Revisiting StoneRidge: Congress Could Restore Aiders' and Abettors' Liability
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A bill introduced to Congress this past summer, and subsequently handed over to a Senate subcommittee for further consideration and/or revisions, could reverse a hotly debated January 2008 US Supreme Court decision. That decision, Stone-Ridge Investment Partners LLC v. Scientific-Atlanta Inc., upheld a lower appeals court’s April 2006 decision that secondary participants in a corporate fraud cannot be held legally liable for their behind-the-scenes participation in the scheme. Their actions, the high court reasoned, were simply too far removed from and could not have been known by investors.
Such so-called secondary participants or “actors” can include investment bankers, accountants/auditors, lawyers, vendors, and customers who have played a role in facilitating a publicly held corporation’s fraud, including helping cover up excessive debt, cooking the books, issuing material misstatements, or filing creative financial statements.
In StoneRidge v. Scientific-Atlanta, institutional investment manager StoneRidge Investment Partners of Malvern, Pennsylvania, sued two suppliers that had helped a St. Louis–headquartered cable company, Charter Communications, to artificially inflate its financial results. In a 5–3 split decision, Justice Anthony Kennedy reasoned that although the suppliers, Scientific-Atlanta and Motorola, had agreed to participate in secret arrangements that allowed Charter to deceive auditors, the two suppliers had no direct hand in the actual issuance of those bogus financial statements. In addition, Kennedy noted, the investors did not rely on any statement or representation issued by the suppliers when determining whether to purchase Charter’s stock.
CONGRESS ADDRESSES THE LIABILITY ISSUE
On July 30, 2009, Senator Arlen Specter introduced a bill to the US Senate, which, if passed by both houses of Congress, would legislatively overturn the StoneRidge decision and grant injured investors the right to file civil suits against secondary participants. The bill, S.1551, which is known as the Liability for Aiding and Abetting Securities Violations Act of 2009, would amend Section 10(b) of the Securities Exchange Act of 1934. As the bill was originally drafted, this proposed law would “subject to liability in a private civil action any person that knowingly or recklessly provides substantial assistance to another person (aids and abets) in violation of such Act.”
In introducing the bill on the floor of the Senate, Specter threw down the gauntlet and challenged his fellow senators to revive shareholders’ rights to sue those who help perpetrate fraud and harm investors. “The massive frauds involving Enron, Refco, Tyco, Worldcom, and countless other lesser-known companies during the last decade have taught us that a stock issuer’s auditors, bankers, business affiliates, and lawyers—sometimes called ’secondary actors’—all too often actively participate in and enable the issuer’s fraud. My legislative response would take the limited, but important, step of amending the Exchange Act to authorize a private right of action under Section 10(b) … against a secondary actor who provides 'substantial assistance' to a person who violates Section 10(b).”
It is unclear why Specter threw his legislative muscle behind this bill now, 18 months after the Supreme Court’s decision. Suggestions have been made that lobbyists representing the rights of investors are likely rallying behind the scenes. An executive at StoneRidge denies having any discussions or influence with Specter either directly or through lobbyists.
The bill won support early on from two cosponsors, Democratic senators Edward Kaufman and Jack Reed. A third cosponsor, Sheldon Whitehouse, a Democrat from the state of Rhode Island, officially jumped on the bandwagon on August 6, 2009.
THE STONERIDGE CASE
In October 2007 the high court heard testimony from lawyers representing Stone-Ridge, the lead plaintiff among a consortium of investors. StoneRidge sought to sue Scientific-Atlanta and Motorola, who both sold cable TV converter boxes to Charter, a cable TV operator. Charter, in turn, then supplied these converter boxes to its subscribers.
The court acknowledged the alleged facts: In late 2000 Charter executives realized that the company would fall short of projected operating cash flow by $15 million to $20 million. In order to make up the shortfall and meet Wall Street’s expectations, Charter entered into separate agreements with both Scientific-Atlanta and Motorola, under which Charter would overpay both suppliers $20 for each cable converter box it ordered for the remainder of the year. Both suppliers then agreed to return the overpayments to Charter in the form of advertising they purchased from the cable company at prices significantly higher than fair value.
The companies drafted documents, which were then backdated, to make it appear as if Charter’s higher fee paid for purchasing converter boxes and as if the two vendors’ agreements to advertise were separate business arrangements conducted in the ordinary course of business. The ruse was intended to deceive Charter’s auditor at the time, Arthur Andersen.
Although the transactions had no true economic value to Charter, the secret arrangements allowed Charter to juice up financial results. Consequently, Charter executives were able to overstate revenues and operating cash flows by $17 million.
Both the lower court of appeals and the Supreme Court agreed that though Scientific-Atlanta and Motorola were complicit in the fraud, the two companies had “no role in preparing or disseminating Charter’s financial statements,” as Kennedy wrote. Moreover, the two suppliers had booked the transactions as a “wash” on their own corporate financial statements, using proper accounting practices so that their own shareholders were not negatively impacted.
CITING HISTORY AND CASE LAW
When making their decision, the high court’s justices considered a 1971 ruling that stated that although Section 10(b) of the Securities Exchange Act of 1934 does not explicitly allow for private rights of actions (the right to bring lawsuits), it does implicitly allow for such suits—as long as several criteria are met. The plaintiff must prove: (1) that the defendant made a material misrepresentation or omission; (2) scienter, also known as “intent”; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) a reliance upon that misrepresentation; (5) the existence of an economic loss; and (6) that this misrepresentation/omission caused the financial loss.
Justice Kennedy also explained the Supreme Court’s reliance on a similar case from 1994, Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., under which the high court determined that liability did not extend to aiders and abettors.
Back in the nineties, when the controversial Central Bank of Denver decision was handed down, it ignited calls for Congress to amend the rules for lawsuits. Legislators considered adding a new provision to the Private Securities Litigation Reform Act of 1995 that would allow legal action against aiders and abettors. The act was intended to stem frivolous lawsuits and reform the burden of proof requirements for plaintiffs. But, after careful consideration, Congress declined to include a provision to allow plaintiffs to sue aiders and abettors.
In light of this history, the high court decided that StoneRidge could not sue either Scientific-Atlanta or Motorola as secondary actors. It acknowledged, however, that the SEC as the top securities regulator is empowered to pursue legal courses of action against those found to have aided and abetted. Moreover, the court volleyed the responsibility right back to the Congress for a legislative fix if that was its desire.
“The Supreme Court expressly stated in its StoneRidge opinion that the decision to extend the cause of action is for Congress, not for us,” says Bruce Ericson, litigation partner and cohead of the national securities litigation team at Pillsbury, Winthrop, Shaw, and Pittman. “Congress is free to override StoneRidge if it chooses to do so, and Congress has overridden Supreme Court decisions about statues many times in the past. Whether in this case it would be wise—as opposed to legal—to override StoneRidge is, of course, another question altogether.”
TO SUE OR NOT TO SUE
Some believe a new securities law allowing for lawsuits against aiders and abettors is long overdue and would provide a new tool for deterrence. “It is very important because very often, with the complexities of business arrangements, it’s not possible to carry out fraudulent activity unless business partners provide active or passive assistance,” maintains Joseph Stocke, CFA and the managing director and chief investment officer of StoneRidge. “If aiders and abettors felt they would be liable, they would likely not assist, and it would make it harder for these acts to occur.”
“The argument that the SEC can step in is not sufficient because the SEC can be overwhelmed by the amount of fraudulent and inappropriate behavior,” Stocke adds. Although Stocke says that he does have a lot of confidence in the SEC, very often the agency has limited resources and a limited staff with which to work.
Some believe that empowering individuals to sue aiders and abettors would lead to an avalanche of lawsuits and could potentially cripple US companies, as well as their auditors, bankers, lawyers, and business partners. “I don’t believe it would lead to a flood of inappropriate lawsuits because it is expensive to litigate—and it costs money to hire forensic accountants and others,” Stocke observes. “It’s not the kind of thing that would be done frivolously.”
Robert Prentice, a professor at the McCombs School of Business at the University of Texas at Austin, believes that if Congress allows secondary players to be sued, there may be an increase in lawsuits. “But it’s far from a surety that it will have a huge impact,” Prentice says. “There will be a strong burden of proof on plaintiffs in order to plead cases. Plaintiffs must always prove, and prove clearly, that defendants knew they were helping a fraud.”
“The litmus test is did they engage in a scheme? People giving substantive assistance to the substantial execution of fraud should be liable,” says Gary Brown, shareholder and lawyer in the Nashville, Tennessee, office of the law firm of Baker Donelson. “Companies shouldn’t care about expansion of liability laws, they should applaud it.”
But not everyone agrees that Congress should pave the way for litigation. “My opinion is to keep it out of the courts and let the SEC or the Department of Justice get involved,” remarks Antony Page, a professor of law at the Indiana School of Law, in Indianapolis. “We should be spending a bit more money on enforcement and regulation to deter such activities.”
READYING FOR A NEW LAW?
The Senate Judiciary Committee’s Subcommittee on Crime and Drugs held hearings to further discuss S.1551 on September 17, 2009. Speakers on both sides of the issue provided their perspectives and made suggestions for potential revisions to the bill.
During his testimony, John Coffee, a professor of law at Columbia University, acknowledged that many class-action lawsuits end with “pocket shifting wealth transfers,” in which former shareholders involved in the suit are compensated by current shareholders. But, he added, this is not true for secondary participant cases because recoveries come directly from secondary fraudsters. “To give these gatekeepers immunity from private liability is to abandon what logically is the most efficient technique for deterrence: namely, to focus on the party who has both the ability to block the illicit transaction and the weakest incentive to engage in it.”
Coffee recommended that private aiding and abetting liability be restored, but he suggested a ceiling on damages against secondary defendants in order to prevent another unintended nuclear wipeout similar to Arthur Andersen’s demise during the Enron debacle. “The goal should be to devise a penalty that is sufficiently painful to deter, but not so large as to threaten insolvency.”
“As with any market system, the capital markets will function most efficiently and fairly if investors themselves have the legal tools necessary to hold accountable those who knowingly or recklessly put their investments at risk,” said Patrick Szymanski, general counsel of the organization Change to Win, which represents nearly six million union workers with retirement plans holding $200 billion in assets. “The SEC cannot be the sole cop on the beat,” he told subcommittee members in his testimony.
But those in favor of the status quo and against a Congressional bill allowing for broader liability also spoke. Robert Giuffra, Jr., a partner with the law firm of Sullivan & Cromwell and former chief counsel of the US Senate Committee on Banking, which drafted the Private Securities Litigation Reform Act of 1995, believes Congress acted deliberately, not haphazardly, in not extending securities liability when litigation reforms were enacted.
“Congress made the right decision in the 1995 Reform Act to permit only the SEC—and the Department of Justice in criminal cases—to bring so-called ’aiding and abetting’ securities claims against third parties,” he said. Giuffra also believes the competitiveness of the US capital markets would be hurt by expanded liability concerns among foreign private issuers who list shares on US exchanges. He further advocated leaving sanctions to the SEC and Department of Justice. “If the threat of a long prison sentence doesn’t deter aiding and abetting, it’s highly doubtful that the risk of a class-action lawsuit is going to stop such conduct.”
Giuffra raised concern about loose phrasing in S.1551 and the lack of precise definitions of what constitutes “recklessly” aiding and abetting and what counts as providing “substantial assistance” to other persons. He recommended that Congress first enhance the bill by adopting strict parameters and precise definitions for these ambiguous concepts.
It is not yet clear whether Specter’s bill will be referred to another Congressional committee, will be remanded back to the full Senate for a vote, or will simply die in committee.
--Lori Pizzani is an independent journalist in Brewster, New York.