Securities and Exchange Commission (SEC) Commissioner Annette Nazareth resigned on Jan. 31, leaving the five-member Commission with only three commissioners — all Republicans.
Control over the SEC will be determined by the 2008 elections, with Democrats and Republicans promoting different visions of the Commission’s role and purpose. The Supreme Court raised the stakes in January with two rulings that reduced the potential scope of third-party liability in securities class-action lawsuits — leaving policing of such legal complaints largely to the SEC.
Those decisions cap a recent trend of business-friendly rulings, which buttress the relative importance of the SEC. Two of those decisions carried particular significance for the financial markets, as Tellabs v. Makor made it significantly more difficult to plead securities class actions, and in Credit Suisse v. Billing, the Court held that the securities laws implicitly supercede antitrust laws as they apply to underwriting activities. This has increased the significance of the political bent of the SEC:
Although the structure of the SEC allows no more than three of the five commissioners to serve from the same political party at any time, presidents can exert great influence even in their choice of appointments from the opposite political party.
A president can also shape SEC policy, via lower-level appointments, and staffing, budgeting and resource allocation decisions.
‘Third-party defendants’ controversy.
The Supreme Court’s two most recent actions both concern the ability of shareholders to sue deep-pocketed third-party defendants — such as accountancy firms, investment banks and law firms — in securities class actions. Shareholders target such defendants to recoup investment losses following corporate collapses, since although it may be easier to make a successful legal claim against the company involved in the alleged fraud, there are often no assets available to pay out on a successful judgment.
The area of third-party liability has been particularly fraught since the 1994 decision in Central Bank of Denver v. First Interstate Bank of Denver, in which the Court determined that so-called 10(b) liability (an implied private right of action under the authority of the Securities Exchange Act of 1934 and SEC Rule 10(b)) does not extend to “aiding and abetting” liability. The Private Securities Litigation Reform Act of 1995 (PSLRA) overruled one element of the Central Bank decision and restored a right to bring such actions to the SEC.
Key tort rulings.
Yet the Court changed the rules of the game again in January with three key decisions:
• Stoneridge vs Scientific Atlanta. The Court’s Jan. 15 decision in Stoneridge Investment Partners v. Scientific Atlanta was perhaps its most significant securities law decision in several years, and it represents the fifth major pro-business securities law decision by the Court since 2004. Justice Anthony Kennedy’s 5-3 majority opinion resolved a conflict between circuit courts of appeals concerning when an investor can make a rule 10(b) claim to recover from a party that neither makes a public statement nor violates a duty to disclose but does participate in a scheme to violate 10(b).
The decision had three major elements:
• Higher barriers to plaintiffs. It rejected endorsing the theory of “scheme liability,” and instead held that plaintiffs must show they relied on fraudulent statements when making their investment decision. Plaintiffs must not only prove the deceptive behavior of such third parties, but if this behavior is not communicated to the marketplace, it cannot as a matter of law induce reliance. Suits may also only be brought against parties who “controlled” the alleged fraud.
• Enhanced SEC role. It interprets the PSLRA to reserve an exclusive right to bring “aiding and abetting” causes of action to the SEC.
• International competitiveness concerns. The Court also raised concerns about the extensive discovery and potential for uncertainty and disruption, which may allow plaintiffs with weak claims to extort settlements from innocent companies.
The Court recognized that these concerns could deter overseas firms from doing business in the United States, and could shift securities offerings from domestic capital markets.
The Stoneridge action had provoked a split within the administration of President Bush, with SEC Chairman Christopher Cox, who had been a principal author of the PSLRA during his tenure in the House of Representatives, voting to join the Democratic commissioners in endorsing a brief arguing in favor of allowing private plaintiffs to bring third-party actions. However, following heavy pressure by investment banks and other potential defendants, Bush directed the Justice Department to put forward a brief arguing for a narrow interpretation of the PSLRA.
• Enron decision. The Court followed the Stoneridge ruling on Jan. 22 by denying an appeal in Regents of the University of California v. Merrill Lynch, Pierce, Fenner and Smith. The case was a third-party liability class action brought by Enron shareholders against major investment banks including Merrill Lynch, Barclays, Credit Suisse and Pershing. The Court’s decision to deny the appeal allowed a decision to stand by the United States Court of Appeals for the Fifth Circuit in New Orleans to dismiss a class action on the grounds that the plaintiffs had failed to establish reliance on the actions of the investment banks.
• Cendant action. The Court also sent back for further review, in light of the Stoneridge decision, a class action brought by the California State Teachers’ Retirement System against Cendant and Time Warner, concerning their alleged involvement in a scheme in which Homestore.com inflated its revenues.
• Consequences of Stoneridge. While the Stoneridge decision is highly significant, its implications should not be overstated:
• Plaintiffs can still pursue offending companies; the ruling is confined to third-party liability claims only.
• The SEC’s exclusive authority to bring third-party liability claims remains a potent weapon, and the SEC has used it; in December, the SEC sued a partner in a major law firm for alleged involvement in a fraud perpetrated by defunct broker Refco.
• The SEC can and has referred major causes to the Department of Justice to bring criminal charges.
• Private plaintiffs may pursue third parties if they issued statements upon which the investors relied; therefore, Stoneridge will likely not serve as a major direct bar to litigation arising from the sub-prime crisis, where the conduct of major investment banks and asset managers, for example, has been called into question. (However, the Court’s reluctance to construe statutes narrowly may prove to be an obstacle to plaintiffs’ claims, even if Stoneridge and other pro-business precedents do seem directly relevant.)
• Creative plaintiffs’ attorneys can be expected to craft novel lines of legal argument, and indeed, the lead plaintiff in the Enron action (the University of California) intends to file a new action outlining a fresh legal theory in federal district court.
• Inspired by the example of former New York state Attorney General Eliot Spitzer, state legal officials, especially Andrew Cuomo, Spitzer’s successor, continue to play a leading role in driving the regulatory agenda concerning financial-sector transgressions, and will remain a significant force, regardless of federal-level developments.
Oxford Analytica is an international consulting firm providing strategic analysis on world events for business and government leaders. See www.oxan.com.