At the U.S. Supreme Court on Tuesday, the justices heard arguments in a case widely viewed as the most important test of investor rights in decades. At issue is whether defrauded investors seeking to recover losses can sue third parties such as banks, accounting firms, and insurance companies that were involved in a stock manipulation.
At stake is billions of dollars, and suits like the one brought by Enron investors against banks that allegedly helped Enron design phony transactions to cover up the company's perilous condition. The case before the court Tuesday involves somewhat similar allegations against a company called charter communications, which allegedly conspired with two of its vendors to make its balance sheet look better than it was.
The Securities and Exchange Commission alleged that in 2000, when charter realized its cash flow would not meet projections, it offered to pay its set top-box vendors about $17 million dollars more for their product than previously agreed to, and in exchange, the vendors would plow the money back into charter, getting free advertising and making the company's balance sheet look more viable.
When charter's stock finally tanked, the investors sued not just charter, but the vendors, too, alleging that they had backdated documents and conducted sham transactions to facilitate a scheme to keep the stock price artificially inflated.
A federal appeals court threw the case out, declaring that the vendors were mere aiders and abettors, and under a 1994 Supreme Court decision, aiders and abettors cannot be held liable.
On the steps of the Supreme Court on Tuesday, lawyer Stanley Grossman, representing the charter investors, said that if the vendors can't be sued in this case, neither can lawyers, accountants, or banks who facilitated the Enron fraud. Any penalty imposed by the SEC, he noted, is a fraction of what can be recovered in an investor lawsuit.
"Unfortunately, you'll have people out there who will be given a blueprint in how to defraud the public," Grossman said.
But Steven Shapiro, representing the vendors, said Congress never intended to allow such lawsuits.
"The Security and Exchange Commission is supposed to bring these cases, not private trial lawyers," Shapiro said.
Inside the high court, Grossman, the investors' lawyer, ran into a buzz saw of hostility.
"This doesn't seem any different than aiding and abetting," Justice Alito said.
"Nobody bought or sold stock based on the way the deal was structured. …You're asking us to expand the rights of private investors to sue," Chief Justice Roberts said.
"There are any number of kickbacks and petty frauds in business," Justice Kennedy said. "I see no limitation to your proposal for liability."
Grossman noted that the SEC has agreed with the investors in this case that under the existing securities law, individuals and companies that actively and knowingly facilitate a fraudulent scheme to keep a stock price artificially high are themselves liable.
"Are you making a distinction that doesn't exist in the real world?" Justice Souter asked. "When would a third party engage in some fraudulent conduct not intended to affect the stock price?"
Grossman said the limiting factors are that the third party has to engage in deceptive conduct, and must do it knowingly and intentionally.
Following Grossman to the lectern was lawyer Steven Shapiro, representing the charter vendors, Scientific Atlanta and Motorola.
"The question is: Is there a middle category between an aider and abettor who does nothing deceptive and primary actors who make fraudulent statements to investors?" Justice Ginsburg said.
Shapiro maintained that the vendors had not engaged in deceptive conduct, because it was up to charter to account for the transactions to investors.
"But charter said, 'Vendors, I need you to help us make a deceptive accounting,'" Justice Ginsburg said.
"Do you take the position there would be no liability unless the vendors made a statement to the investors?" Justice Souter asked.
"Yes," Shapiro said.
"This fraud only works, though, if the vendors are silent. If the vendors communicate anything, then the whole thing fails," Ginsburg said.
"If we accept your position, and we find an accountant or an attorney who prepares false statements, would they be liable?" Justice Kennedy asked.
"They would have to prepare false disclosure statements to investors. ....Independent actors who don't speak to markets are not liable for damages to investors," Shapiro said.
Only eight justices heard Tuesday's argument because Justice Breyer is recused, presumably because he holds stock in one of the involved companies. That leaves eight justices, and even Patrick Coglin, the lead lawyer representing Enron investors, couldn't count more than four votes for the proposition that defrauded investors can sue offending third parties to recover damages.
"It's most likely a 4-4 vote is our best chance," Coglin said.
A 4-to-4 tie would mean the lower-court decision is upheld, the case against the vendors is tossed out, but there is no Supreme Court decision in the case, and the question would have to be re-argued in a later case with a full court.