Scheme Liability

Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc.156 is easily the most controversial of the Roberts Court’s securities decisions, provoking a (failed) attempt at a legislative override. Appropriately, the decision is a sequel to the Rehnquist Court’s most controversial effort to curtail securities class actions—Central Bank of Denver v. First Interstate Bank of Denver157—which provoked a partial legislative override of its own. Central Bank, like Stoneridge, was written by Justice Anthony Kennedy. A brief summary sets the stage for Stoneridge. The issue presented in Central Bank was whether private civil liability under § 10(b) (the authorizing statute for Rule 10b-5) extends to aiders and abettors of the violation. The open-ended nature of aiding and abetting liability worried Kennedy. In Central Bank, he warned that uncertainty over the scope of liability could induce secondary actors to settle in order “to avoid the expense and risk of going to trial.”158 The risk of having to pay such settlements could cause professionals, such as accountants, to avoid newer and smaller companies, and their litigation costs “may be passed on to their client companies, and in turn incurred by the company’s investors, the intended beneficiaries of the statute.”159

In an effort to increase Rule 10b-5’s predictability, Kennedy’s opinion adopted a two-part framework for addressing the scope of the private right of action under § 10(b). In the first step of the inquiry, Kennedy examined the text of § 10(b) to determine the scope of prohibited conduct. He had little difficulty determining that the text of § 10(b) “prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act.”160 This settled the question for Kennedy: § 10(b) did not prohibit aiding and abetting.

Nonetheless, Kennedy set forth a second-step to the inquiry:

When the text of § 10(b) does not resolve a particular issue, we attempt to infer how the 1934 Congress would have addressed the issue had the 10b-5 action been included as an express provision in the 1934 Act. For that inquiry, we use the express causes of action in the securities Acts as the primary model for the § 10(b) action. The reason is evident: Had [1] [2] [3] [4] [5]

the 73d Congress enacted a private § 10(b) right of action, it likely would have designed it in a manner similar to the other private rights of action in the securities Acts.[6]

The plaintiffs’ argument also failed under this second step, because the explicit causes of action afforded by Congress in the Securities Act and the Exchange Act were similarly silent on the question of aiding and abetting. Whether the question is resolved under the first or the second step of this inquiry has potentially significant consequences. When the Court interprets § 10(b), it is defining not only the limits of the private cause of action, but also the reach of the SEC’s authority. When it constructs the hypothetical cause of action in the second step, only the private cause of action is implicated.

In passing, Kennedy touched on an additional problem with the plaintiffs’ argument, which would have important consequences in Stoneridge: “Were we to allow the aiding and abetting action proposed in this case, the defendant could be liable without any showing that the plaintiff relied upon the aider and abettor’s statements or actions.”[7] The Court left the door open for some liability for secondary participants, such as accountants, investment bankers, and lawyers, but only if they have exposed themselves by inducing investor reliance. The bottom line after Central Bank: a defendant must make a misstatement (or omission) on which a purchaser or seller of a security relies. Kennedy did not explain further the connection between reliance and the scope of Rule 10b-5; that issue would reemerge in Stoneridge.

The scope of a primary violation of Rule 10b-5 came back to the Court in Stoneridge. The Stoneridge plaintiffs attempted an end run around Central Bank: instead of alleging that the secondary defendants had made or participated in the making of a misstatement, the plaintiffs alleged that the secondary defendants were part of a “scheme to defraud,” thus invoking a separate provision in Rule 10b-5.[8]

The scheme alleged by the plaintiffs in Stoneridge involved two suppliers of the cable company Charter Communications: Scientific-Atlanta and Motorola. The plaintiffs’ complaint alleged that Charter committed a massive accounting fraud inflating its reported operating revenues and cash flow. The plaintiffs also named as defendants the two equipment suppliers. The plaintiffs alleged that Charter paid the suppliers $20 extra for each cable set-top box in return for the supplier’s agreement to make additional payments back to Charter in the form of advertising fees. Charter then capitalized the $20 extra expense (shifting the accounting cost into the future) while treating the advertising fees as current income, artificially boosting Charter’s current accounting revenues. The suppliers had no direct role in preparing or disseminating the fraudulent accounting information, nor did they approve Charter’s financial statements. The plaintiffs alleged, however, that the vendors facilitated Charter’s deceptions by preparing false documentation and backdating contracts. The district court granted the suppliers’ motion to dismiss, relying on Central Bank to hold that the vendors were not primary violators under Rule 10b-5. The court of appeals affirmed, concluding that the suppliers had not engaged in any deception because they had made no misstatements, had no duty to disclose to Charter’s investors, and had not manipulated Charter’s shares.[9]

As noted in the preceding text, the SEC has consistently supported the expansion of private securities class actions.[10] So, too, in Stoneridge, with the majority of the commissioners voting to file a brief siding with the plaintiffs.[11] The agency was overruled, however, by the Solicitor General, who sided with the defendants.[12] Here, the government’s argument was essentially adopted in toto by the Court, so we have deference to the government, but not to the SEC.

The Supreme Court, by a vote of 5-3 (with Justice Breyer recused), affirmed. Justice Kennedy, writing for the Court, rejected the appellate court’s holding that there was no deception, noting that “[c]onduct itself can be deceptive.”[13] He instead hung the affirmance on the other doctrinal point from his Central Bank decision, the incompatibility of aiding and abetting liability with the “essential element” of reliance.[4] In this case, investors relied on Charter for its financial statements, not the cable set-top box transactions underlying those financial statements.[4]

Why did Kennedy focus on defendants’ conduct, rather than the plaintiffs, when assessing reliance? According to Kennedy, “reliance is tied to causation, leading to the inquiry whether [suppliers’] acts were immediate or remote to the injury.”[16] Kennedy treats the reliance inquiry as a species of the tort concept of proximate cause. Kennedy’s principal concern was the specter of unlimited liability, as it was in Central Bank: “[w] ere this concept of reliance to be adopted, the implied cause of action would reach the whole marketplace in which the issuing company does business.”[4] The plaintiff’s theory threatened to inject the § 10(b) cause of action into “the realm of ordinary business operations.”[18]

Kennedy’s rationale for limiting the concept of reliance would have more naturally fit in § 10(b)’s “in connection with the purchase or sale of any security” language. Kennedy pointed to that language, but said that it did not control in this case because the “in connection with” requirement goes to the “statute’s coverage rather than causation.”[16] Another reason for not putting the limit into that doctrinal category is that the Court had only recently affirmed a very broad scope for that requirement.[20] A more substantial reason is that cabining Rule 10b-5 through the “in connection with the purchase or sale” requirement would limit not only private plaintiffs, but, potentially, the SEC, whose enforcement authority is limited by the reach of the statute. Kennedy conceded that the SEC’s enforcement authority might reach commercial transactions like those between Charter and its suppliers, but he was reluctant to grant the same freedom to the plaintiffs’ bar.[21]

Given the need to cabin the plaintiffs’ bar, but maintain the SEC’s discretion, the reliance requirement was an attractive tool. The reliance requirement, despite being an “essential element,” does not flow from the language of § 10(b), but is instead derived from the common law of deceit.[22] More importantly for Kennedy’s purposes, reliance does not apply in enforcement actions brought by the SEC or criminal prosecutions brought by the Justice Department.[23] Using the reliance element to limit on secondary party liability allowed the Court to have its cake—unfettered government enforcement—and eat it too—constrain the scope of private actions.

The importance of the SEC’s enforcement efforts had been reinforced by Congress’s response to Central Bank. Rebuffing calls to restore aiding-and- abetting liability, Congress instead gave that authority only to the SEC.[24] Accepting the plaintiff’s argument in Stoneridge, Kennedy reasoned, would thus “undermine Congress’ determination that this class of defendants should be pursued by the SEC and not by private litigants.”[25] Kennedy’s rationale for the need to constrain private litigants echoed and amplified his policy concerns from Central Bank. Expanding liability would undermine the United States’ international competitiveness and raise the cost of capital because companies would be reluctant to do business with American issuers. Issuers might list their shares elsewhere to avoid these burdens.[26]

Looking at the question of reliance, it is difficult to extract any consistent guiding principle from the Court’s decisions. Justice Stevens, dissenting in Stoneridge (as he had in Central Bank), hammered on this point:

The fraud-on-the-market presumption helps investors who cannot demonstrate that they, themselves, relied on fraud that reached the market. But that presumption says nothing about causation from the other side: what an individual or corporation must do in order to have “caused” the misleading information that reached the market. The Court thus has it backwards when it first addresses the fraud-on-the- market presumption, rather than the causation required.[27]

The point is not that one side or the other is correct in their divining of congressional intent. That quest seems futile. Rule 10b-5’s reliance element is nowhere to be found in the language of § 10(b) or Rule 10b-5; the Court borrowed it from the common law of deceit. Despite that borrowing, the Court does not refer to the common law when it is interpreting the reliance requirement for the Rule 10b-5 private cause of action. In Stoneridge, Kennedy brusquely rejected the argument that the plaintiffs had adequately pled reliance under common law standards: “Even if the assumption is correct, it is not controlling. Section 10(b) does not incorporate common-law fraud into federal law.”183 It would seem more accurate to say that the incorporation is selective: the Court borrows the common law element of reliance, without really explaining why, but then disregards it when inconvenient. Kennedy’s rejection of common law standards in Stoneridge suggests that the Court is charting its own common law course. The Court’s interventions, however, are episodic; the Court takes an insufficient number of securities cases to develop this “common law” in any meaningful manner. Will the larger number of cases heard by the Roberts Court change this? Given the framing of the debates in these cases, it seems unlikely.

The two-part interpretive approach framed by Kennedy in Central Bank purports to depart from the common law interpretation that typified Rule 10b-5 for many years. Prior cases focused on assuring recovery for plaintiffs, with little regard for the costs created by private litigation. The Court used a common law, policy- oriented approach when it was expanding the Rule 10b-5 private cause of action, then seen as an “essential supplement” to SEC enforcement.184 Central Bank promised a textual, formalist approach when the Court turned to reining in the reach of the private cause of action. Stoneridge, with its return to a fuzzy “requisite causal connection” notion of reliance,185 fails to deliver on that promise, instead returning to common law decision making. The opinion does little more than tell us that the defendants’ conduct was “too remote” for plaintiffs to rely on.186 Both factions of the Court manipulate the reliance element to scale the scope of the securities fraud cause of action to their liking. Lately, the faction resisting expansion has prevailed.

  • [1] 552 U.S. 148 (2008).
  • [2] 511 U.S. 164 (1994).
  • [3] Id. at 189.
  • [4] Id.
  • [5] Id. at 177.
  • [6] Id. at 178 (citations and internal quotations omitted). The Court has used the approach oflooking to express causes of action to infer appropriate elements under the implied cause of actionunder Rule 10b-5 in other cases. Lampf v. Gilbertson, 501 U.S. 350 (1991) (applying statute of limitations from Securities Act claims to Rule 10b-5 claim); Musick v. Employers Ins. of Wausau, 508U.S. 286, 297 (1993) (finding an implied right of contribution under Rule 10b-5 based on expressright of contribution under explicit causes of action in the Exchange Act).
  • [7] Central Bank, 511 U.S. at 180.
  • [8] Exchange Act Rule 10b-5(a).
  • [9] In re Charter Commc’ns, Inc. Sec. Litig., 443 F.3d 987, 990-93 (8th Cir. 2006).
  • [10] See, e.g., Donald C. Langevoort, Basic at Twenty: Rethinking Fraud on the Market, 2009 Wise.L. Rev. 151, 157 (2009) (“[T]he Basic opinion was for all practical purposes drafted by the SEC andthe Office of the Solicitor General. Most all of the key arguments, analysis, quotes and citations thatone finds in the Courts’ holdings on both materiality and reliance come directly out of the amicuscuriae brief filed on behalf of the SEC.”).
  • [11] The vote was 3-2. See Paul Atkins, Just Say "No” to the Trial Lawyers, Wall St. J., October 9,2007, at A17. Chairman Christopher Cox voted with the majority, despite having introduced thebill that in 1995 that would have reversed Basic. Joel Seligman, The Transformation of WallStreet 663-64 (3d ed. 2003). The SEC had filed a brief in a Ninth Circuit case raising similar issuesarguing that “[t]he reliance requirement is satisfied where a plaintiff relies on a material deceptionflowing from a defendant’s deceptive act, even though the conduct of other participants in the fraudulent scheme may have been a subsequent link in the causal chain leading to the plaintiff’s securities transaction.” SEC Reply Br. at 12, Simpson v. AOL Time Warner, Inc., No. 04-55665 (Feb.7, 2005), available at (last accessedJune 26, 2013).
  • [12] Brief for the United States as Amicus Curiae Supporting Affirmance (Aug. 15, 2007).
  • [13] Stoneridge, 558 U.S. at 158.
  • [14] Id.
  • [15] Id.
  • [16] Id. at 160.
  • [17] Id.
  • [18] Id. at 161.
  • [19] Id. at 160.
  • [20] See Merrill Lynch v. Dabit, 547 U.S. 71 (2006); SEC v. Zandford, 535 U.S. 813 (2002).
  • [21] Stoneridge, 552 U.S. at 161 (“Were the implied cause of action to be extended to the practicesdescribed here ... there would be a risk that the federal power would be used to invite litigationbeyond the immediate sphere of securities litigation and in areas already governed by functioningand effective state-law guarantees.”).
  • [22] See, e.g., List v. Fashion Park, Inc. 340 F.2d 457 (2d Cir. 1965).
  • [23] Geman v. SEC, 334 F.3d 1183, 1191 (10th Cir. 2003) (“The SEC is not required to provereliance or injury in enforcement cases.”); United States v. Haddy, 134 F.3d 542, 549-51 (3d Cir.1998) (government need not prove reliance in criminal case).
  • [24] PSLRA § 104, 109 Stat. 757 (codified at 15 U.S.C. § 78t(e)). Congress recently expanded theSEC’s authority by reducing the state of mind requirement from knowledge to recklessness. See H.R.4173, 111th Cong., § 929O (amending § 20(e) of the Exchange Act).
  • [25] Stoneridge, 552 U.S. at 163.
  • [26] Id. at 163-64.
  • [27] Id. at 170-71 (Stevens, J., dissenting).
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