Stoneridge, Primary Liability and Sham Transactions

Since we are revisiting Stoneridge and the definition of primary liability under Rule 10b-5, a subject that is currently before the Supreme Court, we thought we would discuss an interesting case that illustrates the role third parties and sham transactions can play in inaccurate disclosure. 

Which leads us to the cases recently brought by the SEC against IBM (an administrative proceeding) and Kevin Collins, a business executive at the company (an injunctive proceeding).   

The enforcement actions arose out of a plan developed by Collins to help Dollar General obscure losses from cash registers taken out of service (and replaced by new ones bought from IBM).  As part of the scheme, IBM agreed to purchase the discontinued registers in what the SEC described as a "sham transaction." According to the release in the administrative proceeding, the purchase was not:

• a bona fide transaction because, among other reasons, IBM’s purchase price for the Omron equipment was repaid to IBM by an offsetting increase in the amount that Dollar General was to pay for the new IBM equipment. In addition, although IBM agreed to buy the Omron equipment for more than Dollar General was going to pay for the new IBM registers, IBM knew that the Omron equipment was worthless, IBM intended to destroy it, and ultimately IBM never took possession of any of the sales registers. Nevertheless, the “purchase” occurred and Dollar General removed the Omron equipment from its books and minimized the negative impact on its earnings in fiscal year 2000."

In other words, the transaction was entirely without economic substance, designed solely to provide Dollar General with favorable accounting treatment.  By avoiding the adverse accounting treatment, Dollar General was willing to buy the IBM cash registers all at once, increasing IBM's revenues.

The Commission considered IBM to be a cause of Dollar General's false disclosure and imposed on IBM a fine of $7 million.  Collins was treated as aiding and abetting a violation of Rule 10b-5 by Dollar General and required to pay $95,000, consisting of disgorgement, interest and a penalty.  

The SEC has the luxury of bringing charges for aiding and abetting since it has the statutory authority to do so.  In the private realm, however, no such luxury exists.  Whether Collins and IBM could be liable under Rule 10b-5 depends upon the reach of primary liability.  In the 8th and 5th Circuit, IBM could not be sued for primary liability.  In the 9th Circuit, it could.  It is now up to the Supreme Court to resolve the disagreement.