Supreme Court keeps investor suits narrow

In a 5-to-3 ruling, justices say firms that merely abetted fraud can't be sued.

By , Staff writer of The Christian Science Monitor

Vendors, accountants, lawyers, and others who conduct business with a corporation that engages in securities fraud cannot be sued for damages by outraged investors when they merely aided or abetted in the fraud.

Instead, in a 5-to-3 decision announced on Tuesday, the US Supreme Court ruled that investors must focus their legal efforts on the offending corporation itself and its officers.

The much-anticipated decision is considered one of the most important securities-law rulings in a generation.

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In adopting a narrow reading of the securities laws governing class-action lawsuits, the high court has made it harder for investors to hold a wide spectrum of business players legally responsible for unlawful business practices at publicly traded companies.

The decision comes in a case called Stoneridge Investment Partners v. Scientific-Atlanta and Motorola. It marks a significant setback for investors, including those seeking to recover losses in the massive Enron scandal. It's also a setback for corporate watchdogs who were hoping the justices would adopt a broad enough reading of the securities laws to put all business associates on notice that they could be held accountable for involvement in business fraud.

The decision marks a victory for various business groups that had argued that broad liability in securities-fraud cases could unleash a flood of class-action litigation that would hurt the US economy and American competitiveness.

In the majority opinion, Justice Anthony Kennedy writes that US securities laws authorize investor class-action suits only when the investors have relied on false or deceptive statements from a business official who has a duty under securities laws to disclose accurate information to the investing public.

The suing investors in the Stoneridge case had purchased stock in Charter Communications, a cable TV company. After settling their suit against Charter, the investors then sued two of Charter's vendors, Scientific-Atlanta and Motorola for their alleged involvement in helping cover up an ongoing fraud at Charter.

In disallowing the second suit against Scientific-Atlanta and Motorola, the high court declared the two companies were too remote from any investor deception at Charter to trigger legal liability for the vendors.

"It was Charter, not [Scientific-Atlanta and Motorola] that misled its auditor and filed fraudulent financial statements," Justice Kennedy writes. "Nothing [the vendors] did made it necessary or inevitable for Charter to record the transactions as it did."

In a dissent, Justice John Paul Stevens accused the majority justices of waging a continuing campaign to render "toothless" regulations authorizing private investors to sue to remedy corporate wrongdoing.

He said the ongoing fraud at Charter Communications could not have been kept secret from its auditor and investors were it not for the deceptive actions of Scientific-Atlanta and Motorola. Because they used deceptive methods in their dealings with Charter, they should also be legally liable to investors, Justice Stevens writes.

The case stems from a financial scandal at St. Louis-based Charter Communications. In August 2000, executives at the company realized they were more than $15 million short of projected cash flow for the year. If stock analysts discovered the company's weak performance, their share price might have suffered. The executives needed an infusion of cash.

Company officials devised a plan to artificially boost Charter's bottom line. They set up a system in which they overpaid two of their suppliers for television cable boxes. They paid $20 per box above the usual price – generating $17 million in overpayments. The suppliers – Scientific-Atlanta and Motorola – then agreed to pay $17 million to Charter to purchase advertising from Charter.

In effect, Charter was giving the suppliers free advertising but booking the recycled $17 million as new revenue.

To help throw Charter's auditors off the trail, Scientific-Atlanta and Motorola backdated phony contracts and were asked to send letters to Charter justifying the $20 extra charge per box, according to a federal indictment. One of the suppliers sent false invoices, the indictment says.

The moves inflated Charter's bottom line and prevented a stock plunge, but only temporarily. When Charter's true financial situation was revealed (amid other questionable activities), the company's stock fell from $26 per share in 2000 to 76 cents per share by 2002.

A shareholder suit against Charter's top executives was settled out of court. The shareholders then sued Scientific-Atlanta and Motorola for their alleged role in the fraud.

But that suit – the subject of Tuesday's Supreme Court decision – was dismissed by a federal judge and the Eighth US Circuit Court of Appeals in St. Louis.

Both lower courts ruled that such civil lawsuits by shareholders could be pursued against the primary perpetrators of the fraud at Charter, but that Motorola and Scientific-Atlanta were not involved deeply enough in the fraud.

The courts cited a 1994 Supreme Court case, Central Bank v. First Interstate Bank, that ruled that those who merely aid and abet a fraud can not be sued by shareholders. Instead, investors may only request enforcement action by state or federal prosecutors or by the Securities and Exchange Commission.

"Secondary actors are subject to criminal penalties and civil enforcement by the SEC," Kennedy writes. "The enforcement power is not toothless."

Kennedy justified the narrow reading of the securities law by saying that when Congress last amended the law, it declined to include specific authorization for investor suits against vendors and other secondary actors.

"The determination of who can seek a remedy has significant consequences for the reach of federal power," Kennedy writes. "The decision to extend the cause of action is for Congress, not for us."

Stevens counters in his dissent that "the court is simply wrong when it states that Congress did not impliedly authorize this private cause of action when it first enacted the statute."

He adds, "Congress enacted [the securities regulations] with the understanding that federal courts respected the principle that every wrong would have a remedy."

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