Lessons Not Learned from Enron:
The Supreme Court's Stoneridge Decision

By Robert Prentice

Imagine that Joe wants to buy your thousand shares of Google stock. Because Joe wishes to buy on credit, paying you the purchase price plus interest six months from now, you inquire about his net worth. He shows you his name on the deed to a house worth a million dollars, so you make the sale. Only after Joe fails to pay and takes bankruptcy do you learn that he had bought the house from Ann for $2,000 just two days before your deal, and sold it back to Ann for $1,000 four days later.  Ann made $1,000. Joe got your stock. You got the shaft. Worse yet, the Supreme Court ruled Jan. 15 that you cannot sue Ann for securities fraud, even though she knew that the only reason for the fictitious sale of her house was to enable Joe to fool you into selling your stock.
 
In 1929 when the stock market crashed, the common law of fraud held liable all those who knowingly participated in schemes to defraud. Congress further strengthened investor protection when in 1934 it outlawed the use of any “deceptive device or contrivance” that violates Securities and Exchange Commission rules that make it illegal “to employ any device, scheme or artifice to defraud.”  Common sense and every antecedent body of law from which Congress could have drawn hold that Ann should be liable to you because she knowingly participated in Joe’s scheme to defraud you. This has also been the result under jurisprudence for most of the existence of the 1934 Act.
 
Why did the Supreme Court change the law? The majority in Stoneridge Investment Partners v. Scientific-Atlanta Inc. explained that because it was Joe who deceived you while Ann hid in the shadows, you did not rely on anything she said. Your lack of reliance bars recovery from her. This reasoning only encourages clever crooks. In the Enron fraud, Merrill Lynch pretended to buy barges from Enron solely to enable Enron to claim revenue from the transactions and thereby make its quarterly numbers and artificially maintain its inflated stock price.  The sale was a fraud because Enron had secretly promised to repurchase the barges from Merrill within six months at a handsome profit to Merrill, yet Stoneridge bars investor recovery from Merrill.
 
In Stoneridge, Charter Communications had contracts to buy cable boxes at a set price from vendors, but agreed to pay them an additional $20 per box in exchange for their agreement to backdate documents and roundtrip the extra revenue back to Charter in exchange for advertising that they did not want or need. The vendors knew that these were sham transactions undertaken solely to enable Charter to fool investors regarding its advertising revenue, yet because it was Charter and not the vendors that lied directly to investors, the Court dismissed their suit.
 
Under this reasoning, a lawyer working for Enron could devise a devious scheme, convince Ken Lay to approve it, draft a misleading press release, and yet escape liability to victims because Enron’s name was on the press release, not his. That has never been the law. Many cases through the years have involved A intentionally participating in B’s scheme to defraud C. All have allowed C to sue A. Until now.
 
The law has always required only that fraud victims rely upon the misrepresentations or acts generated by the fraudulent scheme in which defendant participated. It has never required that victims rely upon a particular defendant’s identity. Fraud law has always been “designed to reach silent and secret actors in wrongdoing, as well as those acting openly.” The Supreme Court has just written Chapter 1 in the crook’s manual: stay in the shadows and you can no longer be sued by your victims.
 
The rest of the Court’s opinion consists primarily of a pastiche of exceedingly selective and one-sided quotations from previous opinions (each of which could easily be countered by other quotations expressing contrary sentiments) and a discussion of the disadvantages of fraud lawsuits that could have been written by Enron lobbyists. The arguments are plausible, but no more so than their opposites.  Indeed, there is substantial empirical evidence that allowing fraud victims to sue aids development of capital markets by encouraging people to invest. For the time being, hold on to your wallets!