Reliance the wrong path

Supreme Court Limits Lawsuits by Shareholders - The Court ruled that shareholders of Charter, a now bankrupt cable TV company, could not sue its vendors on a theory of "scheme liability". The challenged scheme was carried out in the fall of 2000. Investors claimed the scheme was designed to provide the appearance of additional cash flow for Charter by getting its TV set-top box vendors, Motorola and Scientific-Atlanta, to engage in “sham” deals under which Charter paid extra for the boxes but the companies simply turned around and paid that money to Charter in advertising at above-market rates on its cable TV outlets. The result, the lawsuit contended, was to generate some $17 million in phony revenues, so that Charter’s cash position – in reality, a shortfall of $15 to $20 million — did not appear to be below the amount projected by the company and by stock analysts. Note that the sham extra payments for the cable boxes were accounted for as the purchase price of assets that were capitalized, so the sham expense would have been spread over several years on Charter's financial statements, while the equivalent amounts returned to Charter as sham advertising revenues would have been booked entirely in the year the ads were sold.

The Court decided that because the scheme was never publicized, investors who bought Charter stock could not have relied upon the scheme, therefore the vendors are not liable to the investors. Charter itself has all kinds of liability, but then Charter is bankrupt.

Perhaps private rights of action under Section 10 (b) of the 34 Act should be limited, even eliminated, but the "reliance" approach taken by the Court defies the reality of the market. Everyone involved understood that the only possible purpose of the scheme was to create phony revenue for Charter. Everyone understood that this revenue would appear in Charter's financial statements, upon which investors would rely. That was the whole point. As Good As News helpful hint to Justice Roberts, if you want to limit liability arbitrarily then use good old fashioned privity. If you want to use reliance, then recognize that public companies publish financial statements and investors rely upon them. Look to the question of whether or not the "scheme" could have any purpose other than the fraudulent manipulation of the financial statements if you want to use a realistic reliance approach that gives some comfort to suppliers of legitimate goods and services caught up as alleged accomplices in securities fraud.