A Class-Action Scheme
The Supreme Court's business case of the year.
Saturday, October 6, 2007 12:01 a.m. EDT
Next week the Supreme Court takes up what may be the business case of the year when it hears oral arguments in Stoneridge v. Scientific Atlanta. At stake is whether a company can be sued merely for doing business with another firm that commits fraud. That claim has been shot down by the trial judge and appeals court, but if the Supreme Court reverses and allows the suit to go ahead, it will open the flood gates on the next class-action bonanza.
Seven years ago, Scientific-Atlanta and Motorola agreed to sell cable boxes to Charter Communications. In both cases, Charter offered to pay a premium that was then paid back to Charter as a "marketing expense." So far, so routine. But then Charter got "creative," immediately booking the advertising revenue from the cable-box makers while spreading out the cost of the premium over time.
No one was the wiser until April 2003, when Charter announced that it had misstated its financial results in a variety of ways, one small part of which was the revenue booked from the marketing deals with Scientific-Atlanta and Motorola. The two cable-box makers themselves booked no net gain from the way the transactions were structured and accounted for them properly on their own books. It is not even clear whether they were aware of what Charter was up to. The deals were not publicly disclosed and the modest revenue gains were not broken out separately in Charter's cooked books.
But then came Stoneridge, an investment firm that had owned Charter stock. It sued the two suppliers, alleging they engaged in a "scheme" with Charter management to defraud investors in Charter stock. In fact, Scientific-Atlanta and Motorola did no more than enter into contracts with a customer on terms requested by the customer. No one bought or sold Charter stock on the basis of Charter's accounting for those contracts, because no one outside of Charter knew what Charter had done. The lawsuit, therefore, represents a brazen attempt to drag deep-pocketed suppliers into a fraud in which they played, at most, a minor and essentially passive part.
The Supreme Court has examined this issue before. In a 1994 case, Central Bank of Denver v. First Interstate Bank of Denver, the Supreme Court found that private parties could not sue third parties that had merely "aided and abetted" a fraud by someone else. A year later, the SEC asked Congress to clarify whether it had the authority to go after aiders and abettors. And in its 1995 securities class-action reform, Congress gave the SEC that authority--but at the same time also declined to give private parties the right to sue in such cases.
The question came up again when Sarbanes-Oxley was debated. But Congress, which was hardly shy about creating new causes of action in Sarbox, again declined to give private parties the right to sue third parties in securities-fraud cases.
So the record is clear enough, and the reasons for it equally obvious. Allowing investors to sue a company simply because it did business with someone else who broke the law is a recipe for litigation mayhem. As it is, most shareholder class actions are shams, transferring wealth from one group of shareholders to another, with a big cut for the lawyers. Permitting them to bleed other companies' innocent shareholders merely for doing business with a bad actor would add injury to injury. The SEC already has authority to act in cases in which a supplier or customer really did facilitate a fraud. And thanks to Sarbox, the SEC can distribute fines collected in the process to those hurt by the fraud.
Amazingly, the Bush Administration seemed unsure at first which side to take in this case. SEC Chairman Chris Cox had inherited a policy of support for the "scheme liability" theory, and he declined to vote to change the SEC's position. But over the summer, Solicitor General Paul Clement filed a brief supporting dismissal of the suit. The New York Stock Exchange and Nasdaq have also filed briefs, arguing that such suits would make a difficult U.S. legal environment even less attractive to foreign investors and companies.
The difficulty would lie in the impossibility of knowing who among your customers and suppliers might be doing something shady. Sure, one can imagine corporate lawyers coming up with a raft of new forms, waivers and contracts in which all would promise they were not engaged in accounting fraud using your widgets. But aside from goosing the billable hours at white-shoe law firms, it's hard to see how that would do anyone any good. What's more, it probably still wouldn't prevent a lawsuit.
The Supreme Court under Chief Justice John Roberts has a pretty good track record on restoring sanity to corporate law. In both Bell Atlantic v. Twombly and Credit Suisse v. Billing last term, the Roberts Court reined in overreaching trial lawyers looking to break new ground. Stoneridge is an opportunity to add to that record. This is one that should be unanimous.
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