U.S Supreme Court to Hear Arguments on “Scheme Liability”

Today, the United States Supreme Court will hear oral arguments in what many are calling the most significant business case to come before the high court in decades.  The case, Stoneridge Investment Partners v. Scientific-Atlanta and Motorola, challenges the well-established precedent that only those parties that violated securities laws — and not outside advisors and vendors — may be sued.

In an article published by the Washington Legal Foundation, Bracewell trial partner Andrew Edison provides a thorough review of the case and its potential implications for investment banks, brokerage houses, accounting firms, attorneys and other third parties.  Should the high court find in favor of the plaintiff and reverse earlier high-court decisions that barred “aiding and abetting” claims for securities fraud against so-called secondary actors, it could unleash a flood of lawsuits against parties with no direct connection to securities-market activity.

Background

Stoneridge v. Scientific Atlanta has its roots in a class action lawsuit brought against Charter Communications, Inc. (“Charter”), a provider of cable television services, and two equipment vendors, Scientific-Atlanta and Motorola, on behalf of purchasers of Charter securities.  In the lawsuit, the plaintiffs alleged that the defendants entered into sham transactions designed to improperly inflate Charter’s reported operating revenues and cash flow, in an effort to influence the stock recommendations of Wall Street analysts.

A federal district court in Missouri dismissed the plaintiff’s claims against the equipment vendors, reasoning that the claims amounted to nothing more than aiding and abetting allegations that were precluded by the Supreme Court’s 1994 decision in Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994).  The U.S. Court of Appeals for the Eighth Circuit affirmed the dismissal.  Subsequently, the Supreme Court agreed to hear the case. 

Legal Developments

Section 10(b) of the Securities Exchange Act of 1934 prohibits the use or employment of manipulative, misleading or deceptive devices, schemes, statements or practices in connection with the purchase or sale of a security.  Prior to the 1994 high-court decision, plaintiffs regularly sought to impose liability on parties whose conduct allegedly facilitated a public company’s fraud — but whose conduct was not relied upon by investors — by accusing them of “aiding and abetting.”

In Central Bank, the Supreme Court ruled that secondary actors, including lawyers, accountants and banks, could be held liable as a primary violator of securities laws only if these parties met all of the requirements for primary liability under Rule 10b-5 (which implements Section 10(b)).  In effect, secondary actors were protected if they did not make statements that were relied upon by investors in making investment choices.

Plaintiff’s lawyers have subsequently created the concept of “scheme liability,” in which they assert that the Central Bank decision allows suits against secondary actors for violations of Rules 10b-5(a) and (c), by participating in schemes and/or a course of business that operates as a fraud or deceit.  This argument holds that proof of fraudulent misrepresentation or failure to disclose is unnecessary.

Three federal circuit courts have addressed whether plaintiffs are permitted to sue secondary actors under a theory of scheme liability.  The Fifth [1] and Eighth [2] circuits have refused to approve scheme liability, while the Ninth Circuit [3] has approved a form of scheme liability. 

Public Policy Concerns 

A primary concern for the business community is the possibility that Supreme Court approval of the theory of scheme liability could unleash a flood of wasteful and merciless litigation.  Securities litigation is quite costly, in terms of its direct costs as well as its adverse impact on ongoing, normal business activities.  Scheme liability will significantly increase the risk that secondary actors will be identified as “deep-pockets targets” and be faced with a higher likelihood of investor lawsuits — even in matters in which they have, at best, a marginal connection.