U.S. Supreme Court Issues Landmark Decision Limiting Secondary Liability Under the Federal Securities Laws

In a highly anticipated decision, the U.S. Supreme Court has rejected a push to expand the scope of secondary liability in private lawsuits under the federal securities laws. In Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., No. 06-43, a private securities plaintiff sought to hold two companies responsible for participating in a third-party’s scheme to artificially inflate its own financial statements. The Supreme Court’s decision considered “when, if ever, an injured investor may rely upon §10(b) to recover from a party that neither makes a public misstatement nor violates a duty to disclose but does participate in a scheme to violate §10(b).” In an opinion written by Justice Anthony Kennedy for the 5-3 majority, the Court held that “because the investors did not rely upon [the companies’] statements or representations,” the companies could not be held liable in a private securities lawsuit.

The case arose from an agreement allegedly reached by Charter Communications, Inc. (“Charter”), a cable television provider, with two of its equipment vendors. Under this alleged agreement, Charter would pay an extra $20 for each set-top box the vendors provided, and the vendors would return that money to Charter in the form of advertising fees. Charter allegedly used this arrangement to inflate its financial health by capitalizing its extra costs as an equipment expense and reporting the vendors’ payments as revenue. The vendors themselves did not make any public statements about their alleged agreements with Charter, nor were they under any duty to do so. Nonetheless, one of Charter’s investors sued the vendors for securities fraud on the theory that knowingly entering into these “sham transactions” was deceptive conduct prohibited by §10(b) of the Securities Exchange Act of 1934. The district court disagreed and dismissed the claims against the vendors, and the Eighth Circuit affirmed.

The Supreme Court affirmed in a decision that effectively rejects the notion of “scheme liability” in private securities fraud lawsuits. The Court held that a private plaintiff may recover under the securities laws only if he relied on the defendant’s misrepresentations, deceptive acts, or omissions—as when the defendant either omitted some information that it had a duty to disclose (as in Affiliated Ute Citizens of Utah v. United States, 406 U. S. 128 (1972)), or engaged in manipulation or made a misrepresentation that became public in the marketplace and was reflected in the market price of the security (as in Basic Inc. v. Levinson, 485 U.S. 224 (1988)).

The Court offered a wide range of reasons to support its decision, perhaps reflecting the 30 amicus briefs filed in the case. First, plaintiffs’ theory of reliance— “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”—was unreasonably broad. “Were this concept of reliance to be adopted, the implied cause of action would reach the whole marketplace in which the issuing company does business; and there is no authority for this rule.” Second, the Court noted that the fact that investors do not rely on undisclosed conduct suggests that such conduct is too remote from “the purchase or sale of any security” to be the cause of the harm the securities laws were meant to redress.

A third concern, similarly related to the breadth of securities liability, is that federal securities laws should be confined to the markets, leaving “the realm of ordinary business operations” to state law. The Court noted, “[w]ere the implied cause of action to be extended to the practices described here, . . . there would be a risk that the federal power would be used to invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees.” The Court also recognized that accepting plaintiffs’ theory would be bad business—in that it would impose litigation risks on a whole new class of potential defendants for business conduct and could also deter overseas firms from doing business in the United States, which could, in turn, “raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.”

As a matter of congressional intent, too, the Court found plaintiffs’ position wanting. In the wake of Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., 511 U. S. 164, 191 (1994), in which the Court first held that there was no private right of action for aiding and abetting securities fraud, Congress held hearings and considered overturning the Court’s ruling. The result, however, was not a legislative reversal, but a limited abrogation: Congress passed §104 of the Private Securities Litigation Reform Act, authorizing the SEC to prosecute aiders and abettors, but leaving intact the bar on lawsuits by private parties. Moreover, Congress’s imposition of heightened pleading and loss causation requirements in the PLSRA was taken by the Court to mean that Congress ratified Central Bank and “accepted the §10(b) private cause of action as then defined but chose to extend it no further.” Not surprisingly, the Court’s decision has already prompted some to call for additional legislative action.

In what is otherwise a strongly positive decision for businesses and consumers, the Court did reject the position staked out by the Eighth Circuit—that, in the absence of a duty to speak, a specific oral or written statement is necessary to support a private claim for securities fraud under §10(b). Instead, the Court ultimately based its decision on a middle ground proposed by the Solicitor General—namely, the lack of reliance where a party’s acts or statements are not disclosed to the market. “Conduct itself can be deceptive,” the Court declared. But this note notwithstanding, the Court’s message in Stoneridge is clear: the private right of action under §10(b) is a narrow one and will not be expanded lightly.