Supreme Court Rejects Scheme Liability Theory Under Rule 10b-5

Secondary non-speaking actors said to have participated with a company in a securities fraud scheme were not liable in a private action under Rule 10b-5 since the acts of suppliers said to have participated in the fraud were too remote to satisfy the antifraud rule’s reliance requirement. Since the company was free to do as it chose in preparing its books, conferring with its auditor, and issuing its financial statements, reasoned the Court, the investors cannot be said to have relied upon any of the deceptive acts of the suppliers said to have assisted the fraud. This was a 5-3 opinion, with the majority opinion rendered by Justice Kennedy. Stoneridge Investment Partners, Inc. v. Scientific-Atlanta, Inc. (No. 06-43, Jan. 15, 2008).

Rejecting the concept of scheme liability, the Court said that to accept that in an efficient market investors rely not only upon the public statements relating to a security, but also upon the transactions those statements reflect, would be an unauthorized and unwarranted extension of the Rule 10b-5 implied cause of action to embrace the whole marketplace in which the issuing company does business. Judicial precedent and congressional intent argue against this broad extension of the Rule 10b-5 private cause of action beyond the securities markets into the realm of ordinary business operations, which are essentially governed by state law.

In addition, the practical consequences of expanding an implied private right of action for securities fraud militate against the acceptance of scheme liability. The extensive discovery and the potential for uncertainty could allow investors with weak claims to extort settlements from innocent companies. It would also expose to such risks a new class of defendants, said the Court, namely overseas firms with no other exposure to U. S. securities laws, thereby deterring them from doing business the US. In turn, this would raise the cost of being a publicly traded company under U. S. law, thereby shifting securities offerings away from domestic capital markets.

The investors alleged losses after purchasing common stock. They sought to impose securities fraud liability on suppliers alleged to have participated in arrangements that the company used to mislead its auditor and issue a misleading financial statement affecting the stock price. Specifically, it was alleged that the suppliers produced documents falsely claiming that costs had risen and signed contracts they knew to be backdated in order to disguise the connection between the increase in costs and the purchase of advertising.

The suppliers had no role in preparing or disseminating the company’s financial statements, noted the Court, and their own financial statements booked the transactions as a wash, under GAAP. It is alleged that the suppliers knew or were in reckless disregard of the company’s intention to use the transactions to inflate its revenues; and knew the resulting financial statements would be relied upon by research analysts and investors.

Citing its Central Bank ruling, the Court observed that, since Rule 10b-5 implied private right of action does not extend to aiders and abettors, the conduct of a secondary actor must satisfy each of the elements or preconditions for liability; and reliance is an essential element of Rule 10b-5. The reliance element ensures that, for liability to arise, the requisite causal connection between a misrepresentation and an investor’s injury exists as a predicate for liability.

The Court has found a rebuttable presumption of reliance in two different circumstances. First, if there is an omission of a material fact by one with a duty to disclose, the investor to whom the duty was owed need not provide specific proof of reliance. Second, under the fraud-on-the-market doctrine, reliance is presumed when the statements at issue become public. Neither presumption applies to this case, said the Court, since the suppliers had no duty to disclose and their deceptive acts were not communicated to the public. Because no investor had knowledge of the deceptive acts during the relevant times, held the Court, no investor could show reliance upon any of suppliers’ actions except in an indirect chain that was too remote for liability.

The US Solicitor General has urged the Supreme Court to reject scheme liability for non-speaking secondary actors in private securities fraud actions since such an expansion of liability would upset the delicate balance Congress has crafted. In its brief, the government argued that scheme liability runs counter to the congressional balance between exposure to private actions for aiding and abetting and empowering the SEC alone to pursue secondary claims against non-speaking actors, such as lawyers and accountants