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After the 1929 stock market crash, the government enacted federal securities laws to prohibit anyone from employing “any device, scheme, or artifice to defraud” or engaging in “any act [or] practice” that operates “as a fraud or deceit.” While those who commit securities fraud are infinitely—and perhaps wickedly—clever, the laws were drafted broadly enough to reach fraud in whatever guise it took. In the ensuing seven decades, as our country’s financial marketplaces experienced unprecedented growth and success, defrauded investors used these laws to recover billions of dollars and encourage honest corporate disclosure.
Now, only a few seasons removed from the largest wave of U.S. corporate scams in history, many of which required the knowing participation of investment banks, lawyers, and other third parties, the Stoneridge vs. Scientific Atlanta case will oblige the Supreme Court to decide whether these laws apply to everyone who participates in a fraud or will be narrowly circumscribed at the behest of corporate interest groups.
The case revolves around Stoneridge Investment Partners, an institutional investor that suffered losses when Charter Communications allegedly aided Scientific Atlanta—now owned by Cisco (CSCO)—in a fraudulent arrangement in 2000 and 2001 that caused Charter’s stock to inflate to $26.31, then drop to 76 cents. (The Eighth Circuit Court of Appeals ruled for the defendants.)
Parties such as Scientific Atlanta argue that those who intentionally commit fraud are immune from private lawsuits as long as they do not make a public statement. Thus, investment banks or law firms could willfully participate in a fraud for their corporate clients, but remain safely beyond the reach of the securities laws because they have not signed the company’s SEC filings.
This argument stands contrary to the plain language of the law, which states that anyone who commits securities fraud can face a lawsuit. In addition, the defendants ignore history when they argue that allowing investors to sue those who remain silent while committing fraud would destroy America’s “competitiveness.” Our capital markets rank as the world’s best because investors can defend themselves against wrongdoers, not despite it.
Indeed, even the SEC has rejected the defendants’ position, concluding that silence is not a defense and urging the Solicitor General to support investors in Stoneridge—advice the Bush Administration simply ignored in favor of siding with defendants.
Stoneridge provides a unique opportunity for the Supreme Court to protect the small investor against corporate interests. Let’s hope it is up to the challenge.
Allowing private securities fraud suits against third parties is only a good idea if you think our economy is suffering from a shortage of litigation. The media tend to portray this issue as one that pits Big Business against shareholders. But turning third parties into potential defendants will hurt business, shareholders, and the economy as a whole, and help only lawyers.
There’s nothing wrong, in principle, with making wrongdoers pay for causing harm. In the real world, though, plaintiffs’ lawyers (who get a percentage of any settlement) don’t have much incentive to sue only the guilty, as opposed to any potential deep pocket—banks, lawyers, even vendors—connected with a company whose stock has declined. Imposing the costs and risks of securities fraud suits on this much broader group of potential defendants would translate into higher interest rates, higher professional fees, and more expensive products throughout the economy.
This might be justified if it were necessary to compensate injured victims. But it isn’t, because for every investor hurt by buying a stock at a price inflated by fraud, another is helped by selling at the higher price—and studies show that in the long run diversified investors break even. Settlements are little more than transfers from one group of shareholders (the defendants’ current shareholders) to another, with a massive deduction for legal costs and fees.
Even without third-party liability, securities fraud claims caused nearly $25 billion in shareholder wealth to be “wiped out just due to litigation,” according to an Institute for Legal Reform study. Allowing third-party suits would exponentially increase the number of potential defendants and take an even bigger bite out of the economy, while accomplishing nothing other than feeding the legal beast.
Congress made the right decision when it authorized “aiding and abetting” securities fraud suits against third parties by the SEC but not by private plaintiffs. The decision to bring such cases should rest with a responsible government agency, not with lawyers who have a financial interest in suing as many defendants as possible.Opinions and conclusions expressed in the BusinessWeek Debate Room do not necessarily reflect the views of BusinessWeek, BusinessWeek.com, or The McGraw-Hill Companies.
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