In a 5-3 decision, the Supreme Court of the United States (the “Court”) held that private litigants could not pursue a suit under the anti-fraud provisions of Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 thereunder, against suppliers of cable boxes for their role in transactions with an issuer of publicly traded securities that issued misleading financial statements based on those transactions, which in turn affected the issuer’s stock price. The Court’s decision followed a dismissal of the plaintiff’s complaint by the District Court on the grounds that it failed to state a claim on which relief could be granted; the United States Court of Appeals for the 8th Circuit affirmed. In its decision, the Court indicated that the Courts of Appeals were in conflict over whether an injured investor may sue under Section 10(b) to recover from a party that participates in a scheme that violates Section 10(b), even when the party does not make a public misstatement or violate a duty to disclose.
The Plaintiffs’ Allegations. The plaintiffs alleged that the defendants and the issuer set up an arrangement where the issuer bought cable converter boxes from the defendant suppliers at a $20 premium over the usual price per unit with the understanding that the suppliers would use the amount of these overpayments to purchase advertising from the issuer. The plaintiffs claimed that the transactions had no economic substance and were designed to allow the issuer to record the advertising purchases as revenue and capitalize its purchase of the cable boxes in violation of generally accepted accounting principles. The complaint also alleged that the companies drafted documents to make the cable box and advertising transactions appear unrelated: among other things, the agreements to purchase new cable boxes were backdated to make it appear they were negotiated a month before the advertising agreements. The issuer recorded the advertising payments as revenue which was shown in financial statements filed with the SEC and reported to the public. The amount of revenue recognized was approximately $17 million, which enabled the issuer to meet operating cash flow projections. The defendant suppliers had no role in preparing or disseminating the issuer’s financial statements; their own financial statements showed the transactions as a wash in accordance with generally accepted accounting principles. The plaintiffs alleged that the defendant suppliers (a) knew or were in reckless disregard of the issuer’s intention to use the transactions to inflate its revenues to make projections and (b) knew that the resulting financial statements for the issuer would be relied upon by research analysts and investors.
The Court’s Decision. The Court began its analysis by noting that under Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) (“Central Bank”), the implied private right of action under Section 10(b) did not extend to aiders and abettors; therefore, the conduct of secondary actors like the defendant suppliers must satisfy each of the elements for liability under Section 10(b). The Court’s decision focused on the reliance element of Section 10(b) (the requirement that there be reliance on a defendant’s material misrepresentation or omission) and held that because the defendant suppliers had no duty to disclose and their deceptive acts were not communicated to the public (i.e., did not fall within the fraud‑on‑the‑market doctrine), the plaintiffs could not show reliance by the plaintiffs on any of the defendant suppliers’ actions except in an indirect chain that the Court found too remote to support liability. The Court noted that nothing the defendant suppliers did made it necessary or inevitable that the issuer would record the cable box purchases and advertising revenue as it did. In further support for its position, the Court cited its concern that construing Section 10(b) in the manner proposed by the plaintiffs, i.e., that investors relying not only upon public statements relating to a security, but also upon the transactions underlying those statements, would cause federal power under the guise of securities litigation to invade the realm of state law governing ordinary business operations. The Court stated that although Section 10(b) is not limited to preserving the integrity of the securities markets, it does not reach all commercial transactions that are fraudulent and affect the price of a security in some attenuated way. The Court also cited the Congressional response to Central Bank reflected in Section 104 of the Private Securities Litigation Reform Act which the Court viewed as reflecting Congress’ intention that aiders and abettors should be pursued by the SEC and not by private litigants. Finally, the Court cited the practical concern that permitting the plaintiffs’ theory of liability under Section 10(b) would result in an expansion of securities litigation, which would raise the cost of doing business for U.S. issuers, deter overseas firms from doing business in the U.S. and shift securities offerings overseas. Although it found the defendant suppliers were not subject to a private right of action under Section 10(b), the Court observed that secondary actors were still subject to criminal penalties, civil enforcement by the SEC and in some cases, state securities laws that permit state authorities to seek fines and restitution from aiders and abettors. (Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., No. 06-43 (Jan. 15, 2008).)Goodwin Procter’s Securities Litigation & SEC Enforcement Practice Area is preparing a Client Alert that discusses the Court’s decision and its ramifications in greater detail. The Client Alert will be provided to Alert readers when it becomes available.