New York – The Supreme Court recently reached a decision in the case of StoneRidge Investment Partners v Scientific Atlanta.This is one of the more important corporate law decisions to be made by the court in recent years, and has significant repercussions for investors, bankers, and independent research firms.
The crux of the case came down to an allegation by StoneRidge and other investors in Charter Telecommunications that two vendors, Motorola and Scientific Atlanta, had participated in a scheme to defraud or mislead Charter shareholders. The purported scheme involved booking dummy transactions that shuttled money back and forth between Charter and its vendors, and artificially inflated Charter’s revenues. On January 15th, the majority of the Supreme Court ruled that a firm could not be held liable for securities fraud merely because it was a business partner of a company that committed the fraud. The decision strikes a blow against the notion of “scheme liability”.
The justices argued, firstly, that the vendors in this instance had not made any statements or representations intended to mislead Charter shareholders. “Unconventional as the arrangement was, it took place in the marketplace for goods and services,” the court wrote, “not in the investment sphere.” This strikes us as a plausible explanation for why the transaction should be held exempt from Rule 10b-5.
Furthermore, the justices seemed to make the ruling, at least in part, based on a broader concern regarding America’s capital-market competitiveness. The majority observed that, had they favoured StoneRidge and the other Charter investors, “overseas firms with no other exposure to our securities laws could be deterred from doing business here…This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.”
It is important to note that the justices’ decision hinged on the essentially non-informational nature of a transaction carried out by a third party vendor – these vendors were not making any statements to Charter shareholders or the general public, they were merely selling or buying goods and services. Thus, while suppliers and vendors should be relieved, this decision does not appear to mean that investment bankers, accountants, law firms, ratings agencies, and paid-for research firms are off the scheme-liability hook. To the extent that such firms make misleading statements and representations regarding a client’s financial condition, they would certainly still be liable.
Thus, the media hysteria regarding the purportedly anti-investor message of this ruling (see example here) strikes us as rather overblown. It should also be pointed out that the aggregate effect of this ruling is probably neutral for investors. Rather than favoring “corporate management” over “investors”, as some in the media have argued, this decision can also be seen as a ruling that protects the shareholders of Scientific Atlanta and Motorola against claims by the shareholders of Charter Telecom. Surely, many investors must be pleased to hear that the companies they own will not be liable for scheme liability lawsuits arising from their business partners’ shenanigans. While it is impossible to forecast in advance exactly which shareholders will be hurt and helped by this decision, it does not seem fair to say that the decision systematically tilts the balance away from shareholders and towards corporate management.
One sector of the financial industry that might benefit from this decision are the expert networks, like Gerson Lehrman, Vista Research, and Guidepoint Global – they act, essentially, as a concierge service connecting experts and investors. Although they have extensive systems in place to prevent insider information being supplied, it is quite possible that certain unscrupulous members or clients will abuse the system. While the participants in an illegal transfer of securities information would be liable in any case, it seems that the expert network firm should not be at risk under scheme liability merely because some of the users of the platform attempt to commit securities fraud.
The expert network firms do not take any position regarding a company’s financial condition, nor do they attempt to vouch for the accuracy of statements made by experts in their network. Due to the distinction made by the Court between firms that provide statements or information to investors, and third-party firms that simply partake in non-securities-oriented transactions, it can be plausibly argued that an expert network firms falls in the latter category. Insofar as third-parties who do not provide financial information are exempt from scheme liability lawsuits, the management and owners of many expert network firms must be breathing a sigh of relief.