Clarinet.Woodwinds.Com | STONERIDGE INVESTMENT PARTNERS, LLC v. SCIENTIFIC-ATLANTA, INC., ET AL.

Before the v. we have Stoneridge Investment Partners, LLC. According to its website, Stoneridge is an investment company started in 1999 for institutional investors. Stoneridge manages stock portfolios, and it owns many different companies. In 2000, Stoneridge owned stock in a company called Charter Communications, Inc. Charter Communications (for those of you that don't recognize it) is a mid-western cable tv and internet provider.

After the v. are some companies that were suppliers, and customers, of Charter Communications: Scientific-Atlanta, Inc. and Motorola, Inc.

How did they end up on the two sides of the v.?

Stoneridge (and a gang of class action plaintiffs who also invested in Charter) focused its wrath mostly at Charter Communications, but also at a whole bunch of other people: Arthur Anderson (Charter's accountant), Scientific-Atlanta, Inc., and Motorola (supplier/customers). Here's what Stoneridge thinks happened:

In 2000, Charter Communications, just like some other notable companies in those late years of the technology bubble, was playing fast and loose with accounting rules to inflate its stock price. It did different things to that end. It misclassified its customers; delayed reporting terminated customers; capitalized costs as expenses; and manipulated billing cutoff dates to show larger revenues. All of that scheming wasn't enough to meet its projected revenue and cash flow projections. So Charter moved on to a more devious plan.

It conspired with Scientific-Atlanta and Motorola to create a false accounting that would make its revenue look larger, and its capital outlook look better. Charter would buy set top boxes from Motorola & Scientific-Atlanta at $20 more per box. Then, Motorola & Scientific-Atlanta would "buy" advertising services for the difference of the regular prices and the inflated prices.

For someone without an accounting degree, this doesn't sound like a big deal, but it is. First, the purchases of advertising make it look like revenue is up - a good thing. Second, set top boxes are an asset - so with more valuable assets the company looks even better. The stock price rises because the company reports that it is performing well. And everyone believes these numbers because Arthur Anderson, one of the most respected accounting auditors in the country, is reporting the increase in revenue & assets.

But, if these were sham transactions, then Charter didn't have the increased value in assets (the set top boxes were actually worth less) and the there wasn't real revenue from advertising because Charter had actually paid its customers to purchase the advertising. Scientific-Atlanta and Motorola played along and generated false invoices that didn't make them look any better, but allowed Charter to hide the scheme from its accountants, federal regulators, and the public.

Eventually, just like Enron, WorldCom, and AOL, Charter was caught.

Now the question is: Would Motorola & Scientific-Atlanta be liable to Stoneridge for their role in the scheme?

How did this case get to the Supreme Court?

Stoneridge sued using section 10(b) of the Securities and Exchange Act. Before there was even a trial, the Federal District court concluded that, even assuming everything that Stoneridge said was true, Scientific-Atlanta and Motorola could not be liable to Stoneridge for their role in Charter's deception.

Stoneridge appealed, and lost in front of the Eighth Circuit.

Stoneridge appealed to the Supreme Court, which granted the appeal.

What is section 10(b) of the Securities and Exchange Act?

Get ready for some quoted statutory text - as taken from the Court's opinion - the law says:

Section 10(b) of the Securities Exchange Act makes it "unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . [t]o use or employ, in connection with the purchase or sale of any security. . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors." 15 U. S. C. § 78j.

The SEC, pursuant to this section, promulgated Rule 10b-5, which makes it unlawful "(a) To employ any device, scheme, or artifice to defraud,
"(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
"(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, "in connection with the purchase or sale of any security." 17 CFR § 240.10b-5.

Now this statute is old (from the 1930's), so don't expect that you understand it just because you read it. Every word has been parsed and ground as fine as Turkish coffee. The rule is that companies can't lie to improve their stock price.

The statute also has a non-obvious characteristic. The statute has an implied private right of action that allows damaged stock buyers to sue the companies that violate the statute. To win, Stoneridge had to allege that Scientific-Atlanta & Motorola:

made "a material misrepresentation or omission . . .;
[they did it with] scienter;
[there was a] connection between the misrepresentation or omission and the purchase or sale of a security;
reliance upon the misrepresentation or omission;
[Stoneridge suffered] economic loss;" and
the misrepresentation caused the loss.

What did the Court decide?

The Court decided that the district court and the court of appeals were right: Scientific-Atlanta and Motorola are not liable to Stoneridge.

Even so, the Supreme Court decided that the Court of Appeals got it right for the wrong reason.

What was the difference between the Supreme Court's decision and the Eighth Circuit Court of Appeals decision?

The Eighth Circuit decided that these two companies were not the ones who decided to publish the false numbers to the public, so, they did not engage in a misrepresentation.

The Supreme Court disposes of this lame reasoning without much comment. Deceptions can be more subtle, and do not require that we lie with words. A lie can be created through action.

But, the Court does agree that what Scientific-Atlanta and Motorola did here did not have "proximate relation" to the harm that Stoneridge experienced. Proximate relation meaning, in this instance, Scientific-Atlanta and Motorola did not cause Stoneridge to rely on the crooked deals when Stoneridge bought Charter's stock.

How did the Court decide?

First, the Court distinguished some doctrines that make it easier to plead violations of the Securities and Exchange Act. The Court presumes that the securities consumer relied on the defendant in two instances: 1) when the defendant who has a duty to disclose chooses not to disclose, and 2) when a defendant's false statement become public.

In this case, neither applied. Motorola & Scientific-Atlanta did not actually publish anything, and the Court rules that they didn't have a duty to expose Charter's fraud.

Second, the Court has to deal with an emerging area of Securities law, called "scheme liability." Scheme liability proposes that members of a scheme to defraud the public should be held liable, even if those members do not make public statements.

The Supreme Court is not convinced that scheme liability, as applied to this case, adequately addresses causation.

There were a big list of reasons:

If transactions can be a basis for securities fraud actions, the entire marketplace could be liable for ordinary transactions outside the security transactions.
Federal power should not be exercised outside the realm of securities when state laws cover the area.
Precedent indicates that extension should be disfavored.
Even if this would be a violation of common-law fraud, precedent indicates that it would be inappropriate to equate common-law fraud to securities fraud.
Congress passed a law (after the Supreme Court ruled that aiding and abetting securities fraud was not a crime) that only allowed aiding and abetting cases to be brought by the government.
Congress has not generally relied on the courts to provide the substance of the violations.
The practical consequences of expanding the law to cover this behavior will be trouble for a whole new class of defendants.

Third, the Court goes on, in a separate section, to add some commentary on the idea behind the non-obvious and implied private cause of action.

The Supreme Court implied a private cause of action in Section 10(b). But modern cases rarely imply private causes of action. That fact cautions against the Supreme Court expanding the right. Modern cases even disfavor creating implied private causes of action based on new federal laws. Thus, the Court doesn't want to make more law in this area.

Finally, the Court gives a parting shot toward any detractor who might be upset that Stoneridge can not pursue its case. While Stoneridge might not be able to sue Scientific-Atlanta & Motorola for their part in the scheme, the Federal Government could punish those companies with criminal and civil penalties. The SEC can even make the two companies pay back money to injured investors. Also, some state laws would allow Stoneridge to bring a case against Scientific-Atlanta & Motorola based on their misrepresentations.

Who won?

Scientific-Atlanta & Motorola

So what was the vote tally?

Justice Kennedy wrote the opinion, and Roberts, Scalia, Thomas and Alito joined him. Justice Stevens, Souter and Ginsburg dissented. Breyer sat this one out. So the vote was 5-3 in favor of Scientific-Atlanta & Motorola.

What are those dissenters complaining about?

We are talking about a lot of $20 added onto set top boxes that was then booked as revenue. $17 million dollars worth. This went straight into Charter's revenue statement. And every investor relies on revnue statements. Even the majority conceded that had the government brought the case, the government would have been able to win.

So, primarily the dissent complains that the majority required excessive work from plaintiffs without good reason.

The dissenters disagree that this is an aiding and abetting violation. Scientific-Atlanta & Motorola engaged in a specifically designed deception. They wrote invoices that lied about the reality of the transactions. These companies didn't just "help out" by making it easy to decieve the auditors, they wrote the documents that would decieve the auditors.

The dissenters even disagreed that the remedy is correct. The Supreme Court affirmed the dismissal - instead of remanding the issue to the lower court to determine if Stoneridge could allege actual reliance on Motorola & Scientific-Atlanta's actions. The dissenters thought a better idea would be to send it to the lower court to determine if Stoneridge has a case some other way. A presumption is a thumb on the scales that makes it easier to prove a fact of consequence. Just because a presumption does not apply, does not mean that Stoneridge can never win. Reliance doesn't have to be presumed - it can be proven. The classic causation test is "but for" Scientific-Atlanta & Motorola decision to print false invoices, would Stoneridge have bought Charter's stock? Proximate causation only makes the allegations too remote because the Supreme Court said so - and the Court isn't giving Stoneridge a fair chance to prove that it actually relied on the transactions at issue in this case.

The dissent does not approve of the Court's analysis of the statutory modifications either. The dissent reasons that this is not an aiding and abetting type violation. There's no reason to believe that statutory history has much to add. The statutory history concerned aiding and abetting violations.

Finally, the majority's hostility toward the implied cause of action perturbs the dissent. The Court shouldn't limit the private cause of action. The private cause of action happens to be implied, rather than expressly stated; but when Congress wrote this law, a private cause of action was always implied. It wasn't until 1975 that the Supreme Court started to limit implied causes of action on stautes as a matter of course. In the common-law tradition, "every wrong shall have a remedy." Thus, there is no conflict between a more expansive view of the liabilty here and an implied cause of action.

What's the big idea?

This case many ideas:

Causation in private actions for securities fraud must show a close relationship between the fraud and the actions that lead to it. Ordinary buisness practices can't be proof of fraud. Even sham transactions in transactions may not be enough.
The Supreme Court is reluctant to make an already lucrative area for litigators more lucrative by making it easier to sue parties not directly perpetrating fraud.
Lots of broad state laws give the Supreme Court an excuse to narrow, or at least not broaden, Federal Law.

There is also a sort of philosphical conflict over the role of courts. The majority takes the view that courts should actively work to reduce the burden of private litigation on innocent (or mostly innocent actors) by adopting policies that limit private causes of action. The dissent takes the view that courts should give private litigators space to prove harm in resaonable cases of egregious conduct.

What happens now?

The loser, Stoneridge, wiil continue to attempt to get money out of Charter for Charter's cooked books.

The two winners, Scientific-Atlanta & Motorola, go home without all that litigation stress: you know, the discovery and trial on their helping Charter lie.

Although, the appeal to the Supreme Court couldn't have been cheap.

What's the longest word?

CLARINET.WOODWINDS.COM will omit the longest word. Scientific-Atlanta was long enough. Thankfully, Scientific-Atlanta sold to Cisco, a nice, short, name.