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In a case which many are calling the most important securities case in a generation, the United States Supreme Court will decide whether so-called secondary actors- such as banks, audit firms, lawyers, and vendors- who have engaged in transactions designed to inflate a public corporation's financial statements, but have made no public statements concerning those transactions, can be considered directly liable for securities fraud under Section 10(b) of the Securities Exchange Act of 1934. As discussed below, the case has the potential to expand the professional liability of securities dealers, accountants, audit firms and investment advisors for securities fraud.
On October 9, 2007, the Supreme Court heard arguments in the securities fraud class action case Stoneridge Investment Partners, LLC v. Scientific-Atlanta Inc. and Motorola, Inc., (2006) 443 F.3d 987. Stoneridge Investment Partners filed the class action on behalf of cable company Charter Communications shareholders, alleging that Charter and two of its vendors, Scientific-Atlanta and Motorola, engaged in a "scheme to defraud" by entering into sham transactions that improperly inflated Charter's reported revenues and cash flow. Specifically, plaintiffs allege that the two vendors agreed to accept additional, above-price money for their cable television set-up boxes and to return the money to Charter in the form of advertising fees. According to the lawsuit, the two vendors entered into the sham transactions knowing that Charter intended to account for them improperly and falsified documents to conceal these transactions.
The 8th U.S. Circuit Court of Appeals held that plaintiffs' allegations were insufficient to state a Section 10(b) securities fraud claim against the vendors. Section 10(b) makes it unlawful, directly or indirectly, "[t]o use or employ, in connection with the purchase or sale of any security… any manipulative or deceptive device or contrivance in contravention" of SEC rules promulgated pursuant to that section. In addition, Securities and Exchange Commission ("SEC") Rule 10b-5 prohibits the employment of "any device, scheme or artifice to defraud" and makes it unlawful to "engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person."
Key to the Stoneridge holding was the United States Supreme Court's 1994 decision in Central Bank of Denver v. First Interstate Bank, 511 U.S. 164, in which the Court held that Section 10(b) does not reach aiders and abettors of securities fraud, emphasizing that 10(b) "prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act… the proscription does not include giving aid to a person who commits a manipulative or deceptive act." 511 U.S. at 177. Instead, the Central Bank Court limited securities fraud liability to "primary" actors- those that make fraudulent statements- or secondary actors who meet all the primary actor requirements.1
In upholding the district court's dismissal of plaintiffs' claims against the vendors, the 8th Circuit in Stoneridge found that the vendors could at most be accused of aiding and abetting Charter's improper accounting statements, and that claims against anyone who simply "aids and abets" corporate fraud are barred under Section 10(b). 443 F.3d at 991. The Stoneridge Court emphasized in its decision that the vendors did not make any false public statements on which plaintiffs relied, were not involved in the preparation of Charter's allegedly misleading financial statements, and did not owe any duty to Charter's investors. Id.
The ramifications of the Supreme Court's decision in Stoneridge are sure to be widespread.2 The Supreme Court's decision will likely define the scope of the professional liability of lawyers, securities dealers, accountants, bankers and audit firms for securities fraud under Section 10(b). As evidenced by the numerous amicus briefs filed in this case, these groups fear an increased potential liability if Stoneridge Investment Partners prevails, reasoning that an expansive interpretation of Section 10(b) will impose upon anyone doing business with a public company legal responsibility for that company's financial reporting. Shareholders and investors counter that secondary-actors who are engaged in legitimate transactions have nothing to fear. With so much at stake, the Stoneridge case is sure to be closely watched by anyone who is involved in the securities industry.
1By contrast, the Ninth Circuit has defined the scope of primary liability under 10(b)'s "scheme to defraud" more broadly, stating that "the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of a scheme." Simpson v. AOL Time Warner (9th Cir. 2006) 452 F. 3d 1040, 1048.
2For example, the Supreme Court's decision is expected to determine whether the investors defrauded in the Enron scandal can recover their losses from the banks who participated in the fraud.
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