These are challenging days for American business. Overreaction to the Enron scandal resulted in crushing regulation that has sent corporations scampering for friendlier foreign climes. Worse, a litigation system driven by class-action lawyers in pursuit of mega-paydays has made the cost of defending against frivolous claims so prohibitive that the extortion of million-dollar settlements is attractive compared to its alternative: the extinction portended by runaway juries and billion-dollar verdicts.
On Tuesday, however, business got a reprieve. The trial lawyers seemed poised to push it over a cliff, and with it the integrated global economy — the engine of unprecedented growth that produces jobs, alleviates suffering, and cements international alliances.
Thankfully, the Supreme Court said no.
In retrospect, the frightening thing about Stoneridge v. Scientific Atlanta is that the Court’s liberal wing was prepared to take the plunge. Sanity prevailed because the tribunal’s four reliable conservatives joined Justice Anthony Kennedy’s 5-3 decision (Justice Stephen Breyer did not participate in the case.) The case should not have been that close, and serves as a timely reminder here in primary season that presidential elections matter a great deal.
The facts were straightforward. Charter Communications was a cable television company that was cooking its books to meet Wall Street’s expectations, keeping its stock price artificially high. Despite sundry shenanigans, it still found itself in need of a big revenue influx to hit its projected numbers. So it schemed with two of its cable box suppliers, Scientific Atlanta and Motorola. Charter agreed to overpay for the boxes; the vendors agreed to refund the overpayment as an advertising cost. Charter fully booked the “advertising” as revenue, but it capitalized the box expense (that is, depreciated it over a period of years). Such bookkeeping tricks are accounting no-nos. The fraudulent transaction, moreover, was supported by bogus agreements to make it appear legitimate.
At issue in Stoneridge were the suppliers, “secondary actors” in Charter’s fraud. The high court found that they were not liable to suit. It is thus essential to pause for an important point — one that will be lost on the mainstream media for whom business is a morality play rife with corporate villains. No one, the Court least of all, would tell you that what the suppliers did here was upright. It was dishonest. They may not have known exactly what Charter was up to (though you can bet they did), but they had to know it couldn’t be good. They helped Charter do it because they wanted to make the sales. That’s how they make money.
But Stoneridge is not a case about criminal prosecution. We are talking here about the civil justice system. The point of that system is not to punish wrongdoers; it is strictly to compensate victims. Nothing says these vendor companies could not be charged with crimes, pursued by SEC enforcement actions, and heavily fined. But that was not the issue. This case was about whether the vendors could properly be sued by private parties, namely, investors who took a bath when Charter’s stock price collapsed (and who, it might be noted, had a bath to take only because their stock had theretofore been fraudulently inflated). In the civil justice system, private parties may not be compensated unless they actually rely on fraudulent misrepresentations to their detriment.
A little history is in order. In the tumult of the 1929 crash, Congress radically shifted the investment paradigm, burdening stock sellers to disclose where once it was incumbent on buyers to beware. But the resulting web of disclosure and anti-fraud provisions did not include any private right of investors to sue deceptive sellers. Enforcement would instead be the responsibility of the newly minted Securities and Exchange Commission. Only decades later did federal courts “imply” — which is to say, judicially legislate — a private right of action.
Aside from the fact that it’s not the judiciary’s job, one reason we prefer to have Congress do the legislating is it can look at a problem comprehensively, assessing all the downstream consequences of novel proposals. Courts, by contrast, field issues as they randomly arise in the vicissitudes of litigation. Judges tend to focus on justice for the parties in the well, not order in the system outside the courtroom. Consequently, when courts open a Pandora’s Box that Congress — often quite consciously and prudently — has resisted, we are left to wonder how far the court’s creation should go.
That, in a nutshell, is the history of shareholder litigation. The courts started the train down the track in the 1960s, divining that deceptive sellers should be liable to their buyers. Sounds reasonable enough — it always does at the start. But what about the companies who help the sellers do business, including sharp business, but don’t deal directly with the investors, much less make misrepresentations to them? Or, the next step, what about companies who simply do business with shady sellers and unwittingly facilitate a deceptive practice?
Here, jackpot justice can’t be ignored. A business’s right to defend itself in court is illusory. The risk of losing is prohibitive and all too real — the trial of even a frivolous claim, after all, will pit a sympathetic individual against a deep corporate pocket. And if our concern truly is unfairly victimized investors, what of the defendant company’s shareholders, for whom the lawsuits depress value — to say nothing of rest of us, on to whom the gargantuan costs of litigation are passed in the form of higher prices?
So, in 1994, the Supreme Court put on the brakes. In Central Bank v. First Interstate Bank, it ruled that those secondary actors who aid and abet a fraud but do not themselves deceive investors were not liable. The justices’ reasoning was simple: Congress had not only omitted aiding and abetting liability throughout the securities laws; it had specifically rejected a suggestion by the SEC that such a cause of action be enacted. Government enforcement was Congress’s preferred policy; private suits, the Court deduced, should be limited to situations where the secondary actors made misrepresentations that investors could prove they relied on and that caused them harm.
So why was there a Stoneridge case? How did we get to the point where secondary actors were again hauled into court? Well, it happened because the trial lawyers are relentless and, as AEI’s Ted Frank has recounted, courts let them get away with it.
The stakes here were incredibly high. Companies don’t have the resources or the power to investigate every venture, but the trial lawyers have plenty of capacity to trawl for big fish and leverage to hammer them into big-money settlements. If the cost of doing business includes the risk of being ensnared in ruinous litigation over someone else’s fraud, much less business will be done. If foreign companies must assume such risks as a price of access to American markets, they will withdraw to the comparative safety of their own markets — simultaneously fraying the ties that bind nations and denying American consumers the benefits of trade, competition and choice.
The Supreme Court looked into that abyss and said, No thank you. The global economy should heave a sigh of relief.