In the Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (a.k.a. Charter Communications) case, the U.S. Supreme Court has held that the implied private right of action under Sec. 10(b) for securities fraud does not extend to third parties who neither make alleged misstatements nor engage in deceptive conduct on which investors relied. The 5-3 decision (Justice Breyer did not participate) authored by Justice Kennedy resolves a circuit split over the scope of “scheme liability.”
In Stoneridge, the plaintiffs alleged that Charter and two of its suppliers and customers, Scientific-Atlanta and Motorola, knowingly engaged in a business scheme that allowed Charter to artificially inflate its reported revenues and operating cash flow. The plaintiffs sought to hold Scientific-Atlanta and Motorola primarily liable for the misstatements contained in Charter’s financial statements. The district court, with an affirmance from the U.S. Court of Appeals for the Eighth Circuit, dismissed these claims. On the issue of scheme liability, the Eighth Circuit found that Scientific-Atlanta and Motorola had not participated in the making of the misstatements and “any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under Sec. 10(b) or any subpart of Rule 10b-5.”
On appeal, the Supreme Court took a notably different approach. The Court rejected the Eighth Circuit’s decision to the extent that it could be “read to suggest there must be a specific oral or written statement before there could be liability under Sec. 10(b) or Rule 10b-5.” The Court found that “[c]onduct itself can be deceptive” and provide the basis for liability. Instead, the Court focused on whether the Charter investors could be said to have relied upon the deceptive acts of Scientific-Atlanta and Motorola in purchasing their securities.
The Court concluded that there was no basis for finding that the investors could be presumed to have relied upon the relevant deceptive acts. First, Scientific-Atlanta and Motorola had no duty to disclose their conduct to Charter’s investors. Second, the fraud-on-the-market doctrine was inapplicable because the conduct was “not communicated to the public.” Accordingly, the Court held that the investors could not “show reliance upon any of respondents’ actions except in an indirect chain that we find too remote for liability.”
The rest of the opinion is devoted to various legal and policy defenses of this limitation on the scope of scheme liability. The Court noted that Charter’s investors were seeking to apply Section 10(b) “beyond the securities markets – the realm of financing business – to purchase and supply contracts – the realm of ordinary business operations.” To do so would “invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees.” Moreover, adopting the position advocated by Charter’s investors would “revive in substance the implied cause of action against all aiders and abettors except those who committed no deceptive act in the process of facilitating the fraud” and would undermine Congress’ determination in the PSLRA that this “class of defendants should be pursued by the SEC and not by private litigants.” Finally, the Court expressed concern that “scheme liability” would “raise the cost of being a publicly traded company” and “shift securities offerings away from domestic capital markets.”
Holding: Affirmed.
Notes on the Decision
(1) The Court adhered closely to the argument made by the Department of Justice in its amicus brief. Although some commentators predicted that outcome, the Court’s focus on reliance is interesting given that Chief Justice Roberts (who joined the majority opinion) expressed skepticism at oral argument over whether the issue was properly before the Court. The dissent (Stevens, J.) agreed that the issue was not ripe and suggested that “the fairest course to petitioner would be for the majority to remand to the Court of Appeals to determine whether petitioner properly alleged reliance, under a correct view of what Section 10(b) covers.”
(2) While the media is likely to trumpet the decision as a victory for corporate defendants, it is important to note that the victory was not as sweeping as it could have been. Contrary to the holdings of both the Eighth Circuit and the Fifth Circuit (see here), the Court held that deceptive conduct, even without the existence of an oral or written misstatement, can provide the basis for securities fraud liability if the plaintiffs can establish that they relied on that conduct. Indeed, many courts have defined the distinction between “aider and abettor” and “primary violator” by reference to the level of participation of the individual defendant in making the misstatement at issue and whether the public became aware of the defendant’s alleged involvement. Does Stoneridge open the door to a broader view of “participation”?
(3) The Court’s references to the possible deterrence of overseas firms from doing business in this country and the shifting of “securities offerings away from domestic capital markets” are going to draw criticism as being excessively policy oriented (see here for an early example).
(4) In support of its holding that the investors could not establish reliance, the Court repeatedly cited the investors’ lack of knowledge about the “deceptive acts” in which Scientific-Atlanta and Motorola were alleged to have engaged. Presumably the Court was referring to the failure of the investors to allege that they were aware of the transactions between the companies and Charter, not to a lack of knowledge that the transactions were deceptive. Nevertheless, it struck a discordant note when the Court stated, for example, that the defendants’ “deceptive acts were not communicated to the public.” If the deceptive acts had been communicated to the public, of course, the defendants would have had a completely different lack of reliance defense.
The 10b-5 Daily 
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