A great victory for the status quo

It takes a lot to excite corporate lawyers. They are, by nature and nurture, a relatively constrained bunch. So it is testament to the significance of the Stoneridge v Scientific-Atlantic ruling that, almost five months after the decision was handed down, people are still talking about it.

The case considered whether third-party vendors that participated in a public company’s scheme to defraud investors could be held liable to investors in a private securities fraud class action. The ruling would have serious implications for all public companies, outside vendors (including law firms and auditors) and the broader investor community. With all eyes on the US Supreme Court in January, the decision lived up to its billing and established important principles concerning the scope of the rights of shareholders and their ability to bring action under Section 10(b) of the Securities Exchange Act.

Many say that the decision — which states private investors cannot hold third parties liable for involvement in business transactions with issuers who allegedly accounted for transactions fraudulently on their books — was the result of ‘the most important securities case in a generation.’ And one that sparked an almost continuous debate about shareholder rights and the future of class action litigation.

One of the more recent discussions was hosted by the Rock Center for Corporate Governance at Stanford University and featured a panel with Joe Grundfest, William Franke professor of law and business and co-director of the Rock Center, Timothy Bishop, partner at Mayer Brown, Jay Brown, professor at the University of Denver Sturm College of Law, Andrew Vollmer, deputy general counsel for litigation and adjudication at the SEC, and Steven Williams, partner at Cotchett, Pitre & McCarthy. The erudite group discussed a number of heated topics, addressing questions including: How will Stoneridge affect enforcement policies of the SEC?; What action might Congress take in response to the case?; and, will firms who do business with, or advise, public companies do anything different to fit within the Stoneridge rule?

Although the decision was widely expected, the vote was not unanimous. The Supreme Court voted five to three not to extend the cause of action. Justice Anthony Kennedy, author of the majority opinion in Stoneridge, said as much when he announced: ‘The decision to extend the cause of action is for Congress, not for us.’ Kennedy, along with four of his follow justices, believe that Congress has already asked and answered the question of whether third parties should be held liable.

This wording bears striking similarity to the title of a paper that was released in August last year by Grundfest, ‘Scheme Liability: A Question for Congress, not the Court’.

As Bishop explains: ‘The Supreme Court deliberately stepped back from making new law under Section 10(b) and the private cause of action. The Court had made up the private cause of action that Congress did not in the 1934 Act because Congress did not contemplate that there would be a private action for damages for violations of 10(b). Soon after the Court made this cause of action it realized that this was going to be a problem, and that realization coincided with the rise of the class action device. It became clear to the Court that it had created a cause of action that had nothing to do with finding the truth in litigation.’

Money rules

The cost of defending class action lawsuits created an environment in which even innocent companies are forced to settle – rather than find truth – to avoid becoming involved in a protracted litigation. Potentially enormous payouts for damages also reinforce the pressure to settle. Bishop says these expenses prompted the Court to start applying limits on the cause of actions: ‘The point that we have reached under Stoneridge, which is probably the most interesting part of the case, is the Court is saying, we are getting out of the business of expanding this cause of action.’

‘Congress’, continues Bishop, ‘in the Private Securities Litigation Reform Act of 1995 recognized for the first time that this private cause of action for damages exists and set some limits on it. And in doing so they took over defining the scope of section 10(b) private cause of action.’

The Stoneridge opinion reiterates components of the Act in explicitly stating that it is up to Congress to define the scope of this action. Given that as far back as 1995 Congress established that it wasn’t going to expand the cause of action to reach third parties, Bishop notes, ‘[it] really made Stoneridge a fairly easy decision for the Court.’

Grundfest elaborates on the limits imposed by Congress: ‘This was a great victory for the defense bar but it is important to understand how victory here is measured. I think what this does in many regards is maintain what for many years people felt was the status quo. It prevents what could have been a dramatic expansion of liability in the space.’

It’s illegal, so what can we do?

While the decision has garnered some criticism from the investing community, which accused the Court of sanctioning wrong doing, it is important to note that regulatory and criminal remedies are still available.

‘The single most important point here,’ says Grundfest, ‘and this is something that I keep reminding people of, is the conduct engaged in by the defendants in this case was illegal. No one is arguing that it wasn’t. Nor is anyone suggesting that they should not be punished. The SEC has complete authority to go after the defendants and the DoJ can also pursue criminal proceedings if they so choose. The question is, in addition to all of the other mechanisms available to punish and prevent this kind of activity, does the law as written today allow plaintiff class action litigation under Section 10(b) of the Securities and Exchange Act? That is really the only question.’ And the Court decided that the answer to that question, is no.

Plaintiffs, for perfectly understandable reasons (because it is politically more popular), say that the behavior at issue in this case should be considered illegal. ‘I believe that this fundamentally mis-frames the question,’ counters Grundfest. ‘The real question is: Who should be able to sue under the law as written today? This is a completely separate question as to whether the law should be changed [to allow for private remedy under 10(b)].’

The Court, in line with Grundfest’s logic, held that under the circumstances as defined in Stoneridge, shareholders do not have the right to sue the third-party actors.

Many participants in the legal community (although few on the plaintiffs’ side) rejoiced in the decision. Skadden, Arps, Slate, Meagher & Flom in a memo to clients sent a matter of hours after the decision was brought down, exclaimed: ‘Today’s ruling is a significant victory for the business community.’

The firm’s memo continued on to state: ‘Had the Court sanctioned scheme liability, it would have opened the door to lawsuits targeted at secondary corporate actors merely because they engaged in business transactions with issuers who allegedly accounted for transactions fraudulently on their books. As a result of the Court’s decision, however, such scenarios will not be allowed to develop.’

Supporters of the decision argue that it preserves the ability of companies to conduct business without undue fear of litigation. Furthermore, increased private liability under 10(b) could lead to higher prices for vendor services. Bishop explains that ‘There are a number of practical problems that would have arisen had the Court gone the other way. It would have become extremely dangerous for anyone to do business with a public company in the US because it would be very easy in the hands of a plaintiff lawyer to argue that, if something goes wrong at a public company and your contract was somehow used to cook the books, that you were somehow involved.’ This would result in a company being dragged into litigation and as highlighted earlier, there is a serious disincentive to defend litigation and that leads to an overwhelming tendency to settle.

‘The Court recognized that without a clear no-liability rule, vendors would be forced to charge more because of the increased risk of litigation and therefore companies would start charging a risk premium,’ explains Bishop.

An absence of justice

With companies unwilling to risk taking litigation to trial, the defining line between action and inaction has lost its meaning. Even if a third party had no knowledge of any fraudulent activity they would likely be forced to settle, ‘and litigators know this,’ says Bishop. Guilt and innocence is effectively thrown out the window. ‘Basically this means that lots of innocent companies would get caught up in action because they can get tied up in something that a litigation lawyer dreams up.’

Part of the reason the Court did not have to struggle in making the ruling is because private cause of action is not the only remedy. Both the SEC and DoJ have the enforcement power to levy penalties that can be used to compensate investors or pursue criminal action. There is a clear line of enforcement authority that Congress actually created and you don’t have to struggle to invent a workable private liability rule. Numerous individuals argue the SEC is in fact better placed to defend shareholders than the plaintiffs’ bar.

Many activist investors think the decision is bad for shareholder rights. Bishop disagrees, saying the problem with 10(b) liability in general, ‘is that it makes no sense in relation to shareholder rights because the only people who benefit through 10(b) litigation are lawyers.’ The result of litigation is that a company’s current shareholders end up paying a lot of money for conduct that may have taken place 10 years ago or more, and the money goes to lawyers and consultants instead of to the victims of fraud.

One other point is that investors are all too happy to take advantage of fraud and then sue when things go bad. For example, if you held WorldCom or Enron stock and sold just before the frauds came to light you did very well. Is it then right to turn around and sue upon realizing a loss after the fraud? Those complaining they allegedly suffered from fraud rarely suggest giving money back for the gains made from said fraud. ‘In an economy where most people are broadly diversified it doesn’t make a lot of sense to allow private action under 10(b),’ says Bishop.

The SEC has been particularly active in the past several years in making sure the real victims of fraud receive restitution. The DoJ has also been very effective in investigating and punishing fraud from a criminal perspective. ‘It is reasonable to believe that the Court feels that, because the SEC is doing such a good job, it does not need to get as involved as if the SEC wasn’t doing a good job. Basically, because the SEC provides an effective deterrent, there is no need for the courts to get involved,’ says Bishop

Despite the decision, it is unlikely this is the last we have heard on the matter. The differing viewpoints among the justices will encourage some to challenge the ruling while plaintiffs will litigate what they perceive as the decision’s ambiguities in the lower courts. For now, though, it appears to be business as usual.