Mining for deep pockets fails in Supreme Court

Wall Street Journal Editorial:

The Supreme Court did the economy a favor yesterday by declining to open up a whole new avenue -- er, superhighway -- for securities class-action suits. But the decision in Stoneridge v. Scientific Atlanta may be most remarkable because three justices nonetheless voted to validate the trial bar's "scheme liability" scam.

The case rested on the notion that Scientific Atlanta and Motorola, which sold cable boxes to Charter Communications, should be liable for an accounting fraud by Charter in 2001. Charter faced an earnings shortfall and prevailed on the cable-box makers to structure sales agreements in a way that Charter used to boost its reported cash flow. Both Motorola and Scientific Atlanta properly accounted for the sales. But Stoneridge, an investment firm that owned Charter stock, also named them as defendants in a class action filed after Charter's fraud came to light. Stoneridge's argument was, in effect, that by doing business with Charter on Charter's terms, the two companies facilitated the fraud.

Anthony Kennedy's majority opinion was joined by Antonin Scalia, Clarence Thomas, Samuel Alito and Chief Justice John Roberts. Justice Kennedy correctly observes that dragging Charter's suppliers into the case amounts to "a private cause of action against the entire marketplace in which the issuing company operates." Pleasantly surprising for this too-activist Court, the majority even notes that Congress debated whether to create a private cause of action against "aiders and abettors" when it passed the Private Securities Litigation Reform Act in 1995, and decided against doing so.

And yet the three dissenters -- John Paul Stevens, Ruth Bader Ginsburg and David Souter -- argued for precisely such an expansion of class actions. (Stephen Breyer recused himself.) Justice Stevens's dissent argues that "every wrong shall have a remedy."

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The ruling make sense for investors and for business. Disclosure rules are based on the premise that a party is in a position to know and to disclose material facts about an issuer of securities. The defendant has to be a link in the chain leading to a sale. Thus an underwriter and an issuer are held responsible for disclosures about the business for which securities are being issued.

No one claims that the Post Office is a link in the chain leading to the sale, because it has a commercial transaction to deliver prospectuses for the issuers and underwriters. The same goes for FedEx and UPS. Yet the plaintiff's theory could eventually be stretched to bring in these delivery companies as defendants.

In this case the Plaintiff's real gripe is with the accounting rules, but it obviously thought suing the accounting boards who crafted them was a bridge too far. The Enron cases, which were in the shadows on this case demonstrate how accounting rules can be abused to the detriment of investors. There are better ways to deal with those problems than enriching greedy trial lawyers.