Between November 1999 and August 2002 Charter Communications allegedly padded its books with $17 million in round-trip sales involving two equipment vendors–Scientific Atlanta and Motorola. Charter agreed to pay an extra $20 for each set-top box it purchased, in exchange for an equal amount of advertising fees paid by the two vendors. In effect, the scheme boosted Charter's ad-sales profits with money from its capital budget.

When Charter's shareholders sued Charter for securities fraud in 2002, the lawsuit named the two vendors as co-defendants because they participated in the sham transactions. Charter settled the case for $144 million in 2004. But Scientific Atlanta and Motorola contested the claims against them, arguing private shareholders did not have standing to sue them. In April 2006 the 8th Circuit affirmed a district court's decision to dismiss the case, Stoneridge Investment Partners v. Scientific-Atlanta Inc. The Supreme Court will hear the case in its October 2007 term.

The High Court will consider whether the vendors' participation in Charter's transactions constituted a scheme to defraud Charter shareholders, or whether the vendors merely aided and abetted the alleged securities fraud–a violation only the government can prosecute. The question is further complicated by conflicting legal standards in the circuit courts.

“The courts have developed different standards for deciding whether a claim is really an aiding-and-abetting claim dressed up as a primary-liability claim,” says Eric Rieder, a partner at Bryan Cave. “If the Supreme Court decides the plaintiff can sue the vendors for scheme liability as a primary-liability claim, it could significantly expand the number and types of players who can be brought into securities-fraud cases.”

Aiding and Abetting

The outcome of Stoneridge hinges on how the court will interpret the relevant securities laws–Section 10(b) of the Securities Exchange Act; the SEC's implementing regulation, Rule 10b-5; and especially the Supreme Court's 1994 precedent in Central Bank of Denver v. First Interstate Bank of Denver.

In Central Bank the High Court said shareholders may sue third-party defendants for primary violations of Section 10(b)–which prohibits deceptive statements and manipulative practices–but not secondary violations such as aiding and abetting. That doctrine limits the universe of defendants in shareholder suits to the issuers of securities, their officers and directors and third parties who make deceptive statements or take manipulative actions to affect share prices.

In dismissing Stoneridge, the district court said the plaintiffs' claims fell short of the Central Bank standard for primary liability under Section 10(b). Charter's shareholders sought to hold the vendors liable for transactions Charter improperly characterized in its accounting–essentially an aiding-and-abetting claim.

“The vendors had nothing to do with the financial statements of Charter,” Rieder says. “So the court said they can't be held liable in a private action under the securities laws.”

The 8th Circuit affirmed the decision, citing Central Bank as well as Santa Fe Industries v. Green, in which the Supreme Court defined “manipulative” under Section 10(b) as directly engaging in fraudulent securities-trading practices. The Supreme Court granted cert because of a conflicting standard used in the 9th Circuit.

In Simpson v. AOL Time Warner, the 9th Circuit said shareholders can sue third parties for “conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme.”

Now the High Court will consider which standard to adopt in the Stoneridge case–and by extension, other shareholder lawsuits naming third-party defendants.

Scheme Liability

Shareholder advocates say the language of Section 10(b) supports the 9th Circuit standard, because it specifically prohibits participating in a “scheme to defraud”–and therefore gives shareholders a private right of ?? 1/2 action against any party that participates in fraudulent dealings.

“Aiding-and-abetting liability is distinct from scheme liability,” says Adam Savett, vice president of securities class-action services for Institutional Shareholder Services in Rockville, Md. “Scheme liability implies direct participation, and there's an implicit private right of action for that under Rule 10(b)-5.”

The 9th Circuit is not alone in favoring this interpretation of scheme liability. Judge Lewis Kaplan of the Southern District of New York applied such a standard in 2005 for In re Parmalat Securities Litigation. The SEC also supported the 9th Circuit's broad approach with an amicus brief in California State Teachers' Retirement System v. Homestore.com, and asked the solicitor general to submit an amicus brief in favor of the plaintiff in Stoneridge–a request the White House reportedly overruled.

Moreover, shareholder advocates say Congress has spoken by leaving the language of Section 10(b) broad enough to allow shareholder lawsuits against third parties for scheme fraud.

On the other hand, the 8th Circuit's narrower approach is similar to that used by the 5th Circuit in March 2007, when it rejected class certification in an Enron derivative lawsuit, Regents of the University of California v. Credit Suisse First Boston.

How the High Court will parse the various standards is difficult to predict. Recent history suggests its legal approach more closely resembles the 8th and 5th Circuits. However, the Court could be swayed by the 9th Circuit's statutory argument–in which case, all bets may be off for third parties in securities suits.

“If the Supreme Court accepts a broad scheme-liability theory,” Rieder says, “that outcome would be of particular concern for lenders, investment bankers and all the other counterparties who deal with public companies.”