Scientific-Atlanta Off the (Private) Hook in Fraud Case

by Kurt Schulzke on January 16, 2008

The corporate defense bar should be smiling today. Yesterday, the U.S. Supreme Court declined to make it easier — not the same as “made it harder,” as some commentators may claim — for investors to get relief in federal securities fraud cases. In its 5-3 decision in Stoneridge Investment Partners v. Scientific-Atlanta, Inc., the Court rejected the petitioner’s bid to extend the implied private cause of action under Securities Exchange Act §10(b) to apply to “secondary actors” such as customers or suppliers who do not commit “primary violations” of §10(b) or SEC Rule 10(b)(5).

In plain English, if an SEC registrant (like Charter Communications) misleads its investors by creating fictitious revenue with the help of a supplier (like Scientific-Atlanta), the investors cannot sue the the supplier for securities fraud for aiding and abetting the production of the registrant’s misleading financial statements. The Court hastened to add that although private parties have no recourse against such secondary actors, the Securities and Exchange Commission and Justice Department, both, can proceed with civil or criminal enforcement.

Key excerpts from the Court’s opinion follow. Accountants and auditors should note carefully the facts. Some secondary actors, such as auditors, can be open to private causes of action under similar circumstances:

This class-action suit by investors was filed against Charter Communications, Inc. . . . [by] Stoneridge Investment Partners, LLC, a limited liability company organized under the laws of Delaware . . .

Charter issued the financial statements and the securities in question. It was a named defendant along with some of its executives and Arthur Andersen LLP, Charter’s independent auditor during the period in question. . . . Respondents are Scientific-Atlanta, Inc., and Motorola, Inc. They were suppliers, and later customers, of Charter. . .

Charter, a cable operator, engaged in a variety of fraudulent practices so its quarterly reports would meet Wall Street expectations for cable subscriber growth and operating cash flow. The fraud included misclassification of its customer base; delayed reporting of terminated customers; improper capitalization of costs that should have been shown as expenses; and manipulation of the company’s billing cutoff dates to inflate reported revenues. In late 2000, Charter executives realized that, despite these efforts, the company would miss projected operating cash flow numbers by $15 to $20 million. To help meet the shortfall, Charter decided to alter its existing arrangements with respondents, Scientific-Atlanta and Motorola . . .

Respondents supplied Charter with the digital cable converter (set top) boxes that Charter furnished to its customers. Charter arranged to overpay respondents $20 for each set top box it purchased until the end of the year, with the understanding that respondents would return the overpayment by purchasing advertising from Charter. The transactions, it is alleged, had no economic substance; but, because Charter would then record the advertising purchases as revenue and capitalize its purchase of the set top boxes, in violation of generally accepted accounting principles, the transactions would enable Charter to fool its auditor into approving a financial statement showing it met projected revenue and operating cash flow numbers. Respondents agreed to the arrangement.

So that Arthur Andersen would not discover the link between Charter’s increased payments for the boxes and the advertising purchases, the companies drafted documents to make it appear the transactions were unrelated and conducted in the ordinary course of business. Following a request from Charter, Scientific-Atlanta sent documents to Charter stating–falsely–that it had increased production costs. It raised the price for set top boxes for the rest of 2000 by $20 per box. As for Motorola, in a written contract Charter agreed to purchase from Motorola a specific number of set top boxes and pay liquidated damages of $20 for each unit it did not take. The contract was made with the expectation Charter would fail to purchase all the units and pay Motorola the liquidated damages.

To return the additional money from the set top box sales, Scientific-Atlanta and Motorola signed contracts with Charter to purchase advertising time for a price higher than fair value. The new set top box agreements were backdated to make it appear that they were negotiated a month before the advertising agreements. The backdating was important to convey the impression that the negotiations were unconnected, a point Arthur Andersen considered necessary for separate treatment of the transactions. Charter recorded the advertising payments to inflate revenue and operating cash flow by approximately $17 million. The inflated number was shown on financial statements filed with the Securities and Exchange Commission (SEC) and reported to the public.

Respondents had no role in preparing or disseminating Charter’s financial statements. And their own financial statements booked the transactions as a wash, under generally accepted accounting principles. It is alleged respondents knew or were in reckless disregard of Charter’s intention to use the transactions to inflate its revenues and knew the resulting financial statements issued by Charter would be relied upon by research analysts and investors.

Petitioner filed a securities fraud class action on behalf of purchasers of Charter stock alleging that, by participating in the transactions, respondents violated §10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. . . .

Here respondents were acting in concert with Charter . . . as suppliers and, as matters then evolved in the not so ordinary course, as customers. Unconventional as the arrangement was, it took place in the marketplace for goods and services, not in the investment sphere. Charter was free to do as it chose in preparing its books, conferring with its auditor, and preparing and then issuing its financial statements. In these circumstances the investors cannot be said to have relied upon any of respondents’ deceptive acts in the decision to purchase or sell securities; and as the requisite reliance cannot be shown, respondents have no liability to petitioner under the implied right of action. This conclusion is consistent with the narrow dimensions we must give to a right of action Congress did not authorize when it first enacted the statute and did not expand when it revisited the law. . .