October 9, 2007

Stoneridge: Legalized Fleecing Or Corporate Waterloo?

Bill Hobbs has followed the legal case of Stoneridge v. Scientific-Atlanta with his usual tenacity. The complex case pits trial lawyers seeking greater compensation for alleged corporate malfeasance towards investors against public companies already reeling from the effects of Sarbanes-Oxley. The Supreme Court will review the case this session, and the result will have a heavy impact on nearly everyone in this investor-heavy environment:

The issue in Stoneridge is simple: If a company that is traded on a U.S. exchange violates American securities laws by misreporting in its financial statements a transaction of any kind, may shareholders sue the entity on the other side of that transaction for the damages that the misreporting caused—even when there is no specific reference to the transaction at issue and it is subsumed along with hundreds of thousands of other transactions in the public company’s annual financial statements? ...

The issue is NOT: do these other companies get off free if they knowingly helped in the misreporting? The Justice Department and SEC have enforcement authority where they find that someone has aided and abetted a securities fraud. They bring actions and collect fines.

The issue is also NOT: can those who lost out in the fraud receive compensation? Following the Enron scandal, as part of Sarbanes-Oxley, Congress established a fund (called the FAIR fund) into which fraud fines are paid and which is used to compensate securities fraud victims.

The issue is SOLELY: does U.S. securities law allow private securities fraud suits against someone who does not make the statement that allegedly misled investors (other than the public company’s officers and directors, who are liable under existing law)?

Ted Frank of Overlawyered and AEI wrote about this in June He wondered why the Supreme Court granted certiorati for the appeal, and hopes it's just for the "me too" opportunity:

The case's facts are straightforward: Charter Communications purchased set-top cable boxes, but got back some of the money in the form of advertising bought by the vendors. Charter executives recorded the outgoing money as a "capital expenditure" (to be depreciated over several years) but the incoming money as revenue recorded within a single year, thus falsely inflating operating cash flow. Three Charter executives went to prison over the shenanigans. Plaintiffs' attorneys sued Charter and the executives, of course, but named as codefendants two of the vendors, Motorola and Scientific-Atlanta.

The suit makes little sense. The vendors had no say in how Charter accounted for or reported its transactions. Worse is the precedent it represents: How can a business function if it is potentially liable for hundreds of millions because those whom they trade with misreport a day-to-day transaction? The Supreme Court stopped such private "secondary liability" suits in Central Bank v. First Interstate Bank, a 1994 decision that Congress ratified the next year, explicitly rejecting private suits for "aiding and abetting" in the Private Securities Litigation Reform Act (repeating the rejection in the 2002 Sarbanes-Oxley Act.)

A federal court in Missouri dismissed the case against the equipment vendors, and the Eighth Circuit Court of Appeals affirmed that decision: Such liability would, the court said, create far-reaching "uncertainties for those engaged in day-to-day business dealings." Nevertheless, the Supreme Court has agreed to hear an appeal.

Why? The Court may—one hopes—be stepping in to reassert itself, since some courts have permitted plaintiffs' lawyers to whittle away at Central Bank. In the Enron litigation, for example, a federal court in Houston erroneously certified a class action after plaintiffs alleged investment banks doing business with Enron were "primary violators" of the securities laws—even though these defendants took huge losses when Enron collapsed. With plaintiffs claiming total liability of $40 billion, many banks caved when offered a chance to settle for less than a nickel on the dollar. Such a settlement is a better bargain than a 90% chance of winning at trial—a basic cost-benefit analysis the plaintiffs' bar counts on when bringing baseless litigation.

The expansion of the case to Motorola and Scientific-Atlanta makes no sense, as Frank reports. They had nothing to do with the fraudulent reporting of cash flow by Charter. The addition of the two vendors appears only to serve as additional "deep pockets" for trial lawyers to exploit.

We need to keep an eye on what the Court does with this case. If it overturns the appeal, it could be open season on secondary actors, which will inflate commercial risk exponentially. With businesses already overburdened by Sarbanes-Oxley auditing requirements, a requirement to audit one's customers seems to be going several steps too far.

Ted Frank will join me today to discuss this on Heading Right Radio at 2 pm CT.


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Comments (12)

Posted by Al in St. Lou | October 9, 2007 1:01 PM

I don't understand this at all. Where's the fraud? Look, if you own a print shop, and your family owns four cars, and you go to the local tire store and buy sixteen tires, you've made a capital investment. If the tire store uses your print shop to print fliers, brochures, newsletters, coupons, etc., you've gained revenue. Now, why would it make sense for the federal government to insist that your business didn't generate the revenue but that you just got a discount on your tires?

Okay, it would be a whole different story if the allegation were that you paid an inflated price for your tires and you received the extra money back because you sold your services to the tire store with compensating overcharges, but if the prices were legitimate, I don't see where there can be any alleged fraud.

Posted by Carol Herman | October 9, 2007 1:58 PM

I have zero faith in the supremes. A batty collection of deaf, dumb, and blind people. Who've been skirting around the issue of ROE.

Start with this. Prior to ROE, women had back alley abotions.

ROE has saved lives.

It's also split the republican party to pieces. Given that to "pass go" and get "benched up to the supremes" ... you go through this dog fight in congress, where truth remains unknown.

So, you get candidates who swear "they've never even thought about this subject." To others, like Ruth Bader Ginsberg, who slam-dunked her appearance, by basically telling the senators she wouldn't tell them how she intends to vote. Very low key. Of course. Woman talks in a monotone.

And, given the ramifications not just of Sarbanes-Oxley. But of McCain-Feingold. And, all the pork fests. Where Larry Craig has also added his Wide Stance. While he fooled most of you.

Do you know how? Besides his right hand, flap-doodling under the stall partition; before the cop dropped his badge, Craig's LEFT HAND appeared.

Guess what? He was gonna crawl thru.

In case you thought toilet sex was all done over cell phones. Not true.

You've been had!

And, congress is full of turkeys.

Which is what you get when the party apparatus has gatekeepers that stink.

Now. What can happen in '08? Anyone betting on a solid run by an independent, who toodles out of the gate next spring?

Why not? The current system seems as divisionary as ever.

And, the future usually holds surprises.

Sarbanes-Oxley, by the way, hoisted CEO's up, where doctors used to be. Made for the criminal courts, just by the wording in the documents.

Stupid is as stupid does.

But when bubbles burst? Surprisingly beneficial. But not for the dudes who face bankruptcy.

By the time the supreme's get together and vote in unison? You're gonna need a few of the present turkeys to fall from their perches.

Posted by Bill Hobbs | October 9, 2007 2:39 PM

A ruling for the defendants in Stoneridge would leave current law unchanged, while a ruling for the plaintiffs would radically alter current law.

The Court and every federal circuit court but one have made secondary liability (the plaintiffs call it “scheme� liability) off limits for private suits.

However, neither the Court nor Congress have set prosecution of accomplices off bounds in securities
cases - they have simply left that task solely to the SEC and the Justice Department.

This balances the need for justice in such cases with the need to protect the economy from being hamstrung and hog-tied by an avalanche of lawsuits.

The blog "10b-5 Daily" had an interesting post recently headlined "NERA Releases Study on Recent Trends In Shareholder Class Action Litigation."

The gist of it is that the NERA Economic Consulting study, included the following info:

The number of such filings has increased, with 76 new filings through the first half of 2007. The projected annual total of 152 would be a 12% increase over last year.

The average settlement value during the first half of 2007 (excluding settlements over $1 billion) hit a new high of $30 million. There is evidence, however, that this trend may reverse direction based on a decline: (i) in the investor losses associated with recent filings; and (ii) in the prevalence of accounting allegations in recent filings.

Eight of the top ten settlements of all time have resolved in 2006 or 2007, or are pending. Tyco’s announced preliminary settlement of $2.975 billion would be the largest amount ever paid by a single settling defendant.

Here’s the link: http://www.the10b-5daily.com/archives/000853.html

If the Stoneridge case is decided for the plaintiffs, the number of such lawsuits would skyrocket, putting a huge "scheme liability" tax on the economy.

And the economic costs of our out-of-control legal system are already huge:

According to the Pacific Research Institute's study Jackpot Justice: The True Cost of America's Tort System , America's out-of-control legal system imposes a staggering economic cost of over $865 billion every year calculated that the nation's tort system imposes a yearly "tort tax" of $9,827 for a family of four and raises health care spending in the U.S. by $124 billion.

In addition, according to the PRI study, the impact of America's overly expensive liability system on the health care industry costs lives because it "increases the cost of many risk-reducing products and services and health care services, making them less accessible, and in some cases unavailable to consumers.

From "Jackpot Justice":

PRI estimates that more than 114,000 people would be alive and working today, but are not due to inefficiencies in the tort system over the last two decades.

The practice of "defensive medicine" by litigation-fearing physicians increases American health care costs by $124 billion per year and adds 3.4 million Americans to the rolls of the uninsured.

PRI estimates that American companies suffer more than $367 billion per year in lost product sales because spending on litigation curtails investment in research and development, and lawsuits against American corporations generate an annual loss of $684 billion in shareholder value.

PRI study link: http://www.legalreforminthenews.com/PRI_JJ/07PRI_JackpotJustice_Launch.html

Posted by RD | October 9, 2007 3:14 PM

It seems like every month I get a notice from some company of another stockholder lawsuit against the company in which I also am a minor stockholder. I can sign on or not-doesn't matter it's been done in my name as a shareholder(class action). I have yet to figure out how these suits help me or the value of the company. The winners are the lawyers who bring these suits not the stockholders, IMO. It's legal robbery, again IMO. Some law firms seem to make a living with these frivolous lawsuits which they also seem to solicit(IMO). I wish I had the copy of the settlement of the lawsuit concerning scotch tape and its purchasers (so I could quote it accurately here) How many rolls of scotch tape does the average person buy per year? But the lawyers collected big time while the few aggrieved winners of the lawsuit collected coupons (literally). For settlements of equally silly types of lawsuits check out your weekly magazine supplements in your Sunday newspaper (such as "Parade") and read the fine print of the settled lawsuits which are published in these magazines. Reform is badly needed to protect shareholders and the public from lawsuits such as these.

Posted by RD | October 9, 2007 3:33 PM

I wonder what would happen if stockholders (who are victimized by loss of value of their stock by class action suits) banded together to sue the lawyers in a reverse class action suit? Would it have an effect? That's the kind of lawsuit I could join.

Posted by AW1 Tim | October 9, 2007 3:57 PM


Well, here's my concerns. If suppliers of an item to a third party are to be held liable for the illegal action(s) of that third party, which is basically what this suit alledges, then could not such precedent be used to, for example, sue firearms makers for the actions of armed criminals? Could one not then sue an automobile maker for the actions of a drunk driver?

Yes, this lawsuit is about financial losses and the culpability of ancillary partners, but it seems to me that there is a dangerous precedent being bandied about in the quest for casting the culpability net far and wide.


Posted by Al in St. Lou | October 9, 2007 4:03 PM

I was once the beneficiary of a class action lawsuit. It was against my auto insurance company. The settlement was something like $6 million for the law firm and $6 each for approximately one-million customers. I deposited my $6 check, but I wondered how much the settlement really helped any customer. Class action suits seem to be a racket for lawyers to legally steal from corporations.

Posted by burt | October 9, 2007 4:42 PM

"First kill all the lawyers." Include John and Elisabeth Edwards.

Al in St. Lou, I think that coupons are not an uncommon outcome of class action litigation. I have been offered coupons a couple of times for actions I didn't support.

Bill Hobbs, I have been unhappy with our tort law for years. You sure didn't help my mood.

Posted by quickjustice | October 9, 2007 4:47 PM

I heard Richard Epstein's brilliant lecture about this case, which I'll summarize as follows: the case is about how broad a net the courts should cast to impose "aider and abettor" liability on innocent people. Older tort law applied "aider and abettor" mechanically, which works with two or three abettors, but fails miserably if you end up roping in thousands of innocent people who unknowingly profited from the fraud, while having nothing to do with it. That's the result for which plaintiffs are arguing. If plaintiffs win, expect the current migration of securities offering from New York to London to accelerate.

If such a trend is created and continues, U.S. securities markets will cease to exist. That means thousands of great jobs lost overseas.

A better outcome to to apply principles of statutory construction, which enable courts to place reasonably restraints on the scope of persons held liable for aiding and abetting to those who actually did something wrong. That would be a reasonable outcome. It says a great deal about the condition of the federal courts that one must hold one's breath in awaiting the outcome.

Posted by Bennett | October 9, 2007 8:00 PM

The defendants in this case are not exactly innocent bystanders, if the allegations are true, and I can see the argument for extending liability to them.

"In 2000 to 2001, technology companies Motorola and Scientific Atlanta (now owned by Cisco Systems) allegedly agreed to supply cable TV provider Charter Communications with equipment at a $20 premium over the traditional cost with the knowledge that Charter intended to account for the transactions improperly as advertising revenues (the vendors used the extra funds to buy advertising space).

These "sham" transactions inflated Charter's revenue by $17 million. When the revenue inflation came to light in 2002, Charter's stock crashed from $26.31 to 76 cents, a $7 billion loss in market cap. StoneRidge, an institutional investor in Charter, accused the two vendors of participating in a "scheme to defraud" investors and now wants the right to sue them for remediation."

I think the Court may want to revisit the Central Bank case because clearly government enforcement of existing securities laws hasn't worked to prevent this kind of behavior from happening.

SEC investigations may have their place but the idea that this alone is going to be enough to scare third parties away from knowingly participating in these kinds of schemes is fairly laughable. The SEC doesn't have the manpower to mount sufficient investigations and having to pay a fine even if you are caught is pretty small beer for a lot of companies, well worth the risk when you know you don't face any significant exposure otherwise.


Posted by Aw1 Tim | October 9, 2007 8:46 PM


I would also add that we need to define "how much is enough". I would guess that that very question is the basis for torte reform.

Still and all, A great nation needs to be able to define the point at which litigation is stopped, in order for the smooth transition and operation of the judicial branch. Justice is not served when it is hounded into a corner by packs of ravenous wolves, who would as soon see the whole process cut down to satisfy their bloodlust.

Either the lawyers learn to practice self-restraint, or the legislative branch will do it for them, and it would be far better for the lawyers to learn to police themselves than for the Federal Government to step in and do it for them.


Posted by Al in St. Lou | October 10, 2007 10:32 AM

Thanks, Bennett. Back when I was single, I subscribed to Forbes magazine. Capitalist Tool, indeed! I still remember the biblical quotation put in by B.C. Forbes, "With all thy getting, get understanding." Malcolm Forbes kept it in every issue.

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