Supreme Court Refuses to Expand Third-Party Liability for Stock Fraud
On January 15, 2008, the United States Supreme Court issued an opinion in Stone Ridge Investment Partners LLC v. Scientific-Atlanta, Inc., et al., No. 0643, which is being hailed as a victory for the business community. The effect of this decision is to severely limit the potential civil liability of third parties who do business with a public company in securities fraud actions brought by investors. The Court limited the potential liability of third parties by holding that investors must establish that they relied upon the third parties' alleged fraudulent conduct to state a cause of action. In most cases involving third party liability claims, however, investors will be unaware at the time of purchase of the third party’s alleged misrepresentation or omission and, therefore, will be unable to prove reliance. The Court in Stone Ridge specifically rejected the investors’ theories based on aiding and abetting and "scheme liability" which would have enabled investors to establish party liability without strictly complying with the reliance requirement. Of course, business partners and other third parties still face potential criminal and civil penalties in enforcement actions brought by the Securities and Exchange Commission (SEC).
In Stone Ridge, the plaintiff investors pursued fraud claims in a securities class action under Section 10(b) of the Securities Act of 1934. The investors brought this action against Scientific-Atlanta and Motorola (the "suppliers") who were two suppliers of the publicly traded cable television company, Charter Communications, Inc ("Charter"). The investors alleged that Charter and the suppliers entered into a fraudulent scheme to inflate Charter’s earnings. As part of the scheme, Charter agreed to overpay the suppliers $20.00 for each cable box it purchased from them with the understanding that the suppliers would return the overpayment by purchasing advertising from Charter the following quarter at an inflated rate. To hide this fraudulent scheme from Charter’s auditors, Arthur Anderson, the suppliers and Charter backdated documents to make it appear that the sale of the boxes was negotiated a month before the advertising agreements were signed. Charter used this scheme to inflate revenue and operating cash flow by approximately $17 million dollars during the last quarter of 2000 in publicly available reports filed with the SEC.
In analyzing whether the investors were able to state a cause of action based upon fraud against the suppliers, the Court first recognized that in a typical Section 10(b) private cause of action, plaintiffs must prove (1) a material misrepresentation or omission; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance on the misrepresentation or omission; (5) economic loss and (6) loss causation. The Court rejected the investors' argument that they could maintain a private cause of action against the suppliers without proving reliance because the suppliers were aiders and abettors of securities violations by Charter. The Court held that Section 10(b) requires plaintiffs to satisfy each of the elements, including reliance, to establish liability. The Court also emphasized that aiders and abettors are subject to criminal prosecution and civil enforcement by the SEC without proof of reliance. In analyzing the reliance element of proof, the Court found that the investors could not prove the necessary causal link to establish reliance because they were not aware of, and did not rely upon, the suppliers' alleged fraudulent acts in deciding to purchase the securities. In addition, the Court found that the suppliers had no duty to disclose this information to the plaintiffs and that the “fraud on the market” doctrine, in which reliance is presumed when the statements at issue become public, did not apply because the suppliers’ deceptive acts were not communicated to the public.
Finally, the Court considered and rejected the investors’ attempts to establish liability under a “scheme liability” theory. In making this argument, the investors asserted that in addition to relying upon public statements which appeared in the reports filed with the SEC, they relied upon the fraudulent transactions reflected in the financial statements included in the reports filed wit the SEC. The Court rejected this argument, reasoning that if this concept of reliance were to be adopted, investors would be able to maintain a cause of action against the entire market place in which the issuing company does business. The Court cautioned that reliance must be tied to causation and concluded that because the transactions at issue were not disclosed to the investing public, any causal link was too remote because it was Charter, not the suppliers, who misled its auditors and the investing public by filing fraudulent financial statements. Although the case did not specifically discuss the potential liability of professional advisers such as attorneys and accountants, they and other advisers are taking comfort in the Court's reluctance to expand third party liability.