Overturning Stoneridge:

The WSJ law blog reports that Senators Arlen Specter (D-PA) Jack Reed (D-RI) and Edward Kaufman (D-DE) are pushing legislation to overturn the Supreme Court's decision in Stoneridge Investment Partners v. Scientific-Atlanta. In this case, the Supreme Court held, 5-3, that private rights of action under Section 10(b) of the Securities Act do not reach third-party actions where shareholders did not rely upon the third party's actions or statements. Section 10(b) did not create such "scheme liability," the Court held.

Stoneridge was a very significant case — easily one of the most important securities-law cases of the past ten years. Overturning it would also be quite significant. As the WSJ reports, it would "give plaintiffs lawyers — especially those who file shareholder fraud suits — a shot in the arm."

For prior VC posts on Stoneridge see here, here, and here. In addition, here is a a Federalist Society on-line debate on the decision and background materials and the webcast of a mini-conference on the case sponsored by the Center for Business Law and Regulation at Case Western Reserve University.

UPDATE: Professor Bainbridge has a lengthy post on Stoneridge and the proposed legislation here.

Related Posts (on one page):

  1. Overturning the Roberts Court:
  2. Overturning Stoneridge:
It's sad that there are some people whose principal mode of analysis consists of "will it benefit the plaintiffs' bar?"
8.5.2009 10:50am
Cornellian (mail):
It's probably Specter's second worst idea in years, right after his idea to reverse Iqbal and go back to the bad old days of Conley v. Gibson.
8.5.2009 10:55am
Jonathan H. Adler (mail) (www):
Steve --

There's plenty of substantive analysis of the decision and the its effects at the links provided in the post.

8.5.2009 10:56am
Sure, Prof. Adler, I can see that. I was remarking on the WSJ law blog wasting its time talking about the effect on the plaintiffs' bar rather than talking about any of the policy arguments.

Of course, that kind of statement is red meat for some, who don't need to know any more than that to know that they oppose the bill. I was sort of disappointed to see you give a nod to that element, though.
8.5.2009 11:06am
ruuffles (mail) (www):
So where is the outrage on veesee about the DC circuit's decision Monday to rehear en banc a decision dismissing a case about Clinton's executive privilege to make statements about terrorists?
8.5.2009 11:08am
Houston Lawyer:
Sometimes all you need to know is that the primary beneficiaries of a change in policy, like allowing the immediate write-off of expenses fronted in contingency fee cases, are plaintiffs' attorneys. It's not like they didn't already have hundreds of billions of dollars given to them in the tobacco settlement. They always need a new source of revenues and the best way to get that is an expansion of liabilities to deep pocket defendants.
8.5.2009 11:52am
MarkField (mail):
I guess that the assault upon the citadel of privity is proceeding in these days apace.
8.5.2009 12:16pm
J. Aldridge:
Specter thinks he is regulating commerce here?
8.5.2009 12:42pm
How about private criminal prosecutions? :)
8.5.2009 1:02pm
Philly Adam:
If the Senators are successful, it will be another successful episode of inter-branch communication and coordination.

It's been awhile since I took Securities, so I have to rely on the squib. But if we read Stoneridge as limiting the "intentially-broader-than-common-law" securities fraud rules, I think it's perfectly valid for Congress to weigh in and fix the mistake. Even at the risk of enriching the Plaintiffs' bar.

The interesting question to me is what would the Senators' proposed rule look like?
8.5.2009 1:11pm
Commentor (mail):
Although I agree generally regarding third party liability in securities class actions, i.e. in the result of Stoneridge, it was a good example of judicial activism that required a quite tortuous reading of the statues to reach the result it did.
8.5.2009 1:14pm
Mike& (mail):
Sometimes all you need to know is that the primary beneficiaries of a change in policy, like allowing the immediate write-off of expenses fronted in contingency fee cases, are plaintiffs' attorneys. It's not like they didn't already have hundreds of billions of dollars given to them in the tobacco settlement.

This is more than a little nutty. The immediate write-off would benefit work-a-day lawyers - who have the cash flow problems that the tobacco lawyers don't have. It's also nutty to talk about giving "them" hundreds of billions of dollars. It was a small group of criminals who got that money. Stop being so kooky.

It's sad that there are some people whose principal mode of analysis consists of "will it benefit the plaintiffs' bar?"

Shareholders derivative suits are notoriously shady. Such suits almost never serve any broader interest. Even people who file them admit as much: "Yeah, these suits are not really helping anyone. But they are legal and I get paid. So who cares?"
8.5.2009 1:18pm
Guesty (mail):
Didn't the Stoneridge court pretty explicitly say that it would not read a private right of action for scheme liability because Congress had only extended 10b that far for government enforcement actions? I.e., if Congress wanted to have a private right of action, they needed to amend the statute?
8.5.2009 1:26pm
SuperSkeptic (mail):
Shareholders derivative suits are notoriously shady. Such suits almost never serve any broader interest. Even people who file them admit as much: "Yeah, these suits are not really helping anyone. But they are legal and I get paid. So who cares?"

Are they not useful in the sense that they impose some sort of accountability on Boards of corporations who are otherwise largely unaccountable to anyone but themselves, or SLC's that they hire to oversee themselves?
8.5.2009 1:28pm

Shareholders derivative suits are notoriously shady. Such suits almost never serve any broader interest.

Well, there's a broader interest served when my neighbor shareholder deriv lawyer pays the contractors doing the pool and massive addition on his house, and the dealership/mechanic who take care of his Lambo. Certainly he knows better what to do with the money than the corporation he extorted righteously won it from. Heck, I even benefit from one more full-freight tuition being paid at my kids' private school.
8.5.2009 1:35pm
Shareholders derivative suits are notoriously shady.

That's great, but Stoneridge has nothing to do with derivative suits.

The challenge here is non-trivial and it's sad to see people dismissing it with silliness like "if it benefits the plaintiffs' bar, I automatically know it's bad." On the one hand, we're looking at serious examples of intentional fraud that may cost shareholders billions. In some cases, third parties are active participants in the fraud, such as when they facilitate phantom transactions in order to help the company "make its numbers," and it's hard to see how they should have zero responsibility to all the people who are tricked into buying stock because they thought the company had legitimately made its numbers.

On the other hand, you have the problem of the net being cast too wide and ensnaring innocent third-parties, who may have to expend substantial sums defending themselves against a class action. This is a real problem and, in my view, it's best handled with a legislative remedy like the PSLRA that imposes a high bar for getting these cases in the door. But we shouldn't go so far in seeking to protect innocent third parties that we completely bar meritorious lawsuits as well.

Stoneridge actually struck the balance pretty well, as Prof. Bainbridge's linked post suggests. At a minimum, if Congress is going to overturn Stoneridge, it needs to craft a solution that is smarter than "aiding and abetting liability is in play again, full stop." Most often, people who do business with a company have no clue that they're engaging in accounting fraud, and there have to be protections for them that go beyond "let them defend themselves and sort it out in discovery." These cases are way too expensive.
8.5.2009 1:59pm
Spector's bill, which is co-sponsored by Jack Reed (D-R.I.) and Edward Kaufman (D-DE), would reverse that decision by amending the securities laws to allow for private litigation against a person that provides "substantial assistance" in violating the law.

- From the linked story.

One would presume that law firms and auditors with low standards and real culpability are the primary losers under the law (perhaps some investment bankers as well). The proposal, by definition, also appears to forbid liability where there is no primary violation by someone else.

Since the liability of those who provide substantial assistance appears to be entirely derivative of the primary violation by a corporate executive or the corporation, the measure of damages is unchanged, as are the number of primary violations. So, if the primary violator is solvent even after the damage award the impact upon the Plaintiff is zero.

Substantial assistance liability only comes into play where the primary violator has caused damages in excess of that violator's ability to pay. Typically, these cases involve companies that have collapsed when the fraud that is being litigated was discovered (although this isn't necessarily true).

Providing substantial assistance to a client who is perpetrating securities fraud is, of course, a generally a violation of the professional ethics rules that apply to attorneys and accountants respectively. It is also a situation where the crime-fraud exception will generally cause the attorney-client and accountant-client privilege to be inapplicable. Often it is a situation that gives rise to liability for SEC driven claims civil liability (IIRC, Stoneridge preserved these claims) and federal criminal securities fraud liability as well.

Unclean hands doctrines will frequently prevent primary violators who are in privity with culpable secondary violators from suing their advisors for malpractice under current law (perhaps rightly).

So, the law would allow people who can already bring private suits against businesses, which are subject to strict pleading requirements and generally confined to federal court forums, against parties who have culpability and are already theoretically on the hook for that culpability.

The only way that this is a bad thing is if securities law reforms enacted and implimented by Congress after Stoneridge haven't worked (i.e. it is profitable for private attorneys to bring suits without merit against public corporations for securities fraud) and the SEC prosecutes every meritorous securities fraud case.

This is certainly not obviously true.

Pleading requirements make the likelihood that suits without merit (and a good many suits with merit) will be dismissed on the pleadings much greater, and narrow the issues in the cases that remain, thereby reducing the cost of the litigation. The requirement of a federal forum and other venue requirements reduces the ability of securities fraud plaintiffs to venue shop. Repeat players lose the settlement credibility necessary to make securities fraud litigation profitable if they repeatedly lose motions to dismiss.

The SEC clearly misses some meritorous securities fraud cases for extended periods of time. Look how long it took them to clue into the Madoff case despite the fact that they were tipped off about it years earlier. The cost of a delay in SEC, federal or state blue sky enforcement can be almost as harmful to investors as failing to seek relief at all.

The incentives of plaintiff's lawyers are also not indiscriminate. Only quite profitable law firms and accounting firms providing substantial assistance to firms which are engaged in fraud bring enough assets to the table to be worth suing, and then only when the firm alleged to have engaged in fraud are not good for the expected judgment.

Seeking secondary liability from bit players, like the tiny and marginal accounting firm that prepared statements for Madoff, doesn't make much economic sense for Plaintiffs lawyers in cases involving big frauds. It is more work, will be fought furiously, and won't add much to the pot.

The risk faced by big firms is similar to the risk involved in writing opinion letters about other matters, routine part of a lot of securities work and major tax sensitive transactions. Indeed, the expanded liability may well provide law firms and accounting firms for a justification for fee increases for marginal clients in a time of slumping revenues. The fact that big firms on Wall Street could be on the hook for secondary liability that they substantially assist in makes public offerings by their clients more credible in the eyes of the investing public. This in turn may allow clients to obtain bigger IPO returns for the same stock than they would with other firms. This, in turn, may help justify higher fees for the same work. And, in a well documented file prepared on the up and up, by a big firm, proof of lack of involvement in a fraud may be meticulously in place already when the suit is filed and could be cheap to comply with.

Big law firms and accounting firms rarely got tagged with liability for securities fraud even pre-Stoneridge, despite the fact that they collectively represented the lion's share of the U.S. economy in the form of aggregate publicly held business valuations. Now, Congress has made it considerably harder to bring the same kinds of lawsuits.

Suppose that the impact is not that there is more liability for big law firms and accounting firms, but that more clients are declined, and forced to turn to placements with private equity (which is required by the SEC to have indica of greater sophistication than public company investors) rather than engaging in IPOs? Is this really a big problem?

Can one imagine better gatekeepers to the public capital markets than sophisticated players at big law firms and accounting firms with a strong profit interest in saying "yes" to new, premium pay work if risk can be adequately controlled?

The idea that high risk investments ought to be confined to people wealthy and sophisticated enough to look out for themselves is a long standing principal of modern securities regulation. Widows and orphans get regulation; savvy business people get the free market and the associated risks.
8.5.2009 7:39pm
Auditors and law firms are generally liable as primary violators, because they sign things like audit letters.
8.5.2009 9:12pm
I still fail to see how reliance was lacking in Stoneridge. Motorola and Scientific-Atlanta falsified wash sales with Charter in order to pump charter's books. Investors relied on those fake revenues to invest. It takes an intentionally strained view of reliance to say the plaintiff shareholders did not rely on the fraudulent actions of the defendants in the case.
8.6.2009 2:04am
Investors relied on those fake revenues to invest. It takes an intentionally strained view of reliance to say the plaintiff shareholders did not rely on the fraudulent actions of the defendants in the case.

I don't think it's that strained, if there was no specific disclosure regarding the revenues from Motorola and Scientific-America. Otherwise, the theory is that if the revenue number is falsified for a given year, everyone who did business with the company during that year becomes a defendant based on "aiding and abetting." No one relied on the specific revenue from a specific source, they simply relied on the company's statements in general."

A different case would be presented if the company announced "we signed a deal with Motorola that we expect to materially improve our finances." If the deal was a sham and Motorola was a culpable participant, then you have reliance.
8.6.2009 10:42am
markm (mail):
Did Motorola and Scientific-America get any actual advertising from the deal?
8.6.2009 6:35pm
Spectre's proposed legislation takes a perhaps more direct stab at Central Bank of Denver v. First Interstate Bank of Denver, which ended aider and abetter liability, than it does at Stoneridge which limited scheme liability as an loophole escape route from aider and abetter liability.

Notably, while the Central Bank of Denver case a landmark in federal securities regulation, the win in the U.S. Supreme Court was illusory for the defendant relieved of federal liability by the case. The Plaintiff refiled in state court and was made whole from the same defendant on a state law theory.

The deeper problem with securities fraud cases is not really the reliance issue raised in Stoneridge. It is the issue of damages. In the typical case, that does not involve an IPO, the vast majority of the harm from a securities fraud violation take place in the secondary market between third party traders. The issuers who is primarily responsible for producing accurate disclosures neither gains nor loses in many cases, although culpable related parties often do gain from the fraud (most notably senior executives with stock options).

Those who lose money as a result of a securities fraud have often either relied upon the false statements, or indirectly relied on the false statements by following the lead of smart money that has relied upon the false statements.

But, securities fraud typically produces a lot of completely innocent winners in the secondary market as well. Unlike buyers, some winners may even be selling their stock out of necessity, rather than because they think that the stock is inappropriately priced. Perhaps they have margin loans or college tuition bills that have come due or a loan that is in default and must be paid. They may not know or care much about what the going price is because they have little choice in the matter.

Other winners in the secondary market may be completely uninvolved traders who suspect that something is amiss and are trading speculatively for a brief period of time, not unlike people who buy knowing that there is a bubble in something's price because they believe that they can get out before the bubble bursts (sometimes known as the "greater fool" situation).

But, innocent winners, who often receive the lion's share of the economic benefit from a securities fraud, are almost never made to disgorge the benefits they have received from a third party's fraud, or even identified at all.

Similarly, non-culpable people who put money into Ponzi schemes, but manage to get out (often by happenstance) before they collapse, are almost never required to disgorge the above market rate profits that they have received, even though most of the losses suffered by the scheme's losers ended up benefitting them.
8.7.2009 1:05am

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