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House Leaders Urge Supreme Court to Approve Scheme Liability in Securities Fraud Actions

Although the SEC and the Department of Justice did not file an amicus brief in the scheme liability case now before the Supreme Court, two House leaders have filed a brief on behalf of investors urging the Court to hold that non-speaking actors who engage in deceptive acts as part of a scheme to defraud investors may be liable under rule 10b-5 even if they did not directly issue fraudulent statements. This is also the position of the SEC, according to Representatives Barney Frank (D-MA) and John Conyers (D-MI), respective chairs of the Financial Services and Judiciary committees.                                       

The House chairs filed the brief because they believe the law in the case is clear that third parties who knowingly engage in manipulative or deceptive acts as part of a scheme to defraud investors should be held liable for their actions under the federal securities laws. In the brief, Frank and Conyers noted that, if the Supreme Court decides against investors in this case, third parties will effectively be immune from suit no matter how reprehensible their conduct.

In Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (No. 06-43), the Court is slated to determine whether non-speaking actors, such as investment banks and auditors, that knowingly commit securities fraud can be held liable for their actions. The brief addressing this question, a concept known as scheme liability, was filed in support of the investors in the Stoneridge case.

The battle over scheme liability is joined when investors argue that an investment bank or auditor need not have made misleading statements or omissions to be liable for securities fraud since participating with scienter in a sham transaction with no legitimate business or economic purpose should suffice. The countervailing argument is that the actors must make a misleading statement to be held liable under rule 10b-5, so scheme defendants who remain silent and owe no duty of candor to investors are categorically exempt.

The circuit courts are split on this issue. The Ninth Circuit articulated a test under which participants in schemes with the principal purpose and effect of defrauding investors are held liable whether or not they made misleading statements to investors. By contrast, the Eighth Circuit in Stoneridge and the Fifth Circuit in Enron have adopted what earlier amici called a narrow interpretation of scheme liability based on an erroneous interpretation of the Supreme Court's 1994 decision in Central Bank of Denver v. First Interstate Bank of Denver.

The brief notes that the Solicitor General rejected the SEC's specific recommendation that the U.S. file an amicus brief in support of investors and urged the Court to follow the Commission's long-standing interpretation of the statutory and regulatory provisions at issue. Frank and Conyers were disturbed by what appears to have been done as a result of White House intervention. They called the Solicitor General's decision to follow the directives of the President rather than support the SEC's position a dangerous course to follow.

The rejection of scheme liability for non-speaking actors elevates a policy argument over the clear text of the antifraud statute, according to their brief, and is an invitation to engage in the policy-based judicial activism the Court has repeatedly condemned in statutory interpretation cases. Unless and until Congress amends section 10(b), Frank and Conyers said the Court should honor the legislative policies established by Congress which is reflected in the clear language of the statute and in SEC rules, as well in the Court's precedents.

The Financial Services committee stands ready to facilitate through hearings a discussion of whether to amend section 10(b) to immunize from liability persons who knowingly engage, directly or indirectly, through conduct or speech, in manipulative or deceptive acts as a part of a scheme to defraud investors, according to the brief.

In earlier briefs, Attorneys General representing more than 30 states pointed out that, without scheme liability, many defrauded investors would have no redress. Eliminating scheme liability for what the state officials called "non-speaking actors" will significantly diminish victims' rights to compensation under the securities laws. The AGs pointed out that virtually all of the record $7.1 billion settlement to investors in Enron came from such non-speaking actors. Without those funds, many individual Enron shareholders would have received nothing. Without scheme liability, many more defrauded investors will receive nothing, the AGs advised.

James Hamilton