”  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.

9 responses to Stoneridge Securities Fraud Opinion from the Supreme Court


    Professor NOWICKI (my apologies).


    No, duty would be an necessary element of a 10(b) cause of action under these circumstances. SA and Motorola could not be liable for an affirmative misrepresentation (since they made none). But if SA/Motorola had a duty of disclosure and did not do so, then they would be liable for a failure to disclose. So duty is absolutely relevant.

    The most interesting thing about Stoneridge to my mind is that the avowed textualists on the Court (Justices Scalia, Thomas, Alito, et al.) took an explicitly non-textual tack in this case. Setting aside the policy stuff for/against extending civil liability to SA/Motorola in situations like Stoneridge, the plain text of Rule 10b-5(a) and (c ) arguably support the idea of “scheme liability.” After all, it’s not hard to get from the words “any person” who “directly or indirectly” employs “any … scheme” to the idea of “scheme liability.” (Justice Stevens’s dissent alludes to this jurisprudential nuance, but not as vigorously as it perhaps could have done.) The textualists on the Court thus ignored (if indeed they didn’t outright set aside) the plain meaning of the statute [notice how Kennedy’s opinion contains absolutely no statutory analysis; he just quotes the statute, and then moves on to caselaw] in favor of their interpretation that Congress didn’t want the result necessitated by scheme liability, given that Congress twice considered and rejected (in 1995 and 2002) the idea of extending private civil liability to secondary actors in situations like this. (The oral argument shows this even more conclusively.)

    Nonetheless, it was the right decision.


    “Both Scientific-Atlanta and Motorola knew, it is alleged, why Charter wanted to enter into these wash transactions with them.”

    I don’t know enough about the nuances and precedents of 10(b) to know whether or not there was a better legal basis for this decision. Larry Ribstein suggests there was. Jay Brown suggests there wasn’t. Elizabeth here suggests there might have been, but maybe not. What strikes me, as someone who straddles the world of economics and law, is (a) how poorly people outside of the legal world understand the downstream impact of a decision based, as this one appears to be in part, on policy considerations, and (b) how poorly most people outside of business really get the downstream impact of the policies being debated around decisions like this one.

    From a legal perspective, I have to share Elizabeth’s extreme skepticism (even revulsion) about a Supreme Court judge basing their decision on economic policy concerns, even those with which I am very sympathetic. While most businessmen cheer this decision, a few years down the road another judge is going to provide some public policy reason why a good law should be shut down. It’s very hard for non-lawyers to see how the stripping of a rich man’s property in Hawaii a couple decades back led directly to a middle-class woman in Connecticut losing her home to private developers. No-one knows what will come from this muddled attempt to insert economic policy considerations into a judgment of law, except that some court down the road will feel emboldened to do the same thing with god-knows-what effect, which corrodes the rule of law.

    On the other hand, and not to justify this breach, I know how bad it really is out here in the real world where lawyers have to crawl into ever finer nooks and crannies of every transaction because of the increasing scrutiny, most of it well-intentioned, to prevent fraud. For every case where bad behavior can be clearly and plausibly “alleged,” as in Stoneridge, there is an almost infinite set of border-line or innocent behaviors that could also be “alleged” which will collectively cost shareholders far more than the losses of the one or two percent who might be truly victimized by what was alleged in something like scheme liability. From the perspective of a governance practitioner working diligently for the investors, the call for “shareholder rights” often obscures the fact that nearly all shareholders would, at the margin, much rather have higher risk-adjusted returns than more rights. The policies designed to prevent the bad two percent from screwing their shareholders affect 100 percent of the companies. Most people outside of the business world have no idea how real and how significant that cost is.

    And still, Elizabeth is right. It’s no excuse for a judge to use anything other than the law and precedent to make their decisions.

    Franklin Townsend 16 January 2008 at 12:52 pm

    With all respect to Professor Nowicki, her reading of Stoneridge and the elements of a securities claim is off the mark. First, the plaintiffs did not assert reliance on the contracts in question but, as the Court noted, on the financial statements which aggregate the financial impact of all such contracts. The Court declined to reach behind the financial statements to presume reliance on all documents comprising such underlying transactions. In the scenario posited by the Professor, which was not present in Stoneridge, the investors inspects the books and records of Charter (thus obviating the need for a theory of presumed reliance) and sees the phony contracts and relies, presumably not merely on the contracts but on how Charter reflected the financial impact of those contracts in its financial statements (an independent step that, as the Court noted, was not necessarily predetermined by the terms of the contracts themselves). Could such even such an “eyeball” review provide the necessary element of reliance? That would merit a lot more thought than the off the cuff reaction here since it would place a lot of stress on the “in connection with” concept (albeit primarily a jurisdictional element) and the notion of proximate cause.

    The question of duty is relevant because one could view the role of the secondary defendants as involving an omission to disclose their misconduct. In such an instance, reliance cannot be established but liability will not follow unless there was a duty to disclose. None was present here, leaving only the reliance concept to supply the necessary causal link.

    Much of the rest of the opinion is intended to explain why the majority believed that the scheme theory, if adopted, would be harmful. Such a discussion may be unavoidable when the Court is faced with the question of whether or not to supply an expansive reading to a cause of action that, in reality, Congress did not originally intend to create, whatever the merits of doing so now would be.

    I have to also disagree with the Professor’s assessment of what the impact of a contrary ruling would be. Scheme liability was a notion that was controversial at best, rejected by a number of circuits. The lower courts had not yet adopted it in large numbers. Had it been approved in Stoneridge, I can assure you that every case would have included new peripheral defendants to add to the inevitable settlement, especially if there was any doubt to the financial stability of the primary defendants. This could well have discourage companies from doing business here.


    The case was certainly anti these investors–the ones who lost. To say it is anti-investor generally (which is what the press keeps saying, with no basis at all for even knowing what the relevant trade-off is, let alone which way it cuts; and which you say in para 7) is dramatically overblown. I don’t doubt that the Court’s reasoning has flaws, but I also don’t doubt that a holding that helps to stem the tide of frivolous securities litigation is good for investors. Of course the media believe that the only things that protects investors from lying, thieving businesspeople are the SEC and the plaintiffs’ bar, and these come at no cost. But that’s facially absurd, of course, and I think it almost certain that investors will be helped by this restraint on the bar (and, one hopes, the SEC).

    Michael Guttentag 15 January 2008 at 4:22 pm

    Professor NOWICKI (my apologies).

    Michael Guttentag 15 January 2008 at 4:21 pm

    I’m with Professor Nowitzki in being rather unimpressed by the quality of the thinking in the majority opinion. The parade of horribles that Kennedy lists if the Court had decided this case the other way is laughable. The basis for liability here is an active and direct participation in a fraudulent scheme, and need not reach nearly as broadly as the Court implies. The case may be rightly decided (it’s a close call case), but the reasoning is grandiose and motivated by a dislike of a private actions generally, not the issues of case at hand.


    Along with Elizabeth, I was troubled that customers and suppliers would potentially be liable for the securities law violations of their public company business partners. While this case substantially reduces this risk in the context of private litigation, it’s worth noting the SEC enforcement division has been bringing very similar aiding and abetting cases against customers and suppliers of public companies for the last several years (there is no private right of action for an aiding and abetting claim, but the SEC can bring enforcement actions using the aiding and abetting theory). See, e.g., the Fleming, K Mart and AIG cases. See also “Liability of Vendors, Customers and Lenders under the Federal Securities Laws,” Insights (March 2005). These cases, in essence, attempt to force companies to police the accounting practices of their public company customers and suppliers.

    There is language in the Stoneridge opinion that the SEC should consider before bringing any more of these cases. “Were the implied cause of action to be extended to the practices described here, however, there would be a risk that the federal power would be used to invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees.” This would seem to apply as much to SEC enforcement actions as private litigation. Perhaps the enforcement division should reconsider its activist approach in these cases.

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