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Scheme Supreme

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1 Scheme Supreme Will the Supreme Court Absolve the “Secondary Actors” Who Are the Real Culprits in Recent Corporate Scandals? By Gary M. Brown* The Supreme Court recently heard oral argument in the case of Stoneridge Investment Partners LLC v. Scientific Atlanta, Inc., et al. The case will be the latest of numerous Supreme Court decisions that have given substance to the nature and extent of liability under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 promulgated thereunder. The facts in Stoneridge, as well as those of other companion cases awaiting action by the Court (e.g., Enron), have been the subject of numerous Wall Street Journal editorials over the past two years. The most recent, A Class Action Scheme, referred to Stoneridge as the “business case of the year.” That’s cliché and, like much of the discussion of the theoretical underpinnings of the case over the last two years, understates the importance of the case. Stoneridge will be the most significant securities case in a generation – a venerable Brown v. Board of Education of securities law – further refining the question of who can be sued and who cannot under Rule 10b-5. Should the Stoneridge plaintiffs prevail and “scheme” liability be expressly recognized (to the extent that it already wasn’t in the Supreme Court’s 2002 * Mr. Brown is the Chairman of the Corporate Department at the national law firm of Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C. Former Special Counsel to the U.S. Senate Committee on Governmental Affairs in the 2002 Enron investigation, he also is an adjunct professor of law at the Vanderbilt University School of Law where he teaches corporate and securities law. He can be reached at [email protected] or at (615) 726-5763.2 Zandford decision), future litigation will be required to determine the scope of the cause of action and the extent to which settled 10b-5 principles will carry over. This happens frequently – litigation has been required since 1947, when a federal court first recognized an implied cause of action under Rule 10b-5, to refine the scope of 10b-5. It should not be viewed, however, as some have described it, a “breathtaking new legal standard” (as the Wall Street Journal did in a June 10 editorial, Supreme Liability) or an attempt to “allow the tort equivalent of guilt-by association” (as in the Journal’s August 23 editorial, Guilt by Contact). It also should not “open the flood gates to the next class-action bonanza (as described in the Journal’s October 6 editorial, A Class-Action Scheme). Before discussing the merits, however, let’s first put all this in some context. Consider the following findings of a U.S. Senate Committee report: • Americans have become suspicious of banking and business practices that, in the public view, have undermined the prosperity of the past decade. • Congressional investigations have exposed cases of double-dealing in the securities business. Self-dealing and outright fraud (not the least of which involved a gigantic, rapidly growing energy operation) have become associated with erosion of the stock market. • Senate hearings have revealed financial irregularities of large New York banks, their executives, affiliated securities companies, and Wall Street investment bankers and securities analysts.3 • Leading Wall Street investment banks are under fire for their lending and investing practices, including transactions designed to allow companies to misstate their financial results. Private side deals and tax avoidance have evoked much criticism of executives and their corporate activities in banking and commerce. These findings, which sound like they could be the headlines of the early 21st century, actually are the findings of a 1932 Senate Committee investigating the causes of the 1929 stock market crash. The type of activities outlined above spurred Congress, with the encouragement and full support of President Franklin Roosevelt, to pass the U.S. federal securities laws, including the Securities Act of 1933 and the Securities Exchange Act of 1934. Those two laws today still form the backbone of the federal securities regulatory scheme. Congress passed the ‘34 Act to, among other goals, “prevent inequitable and unfair practices” in and to “insure the maintenance of fair and honest [securities] markets.” One of the most important sections of the ’34 Act is §10(b), which provides generally that it is “unlawful . . . [t]o use or employ any manipulative or deceptive device or contrivance” in contravention of such rules and regulations as the Commission may prescribe . . ..” Section 10(b) is a residual provision that follows the more specific prohibitions against market manipulation in sections 9 and 10 of the ’34 Act. Its purpose – as one of the drafters said of a somewhat broader earlier version – “Thou shalt not devise any other cunning devices.”4 Section 10(b) is not self-effecting – that is, it took action of the SEC to give the section any meaning. It is one of those sections of the federal securities laws in which the SEC, as regulator, is given a “blank slate” on which to write. And write they did. To give §10(b) meaning, the SEC promulgated Rule 10b-5. In three distinct subsections, Rule 10b-5 prohibits three distinct activities: • Employing devices, schemes or artifices to defraud (subsection (a)); • Making untrue statements of material fact or failing to disclose material facts necessary to render the statements made not misleading (subsection (b)); and • Engaging in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person (subsection (c)). The SEC and the U.S. Department of Justice are given express authority to bring lawsuits for violations of the federal securities laws, including section 10 of the ’34 Act and Rule 10b-5. Despite a number of private rights of action that exist under the federal securities laws, Congress did not provide an express right for


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