Ruling in its most important securities fraud case in years, the Supreme Court on Tuesday placed a towering obstacle in the path of shareholders looking for someone to sue when a stock purchase turns sour.
The decision in the case, Stoneridge Investment Partners v. Scientific-Atlanta, was a major and ardently sought victory for investment banks, accountants and vendors — the deep pockets that have become nearly automatic targets of class-action lawsuits that accuse them of having engaged in a fraudulent scheme with the company that actually issued the stock.
The notion of “scheme liability,” as the theory behind such lawsuits is known, now appears to be dead.
The 5-to-3 decision held that in order to proceed with such a lawsuit, plaintiffs must be able to show that they had relied, in making their decision to acquire or hold stock, on the deceptive behind-the-scenes behavior of these financial institutions, often called secondary actors. But behavior that was never communicated to the marketplace cannot be said to have induced reliance, Justice Anthony M. Kennedy wrote for the majority.
Without such a limitation on the concept of reliance, potential liability “would reach the whole marketplace in which the issuing company does business,” Justice Kennedy said. He added that Section 10(b) of the Securities Exchange Act, the legal foundation for securities fraud cases, “does not reach all commercial transactions that are fraudulent and affect the price of a security in some attenuated way.”
“Section 10(b) does not incorporate common-law fraud into federal law,” he said.
The case, which was dismissed before trial in the lower courts, involved an accusation of a deceptive arrangement between a cable television company and two suppliers that gave the company’s books the illusion of an additional $17 million in revenue.
That is a tiny fraction of the amount at stake in similar lawsuits, like the $40 billion class-action lawsuit by Enron shareholders against the investment banks that advised the company. The federal appeals court in New Orleans dismissed the lawsuit last March on grounds that were similar to the approach the Supreme Court took on Tuesday.
The appeal by Enron shareholders has been pending at the Supreme Court since April. Whether the court now simply denies the appeal, or sends it back to the appeals court for a second look, could indicate whether, in the minds of the justices, there is any distinction between a suit against investment banks and one against an ordinary commercial vendor. The next move of the justices could come as early as Monday.
There was language in Justice Kennedy’s opinion to suggest that the court’s view of the Stoneridge lawsuit as fatally flawed might not automatically spell the death of lawsuits with allegations that went closer to the heart of the integrity of the financial markets. The arrangement between the cable company, Charter Communications Inc. and its two suppliers “took place in the marketplace for goods and services, not in the investment sphere,” Justice Kennedy observed.
Louis M. Bograd, senior litigation counsel for the Center for Constitutional Litigation, a law firm that advocates for the rights of plaintiffs, said, “There’s clearly some daylight there, but it’s too soon to say how much.”
The center had filed a brief on the plaintiff’s side on behalf of the American Association for Justice, formerly known as the Association of Trial Lawyers of America.
Language elsewhere in the majority opinion was quite sweeping, leading Justice John Paul Stevens, in the dissenting opinion, to assert that “the court’s view of reliance is unduly stringent and unmoored from authority.” Justice Stevens added: “I respectfully dissent from the court’s continuing campaign to render the private cause of action under Section 10(b) toothless.”
Justice Kennedy’s majority opinion was joined by Chief Justice John G. Roberts Jr. and by Justices Antonin Scalia, Clarence Thomas, and Samuel A. Alito Jr. Justices David H. Souter and Ruth Bader Ginsburg joined the dissent. Justice Stephen G. Breyer did not participate.
Although decisions under the Roberts court have been notably favorable to business, the trend toward constricting the ability of private plaintiffs to bring securities fraud cases predates the chief justice’s arrival.
In the Central Bank case in 1994, the court ruled that the securities laws did not provide liability for “aiding and abetting” a fraud. Congress responded by restoring the authority of the Securities and Exchange Commission to bring such suits, but private plaintiffs may not do so.
In the landmark securities laws that grew out of the Depression, Congress did not provide for private lawsuits. Neither did it rule them out. The Supreme Court, in a long series of decisions, eventually found that the right to bring private suits was “implied,” not only by the securities laws but also by a variety of civil rights statutes.
The current court has turned sharply away from that approach. “I mean, we don’t get into this business of implying private rights of action any more,” Chief Justice Roberts commented during the Stoneridge argument on Oct. 9.
The decision issued Tuesday “is true to that statement,” one securities law specialist, James D. Cox of Duke University Law School, said in an interview. Professor Cox, who joined other professors in a brief filed on behalf of the Stoneridge plaintiffs, said the majority opinion had failed to explain how to draw the line between a primary participant in a fraudulent scheme and one who simply aided and abetted.
Lawyers on the other side saw no such ambiguity, finding the court’s message clear. “Behind-the-scenes actions that are not communicated to the market can’t be the basis for liability,” said Stephen M. Shapiro, who argued the case for the cable company’s suppliers. The decision won high praise from the National Association of Manufacturers and the United States Chamber of Commerce.
The facts in the case were not in dispute. Charter Communications persuaded Scientific-Atlanta and Motorola, two suppliers of cable boxes, to inflate their prices and to use the windfall to buy advertising on the cable system. Charter then booked the inflated price as a capital expense, while treating the advertising purchases as revenue, thus appearing to meet Wall Street’s revenue expectations. When Charter’s true financial picture came to light, its stock collapsed and a shareholder, Stoneridge Investment Partners, filed the lawsuit.
The case produced a battle within the Bush administration. The Securities and Exchange Commission supported the plaintiffs, while the Treasury Department supported the defendants. Treasury prevailed, and the S.E.C. was denied authority to file a brief. Justice Kennedy’s opinion on Tuesday closely tracked the brief that Solicitor General Paul D. Clement eventually filed.