D&O Liability - Supreme Court Rules That No Private Right of Action Exists Under Section 10(b) of the Securities Exchange Act of 1934 or Rule 10b-5 When Claimants Do Not Rely Upon Statements or Deceptive Acts of Defendants
On January 15, 2008, in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., No. 06-43, the Supreme Court of the United States held in a 5-3 decision that Section 10(b) of the Securities Exchange Act of 1934 and
Rule 10b-5 of the Securities and Exchange Commission (“SEC”) do not provide an implied private right of action against persons, including customers or suppliers of the issuer, when investors do not rely on statements
or conduct by such persons. The Court’s majority opinion, authored by Justice Kennedy, was joined by Chief Justice Roberts and Justices Scalia, Thomas and Alito. Justices Stevens filed a dissent, joined by Justices Souter and
Ginsberg. Justice Breyer did not participate.
In Stoneridge, the plaintiffs alleged that Charter Communications, Inc. issued false financial statements and engaged in fraudulent practices to inflate its reported results regarding cable subscriber growth and operating
cash flow. To hide projected shortfalls in revenue and cash flow, Charter allegedly entered into agreements with Scientific-Atlanta, Inc. and Motorola, Inc., vendors that supplied Charter with the digital cable converters (i.e.,
set-top boxes). The transactions allegedly had no substance, however, because Charter allegedly overpaid the vendors $20 for each set-top box purchased through the end of 2000, and Scientific-Atlanta and Motorola allegedly returned
the overpayment by purchasing advertising from Charter. Charter nevertheless recorded the advertising purchases as revenue and capitalized its purchases of the set-top boxes in violation of Generally Accepted Accounting Principles,
thus inflating its reported revenue and operating cash flow in its SEC filings. Charter’s auditors, Arthur Andersen, allegedly were misled by the sham transactions. Charter later restated its financial statements.
Stoneridge Investment Partners, LLC filed a class action against Scientific-Atlanta and Motorola, arguing that by participating in these sham transactions, the vendors violated Section 10(b) of the Securities Exchange Act and SEC Rule
10b-5. The District Court for the Eastern District of Missouri granted the vendors’ motion to dismiss. The Eighth Circuit affirmed, holding that the vendors made no misstatements relied on by the public and breached no duty
of disclosure. The Eighth Circuit found that, at most, Scientific-Atlanta and Motorola aided and abetted Charter’s misstatement of its financial results, but, under Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.,
511 U.S. 164 (1994), there is no private right of action for aiding and abetting under Section 10(b).
The Supreme Court affirmed, based on its finding that plaintiffs could not show reliance, a critical element to their Section 10(b) claim. In its decision, the Court stated that deceptive conduct (such as backdated contracts) can be
sufficient to trigger potential liability under Section 10(b), thus making clear that liability under the statute is not limited to specific oral or written statements. However, in this case, the shareholders’ claim against
the vendors floundered based on their inability to allege that they relied on any of the vendors’ deceptive acts or statements. Here, no presumption of reliance existed, because the vendors had no duty to disclose information
to Charter’s shareholders, and plaintiffs further had no knowledge of the vendors’ deceptive conduct. The Court further held that there was an insufficient causal link between the vendors’ conduct and the shareholders’
injury, and rejected the plaintiffs’ “scheme liability” argument that Charter’s false financial statements were “a natural and expected consequence of [the vendors’] deceptive acts.”
As the Court stated, “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.” In
Stoneridge, the vendors’ deceptive acts, which were not publicly disclosed, were “too remote” to satisfy the reliance requirement under Section 10(b).
The Supreme Court’s decision recites several policy grounds in support of the result. First, the Court noted that the deceptive acts at issue involved ordinary business operations – purchase and supply contracts –
which are governed by state law. Although the Court recognized that the SEC could exercise its enforcement power where such contracts affect the securities markets, it determined that Section 10(b) does not incorporate common law fraud
and “does not reach all commercial transactions that are fraudulent and affect the price of a security in some attenuated way.” Simply put, Section 10(b) “should not be interpreted to provide a private cause of
action against the entire marketplace in which the issuing company operates.”
Second, the Court explained that the shareholders’ theory was inconsistent with Congress’ specific response to the Court’s 1994 decision in Central Bank of Denver. In promulgating the Private Securities
Litigation Reform Act of 1995, Congress authorized aiding and abetting liability only in actions brought by the SEC. If the shareholders’ construction of Section 10(b) were adopted, “we would undermine Congress’
determination that this class of defendants should be pursued by the SEC and not by private litigants.”
Third, the Court expressed concern about the “practical consequences” of exposing a new class of defendants to the risk of suit under Section 10(b) and the concomitant potential for permitting plaintiffs with “weak
claims to extort settlements from innocent companies.” The Court noted that these risks raise the cost of doing business, may deter overseas firms from doing business here, and ultimately may shift securities offerings away
from domestic capital markets.
Lastly, the Court invoked the doctrine of separation of powers, stating, “[t]he decision to extend the cause of action is for Congress, not for us,” and the Section 10(b) private right, although judicially created, “should
not be extended beyond its present boundaries.”
The Stoneridge decision thus is consistent with the restrictive view expressed by the Court on the reach of the federal securities and antitrust laws in recent decisions issued by it, including Tellabs Inc. v. Makor Issues & Rights, Ltd.,
127 S.Ct. 2499 (2007). The immediate significance of Stoneridge lies in its limitation of Section 10(b) liability to those defendants who make public statements or whose deceptive acts become known to, and thus are directly
relied on by, investors.