Friday Editorial: Stoneridge and the Bottom Line

It was a busy week for advocates in the Stoneridge case. A plethora of briefs were filed on behalf of the Respondent. With both sides having articulated their view (except for the SEC, of course, which was denied the right to enter the case by the Solicitor General), a few general thoughts can be offered. Most of the briefs are on the DU Corporate Governance web site. 

Most of the arguments that primary liability does not extend to ancillary actors like vendors and investment banks rested on the fact that they made no disclosure, had no duty to disclose, and did not participate in the disclosure drafting process. Some also argued that the actions by these parties were not "in connection with" a securities transactions and were not relied upon by investors.

The central problem with the approach is this. Assume insiders of a public company want to increase earnings in order to sell shares at a high price. Assume further that they approach a vendor and agree to enter into an entirely fraudulent transaction. The vendor agrees to provide all of the documentation of a substantial sale and agrees to answer any questions or providing any supporting information to the issuer's auditors. The vendor is paid for the fraud. As a result of the transaction, the company reports a material increase in earnings and profits and the insiders sell their shares.

It is a relatively far fetched hypothetical (although take a look at the enforcement proceeding brought by the SEC against IBM for a sham transaction involving the sale of cash registers) but for those arguing that behavior cannot be deceptive for purposes of Section 10(b) have to explain why a transaction like this does not meet the definition of primary liability. It is false and has no purpose besides allowing a company to falsely state earnings. It is far more than "merely" enabling. Yet under the views of most supporting Respondents (except, however, the Justice Department), this would not result in primary liability because there was no false statement made by the vendor.

It is absolutely the case that there must be some tough lines drawn between primary and secondary liability. Not all assistance equals primary liability. The bank in Central Bank was not part of the transaction that generated the fraud and passively sat by without verifying information used in the offering that it had reason to believe wasn't accurate. The bank (an indenture trustee) did nothing affirmative. Compare that with the hypothetical above where the ancillary party was directly involved in the fraud.

But conceding that ancillary actors can be liable for fraud does not mean that it must be easy to reach them. Their involvement in the fraud must be direct and, as the Solicitor General noted, they must meet all of the other elements of fraud, including scienter and materiality. In Stoneridge, what makes the facts cross the line into primary liability is the alleged deception to the accountants. As the Solicitor General noted: "Respondents’ alleged conduct constituted a “deceptive device or contrivance” because it not only was likely to, but allegedly did, mislead Charter’s outside accountant, Arthur Andersen, about the nature of the transactions into which respondents had entered."  The brief is on the DU Corporate Governance web site. 

For all of the alleged hardship and uncertainty that can arise out of drawing the line between primary and secondary liability, this is not the case that should generate such gnashing of the teeth.  It is not easy to be sympathetic in cases where ancillary parties allegedly entered into sham transactions and then lied about them to an issuer's outside auditor.  Perhaps it is the lie that makes this deceptive and perhaps it is the lie that involves the ancillary actors sufficiently in the "drafting" process to ensnare them as a primary violator.  Any way you look at it, there must be, as the Solicitor General notes, a category of behavior that is sufficient to meet the definition of deceptive, even if there is no independent disclosure or independent duty to disclose.