Supreme Court Speaks, Investors Lose

OPINION ARTICLE

The Supreme Court published its opinion in the Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., et al. This case asked the court to determine whether, under rule 10(b)5 issued by the Securities Exchange Commission pursuant to the Securities Exchange Act of 1934, a company (a third party wrongdoer) that assists a publicly traded company in misleading the public about its financial results can be held liable to the investors in that public company for damages caused by the misleading actions.

In my humble opinion the case can be summarized as follows: It is better to let investors suffer at the hands of fraudulent business activities than to potentially raise the cost of doing business by holding businesses accountable for their fraudulent actions. The SEC can, in its discretion, take action against a third party wrongdoer but private investors cannot.

Here is my short version - the long version (with details) is below:

The Court noted two issues with allowing investors to sue third party wrongdoers other than its review and manipulation interpretation of prior law. The first is that it would raise the cost of doing business because every company would be exposed to potential liability and harassment by discovery proceedings for investors with weak claims. This could drive up the cost of doing business, and so businesses need to be protected from this harassment. The second is that this additional cost of doing business in the United States could deter foreign companies from issuing securities in our markets and doing business with domestic firms. Interestingly, the Court never addresses the cost to businesses or investors of meltdowns such as Enron and Charter and all of the other fraudulent market disasters experienced over the past decade. How can it conclude that the cost to business would increase when it does not even consider the other side of the ledger? What costs would go down if businesses acted more ethically? What about bad debt write-offs for one? Doesn’t this very decision reduce the cost of wrongdoing? These points are not addressed in the opinion. Nor does the opinion address the cost to the economy of a lower level of investor participation due to a lack of confidence in the market. This decision, in my opinion, was pre-determined and I wrote that back in October.

What businesses stand to gain disproportionately from this ruling? Think about the major financial institutions and all of those very complex transactions they helped structure for Enron. Think about those subprime securitizations and CDOs. You are now getting warm.

Here is the long version if you are interested in some specifics.

Two set-top box makers (Motorola and Scientific-Atlanta) knowingly entered into phony transactions with Charter Communications so Charter could fool its accountants and report higher income than it actually had. It was a classic fraud scheme wherein Charter swapped long-term depreciation expense for short-term reportable income. Charter then issued false financial statements, investors purchased the stock, the scheme was revealed, and the investors lost money. Now the investors want the set-top box makers who entered into these fake transactions with Charter to pay. Here are the facts from the Court:

Charter, a cable operator, engaged in a variety of fraudulent practices so its quarterly reports would meet Wall Street expectations for cable subscriber growth and operating cash flow. The fraud included misclassification of its customer base; delayed reporting of terminated customers; improper capitalization of costs that should have been shown as expenses; and manipulation of the company’s billing cutoff dates to inflate reported revenues. In late 2000, Charter executives realized that, despite these efforts, the company would miss projected operating cash flow numbers by $15 to $20 million. To help meet the shortfall, Charter decided to alter its existing arrangements with respondents, Scientific-Atlanta and Motorola…

Respondents supplied Charter with the digital cable converter (set top) boxes that Charter furnished to its customers. Charter arranged to overpay respondents $20 for each set top box it purchased until the end of the year, with the understanding that respondents would return the overpayment by purchasing advertising from Charter. The transactions, it is alleged, had no economic substance; but, because Charter would then record the advertising purchases as revenue and capitalize its purchase of the set top boxes, in violation of generally accepted accounting principles, the transactions would enable Charter to fool its auditor into approving a financial statement showing it met projected revenue and operating cash flow numbers. Respondents agreed to the arrangement.

So that Arthur Andersen would not discover the link between Charter’s increased payments for the boxes and the advertising purchases, the companies drafted documents to make it appear the transactions were unrelated and conducted in the ordinary course of business. Following a request from Charter, Scientific-Atlanta sent documents to Charter stating—falsely—that it had increased production costs. It raised the price for set top boxes for the rest of 2000 by $20 per box. As for Motorola, in a written contract Charter agreed to purchase from Motorola a specific number of set top boxes and pay liquidated damages of $20 for each unit it did not take. The contract was made with the expectation Charter would fail to purchase all the units and pay Motorola the liquidated damages.

To return the additional money from the set top box sales, Scientific-Atlanta and Motorola signed contracts with Charter to purchase advertising time for a price higher than fair value. The new set top box agreements were backdated to make it appear that they were negotiated a month before the advertising agreements. The backdating was important to convey the impression that the negotiations were unconnected, a point Arthur Andersen considered necessary for separate treatment of the transactions. Charter recorded the advertising payments to inflate revenue and operating cash flow by approximately $17 million. The inflated number was shown on financial statements filed with the Securities and Exchange Commission (SEC) and reported to the public.

So what did the court decide? Well, first it determined that the set-top box makers didn’t make any misleading statements, so they didn’t directly violate the statute in question. The next step, then, is to determine if they can be held liable under a theory of aiding and abetting Charter’s misstatements. The court then goes through a long history of cases explaining that the set-top box makers did not do anything “in connection with the sale of a security” so again they are not liable, and they had no affirmative duty to disclose this information to the public nor did they communicate these acts to the public so the public could not have relied on them. The dissenting opinion does a good job of debunking these arguments in my opinion.

The investors argued:

Liability is appropriate, petitioner [the investor] contends, because respondents [the set-top box makers] engaged in conduct with the purpose and effect of creating a false appearance of material fact to further a scheme to misrepresent Charter’s revenue. The argument is that the financial statement Charter released to the public was a natural and expected consequence of respondents’ deceptive acts; had respondents not assisted Charter, Charter’s auditor would not have been fooled, and the financial statement would have been a more accurate reflection of Charter’s financial condition.

Liability is appropriate, petitioner contends, because respondents engaged in conduct with the purpose and effect of creating a false appearance of material fact to further a scheme to misrepresent Charter’s revenue. The argument is that the financial statement Charter released to the public was a natural and expected consequence of respondents’ deceptive acts; had respondents not assisted Charter, Charter’s auditor would not have been fooled, and the financial statement would have been a more accurate reflection of Charter’s financial condition.

Sounds like perfectly sound logic to me, and it would place liability where it belongs, at the doorstep of the wrongdoers. So why does the Court reject this argument? Here we see the true agenda behind this ruling:

Were this concept of reliance to be adopted, the implied cause of action would reach the whole market-place in which the issuing company does business; and there is no authority for this rule…

In Blue Chip [a prior Court case], the Court noted that extensive discovery and the potential for uncertainty and disruption in a lawsuit allow plaintiffs with weak claims to extort settlements from innocent companies…

Adoption of petitioner’s approach would expose a new class of defendants to these risks. As noted in Central Bank [a prior Court case], contracting parties might find it necessary to protect against these threats, raising the costs of doing business… Overseas firms with no other exposure to our securities laws could be deterred from doing business here. See Brief for Organization for International Investment et al. as Amici Curiae 17–20. This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.

So in the end, the Court does not want to protect individual investors from this type of bad activity because it could raise the cost of doing business for all companies. Inherent in that decision is the belief that it is better to let investors and other businesses suffer at the hands of fraudulent business activities than to potentially raise the cost of doing business by holding businesses accountable for their fraudulent actions. Absent from this reasoning is the cost to businesses of fraudulent practices (which has just gone down for the wrongdoers) and the cost to businesses and society due to lower investor participation in the financial markets. How many businesses entered into transactions with Charter based on its reported financial condition to later find out they could have a write-off on their hands? How many investors burned by these frauds have left the market and what is the cost of this loss of participation?

In making its ruling the Court goes beyond this case into what the law is, concluding that there is no private right of action in the Securities Exchange act (a private right means every day citizens can sue under it vs. only the government) for aiding and abetting in a securities law violation. The Court points to legislative action were the congress passed a new law that specifically provides for this liability but only mentions the SEC for enforcement. From this, the Court concludes Congress did not want to provide a private right of action in these cases. So, in the end, we the people as individuals cannot sue to recover damages from companies that aid and abet in these cases, only the SEC can. If it decides not to, nothing happens, and it may or may not recover damages for the investors.

Who may benefit from this ruling? Think about the major financial institutions and all of those very complex transactions they helped structure for Enron. Think about those subprime securitizations and CDOs. You are now getting warm. Who makes fees from underwriting securities? Warm again. The Court, in its infinite wisdom, has determined that protecting these interests is more important than ensuring ethical business practices.

If you would like to read the opinion of the Court, you can find it here.

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