The US Supreme Court has refused a request by Enron investors that their class action against certain major lending banks can proceed, despite an argument that the recent Stoneridge decision does not apply to “financial professionals”
Summary
On 15 January 2008, a 5-3 majority of the Supreme Court in the Stoneridge case ruled that section 10(b) of the Securities Exchange Act 1934 does not extend the right to pursue a private civil claim against aiders and abetters, although they are still exposed to enforcement action by the SEC.
This was bad news for Enron investors who had been arguing a similar line in a federal class action against major investment banks (California Regents v Merrill Lynch, et al). Their lawsuit was barred by the Fifth Circuit Court on 19 March 2003, and an application to the Supreme Court for permission to appeal had been put on hold pending the outcome of Stoneridge.
The Enron investors argued that Stoneridge preserved a cause of action against their defendants, because the banks were “financial professionals” rather than “mere customers or suppliers”. However, yesterday the Supreme Court refused permission to appeal, effectively ending their claim.
The Stoneridge decision
The majority in Stoneridge assumed the following facts. The respondent entities were suppliers and customers of Charter. Charter issued misleading public financial statements. Its shareholders relied upon the statements and suffered a loss when the truth came out and the share price collapsed.
The respondents had entered into sham transactions with Charter. They agreed to supply digital cable converter boxes (set top boxes) at an inflated price in return for purchasing advertising from Charter for the amount of the inflation. Charter recorded the advertising purchases as revenue and as a consequence overstated its operating cash-flow by $17 million.
Whilst the respondents did not have any part in the preparation or dissemination of the financial statements, they knew of (or had reckless disregard for) Charter’s intention to use the transactions to distort the statements, which would then be relied on by investors. The respondents also agreed and signed sham contracts, which helped Charter mislead its auditors.
Prior to the Supreme Court’s decision, there were a number of conflicting Court of Appeal decisions as to when, if at all, an investor who had suffered a loss could pursue a claim for damages against a party who, whilst a participant in a scheme, had not issued a misleading statement or, in breach of duty, failed to make a statement.
Section 10(b) of the Securities Exchange Act 1934 states that it is unlawful for any person:
“ directly or indirectly… to use or employ, in connection with the purchase or sale of any security… any manipulative or deceptive device…in contravention of … rules and regulations…”
The SEC has passed Securities and Exchange Commission Rule 10b - 5, making it unlawful:
“a. to employ any device, scheme, or artifice to defraud,
b. to make any untrue statement of a material fact or to admit to stating material fact …. 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”
Neither provision expressly recognises civil liability for breach, but the US courts have for some time accepted that an implied private cause of action arises. The Stoneridge case concerned the scope of that private cause of action.
In a typical 10(b) civil claim a claimant must prove:
- A material misrepresentation or omission
- The necessary mental element or mens rea/intention (“scienter”)
- Connection between the misrepresentation or omission and the purchase or sale of the security;
- Reliance
- Economic loss
- Loss causation
A previous decision, Central Bank of Denver v First Interstate Bank of Denver 511 UK 164, had held that civil liability under section 10(b) does not automatically extend to aiders and abetters. The Supreme Court in Stoneridge upheld this approach, ruling that the conduct of a secondary actor who aids and abets securities fraud will only found a private claim under section 10(b) of the Securities Exchange Act 1934 if the claimant can prove each of the elements above including, in particular, reliance on a material misrepresentation (by statement or conduct) or omission by the defendant causing the claimant’s loss. A rebuttable presumption of reliance might arise, but only where:
- There is an omission of material fact by someone with a duty to disclose to the claimant; and
- Under the fraud-on-the-market doctrine, when a representation becomes public. This is by reason of the presumed reliance by purchasers and sellers of shareholdings on publicly disclosed statements, which themselves are reflected in the market price of the shares.
In Stoneridge, no member of the public had knowledge of the respondents’ deceptive acts, so that there was only indirect reliance, which was too remote. The fact that Charter’s financial statements were a natural and expected consequence of the respondents’ conduct was not sufficient. Nothing that the respondents did made it necessary or inevitable for Charter to record the transactions as it did.
The Supreme Court accordingly dismissed the claimants’ case. It was influenced by practical considerations, namely that if the claimants’ approach was adopted:
- The resulting extensive discovery and the potential for uncertainty and disruption in a lawsuit might allow plaintiffs with weak claims to extort settlement from innocent companies.
- A new class of defendants would be exposed to these risks. Contracting parties might find it necessary to protect against these threats, raising the costs of doing business. Overseas firms with no other exposure to US securities law could be deterred from doing business in the US.
- That in turn might raise the cost of being a publicly traded company under US law and shift securities offerings away from US capital markets
The court also drew support from a historical review. Following the Central Bank decision, Congress had expressly considered whether to extend the scope of 10(b) to aiders and abetters. It rejected arguments recommending aiding and abetting liability in private claims and instead passed legislation directing prosecution of aiders and abetters by the SEC. The Supreme Court felt that adopting the claimants’ argument would therefore be contrary to Congressional intent and would undermine the principle of the separation of powers.
Although it cut short a potential expansion in the scope of private claims, the Supreme Court made it clear that secondary actors were not immune from civil claims or enforcement. Aiders and abetters are still exposed to civil action if all the elements of a traditional claim can be established. Even in the absence of reliance, they are potentially subject to regulatory action by the SEC, which is not toothless. The Securities and Exchange Act 1934 expressly provides private rights of action against accountants and underwriters in certain circumstances, and an implied right of action remains to cover secondary actors who commit primary violations.
The Enron litigation
The Enron investors had brought a federal class action under section 10(b) seeking US$40 billion from investment banks including Merrill Lynch, Credit Suisse First Boston and Barclays. The investors argued that the banks’ involvement in various transactions helped Enron to conceal its losses. The Fifth Circuit Decision barring the investors claim in 2003 followed a similar approach to the one eventually adopted by the Supreme Court in Stoneridge.
In the Supplemental Brief supporting their application for permission to appeal the Fifth Circuit decision, the investors claimed their case was distinguishable from Stoneridge, because the banks acted as “financial professionals”, whereas the Stoneridge respondents were “customers and suppliers”. The investors relied on two passages in the Stoneridge decision in particular. In the first, the Supreme Court noted that the arrangements with the Stoneridge respondents “took place in the market place for goods and services, not in the investment sphere”; and in the second that the claimants sought 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”.
The Enron investors sought to distinguish their case because the banks were “financial professionals who structured financial transactions that deceived the market and were reported as structured”. They also argued that the banks had made public representations to the markets in underwritings and analyst reports.
The Supreme Court’s decision to refuse permission to appeal effectively ends the federal class action, leaving the investors to consider other options, including state claims. Although the decision does not include an explanation, it is at least a promising indication for the defendant bar that the Court did not agree with the investors’ interpretation of their earlier judgment.
The approach in both Supreme Court cases has special significance in the current litigation environment. The US has recently seen dozens of securities class-actions issued against companies that lost share value as a result of the subprime crisis and the related credit crunch, reversing trends that had seen securities claims dropping off. Some insurers and other interested parties feared that a Stoneridge decision for the claimants might have triggered a landslide of satellite subprime litigation, joining all manner of defendants only indirectly connected with primary actors. The Supreme Court seems to have closed off this avenue for now.
Further reading: Stoneridge Investment Partners v Scientific-Atlanta, Inc & Motorola Inc, (06-43).
California Regents v Merrill Lynch, et al (06-1341).
