Corporate Governance

Stoneridge Redux: The Problems of Result Oriented Reasoning (Part III)

By J. Robert Brown

We are conducting a retrospective on Stoneridge and examining the implications of the case. 

The Court concluded that the case against the vendors had to be dismissed not because the alleged behavior was not deceptive (given allegations of backdating and falsified documents, how could it?) or because they were secondary actors but because there had been no reliance on the vendor behavior.  As the opinion noted:  "In all events we conclude respondents' deceptive acts, which were not disclosed to the investing public, are too remote to satisfy the requirement of reliance." 

The Court provided no meaningful guidance on how to interpret the reliance issue.  Reliance presumably exists if the transaction itself is disclosed.  But in those circumstances, vendor liability depends less upon the behavior of the vendor and more on the particular disclosure made about the vendor by the relevant issuer.  In other words, vendor liability turns on the disclosure of the issuer, something largely out of the control of the vendor.

Moreover, if it is about market reliance, there may well be instances where non-disclosure is still actionable.  Item 1.01 of Form 8-K requires the disclosure of material contracts not in the ordinary course of business.  The report must identify the terms and the parties involved.  There will be at least some instances when the relevant vendor contract designed to affect earnings is material and not in the ordinary course.  The failure of the issuer to reveal the contract despite the affirmative disclosure obligation creates an Affiliated Ute type of reliance. 

In addition, the case at least suggests that the reliance element was imposed on those involved in "ordinary business operations" but not necessarily on those involved in the "realm of finance."  As a result, it is possible that the reliance element imposed in Stoneridge does not apply to anyone involved in the securities business.  This would mean fraud on the market is fine where the defendants are involved in the area of finance (the investment banking firms in Enron for example). 

Sound far fetched?  In In re Able Laboratories Securities Litigation, Civil Action No. 05-2681 (JAG) (D NJ March 24, 2008), the court considered the applicability of Stoneridge to, among others, an officer who served as the Vice President of Quality Control.  The court essentially concluded that Stoneridge was limited to third parties and did not apply to corporate officers.  As the opinion noted:

• The Supreme Court's recent decision in Stoneridge does not focus on the definition of scheme liability, but rather involves the question of liability of outside third parties -- suppliers and customers -- who participated in a scheme to defraud investors. Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761 (2008). In fact, the Supreme Court concluded that, while secondary actors could not be found liable under an aiding and abetting theory, "the implied right of action in § 10(b) continues to cover secondary actors who commit primary violations." Id. at 773-74.  In stark contrast, the allegations before this Court involve high ranking officers of the Company, and not outside third parties. As a result, the cases cited by Shah's counsel are not applicable to this Court's evaluation of the present case.

In other words, Stoneridge only applied to "third parties."  It is an interpretation that seems to be compelled by the decision but not likely to be followed by all courts.  Those courts wanting to dismiss third parties will likely find that the reliance requirement applies to all non-issuer participants, including those operating in the realm of finance.   

Full post as published by The Race to the Bottom on April 09, 2008 (boomark / email).