Letter from America
January 2008
United States Supreme Court Limits
Shareholder "Scheme Liability" Lawsuits
The United States Supreme Court has limited the ability of shareholders to bring proceedings against third-party defendants in cases concerning losses arising from alleged fraud. These lawsuits are often referred to as "scheme liability". This decision could have had a dramatic impact on international firms doing business in the United States, with the prospect of opening the floodgates to proceedings against businesses working with public companies accused of fraud. The Court's decision in Stoneridge Investment Partners LLC v Scientific-Atlanta Inc. (No. 06-43), however, continues the business-friendly trend of the current Supreme Court.
Investors in Charter Communications ('Charter') brought proceedings
against Scientific-Atlanta and Motorola. The claimant alleged that
Scientific-Atlanta and Motorola entered into fraudulent commercial
arrangements with Charter enabling Charter to mislead its auditors and
issue misleading financial statements, which affected the share price.
Charter had agreed to overpay Scientific-Atlanta and Motorola for cable
television set top boxes with the understanding that the companies
would return the overpayment by purchasing advertising from Charter.
Charter then used these purchases to inflate its turnover and operating
cash flow figures.
Scientific-Atlanta and Motorola had not issued the stock in question,
nor had they made any public statements about it; therefore, at most,
Scientific-Atlanta and Motorola had aided and abetted Charter's
securities fraud. US securities law does not explicitly provide for
private lawsuits by shareholders against aidors and abettors, and the
Supreme Court clearly refused to extend such a right of action to
shareholders.
In any claim of a violation of Section 10(b) of the Securities
Exchange Act of 1934, which prohibits fraud and deceit in connection
with the purchase or sale of securities, reliance on the defendant's
conduct is a key element. The claimant alleged reliance not only upon
the public financial statements by Charter about its securities, but
upon the transactions with Scientific-Atlanta and Motorola underlying
those statements. The Court rejected this as too far-reaching and
determined that the claimant could not demonstrate reliance on
Scientific-Atlanta and Motorola's actions, except "in an indirect chain
[that the Court found] too remote for liability".
In reaching its decision, the court took into account the potential
deterrent effect too broad a rule would have on international firms
seeking to do business in the United States, as well as the effects on
the US economy of increased costs of doing business for publicly traded
companies.
The Court made clear that its decision does not eliminate all
redress against aiders and abettors of securities fraud. Third party
defendants may still face criminal penalties and civil enforcement by
the Securities and Exchange Commission. Some state laws allow state
authorities to pursue aiders and abettors of securities fraud. See
e.g. Del. Code Ann., Tit. 6, § 7325 (2005). Third party defendants are
not immune from all private suits: regulations authorise suit against
accountants and underwriters in certain situations (15 U.S.C. § 77k),
and the implied private right of action in Section 10(b) still applies
to primary violations of the law, even if committed by secondary
actors, where all elements, including reliance, can be proven.
The Supreme Court's ruling closes off a significant avenue for
shareholders looking for deep-pocket defendants when stock prices
fall. This ruling could have interesting effects on the Court's
upcoming decision in a case in which shareholders of Enron have sued
investment banks for complicity in Enron's accounting.
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