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Stoneridge Investment Partners versus Scientific-Atlanta: An Introduction and Overview

Welcome to our conversation about the Stoneridge case pending before the US Supreme Court. I’m Professor Steve Bainbridge and I delighted to be joined today by David Fry, a litigation partner with Munger, Tolles & Olson in San Francisco. Mr. Fry received his law degree from the Yale Law School in 1996, where he was awarded the Frances Wayland Prize for greatest proficiency in preparing and presenting a case in negotiation, arbitration or litigation.  Mr. Fry’s practice focuses on complex litigation matters, with particular emphasis on securities litigation.  Mr. Fry has represented issuers, officers and directors, financial advisors, and law firms in securities fraud and corporate governance class actions in both federal and state courts.  Mr. Fry has represented special committees and special litigation committees of boards of directors and conducted internal investigations, including in matters relating to stock options granting practices.  Mr. Fry has also represented broker-dealers in securities arbitration matters and governmental investigations.

Stoneridge Investment Partners versus Scientific-Atlanta has been called one of the most significant business cases to come before the SCOTUS in recent years. The case potentially implicates a wide range of issues, even though the question on which the Court took cert was rather narrow. Technically, the Court asked the parties solely to address the question of:

Whether this Court’s decision in Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), forecloses claims for deceptive conduct under § 10(b) of the Securities Exchange Act of 1934 … and Rule 10b-5 …, where Respondents engaged in transactions with a public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where Respondents themselves made no public statements concerning those transactions.

To answer that question, however, may take the Court into core securities litigation policy and even basic separation of powers issues.

I’ll start by providing a basic background and then ask Mr. Fry to comment.

Rule 10b-5 is probably the most famous, and arguably the most important, of all the SEC’s many rules. The central theme of the Rule’s history is one of repeated judicial glosses on this relatively innocuous text. As Justice Rehnquist has observed, Rule 10b-5 is now “a judicial oak which has grown from little more than a legislative acorn.” In effect, we are dealing here with a species of federal common law only loosely tied to the statutory text.

The anomalous quasi-common law status of Rule 10b-5 came to a head in 1994, when the SCOTUS decided Central Bank of Denver v. First Interstate Bank of Denver.

In Central Bank, the Court held the scope of conduct prohibited by §10(b) (and thus the rule) is controlled by the text of the statute. Where the plain text does not resolve some aspect of the Rule 10b-5 cause of action, courts must “infer ‘how the 1934 Congress would have addressed the issue had the 10b-5 action been included as an express provision in the 1934 Act.’” The court has elsewhere acknowledged this to be an “awkward task,” but Justice Scalia has put it more colorfully: “We are imagining here.” [Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350 (1991).] Central Bank constrained this imaginative process by requiring courts to “use the express causes of action in the securities acts as the primary model for the § 10(b) action.”

To the extent Central Bank repudiates the notion that Rule 10b-5 has become a species of federal common law, the decision poses a significant threat to the further evolution of the Rule’s jurisprudence. In at least some subsequent Supreme Court decisions, however, the interpretive methodology expounded in Central Bank has been essentially ignored.  One is therefore left to wonder whether the strict textualist approach taken by Central Bank was a one time aberration. An initial question presented by Stoneridge thus is whether the Court will rely on the Central Bank methodology.

Just as Stoneridge is situated in the Central Bank line of cases from a methodological perspective, it is also situated in Central Bank from a doctrinal perspective. In Central Bank, the Court held that there was no implied private right of action against those who aid and abet violations of Rule 10b-5. In effect, liability under Rule 10b-5 was limited to primary rather than secondary actors. Hence, some would frame the problem presented by Stoneridge as deciding who qualifies as a primary actor.

Plaintiffs in the case are shareholders of Charter Communications—one of the nation’s largest cable television providers. They allege that Charter engaged in a “pervasive and continuous fraudulent scheme intended to artificially boost the Company’s reported financial results” by, among other things, entering into sham transactions with two equipment vendors that improperly inflated Charter’s reported operating revenues and cash flow. In addition to various other parties, including Charter, plaintiffs sued Scientific-Atlanta and Motorola (collectively, “the Vendors”).

At the time in question, Charter delivered cable services through set-top boxes. Charter purchased the boxes from third-parties, including the Vendors. In August 2000, although Charter had firm contracts with the Vendors to purchase set-top boxes at a set price, Charter agreed to pay the Vendors an additional $20 per set-top box in exchange for the Vendors returning the additional payments to Charter in the form of advertising fees.

Plaintiffs alleged that these were sham or wash transactions with no economic substance, contrived to inflate Charter’s operating cash flow by some $17,000,000 in the fourth quarter of 2000 in order to meet the revenue and operating cash flow expectations of Wall Street analysts. Charter accomplished the fraudulent accounting by improperly capitalizing the increased equipment expenses while treating the returned advertising fees as immediate revenue.

Plaintiffs alleged that the Vendors entered into these sham transactions knowing that Charter intended to account for them improperly and that analysts would rely on the inflated revenues and operating cash flow in making stock recommendations. Plaintiffs did not allege that the Vendors played any role in preparing or disseminating the fraudulent financial statements and press releases through which Charter published its deception to analysts and investors.

One way of looking at the issue is to ask whether Central Bank left any room for secondary liability, and if so, whether the Vendors are secondary actors whose conduct falls into a viable category of secondary liability. Alternatively, one could ask whether the Vendors’ conduct constitutes a primary violation, which would not run afoul of Central Bank.

Alternatively, one can seize upon the phrase “scheme to defraud” in the text of Rule 10b-5 to invoke so-called “scheme liability.”

The SCOTUS took cert in Stoneridge to resolve the circuit split on whether “scheme liability” claims differ substantively from the Central Bank-barred claims for aiding and abetting against those same actors. Although the Eighth and Fifth Circuits have ruled that “scheme” liability cannot be squared with Central Bank’s prohibition on aiding and abetting liability, the Ninth Circuit has ruled that it can under limited circumstances.

And now, I’ll turn it over to Mr. Fry for his thoughts.

Discussion Points

• Court composition: On the cert petition, CJ Roberts and Justice Breyer recused themselves. Of the seven justices that voted on cert, three (Scalia, Kennedy, and Thomas) were in the Central Bank majority.  Three (Stevens, Souter, and Ginsburg) dissented in Central Bank.  The seventh, Justice Alito, was not on the Court when Central Bank was decided. We assume that Roberts and Breyer recused themselves because they owned stock in one of the relevant players. Interestingly, Roberts recently announced that he will participate in the case on the merits. Apparently, he took advantage of a new tax law that allows judges to defer capital gains tax when they sell stock in order to eliminate a conflict of interest.


• Following Central Bank, the SEC sought and received congressional authority to proceed against persons who knowingly provide “substantial assistance” to a person who commits a primary violation.  But Congress did not confer equivalent authority on private plaintiffs; to the contrary, Congress has twice considered, but rejected, pleas to allow private claims against secondary actors.


• Implied private rights of action disfavored. The decision to create a new private right of action—or to extend an existing one—properly lies with Congress, not the courts.  Hence, there is no basis for the SCOTUS to recognize a liability theory that Congress has not.


• There is a wide consensus in the academic community that the out-of-pocket measure of damages used in Rule 10b-5 class actions challenging aftermarket fraud is economically irrational.  This is because well-diversified investors are unlikely to suffer net harm from aftermarket securities fraud.  Every transaction tainted by such fraud will have a winner and a loser, each of which is likely to be an innocent investor; over time, a diversified investor’s gains and losses from aftermarket fraud will tend to net out.  Investors can therefore self-insure against fraud losses by diversifying their portfolios.


• The deterrence justification for private securities class actions premised on “scheme liability” is also questionable, given that substantial deterrents already exist.  The concept of “scheme liability” is not susceptible of precise definition, and defendants faced with scheme liability claims may feel compelled to settle rather than risk expensive and protracted litigation.