The U.S. Supreme Court is due to hear arguments in a case testing the rights of investors who are asking to recover losses from third parties, such as insurance and accounting firms, and banks that they say help corporations perpetrate a fraud.
In June, the Securities and Exchange Commission agreed that the integrity of the marketplace is at stake.
Siding with big business, President Bush overruled the commission, contending that to allow such investor claims to go forward would lead to billions of dollars in potentially abusive lawsuits.
The case before the Supreme Court involves cable company Charter Communications. The St. Louis-based company is alleged to have deceived investors by conspiring with two of its vendors to make Charter's balance sheet look better than it was.
The SEC alleged that Charter realized in August 2000 that its operating cash flow would not meet projections. But in a bid to shield the matter from shareholders, the company offered to pay vendors of its set-top boxes some $17 million more for the product than had been agreed to. In exchange, the vendors would plow the money back into Charter by buying advertising.
The revenue Charter received from arrangements like these was the same amount it needed to cover its shortfall.
When the day of reckoning came, and the stock sank, investors sued Charter and the vendors. Investors alleged that the vendors had backdated documents to facilitate the scheme and that they knew these sham transactions would help Charter keep the stock price inflated.
But a federal appeals court did not agree. It ruled that the set-top box vendors engaged in an arms-length transaction for which they could not be held liable. The court cited a 1994 Supreme Court decision declaring aiders and abettors could not be sued for damages under the securities law.
Shareholders appealed to the U.S. Supreme Court, contending that the vendors were primary actors in the scheme.
Among the case's 28 amicus — or friend of the court — briefs, are two from former heads of the SEC. Their attorney, New York University Law School professor Arthur Miller, says the vendors are intimately involved in the scheme to defraud.
"These are not marginal actors. If you look at the facts of this case, you have blatant, active participation in the creation of transactions that were absolutely phony, that had zero business justification, coupled with falsification of documents and blatant lying," Miller says.
"The only objective was to create a completely false image of revenues and profits; and if that isn't the eye of the statute which strikes out against manipulative and deceptive practices, then nothing is."
The statute bars any device, scheme or artifice that operates as a fraud or deceit on investors. And it allows investors to sue for damages to recover their losses.
Big Business and the Law
But the business community, backed by some former SEC commissioners, argues that the law applies only to those business entities that actually make representations to investors.
Former SEC Commissioner Joseph Grundfest, who now teaches at Stanford Law School, says nobody is arguing that what the vendors did is legal. "The question instead is whether, in addition to prosecution by the SEC, and in addition to the prosecutions that can be brought by the federal government criminally, there should also be the ability for private parties to seek money damages layered upon this? And to that question, the answer is no."
Grundfest contends that if Congress wanted to give investors the right to sue third parties like the vendors for damages, it has had plenty of opportunity to do that in the aftermath of the Supreme Court's 1994 decision ruling aiders and abettors out of bounds for such lawsuits.
But, Congress didn't take any action — even when asked — observes Grundfest. And the vendors here are just aiders and abettors.
"The plaintiffs are engaging in a level of prestidigitation that I just don't think isn't going to fool anybody here," he says.
The Charter investors and their allies, including 33 states and numerous pension funds, counter that there is a big distinction between passive aiders and abettors and the vendors in this case — or the banks in the Enron case.
Says Chris Patti of the University of California Board of Regents, one of the many institutional investors in the Enron case: "If you engage in deceptive conduct, you are not merely an aider and abettor, you're an actual participant in the fraud."
The stakes in this case run in the billions as it's not just Charter and Enron, but other organizations accused of stock fraud.
The vendors and their allies argue that the entire economy could be affected if third parties get roped into being sued for damages.
"The rules for calculating damages in these private class-action lawsuits are absolutely insane," Grundfest says. "You can have a company that was involved in a very small amount of alleged wrongdoing in one of these transactions becoming exposed to billions and billions of dollars of damages in these private class action lawsuits."
Patti counters that federal law limits recovery in proportion to the offender's role in a fraud. He does acknowledge that in some cases, like Enron investors who are suing the banks, the only way to recover losses is to sue the co-conspirators who are still solvent.
"It's true that we're going after the deep pockets; but they're also the main offenders. The fraud could not have occurred if it weren't for the activity of these banks," Patti says. "And in many cases, the banks actually designed the phony transaction that led to the fraud."
William Donaldson, who served as chairman of the Securities and Exchange Commission from 2003 to 2005, supports that notion. Without investor lawsuits, he says, there will be little if any incentive to stay out of these kinds of frauds, because SEC fines are far smaller than paying losses to injured investors.
In many cases, the fines have been smaller by billions of dollars.
"In theory, somebody will be able to be a knowing and active participant and not have any liability for that. And I think that's just wrong in terms of investor protection," Donaldson said.