The critical concept of “scheme liability” will be front and center when the U.S. Supreme Court hears arguments this fall on what may be the most important securities class action question to reach the high court in decades.
The issue is whether shareholders can recover damages from third parties who scheme with a defendant company to engineer a fraud. In the case at hand, cable television provider Charter Communications allegedly inflated its revenue by $17 million. The plaintiffs, StoneRidge Investment Partners, claim Motorola and Scientific-Atlanta were willing partners in the fraud.
According to the plaintiffs, Motorola and Scientific-Atlanta did more than simply “aid and abet” Charter. This is a crucial distinction. Since the Supreme Court’s 1994 Central Bank decision, investors can no longer sue third parties – such as investment bankers, auditors and attorneys – for “merely” aiding and abetting a fraud.
(An aside: We have always puzzled over the use of the word “mere” for aiding and abetting. If you’re aiding in a fraud, shouldn’t you bear some responsibility for it?)
In StoneRidge, a federal district court and the U.S. Court of Appeals for the Eighth Circuit dismissed the investors’ claims, arguing that Motorola and Scientific-Atlanta did not themselves violate any securities laws. According to both rulings, the two companies did aid and abet Charter Communications, but are protected from lawsuits because they did not make public statements related to the fraudulent activity.
Similarly, a recent decision by the U.S. Court of Appeals for the Fifth Circuit ruled against former Enron shareholders who had successfully sued three investment banks in district court. “Presuming plaintiffs’ allegations to be true, Enron committed fraud by misstating its accounts, but the banks only aided and abetted that fraud by engaging in transactions to make it more plausible,” the appeals judges wrote. “They owed no duty to Enron’s shareholders.”
The Supreme Court has not yet decided whether it will hear the Enron case.
According to the StoneRidge complaint, Charter bartered with Motorola and Scientific-Atlanta, agreeing to pay the vendors inflated prices for cable boxes, with the inflated portion to be returned to Charter. Charter allegedly recognized the amounts as revenue, simultaneously capitalizing the equipment costs to inflate revenue.
A ruling in favor of Motorola and Scientific-Atlanta would absolve those who have knowingly created fraudulent transactions for the sole purpose of inflating a public company’s reported revenue and earnings. It’s almost unthinkable that the court would allow companies to behave so badly without any accountability.
In some of the worst examples of fraud – Enron, for one – the company itself has gone bankrupt, leaving no financial remedy for investors. In those cases, it’s critical that other willing participants in the fraud be held accountable, so investors have some opportunity to reclaim the money that was taken from them.
Fears that the Supreme Court would make securities cases harder for plaintiffs never materialized in the recent Tellabs decision, which was written by Justice Ruth Bader Ginsburg (see related article). If anything, the Supreme Court helped investors in that case.
The Tellabs ruling gives us reason to be optimistic for StoneRidge. If Justice Ginsburg takes the lead on Charter, we are confident it will be a sensible decision.
The political wrangling behind the scenes has been as interesting as the case itself. The Securities & Exchange Commission had voted to submit an amicus brief on behalf of the plaintiffs, but the Bush Administration objected and the deadline passed without comment from the SEC.
In August, the U.S. Solicitor General filed an amicus brief in support of defendants.
In other words, the principal government enforcer of securities laws tried to side with investors and the Solicitor General refused to allow it and then took the opposite position. A bipartisan group of former SEC officials was outraged enough to ask the court to let them file an amicus brief after the deadline.
Former SEC Chairmen William H. Donaldson and Arthur Levitt and former Commissioner Harvey J. Goldschmid called the case “critical” for investors.
“Holding liable wrongdoers who actively engage in fraudulent contact that lacks a legitimate business purpose does not hinder, but rather enhances, the integrity of our markets and our economy,” their lawyers wrote. “We believe that the integrity of our markets is their strength.”
The SEC and its former leaders obviously understand the importance of scheme liability in securities cases. Let’s cross our fingers that the Supreme Court justices understand, too.