Stoneridge Redux: Result Oriented Reasoning (Part II)

Stoneridge involved vendors. It was the mission of the majority to stop the "expansion" of Rule 10b-5 and prevent it from extending to vendors.  In doing so, the Court began by introducing a doctrine of remoteness.  Plaintiffs wanted to extend the antifraud provisions beyond the "realm" of finance to "ordinary business operations."  In other words, behavior too remote from the securities markets would not be actionable.

A proposition worthy of consideration, the problem confronted by the Court was that the behavior in Stoneridge was neither ordinary nor remote, at least according to the allegations in the amended complaint.  According to the complaint, the vendors backdated contracts and provided false documentation of the transactions, effectively allowing the transaction to be hidden from the outside auditors. In addition, the complaint asserted that the vendors knew the consequences of the behavior.  They knew that the transasctions were: 

• "knew that these transactions were absolute shams designed solely to give Charter the appearance of increased cash flow (as well as aid themselves by inflating their own revenues)."
• "were structured to inflate Charter’s reported cash flow to investors, and thereby increase Charter’s stock price."

While all of this would need to be proved at trial, the plaintiffs alleged sham transactions ("no economic substance" as the Supreme Court described) and falsified documents, with the vendors aware of the purpose of the transactions.  Moreover, as the Supreme Court conceded, the complaint alleged that the vendors "knew or were in reckless disregard of Charter's intention to use the transactions to inflate its revenue and knew the resulting financial statements issued by Charter would be relied upon by research analysts and investors." 

In other words, while wanting to let remote participants involved in "ordinary business operations" off the hook, the Court was dealing with a set of alleged facts that were directly designed to affect the financial statements.  In order to exonerate the existing vendors, therefore, the Court could not rely on "ordinary" or on remoteness.  Instead, it fell back on reliance, without much explanation of how the element would actually work. 

Because the underlying principle was to prevent the expansion of the antifraud provisions and exonerate the particular defendants at issue, there was no underlying intellectual basis for the decision.  The Court did not rely on the language of Section 10(b) and specifically disclaimed reliance on common law fraud principles.  ("Section 10(b) does not incorporate common-law fraud into federal law.").  As a result, the approach left little guidance to the lower courts on how to apply the element.  The result is that vendors remain at risk but with the confines of the doctrine left to the vagaries of the lower courts.  More on this tomorrow.

Primary materials on this case, including the amicus briefs filed at the Supreme Court, can be found at the DU Corporate Governance web site.