Primary and Secondary Liability Under Securities Law: The Stoneridge Investment Saga

By  Richard A. Epstein

(Professor Epstein spoke at the Manhattan Institute  on this case last Thursday, October 4th; listen to his discussion with Jim Copland here).

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.

Comments

[Bill Hobbs]

It’s worth remembering that a ruling for the defendants in Stoneridge would leave current law unchanged, while a ruling for the plaintiffs would radically alter current law.

The Court and every federal circuit court but one have made secondary
liability (the plaintiffs call it “scheme” liability) off limits for private suits.

However, neither the Court
nor Congress have set prosecution of accomplices off bounds in securities
cases - they have simply left that task solely to the SEC and the Justice Department.

This balances the need for justice in such cases with the need to protect the economy from being hamstrung and hog-tied by an avalanche of lawsuits.

The blog “10b-5 Daily” had an interesting post last week headlined “NERA Releases Study on “Recent Trends In Shareholder Class Action Litigation”

The gist of it is that the NERA Economic Consulting study, included the following info:

The number of such filings has increased, with 76 new filings through the first half of 2007. The projected annual total of 152 would be a 12% increase over last year.

The average settlement value during the first half of 2007 (excluding settlements over $1 billion) hit a new high of $30 million. There is evidence, however, that this trend may reverse direction based on a decline: (i) in the investor losses associated with recent filings; and (ii) in the prevalence of accounting allegations in recent filings.

Eight of the top ten settlements of all time have resolved in 2006 or 2007, or are pending. Tyco’s announced preliminary settlement of $2.975 billion would be the largest amount ever paid by a single settling defendant.

Here’s the link: http://www.the10b-5daily.com/archives/000853.html

Now, imagine if the Stoneridge case was decided for the plaintiffs. The number of such lawsuits would skyrocket, putting a “scheme liability” tax on the economy.

[LAK]

"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."

I don't understand this statement at all. I don't understand Epstein.

No iron barrier? Of course there is: "knowing" and "intentional" direct participation in the scheme. That is difficult to prove. In this case the companies recieved overpayments to funnel back into Charter's advertising, and in doing so agreed to backdate documents to make it look like the advertisment purchases were legitimate. That isn't just aiding and abetting, that is primary participation.

Also could somone explain what this means?
"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."

As a securities fraud lawyer I would highly dispute this. Sure some people made out when they sold at inflated prices which I suppose offsets the losses of those who bought during the price inflation, and the company is the one stuck paying off all the losses, but why is that wrong? Why shouldn'they be responsible? If someone steals a purse and later disards it,a nd someone else finds it and is happy about, do we say the theirf should only be punished for the net social costs he created? Would anyone in their right mind argue that the theif's punishment should be diminished by the fact that someone else found the purse and had their welfare increased? No way. It it an absurd proposition. Should certain have an increase in wlefare due to illegal conduct is neitehr here nor there anywhere in the law- you punishf or the damage you caused without considereing any ofsetting increase in wlefare you crime may have created elseweher.

But the fact is that only a handful of good securities fraud cases get successfully prosecuted each while most fraud goes undetected and unchallenged.That's a fact. Corporations get away with murder due to the heightened pleading standards of securities fraud. Republicans have been so successful at chainging the law in the interests of corproate america for all intensive purposes have to be able to demonstrate intent/scienter at the pleading stage, which is very difficult to do without being afforded any discovery. So if you want to be talking about net social wlefare, you;d better considere the whole system, wherein I can assure anyone readingthis, the frauds make out like bandits.

As for over deterrence, I have no idea what Epstein is taking about. You can be sued for omissions as much as you can be sued for mistatements. Epstein is talking out his ass when he claims "Across the board, harsh penalties for nondisclosure now induce firms to remain silent lest they incurring huge liabilities for modest misstatements." This makes no sense. if anything the harsh penalties cause more disclosure, not less, as well worded warnings and forward looking statements mitigate liability.

I call bullshit. Let's see the proof or Epstein should just admit he is a well paid hired gun for corporate america.

[Seth]

If there is a ruling for the plaintiffs, what is to stop investors from suing anyone who has business connections to a company that has knowingly (or even unknowingly) committed fraud? If Waste Management handles their refuse, are you going to sue them? What about non-executive Directors, who usually only show up at around 2 board meetings a year (oh, and for a look at the corporate ties that might have played a role in this particular case of fraud, check this out http://www.newsvisual.com/newsvisual/2007/10/scientific-atla.html ). A ruling in favor of the plaintiffs will quite simply open a Pandora's box up to new and frivolous lawsuits, which we have enough of already.

[LAK]

Well seth, it's a little thing called proof. You have to be able to prove things to be sucessful in a lawsuit. It doesn't open a pandora's box, it holds parties resposnible who were DIRECTLY involved in teh fraud. This ain't aiding and abetting. This is knowing and willful particiaption, which is difficult to demonstrate.

Do you undersatnd the facts of this case? The companies at issue knowingly and purposefully helped Charter cook their books, even going so far as to back date documents to make sham transactions look legitimate.

And what of teh case of Enron, where the well has dried up, yet there were other companies who knowingly participated in defrauding enron investors? Should those shareholders and pensioners go without becasue Enron was bankrupt and insurance policies were dried up? hardly. If you did more than aid a fraud, if you were a primary player and the fraud could nothave happened without your participation, you should be held primarily liable to those who were damaged by your actions.

[Joan A. Conway - Revealing Corporate Monikers]

Don't you think that some troubled corporations have a perchant for creative naming, like the crooked 'Enron.'

Such names might to undetected so not to expose them to ridicule, because they raise doubts about whether they are seaworthy.

Some company monikers' reveal sentiments for a historical belonging when they draw allusions of a glimpse of the past, such is the case with this demised Charter saga.

What we have here is a modern day dilemma, which is much like the current legislation concerning Motorcycle helmets.

A misture of our public values with someone's private risk taking.

In a corporate world, like-kind entities such as Charter Communications Company, ("herein known as Charter"), Scientific Atlanta ("herein known as one of the Defendants"), and Motorola ("herein known as the other Defendant"), who are co-adverturers with synergistic interactions.

These interactions have anticipatory avoidable consequences.

And these consequences relate back to only two of the co-adventurers, who made no misrepresentations and had no duty to disclose to Stoneridge Investment Partners ("herein known as Stoneridge"), and they did not create a basis for a common-law action for either fraud or deceit in a shareholders derivative action, in the court's opinion, based on Congress' intentions.

But as we should all known the law is never without avenues for redress.

Certainly we can agree that truth and fairness were denied to the investing public. Did Stoneridge receive honest services?

Even though Defendants have no fiduciary obligation to the Plaintiff(s), there was still no duty to disclose a 'scheme to manipulate' anything corporate,' let alone lure these Stoneridge investors, while defrauding them, or even their consumers as corporate stakeholders.

But, consider again, if these Defendants lie, they may be liable for damages. The risk has been transferred and concealed onto the unsuspecting investor(s). Their rights were violated, because they are held to be inferior parties and as a consequence frozen out in an ex ante bargain. Any withdrawal or limits of the investor(s) rights makes their investment purchases null and void, in my humble opinion.

When Defendants' aid and abet the fraud or deceit of Charter, they engage in altering the investment rules with pre-existing illegal 'tying arrangements' about the allocation of risk in their financial statements, as a going concern. Investor(s) were given no 'opt-out' or 'opt-in' options with definite default rules in their stock purchases with Charter, prior to deciding to purchase Chart er's stock.

The omission of rules are always hard to prove, because the third party, the Defendant(s) stand to benefit from Charter being evasive and vaque in order to confiscate the investors' stock purchase and stock value to avoid liability.

Considering the question(s) of the scope of duties of auditors to highlight fraud to management, I detail the weaknesses.

The director(s) duties in relying on employees that handle specific responsibilities, such as the material errors or irregularities when deductible labor expenses where captialized exposing the Charter's director(s) for breach of their duty to exercise due diligence.

See below:

[Joan A. Conway, Revealing Corporate Monikers]

1. Question to ask "did the auditors continue the relationship with the client?

If no claim is made in the case, the result is 'any claim' against the defendant auditors is reduced.

2. To postpone cutting off nonpayment customers reveals an intent to have a lack of cut-off tests performed irrespectively of the level of effectiveness of controls.

The movement of non-pyament customers on either side of accounting date is matched with appropriate accounting entries in the correct accounting periods. Non-payment customers are included as payment customers if they have been treated as 'no payment is due' customers before the year end, and were dispatched until after the year end.

The Defendants are in a pre-existing arrangement with Chart er to ell set top boxes for cable TVs on condition they engage in tying 'advertising' arrangements and exclusive-dealing contracts to create a monopoly in any line of commerce in violation of the Clayton Act, 15 U.S.C. Section 12-27. The illegal actions is a 'scheme' to boost revenue and defer outlays of cash to lure more investors to BUY. Charter is play 'catch-time Charter.'

And each non-payment customer increases the labor expenses to carry their default accounts for the reporting period, which is capitalized in other reporting periods.

The hoodwink investing public, or consumer(s) of common stock relied on the advertising of the stock's performance based on faulty financial reporting, but they are separate and apart, as unequal stakeholders to other dishonest business practices and public services.

The degree of separation moved from the private sphere to the public sphere.

The Charter ship captain allowed tying up his co-adverturers all identified more with each other than Stoneridge, because it allows for Me-First Obstructionism 'schemes.'

Charter and the Defendants lacked a want of care that resulted in the nonrelevant subsequent events that tainted the firm's dishones reporting unreasonable to the investing public and/or consumers of common stock. Under the doctrine of avoidable consequences the Defendants are liable for extrinsic fraud, by denying Stoneridge of full participation as a stakeholder in common stock, entitled to vote on corporate matters.

This is a Breach of Contract with the sellers of Charter's water-logged stock or an anticipatory repudiation that Charter is seaworthy, and runs outside of securities law right into extrinsic fraud. This amounts to consumer rights in stock purchases. But how does an attorney make this work is the legal question that needs to be answered by a specialist, if at all.