Conglomerate Blog: Business, Law, Economics & Society

In a 1993 Foreword appearing in the Fordham Law Review, Milton Freeman described the adoption of Rule 10b-5 in 1942:

Somebody called me and said there is something wrong going on in Boston (a company
president was buying in shares from his own shareholders without telling them of much
improved earnings). He asked what we could do about it. I wasted no time; I got some
people in, we drafted a rule, we presented it to the Commission, and, without any
hesitation, the Commission tossed the paper on the table saying they were in favor of it.
One Commission member said, ‘Well, we’re against fraud, aren’t we?’ So, before the sun
was down, we had the rule that is now Rule 10b-5.

Today the W$J Blog is reporting that Senators Arlen Specter, Jack Reed, and Edward Kaufman are sponsoring a bill to upend the Supreme Court's 2007 opinion in Stoneridge Investment Partners v. Scientific-Atlanta.

Well, we’re against fraud, aren’t we?

Hmm.This is a tough one.

You remember Stoneridge, right? Scientific-Atlanta and Motorola entered into sham transactions with Charter Communications to inflate Charter's accounting numbers. Steve Bainbridge picks up the story from here:

The Court held that there need not “be a specific oral or written statement before there could be liability under Sec. 10(b) or Rule 10b-5." Instead, "[c]onduct itself can be deceptive" and provide the basis for liability. At least in theory, the Vendors conduct thus could constitute fraud in connection with a purchase or sale of a security.

Even so, however, the Court concluded that the plaintiffs could not satisfy the reliance element, The Vendors did not – and had no duty to – disclose their conduct to Charter's investors. Accordingly, plaintiffs could not prove that they relied “upon any of respondents’ actions except in an indirect chain that we find too remote for liability.”

Plaintiffs argued that they need not prove reliance, because reliance should be presumed under the fraud on the market theory. The Court rejected that argument because the Vendor’s conduct was “not communicated to the public.”

Steve thinks the Specter initiative is a "terrible idea." Further: "Stoneridge got the policy right. Specter's bill would once again throw American business to the trial lawyer wolves, weakening our competitive position, at a time when our economy needs all the help it can get."

I am not so sure. For Steve and some members of the Court, this seems to boil down to an obvious competitive risk, but prophylactic rules like the one announced in Stoneridge are not the only means for controlling securities fraud litigation. Far from it.

I always thought this was a close case, and I thought that the Supreme Court's reliance on reliance as the basis for the decision was bizarre. Moreover, I have a hard time explaining, on policy grounds, why firms like Scientific-Atlanta and Motorola should not be liable for securities fraud. I am not persuaded that allowing lawsuits against firms that enter into sham transactions for the purpose of misleading the market is damaging to our competitiveness. To be sure, if this new bill opens the floodgates to unmeritorious litigation, count me among the opposition. Otherwise, let 'em sue the deceivers.

For more commentary and links, see Jonathan Adler at VC. Sometime Glom commenter ohwilleke offers a thoughtful defense of the new bill.

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In a 1993 Foreword appearing in the Fordham Law Review, Milton Freeman described the adoption of Rule 10b-5 in 1942:

Somebody called me and said there is something wrong going on in Boston (a company
president was buying in shares from his own shareholders without telling them of much
improved earnings). He asked what we could do about it. I wasted no time; I got some
people in, we drafted a rule, we presented it to the Commission, and, without any
hesitation, the Commission tossed the paper on the table saying they were in favor of it.
One Commission member said, ‘Well, we’re against fraud, aren’t we?’ So, before the sun
was down, we had the rule that is now Rule 10b-5.

Today the W$J Blog is reporting that Senators Arlen Specter, Jack Reed, and Edward Kaufman are sponsoring a bill to upend the Supreme Court's 2007 opinion in Stoneridge Investment Partners v. Scientific-Atlanta.

Well, we’re against fraud, aren’t we?

Hmm.This is a tough one.

You remember Stoneridge, right? Scientific-Atlanta and Motorola entered into sham transactions with Charter Communications to inflate Charter's accounting numbers. Steve Bainbridge picks up the story from here:

The Court held that there need not “be a specific oral or written statement before there could be liability under Sec. 10(b) or Rule 10b-5." Instead, "[c]onduct itself can be deceptive" and provide the basis for liability. At least in theory, the Vendors conduct thus could constitute fraud in connection with a purchase or sale of a security.

Even so, however, the Court concluded that the plaintiffs could not satisfy the reliance element, The Vendors did not – and had no duty to – disclose their conduct to Charter's investors. Accordingly, plaintiffs could not prove that they relied “upon any of respondents’ actions except in an indirect chain that we find too remote for liability.”

Plaintiffs argued that they need not prove reliance, because reliance should be presumed under the fraud on the market theory. The Court rejected that argument because the Vendor’s conduct was “not communicated to the public.”

Steve thinks the Specter initiative is a "terrible idea." Further: "Stoneridge got the policy right. Specter's bill would once again throw American business to the trial lawyer wolves, weakening our competitive position, at a time when our economy needs all the help it can get."

I am not so sure. For Steve and some members of the Court, this seems to boil down to an obvious competitive risk, but prophylactic rules like the one announced in Stoneridge are not the only means for controlling securities fraud litigation. Far from it.

I always thought this was a close case, and I thought that the Supreme Court's reliance on reliance as the basis for the decision was bizarre. Moreover, I have a hard time explaining, on policy grounds, why firms like Scientific-Atlanta and Motorola should not be liable for securities fraud. I am not persuaded that allowing lawsuits against firms that enter into sham transactions for the purpose of misleading the market is damaging to our competitiveness. To be sure, if this new bill opens the floodgates to unmeritorious litigation, count me among the opposition. Otherwise, let 'em sue the deceivers.

For more commentary and links, see Jonathan Adler at VC. Sometime Glom commenter ohwilleke offers a thoughtful defense of the new bill.

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