Court takes up shareholder rights

In its biggest business case of the term, the high court examines the scope of investors' rights to sue in the wake of corporate fraud.

It is being called the most important business case in a generation. One legal analyst has referred to it as the Roe v. Wade of securities law.

The case is Stoneridge v. Scientific-Atlanta and it arrives on Tuesday at the US Supreme Court amid the kind of hyperbole usually reserved for high-octane cases about abortion or race.

"This is a big one, and lots and lots of money is riding on the outcome," says Georgetown Law Center professor Donald Langevoort.

Jay Brown, a University of Denver law professor, says the case is a "watershed event." It is likely to establish the rules and boundaries for a string of pending shareholder suits, including those that involve the Enron scandal.

At issue in Stoneridge is who can be sued by angry investors in the wake of a major financial fraud at a publicly traded company.

Securities laws and regulations make clear that company officials directly responsible for such fraud can be sued. But what about consultants, vendors, investment bankers, lawyers, accountants, and others who may have had knowledge of the fraud and engaged in deceptive actions that helped keep it quiet?

Possible effect on economy

The case is being closely watched and extensively lawyered, with more than 30 friend-of-the-court briefs filed. It could dramatically expand the legal liability of a significant cross-section of American business. Some analysts are warning that if the Supreme Court rules for investors it would inflict a substantial drag on the US economy by encouraging an avalanche of class-action lawsuits against lawyers, accountants, bankers, and others on behalf of investors.

At the same time, investors – both big and small – argue that corporations and their business associates should be accountable to the investing public when they engage in deceptive and illegal activities. Putting executives on notice that investors expect them to be honest and truthful is a boost to the economy, they say, not a drag on it.

A fraudulent history

The case stems from a financial scandal at Charter Communications. At the time, the St. Louis-based firm was the nation's fourth-largest cable television company.

In August 2000, executives at the company realized they were more than $15 million short of projected cash flow for the year. They worried that if stock analysts discovered the company's weak performance, their share price might suffer. They needed an infusion of cash – fast.

Instead of earning it, company officials devised a plan to artificially boost Charter's bottom line. They set up a system in which they overpaid two of their suppliers for television cable boxes. They paid $20 per box above the usual price – generating $17 million in overpayments. The suppliers – Scientific-Atlanta and Motorola – then agreed to pay $17 million to Charter to purchase advertising from Charter.

In effect, Charter was giving the suppliers free advertising but booking the recycled $17 million as new revenue.

To help throw Charter's auditors off the trail, Scientific-Atlanta and Motorola backdated phony contracts and were asked to send letters to Charter justifying the $20 extra charge per box, according to a federal indictment. One supplier sent false invoices, the indictment says.

The moves inflated Charter's bottom line and prevented a stock plunge, but only temporarily. When Charter's true financial situation was revealed (amid other questionable activities), the company's stock fell from $26 per share in 2000 to 76 cents per share by 2002.

A shareholder suit against Charter's top executives was settled out of court. Shareholders then turned their attention to the alleged roles played by Scientific-Atlanta and Motorola.

But that suit – the subject of the current Supreme Court case – was dismissed by a federal judge and the Eighth US Circuit Court of Appeals in St. Louis. Both lower courts ruled that such civil lawsuits by shareholders could be pursued against the primary perpetrators of the fraud, but that Motorola and Scientific-Atlanta were not involved deeply enough in the fraud.

The court cited a 1994 Supreme Court case that held that those who merely aided and abetted a fraud could not be sued by shareholders. Instead, the shareholders could only request enforcement action by federal prosecutors or by the Securities and Exchange Commission.

In their appeal to the Supreme Court, the shareholders, Stoneridge Investment Partners, argue that Scientific-Atlanta and Motorola did more than merely aid and abet the fraud at Charter. They "engaged in a series of sham transactions; they then falsified documents in order to conceal the true nature of those transactions," says Stoneridge lawyer Stanley Grossman in his brief to the court.

"This is not a case involving an arm's length transaction in which a party acted honestly but perhaps with knowledge that the transaction would be used to mislead investors," Mr. Grossman writes. "This is a case in which [the suppliers] themselves engaged in fraud."

Lawyers for Scientific-Atlanta and Motorola cite the 1994 Supreme Court decision barring such lawsuits against aiders and abettors. They say it was up to Charter to accurately report its financial position, and that as suppliers the two firms had no duty to disclose information about Charter to its shareholders.

In addition, they say, no investors relied on any information from the suppliers.

"Congress did not intend to turn product suppliers who do not speak to investors into watchdogs for the accounting practices of public companies," says Stephen Shapiro in his brief on behalf of Scientific-Atlanta and Motorola.

Divided on threat

The issue has led to a split among the federal appeals courts. Both the fifth circuit in New Orleans and eighth circuit in St. Louis have adopted the more restrictive approach favored by business. The ninth circuit in San Francisco has embraced the more expansive view of investors.

It is unclear how the justices will attempt to balance the substantial competing interests in the case. Unrestrained class-action suits could bring some companies to their knees. But some analysts discount this threat.

"One of the reasons we have the best capital markets in the world is when you invest in a company in the United States you take a risk, but the risk is a business risk – will the company succeed or fail," says Professor Brown of the University of Denver. You aren't taking a risk of investing in a fraudulent enterprise, he says.

"Enron was a Potemkin village, a house of cards," Brown says. "That wasn't supposed to be able to happen here. It wasn't supposed to be the kind of risk that investors took."

If SEC and Justice Department enforcement was enough, he says, the Enron scandal would have been impossible.

"Civil liability is really the only thing companies are afraid of," Brown says. "It is the civil suit that causes companies to be far more honest in their disclosure [to investors] than they might otherwise be."

But honesty isn't always a perfect shield. Class-action lawsuits can create strong pressures even for honest, well-run companies to settle lawsuits rather than endure litigation costs, analysts say.

"American businesses paid more than $42 billion in securities class-action settlements between 1996 and 2006," says former Solicitor General Kenneth Starr in a friend-of-the-court brief on behalf of the Washington Legal Foundation.