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Stoneridge v Scientific Atlanta:

An early case on the Supreme Court's calendar this fall is Stoneridge v. Scientific Atlanta.

Extensive background is provided in Peter Lattman's extensive coverage on the Wall Street Journal Law Blog--a collection of his posting can be found here.

Larry Ribstein and Stephen Bainbridge have co-authored an amicus brief (with several others) and have blogged on the case. Having read some commentary on the case, Larry and Steve's arguments seem persuasive. Ribstein writes:

As a purely legal matter, I must add that the issue is not a no-brainer. The basic problem is that the implied right of action is almost completely open-ended, and facts can be manipulated endlessly in a complaint. Lerach's Enron complaint was 500 pages long. In my article with Kobayashi, Class Action Lawyers as Lawmakers, we compared such complaints to Theodore Dreiser's reconstruction of a crime in his novel, An American Tragedy.

All the more reason why we need clear rules here. My theory is that the Court took cert on the Stoneridge case to provide that clarity, and that it will add the Enron case to the appeal to increase that clarity. By doing this the Court can make sure that secondary civil liability under 10b-5 is really dead, and stays dead, rather than wandering in scheme liability form like some terrifying zombie.

Boyden Gray also had an editorial in the Financial Times a few weeks ago that picks up on some of the policy issues associated with this, especially in the context of international law. The article is subscriber's only, but I found it reprinted here.

Update:

I should add that Mayer Brown LLP, with whom Eugene is affiliated part-time, is representing the respondents in the case.

Related Posts (on one page):

  1. Stoneridge v. Scientific Atlanta Preview:
  2. Stoneridge v Scientific Atlanta:
Harry Niska (mail):
While I certainly understand the policy concerns about runaway plaintiffs' lawyers, I think a lot of the pro-defendant writing on this case is misleading. For example, in the Ribstein post you quote, he says: "At issue is whether, by doing business with a firm that turns out to be violating the securities laws, you can be liable as a participant in a "scheme" to defraud." I believe the WSJ editorial page (to which I am generally sympathetic) has framed the issue similarly.

Ribstein badly misstates the issue. The defendants here are not being sued just because they did business with Charter. They are being sued because they allegedly knew (or should have known) that the deal they were doing with Charter was for the purpose of defrauding Charter's shareholders. Looking at the issue framed that way, it becomes less clear that what we need is a "clear rule" that it is okay to do what the defendants are alleged to have done.
9.14.2007 5:05pm
Tony Tutins (mail):
After finally finding the facts, I have to ask at what point should the equipment vendors have known that their cable tv operator customers were using their supplier rebates to defraud their shareholders? Is it normal to count supplier rebates as income? After she sent in proofs of purchase for three bras, my wife got a coupon for a free bra. Do we need to declare the value of that free bra as income? Or is it simply a discounted sale price for all four?

When I was in the consumer electronics industry, co-op advertising was common, and completely legitimate. Retailers would send us clips of ads that featured our products, and we would send them rebates of part of the cost of the ads. So our customers got back some of the price they paid for the product in exchange for advertising it. Here, the makers of digital cable set-top boxes paid rebates to their customers in exchange for their customers' advertising the digital boxes to their analog customers. Sounds like win-win to me.

I could see how improperly booking income part of which was rebated to customers could defraud Scientific Atlanta's shareholders. But I don't understand how it could defraud the cable company's shareholders. Supplier rebates would have to show up as "other income," not their ordinary income from subscriber fees.

I agree with those who would limit third-party liability for stockholder fraud. Twenty years ago, Miniscribe defrauded their investors by shipping bricks instead of disk drives. Under the plaintiff's theory here, the defrauded investors should have been able to recover from the brick suppliers -- they should have known the disk drive makers wanted bricks for an improper purpose.
9.14.2007 5:41pm
Houston Lawyer:
We need to kill off the private right of action under 10b-5 altogether. What we have now is that some shareholders of a corporation, who are blameless, must have the value of their stock diminished to pay money to other former shareholders who happened to sell at the right time. All the while culpable management uses company money to pay off their misdeeds.

No one appears to benefit from this other than the strike lawyers.
9.14.2007 6:01pm
frankcross (mail):
There is strong cross-country empirical evidence that the private right of action is enormously valuable. Countries with private rights of action have much larger and more efficient stock markets than those without. Fraud is lessened.

Maybe the actual cases filed are often frivolous, but the deterrent effect is great as is the effect on investor confidence.
9.14.2007 6:24pm
Shertaugh:
Here's a classic example of the courts legislating from the bench.

First, Section 10(b) was read to allow an implied right of action about 50 or so years ago, maybe more. Then, starting in the '70s, the courts started to scale back the use of Sec. 10(b) as a vehicle for private recoveries.

Depending on which party controls SCOTUS, you get a different vision as to what 10(b) means.

Where's Congress been in all this?

The most serious question for this group of nine should be whether Sec. 10(b) has been misread all these years? Instead of the constant re-legislating by the Court.
9.14.2007 7:22pm
New Pseudonym (mail):

Ribstein badly misstates the issue. The defendants here are not being sued just because they did business with Charter. They are being sued because they allegedly knew (or should have known) that the deal they were doing with Charter was for the purpose of defrauding Charter's shareholders.


Ah, I see now. It makes all the difference in the world, doesn't it?
9.14.2007 7:47pm
Christopher Cooke (mail):
I am very familiar with scheme liability and the arguments pro and con. In fact, I tried a "scheme" claim when I was at the SEC (but lost on the scheme, but not the false statements claims).

The arguments about scheme liability are very similar to the points made over a decade ago when the Supreme Court decided the Central Bank case, and eliminated aiding and abetting liability in private securities cases.

The problem in a nutshell is that the 10b-5 right of action, originally, was judicially created. And, a good argument can be made that the intial decision was wrong because the Exchange Act granted express remedies for false statements in SEC filings (see, Section 18).

But, the 10b-5 private right of action has been expressly recognized by Congress since 1934, specifically during the various times when Congress has sought to reform the private action, e.g. the Private Securities Litigation Reform Act to limit shareholder suits, as one example.

So, HoustonLawyer's argument is not valid anymore, at least as a matter of statutory construction.

My own view is the distinction between primary and secondary liability that Central Bank made of crucial importance should be very important in deciding this issue. "Scheme" liability is often really just a form of conspiracy liability which, logically, should not exist if aiding and abetting liability does not exist. One can argue that Central Bank was wrong, and, if so, scheme liability probably should exist. But, I just don't see the Supreme Court (not this one, anyways) repudiating Central Bank, so I think it likely the Court will find no private right of action for scheme liability that is functionally no different than a conspiracy to commit fraud.

The problem is that there are other "schemes" or "artifices to defraud" and devices and contrivances that "operate as a fraud or deceit" that are carried out directly by people who are more than aiders and abettors or conspirators. Putting aside the market manipulation context (the Supreme Court has said that market manipulation is different than the typical false statements case), I can see the Supreme Court attempting to carve out some residual claims for these "schemes" that are not simply labels attempting to hide the imposition of secondary liability by another name.

This whole area of the law is difficult because scheme is an amorphous term. As Justice Stewart said (about obscenity), "I know it when I see it" but it is hard otherwise to define.
9.14.2007 8:41pm
Montie (mail):

After she sent in proofs of purchase for three bras, my wife got a coupon for a free bra. Do we need to declare the value of that free bra as income? Or is it simply a discounted sale price for all four?


Hmmm...did your wife consult an attorney and an accountant before sending those proofs of purchase? Did she know whether the company was properly accounting for the promotion?
9.15.2007 2:31am
Jiffy:
"Scheme liability" is shorthand for the question whether defendants can be be liable under section 10(b) of the 1934 Act for engaging in deceptive conduct (other than conduct involving market manipulation such as wash sales), or whether 10(b) imposes liability only for misrepresentations. The 8th Circuit in Stoneridge, and the 5th Circuit in Enron, held that 10(b) prohibits only misstatements of fact. Ribstein is right that "as a purely legal matter" the issue is a "no-brainer," but not the way he means. Section 10(b) provides:


It shall be unlawful for any person, directly or indirectly . . . to use or employ . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.


I'm not sure how any good textualist can read that language and conclude that it requires the making of a false statement. Rather, it appears much more geared to prohibiting deceptive conduct ("directly or indirectly," "use or employ," "deceptive device or contrivance") than deceptive statements, which are not specifically mentioned.

Then there's the part about "in contravention of such rules and regulations as the Commission may prescribe." Rule 10b-5 prohibits employing "any device, scheme, or artifice to defraud" and engaging "in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person." How can those provisions be read as prohibiting only deceptive statements?

Then there's the problem that the 1995 PSLRA also refers to unlawful "conduct."

Even the Solicitor General's Office couldn't bring itself to agree with defendants on the scheme liability issue--it argued that the 8th and 5th Circuits were wrong about scheme liability, but changed the subject to argue that Stoneridge should be affirmed anyway because the plaintiffs failed to adequately allege reliance--an issue that wasn't part of the cert. grant.

Central Bank holds only--and it's express on this point--that defendants who do not engage in deceptive conduct that violates 10(b) (or Rule 10b-5) cannot be held liable under an aiding and abetting theory. It doesn't create a free pass for a defendant who engaged in fraudulent conduct merely because he keept silent.
9.15.2007 2:45am
Cornellian (mail):
The problem in a nutshell is that the 10b-5 right of action, originally, was judicially created.

But, the 10b-5 private right of action has been expressly recognized by Congress since 1934, specifically during the various times when Congress has sought to reform the private action, e.g. the Private Securities Litigation Reform Act to limit shareholder suits, as one example.


I think your post has a typo, in that you didn't mean to say that Congress expressly recognized a private action under 10b-5 in 1934. That wasn't until many years later.
9.15.2007 5:16am
Cornellian (mail):
Here's a classic example of the courts legislating from the bench.

Where's Congress been in all this?


Congress has repeatedly endorsed a private right of action under 10b-5, despite its origins in "legislating from the bench." I guess this is a classic example of the world being more complex than acknowledged in the usual slogans and talking points.
9.15.2007 5:27am
Christopher Cooke (mail):
Cornellian, you are right, I had a typo (or rather, a poorly expressed thought).

I meant only that, Congress at some point after the Exchange Act was passed in 1934 has expressly endorsed the private right of action under 10b-5. Certainly, when the Reform Act was passed in 1995 it did so (original sponsor: Christopher Cox, now SEC Chairman).

I agree with Jiffy's post, largely. Here is the interesting aspect of this area of the law: Section 10(b)'s language, when combined with the recognition of a private right of action under SEC Rule 10b-5, appears to grant authority to the SEC to define what violates the statute, and thus what may form the basis for a claim by a private litigant. No one really knows what to make of this situation. The Supreme Court, in Central Bank, alluded to this situation but assumed that the SEC can't define the private remedy, only Congress can. But that doesn't answer the question because the statutory language grants the SEC broad authority to define what is the illegal conduct that Section 10(b) prohibits.

So, if the SEC concludes that a "scheme" is deceptive conduct that Section 10(b) was intended to make illegal, and re-writes 10b-5 to define what is "scheme-like" behavior, that would appear to overrule the Supreme Court, etc. which the SEC apparently doesn't think it should do.

Here is the other problem, which Jiffy alluded to, with reliance on Section 10(b)'s express language to conclude that scheme participants who do not speak or themselves make false statements are not covered by Section 10(b). The statute prohibits direct and indirect activities, not simply direct activities--"It shall be unlawful for any person, directly or indirectly . . ."
9.15.2007 1:14pm
Harry Niska (mail):
New Pseudonym, yes, there is a significant difference between (a) selling set-top boxes to someone normally, and (b) structuring the sale in a way that you know will lead to a misstatement of their financial statements. The Scientific-Atlanta is being sued for allegedly doing (b), not (a).
9.15.2007 6:22pm
Tony Tutins (mail):
there is a significant difference between (a) selling set-top boxes to someone normally, and (b) structuring the sale in a way that you know will lead to a misstatement of their financial statements. The Scientific-Atlanta is being sued for allegedly doing (b), not (a).

And how should they have known this? What was the tipoff that a rebate policy would lead to a misstatement of their customer's financial statement? Moreover, S-A's primary fiduciary duty was to its own shareholders, to sell product to make profits. Essentially Charter was making a short-term zero interest loan to S-A -- should S-A have demurred, saying, "No, no. Keep it for yourself," or pass the interest savings on to its stockholders?
9.15.2007 7:33pm
David M. Nieporent (www):
Harry, the problem is that it's not the "structure" of the deal that's actionable; it's the way Charter accounted for it. The defendants had no knowledge of what Charter was going to do with its financial statements. They had no way to control what Charter would do with its financial statements. They had no relationship with any shareholders of Charter. They made no statements or representations to shareholders of Charter.
9.15.2007 8:54pm
Jiffy:

The defendants had no knowledge of what Charter was going to do with its financial statements. They had no way to control what Charter would do with its financial statements.



I'm not sure where you come up with these factual assertions. The liability test urged by the SEC includes a requirement that the deceptive conduct have been engaged in for the express purpose of misleading investors.


They had no relationship with any shareholders of Charter. They made no statements or representations to shareholders of Charter.


It's not a derivative case, so the issue isn't "relationship with shareholders of Charter" or even "representation to shareholders of Charter." The issue in a securities fraud suit has to do with misleading investors with respect to their decision whether to purchase Charter stock. Charter had no "relationship" with those investors at the time of its misrepresentations either. The legal duty not to mislead does not arise from any special relationship with potential investors but from the statutory obligation not to engage in deception.
9.16.2007 2:54am
Harry Niska (mail):
I unfortunately do not have time to go into much of the factual detail, but the plaintiff did allege facts about why S-A should have known that the deal was structured as it was for the purpose of misstating Charter's financial statements. Basically, Charter asked S-A to change the prices of the set-top boxes after the fact, and then refunded them the same amount of money as a rebate. I vaguely recall that the SG's brief does a good job of laying out these factual allegations.

Like I said, I am not sure what the outcome of this case is, but it is a lot more complicated than just saying that the plaintiffs are trying to hold the defendants liable for simply doing business with Charter. Of course a business should not be held liable simply for selling set-top boxes to Charter. Instead, the plaintiffs are saying the defendants should be liable because they engaged in wash transactions with Charter that they knew or should have known would be used to mislead shareholders. As a policy matter, the question of whether that type of liability should be allowed seems like a closer call to me.

Basically, most of the arguments here in favor of S-A boil down to "They didn't know that this deal was being fraudulently used by Charter." That's just a factual claim, though, that the plaintiffs would likely disagree with, and they would argue that they have evidence it isn't true. And as you learn in first year Civ Pro, factual issues shouldn't be decided on a 12(b)(6) motion.
9.17.2007 2:50pm
Tony Tutins (mail):
arguments here in favor of S-A boil down to They didn't know that this deal was being fraudulently used by Charter.

Not quite. Plaintiffs argue that S-A should have known. How should they have known? Why should they have known? Harry is arguing that every business transaction should be presumed to defraud investors until proven otherwise. Business would come to a standstill. Instead of 10b-5, this would be part of UCC Section 2.

And the issue of S-A's liability can be decided on a 12b6 motion: failure to state a cause of action. A buyer-seller relationship between A and B does not cause a fiduciary relationship between A and B's investors.
9.18.2007 1:09am
Christopher Cooke (mail):
Tony: alleging that someone "should have known" does not suffice to allege facts demonstrating that the defendants acted with a strong inference of scienter, as required by the PSLRA and renders the complaint subject to a motion to dismiss.

Note that, under the PSLRA, a complaint must survive a motion to dismiss before the plaintiffs can take discovery.

In the Enron "scheme" cases, the district court permitted the case against Merrill Lynch to go forward because of emails in which the Merrill execs explicitly stated that they knew the Nigerian barge deal that they agreed to was being used by Enron to inflate the quarterly results. Thus, the evidence of the defendants' playing a knowing role in an unlawful plan to recognize revenue was pretty good. Indeed, that is why the execs were convicted, in a criminal case.

I think the best way, analytically, to approach the appeal is to assume that the plaintiffs can prove that the scheme defendants knowingly are participating in some bogus transaction designed to inflate the issuer's financial results in a material way (the plaintiffs allege this) and then look at the law and see if it permits such a claim, or not.
9.18.2007 2:14am
Harry Niska (mail):

Plaintiffs argue that S-A should have known. How should they have known? Why should they have known?


Read the SG's brief I mentioned, or try to find a copy of the complaint. The plaintiffs made factual allegations about the transaction in question that make it look really, really fishy.


Harry is arguing that every business transaction should be presumed to defraud investors until proven otherwise.

This is inane. Please explain where I "argu[ed]" that. I am not even sure how the Supreme Court should decide the Stoneridge case. And as far as I know, there is no issue in this case as to whether the burden of proof should be placed on the defendants instead of the plaintiffs. I am strongly in favor of making plaintiffs carry a burden of proof in all securities fraud cases.
9.19.2007 5:28pm