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U.S. Solicitor General Says Scheme Liability Is Counter to Congressional Intent

The U.S. Solicitor General has urged the Supreme Court to reject scheme liability for non-speaking secondary actors in private securities fraud actions since such an expansion of liability would upset the delicate balance Congress has crafted. In its brief, the Solicitor General argued that scheme liability runs counter to the congressional balance between exposure to private actions for aiding and abetting and empowering the SEC alone to pursue secondary claims against non-speaking actors, such as lawyers and accountants. At the same time, the Solicitor General maintained that non-verbal conduct by secondary actors can constitute deception within the meaning of rule 10b-5, but in this particular case, although deception could be alleged, the investors did not rely on any conduct by the non-speaking vendor.

In the case of Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (Doc. 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 defendants in the Stoneridge case.

In urging the Court to reject scheme liability, the Solicitor General said that allowing liability for a primary violation against a non-speaking vendor when the investors did not even allege that they were aware of the transactions that the vendors executed with the company would be a sweeping expansion of judicially implied private actions that could expose accountants and lawyers who advise issuers, as well as vendors far removed from the market, to billions of dollars in potential liability when issuers make misstatements to the market.

In the Solicitor General's view, scheme liability would considerably widen the pool of deep-pocketed defendants that could be sued for an issuer's misrepresentations, increasing the likelihood that the private right of action would be employed abusively. This radical expansion of liability is a task for Congress, not the courts, according to the Solicitor General.

In this case, the parties allegedly backdated transactions as part of a scheme to inflate the issuer's operating cash flow in the financial statements. While this alleged conduct could constitute a deception under rule 10b-5, the Solicitor General said it could be no more than aiding and abetting since the investor alleged no reliance on the vendors' alleged deceptive conduct. The investor relied only on the issuer's alleged misstatements. The Solicitor General said that secondary actors cannot be held liable in a private securities action by virtue of an investor's reliance on misstatements made only by the company.

The Solicitor General emphasized that the principle at the heart of the distinction between primary liability and secondary liability of the kind rejected in Central Bank is that words or actions by a secondary actor that facilitate an issuer's misstatement, but are not themselves communicated to investors, cannot give rise to reliance, and thus primary liability in a private action.

The Solicitor General contended that the issue has international repercussions. Extending liability to vendors could effectively and substantially expand liability for foreign companies that trade with publicly-listed companies. In a brief filed by international organizations, including the Federation of German Industries, they pointed out that Germany and the U.K. limit liability for misstatements to the issuer and potentially certain of its officers and directors. They do not provide for claims against silent third parties to commercial transactions that the issuer misreports.