Supreme Court Report
An Outside Shot at Securities Fraud
It’s too late for Enron defendants, as plaintiffs pursue ‘scheme liability’
Posted Jun 5, 2007 3:50 AM CDT
By John Gibeaut
The criminal stock-fraud charges were straightforward enough against a pair of executives for Charter Communications Inc., one of the nation’s largest cable television operators.
Needing as much as $20 million to meet 2000 year-end cash flow projections, the executives decided to pump up the black side of the corporate ledger. They concocted a kickback scheme in which suppliers of set-top cable boxes agreed to charge Charter an extra $20 per box--then turn around and funnel the increase back to the company through sham advertising contracts.
The case was sufficient to yield guilty pleas, prison time and fines from the two Charter managers accused in the scheme--as well as in a separate plan with two more execs to inflate the company’s subscriber numbers.
“The simplicity of the scheme was trumped only by its brazenness,” a civil plaintiffs lawyer later wrote in court documents.
But so far the kickback plot hasn’t supported a civil securities-fraud complaint against the suppliers who sold the boxes to the suburban St. Louis cable company.
The vendors maintain--and lower courts agree--that statutory and case law give them a pass for any deceptive behavior that occurs outside the public eye. More bluntly, they argue that what investors didn’t know shouldn’t hurt them.
Another Chance for Investors
But the U.S. Supreme Court likely will own the last word this fall after it considers whether investors may hold the suppliers liable for participation in transactions that enabled Charter’s fraud. StoneRidge Investment Partners v. Scientific Atlanta Inc., No. 06-43. When the justices accepted the case in March, they ventured into perhaps the most contentious issue to arise from the 2001 corporate fraud epidemic: how far to extend liability past the offending companies.
The plaintiffs want to use a theory they call “scheme liability” to expand the number of defendants beyond debt-ridden companies to vendors, investment bankers, accountants, bond underwriters, lawyers and other outsiders they say make the cases financially worthwhile.
The plaintiffs trace the blueprint for liability from section 10(b) of the 1934 Securities Exchange Act and the accompanying regulation, which forbids use of “any device, scheme or artifice to defraud.”
That’s simple enough, says New York City plaintiffs lawyer Stanley M. Grossman, who will argue for the StoneRidge investors. He says he counts on Justices Antonin Scalia and Clarence Thomas to stick to the plain meaning of the provision. That means the plaintiffs need to persuade just two more justices to read it the same way, because Chief Justice John G. Roberts Jr. and Justice Stephen G. Breyer have recused themselves. Both have extensive securities portfolios.
“I’m going to have to have the justices read the statute as it was written, and if we do that, we’ll get a favorable decision,” Grossman says. “We thought Congress was perfectly clear when it passed 10(b). It says ‘any’ deceptive act.”
Scheme liability attempts to avoid the decision in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), and the 1995 Private Securities Litigation Reform Act. Both limit private plaintiffs to filing cases only against the troubled companies themselves, their officers and directors, who are regarded as primary violators. Defense lawyers insist that outside advisers and other “secondary actors” are mere aiders and abettors who most always are immune from private suit under Central Bank and the reform act.
Auditors are notable exceptions because they must step forward and publicly attest to the accuracy of their findings, which can entail lies or material factual omissions not at issue in the current cases.
The Securities and Exchange Commission, however, retains the right to sue outsiders for aiding and abetting. As an amicus, the SEC also supports private plaintiffs’ attempts to bring in outside defendants.
Plaintiffs like scheme liability because it doesn’t require them to allege false public statements or other visible attempts to deceive--a tall order to fill against defendants who typically work silently behind the scenes, preparing financial reports, legal opinions and similar materials.
Without outside defendants and cavernous pockets--to pay off both plaintiffs lawyers and investors--the post-Enron litigation boom may have gone bust years ago. No plaintiffs lawyer is going to risk his or her contingency fee on a Pyrrhic fight with an insolvent company.
Both sides say the StoneRidge decision could mean billions of dollars either way. Indeed, the justices accepted the case just one week after the 5th U.S. Circuit Court of Appeals at New Orleans refused to certify a class of plaintiffs seeking $40 billion from investment bankers who advised Enron Corp. before the energy broker collapsed in late 2001. Regents of the University of California v. Credit Suisse Boston, No. 06-20856 (March 19).
“Class certification may be the backbreaking decision that places ‘insurmountable pressure’ on a defendant to settle, even where the defendant has a good chance of succeeding on the merits,” wrote Judge Jerry E. Smith.
Yet a favorable result in the Supreme Court would arrive too late for some defendants.
Payouts, Peace of Mind
Of the $7.3 billion paid to settle other private Enron cases before the 5th Circuit ruled, all but $168 million came from investment bankers, accountants and a law firm. Unsure of the law, outsiders have paid billions more to settle other cases and extricate themselves from the predicaments facing their impoverished clients. Some of those settling defendants may feel the twinge of buyer’s remorse now that the Supreme Court has taken the issue.
Still, the worst could be over for many defendants. Significantly fueled by cases involving monster frauds such as Enron, settlements shattered all records in 2006 at $17 billion, according to the Stanford Law School Securities Class Action Clearinghouse. But the number of new cases has dropped significantly, from 226 in 2002 to 110 in 2006, suggesting that the Enron mess struck at the peak of a cycle that has since ebbed. But defendants who settled earlier aren’t necessarily losers, because they purchased guaranteed outcomes over the uncertainties of continued litigation, says clearinghouse director Joseph A. Grundfest. “That is the nature of a settlement.”
Facing the prospect of nearly $33 billion in added payouts not covered by the settling defendants, the three major investment banks remaining in the Enron case decided to fight instead.
“We had some notion that the conduct alleged in the Enron case traditionally has been considered aiding and abetting,” says New York City lawyer Herbert S. Washer, who represents defendant Merrill Lynch & Co. Inc.
The San Francisco based 9th Circuit is the only federal appeals court to endorse scheme liability, though it set such rigorous standards that the first plaintiff to test them still hasn’t been able to get into court. Simpson v. AOL Time Warner Inc., 452 F.3d 1040 (2006).
The Enron plaintiffs asked the Supreme Court on April 5 to hear their appeal as a companion case to StoneRidge. Lead Enron plaintiffs lawyer William S. Lerach of San Diego attempted to sell the case to the justices as more fully developed factually and closer to the heart of the wider controversy.
“Unlike the vendors of goods in StoneRidge, the banks had wide-ranging involvement with Enron for years, frequently structuring bogus deals to distort its financial statements while selling billions of dollars of its securities to investors and issuing analyst reports recommending its stock,” Lerach wrote in his request to the justices. “Unlike StoneRidge, which involved the actual sale of goods (albeit in contrived transactions), here many of the bank transactions were completely illusory, often with secret, no-loss guarantees or take-out promises, devoid of any economic substance.”
Though the StoneRidge transactions increased Charter’s cash flow by $17 million, none of the companies involved profited because Charter used its own money to enable the suppliers to “purchase” the ads. “If that’s not fraud, then what is?” wonders Grossman.
Neither of the cable box suppliers--Scientific-Atlanta and Motorola--was charged in the criminal case. But the plaintiffs say they’re fair game in the civil matter. “They didn’t merely assist in helping somebody commit fraud,” Grossman says. “They themselves committed fraud.”
Defense lawyers deride scheme liability as nothing more than a semantic shell game that tries to transform aiding and abetting into a primary violation.
“Giving it a different title doesn’t make it any less aiding and abetting,” says Atlanta’s Oscar N. Persons, who represents Scientific-Atlanta.
If fraud did occur in the civil case, then neither supplier was responsible, held the 8th Circuit at St. Louis. The box suppliers never attempted to dupe the investing public into buying Charter stock through lies or other deceit, the appeals panel determined.
Moreover, the vendors didn’t approve Charter’s misrepresentations and had no duty to disclose the company’s financial condition to its investors anyway, the court held. In re Charter Communications Inc. Securities Litigation, 443 F.3d 987 (2006).
“We are aware of no case imposing ... liability on a business that entered into an arm’s-length nonsecurities transaction with an entity that then used the transaction to publish false and misleading statements to its investors and analysts,” wrote Judge James B. Loken.
Settling Up Enron
The five biggest settlements in the Enron case are part of a total $7.3 billion recovery. The outside directors are board members who are not employed by the company. Among other settlements were Arthur Andersen ($72.5 million) and Kirkland & Ellis ($13.5 million.)
Canadian Imperial Bank of Commerce $2.4 billion
JPMorgan Chase $2.2 billion
Citigroup $2 billion
Lehman Brothers $222.5 million
Outside directors $168 million
Source: University of California