ACSBlog: The Blog of the American Constitution Society

by Kent Greenfield, Professor of Law at Boston College and Distinguished Faculty Fellow at the Center on Corporations, Law & Society, Seattle University School of Law

The Supreme Court will hear arguments today (Tuesday, October 9) in what some are calling the most important business case to come before the Court in a decade -- Stoneridge Investment Partners v. Scientific-Atlanta Inc. The facts pertain to the financial shenanigans of a cable television company, but the Court’s decision could have wide ranging implications for law firms, accounting firms, and banks, among others, and – depending on which side you listen to – could either damage the nation’s international financial competitiveness or leave millions of investors underprotected from fraudulent schemes.

The case arose from an alleged fraudulent scheme initiated by Charter Communications, one of the nation’s largest cable companies. In the summer of 2000, it became clear to Charter executives that it would not meet Wall Street’s expectations for annual cash flow and revenue. (Of course, the fact that companies have to focus increasingly on the short-term to the detriment of the long-term health of the company, much less society, is the root of many evils.) Charter asked two of its suppliers, Scientific-Atlanta and Motorola, to help out by inflating the prices it charged Charter for set-top boxes. The suppliers also had to produce private documents lying about the reason and the timing of the increase.

The suppliers agreed to pay back to Charter the same amount of money – $17 million in total – for advertising, which was really free. This “wash transaction” was done to mislead Charter’s external auditor and thus the market. The amounts paid for the set-top boxes were accounted for as capital expenses, appearing on the books over several years. The advertising “revenue” was reported in a lump sum, which made it appear to the auditor and investors that Charter had met its financial targets, which bolstered the stock price. When the fraud came to light two years later, Charter stock plummeted from $26 to 78 cents, costing shareholders millions.

The plaintiff class is a group of Charter shareholders who sued Charter and its suppliers for a violation of Rule 10b-5 of the federal securities laws, which makes it illegal to engage in a “scheme” to defraud. Charter settled. But the district court threw out the case against the suppliers, and the Eighth Circuit affirmed, saying that the suppliers themselves had not made any misstatements to the market and that the Supreme Court had said a decade ago, in Central Bank of Denver v. First Interstate Bank of Denver, that 10b-5 does not reach those who only “aid or abet” a violation. 

Heavy hitters have lined up on both sides of the litigation, deluging the Court with nearly forty amicus briefs. On one side, large pension funds, states, and institutional investors argue that the ability to sue all participants in a fraudulent scheme is necessary to protect investors and the integrity of the securities markets. The suppliers’ actions support more than secondary “aiding and abetting” liability but primary liability as part of a scheme to defraud. The fact that they did not directly make any misleading statement relied on by the plaintiffs is immaterial, since the fraud was “baked in” to the market price of Charter stock.  

On the other side are arrayed advocates for the corporate community, as well as banks, law firms, accounting firms, and the like. They argue that “scheme” liability will expose a wide swath of the business community to liability arising from actions of business partners over which they have little control. The risk of strike suits in such situations would be so high that it would depress business activity and put U.S. companies at a global competitive disadvantage. Business advocates also argue that the securities laws should be narrowly construed, especially when the Court is considering private rights of action.

Apparently there was significant debate within the Bush administration as to which side it would weigh in on, with the Securities and Exchange Commission urging the Solicitor General to file an amicus brief in favor of the investors, and Treasury Secretary Henry Paulson (former head of investment bank Goldman Sachs) prodding the SG on behalf of the defendants. After the White House also stepped in on the side of the defendants, the SG filed an amicus brief arguing that the suit should not be allowed to proceed. 

Earlier in the summer, it looked like the case would be decided by a 7-person Court, as both Chief Justice Roberts and Justice Breyer announced their recusal. But over the summer the Chief rescinded his recusal, apparently after selling some stock he owned. The case will likely turn on his views and those of Justice Alito; since the other six justices split 3-3 when Central Bank was decided.

What this case may really be about is Enron. A case brought by former Enron shareholders against Credit Suisse, Merrill Lynch, and other banks for allegedly helping Enron hide its financial improprieties is on hold until Stoneridge is decided. If the investors win in Stoneridge, the Enron plaintiffs may be able to get some of their money back. If not, those who lost their shirts in the Enron debacle will feel a chill.