Primary and Secondary Liability Under Securities Law: The Stoneridge Investment Saga
By Richard A. Epstein
Tomorrow, October 9th, the United States Supreme Court is hearing oral argument in one of the most important securities law cases in decades, Stoneridge Investment Partners, Inc. v. Scientific-Atlanta. This highly contentious dispute illustrates a proposition long familiar to lawyers: the choice of remedy—administrative enforcement versus private class actions—for admitted violations of the law may prove more momentous than the antecedent legal question of whether a targeted defendant has engaged in any wrongful conduct.
Exhibit A is this litigation aftermath of a securities fraud initiated by key insiders of Charter Communications Company. Between November 1999 and August 2002, these officers had allegedly inflated Charter’s quarterly earnings by using faulty accounting business practices to capitalize deductible labor expenses, to postpone cutting off nonpaying customers, and to enter into sham transactions with Scientific-Atlanta and Motorola.
Starting in August, 2000, Charter deliberately overpaid the two defendants to purchase set-top boxes for cable TVs, on condition that they funnel the extra cash to buy unwanted TV advertisements from Charter. Charter booked the revenues as income, but capitalized its outlays to boost stock price, which dropped substantially when the entire scheme was unmasked two years later.
The plaintiff class, which consisted of all investors who sold during the scheme period, settled with other defendants for $146.5 million. Left open is whether they may also sue the two remaining defendants for damages for what plaintiffs describe as their “direct” participation in a “scheme” to manipulate the stock price and defraud the investing public.
Everyone agrees that the defendants could have been liable in damages to the investors if they had a duty to disclose, or if they had voluntarily made any public disclosures about the sham transactions. But absent either, the Court of Appeals for the Eighth Circuit held that the defendants were subject only to direct administrative sanctions from the SEC.
Stoneridge raises hard questions on what the law is and what it should be. On the former, the defendants are on strong ground in arguing that the key 1994 Supreme Court 5-to-4 decision in Central Bank, N.A. v. First Interstate Bank, N.A. lays down a categorical rule that no private party can bring a damage action under the securities laws against wrongdoers who only “aid and abet” the securities breaches by parties directly subject to disclosure obligations.
Accordingly, Central Bank refused to allow mortgage lenders to sue an indenture trustee, which failed to reassess the value of properties in its portfolio when they had received strong indications that they were no longer worth 160 percent of the unpaid mortgage balance, as the loan covenants required. The Central Bank’s dissenters thought the regulatory prohibition that makes it unlawful “directly or indirectly . . . to employ” any scheme to defraud reached aiders and abettors, including Central Bank.
That case determines this one. If the knowing disregard of the single bond trustee charged with a duty to protect investors does not trigger liability for damages under the securities law, then the same should be true of the numerous equipment vendors with no fiduciary duties at all. After Central Bank, Congress specifically authorized the SEC to bring enforcement actions against aiders and abettors, but it did not change the Central Bank result barring private actions. Clever pleading about “scheme liability” should not, and will not, upend the prohibition on private suits against aiders and abettors given that Congress has refused to overturn the result in Central Bank.
Yet, normatively speaking, why should secondary violators be escape private damage suits brought like those brought against primary wrongdoers? One way to end the discrepancy is to deny all private damage actions against primary offenders, which is not as farfetched as it sounds.
The key vice of these private suits is to overdeter wrongful conduct. For example, the class that sued Charter let all unfortunate buyers at inflated prices recover for their market losses. But it does not require the lucky sellers of overpriced stock to disgorge the fortuitous profits from selling overpriced stock. The net damage recovery from this temporary imbalance in the markets far exceeds the social losses from the underlying chicanery. Across the board, harsh penalties for nondisclosure now induce firms to remain silent lest they incurring huge liabilities for modest misstatements. Administrative remedies can be better calibrated to the severity of the underlying wrong.
Even, if a damage suit against primary wrongdoers makes sense, the second round of suits is overkill. Allow this suit against Scientific-Atlanta and Motorola, then no iron barrier protects any vendors from charges of “knowingly” engaging in fraudulent transactions with hundreds of potential buyers who thereafter mischaracterize these deals in their own financial accounting. Just what fraction of the total loss is attributable to their actions as opposed to other financial gimmicks? And should secondary actors be held liable for all losses if it is hard to isolate a distinct fraction for which they are responsible? The current law of joint and several liability suggests that no apportionment will be made unless it can be made.
Imposing crushing litigation burdens on second-tier defendants who receive no direct benefit from the public fraud is a heavy-handed way to improve transparency of securities markets. The expanded liability has two vices. First, it chews up huge social losses in litigation costs that detract key executives from their major jobs. Second, it leads to erroneous findings on liability rates of error whereby some innocent defendants pay large sums while some guilty parties go free. No system that costly and erratic supplies effective deterrence against fraud.
Empirical judgments about optimal deterrence are always subject to spirited dispute. Owing to the underlying disagreements on policy, what matters is the Court’s current attitude toward securities cases. Here its basic approach rests on two premises. First, don’t rely heavily on the expansive tort analogies, but concentrate on a close reading of the statutory language. Second, don’t initiate major changes in the status quo, but leave that job to Congress. Both these guidelines point to keeping secondary liability under tight rein. My prediction is that the Court will follow its own precedents, and leave it to Congress to decide whether it wants to undo the current uneasy status quo.