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Supreme Court Hears Landmark Investor Suit

On Oct. 9, the U.S. Supreme Court will hear a case that some say may open the flood gates to a tidal wave of investor lawsuits.

The case, Stoneridge v. Scientific Atlanta, is a proxy for Enron shareholder suits against the banks that financed the fraudulent deals.

In both Stoneridge and Enron the question is: Can third party partners -- like banks, lawters and accountants -- also be held liable for fraud?

The concept is known as "scheme liability." A ruling in favor of scheme liability would allow Enron cases to proceed.

Patrick Coughlin, chief trial counsel with Coughlin, Stoia, is the lead trial attorney for the Enron shareholders. On CNBC's "Power Lunch," he presented his argument in favor of scheme liability. Gregory Markel, partner and chairman of the litigation department at Cadwalader, Wickersham & Taft, has represented banks in Enron-related cases. He offered his counterpoint view.

Coughlin's argument in greater detail:

Scheme liability holds accountable any party that knowingly engages in deceptive conduct as part of a scheme to defraud investors. The Securities and Exchange Commission has consistently supported scheme liability.

Enron documents detailed how several large investment banks engineered sham transactions to keep billions of dollars of debt off of the company’s balance sheet in order to create the illusion of increased earnings and cash flow.

For example, Merrill Lynch purchased Nigerian barges from Enron on the last day of 1999, only because Enron secretly promised to buy the barges back within six months, guaranteeing Merrill Lynch a profit of more than 20 percent. When Enron’s illusion of financial strength and profitability -- an illusion that these banks created -- was ultimately revealed and Enron collapsed, innocent investors lost over $ 30 billion.

Stoneridge is a case brought by investors who purchased stock in Charter Communications , a cable company that delivers service through set-top boxes installed on customers’ TV sets.

Charter and Scientific-Atlanta and Motorola devised a scheme whereby Charter would pay $20 more than the normal price for each set-top box, and Scientific-Atlanta and Motorola would return the overpayments back to Charter in the form of advertising fees. Scientific-Atlanta and Motorola knowingly participated in the fraudulent scheme by falsifying and backdating contracts to reflect the extra $20 charge. Charter then characterized the overpayments as revenue on their books – creating a misleading picture of its financial health.

The Supreme Court’s decision in the Stoneridge case will determine if the innocent investors defrauded in the Enron scandal will have their day in court to seek justice from the banks that orchestrated the worst securities fraud in our nation’s history. If the Supreme Court rejects scheme liability, banks, accountants, law firms and others who intentionally commit fraud in order to deceive the investing public will be immune from any responsibility to their victims.

Markel's Counterpoints

Markel'sargument in greater detail:

The important question presented on this appeal [before the Supreme Court] is what parties, under what circumstances, may be liable for a manipulative scheme under Section 10(b) of the Securities Exchange Act of 1934.

The heart of the issue raised by these cases is whether investors should be permitted to sue not only the company that issued the securities and the corporate officials or others who made misstatements to investors about the company’s condition, but also third parties such as financial institutions, accounting firms, lawyers, vendors, customers or business counterparties who did business in some form with the company but made no false public statements about it.

As a policy matter, the implications of permitting such suits would be far-reaching.

If allowed, they would impose significant additional costs on businesses of all kinds. Financial institutions in particular would be forced to engage in extraordinary due diligence on their customers, even when they do not provide underwriting or other services that relate directly to the securities markets.

The problem would extend to others as well. Some scheme liability cases involve parties such as vendors and advertisers. In even routine transactions between businesses, to avoid potential liability, each party would have to evaluate the other party’s financial condition and accounting practices to try to be sure that the other party is not using the transaction to distort its publicly stated financial condition.

The costs of such expansive liability would of course be passed on to society both in terms of higher fees and in detracting from the competitiveness of the United States (already burdened as the world’s most litigious society). Also to be considered is the adverse effect of the uncertainty caused by such an ambiguous potential liability. The incremental cost of such expanded liability of course is only a small part of the enormous cost of litigation.