The simple case against scheme liability

As the Supreme Court prepares to hear arguments next Tuesday in Stoneridge Investment Partners v. Scientific Atlanta, the guns are lined up on both sides of this important case. The proponents of liability argue the deterrence benefits of bringing in those like the vendor in Stoneridge who supposedly enabled fraudulent accounting for the goods it sold. Opponents of liability, such as those participating in the amici curiae brief I joined, argue that securities fraud damages already overdeters fraud, and scheme liability would make this worse.

But there's a simpler argument against the Court's buying the scheme theory: any extension of liability (and the brief just referred to, as well as the huge fuss over this case, makes it quite clear this would be an extension) is a job for Congress. Only Congress can weigh the policy arguments, informed by witnesses representing all of the various interest groups. Only Congress is in a position to be alerted to potential costs and risks of extending scheme liability, examining additional liability in the light of existing checks on securities fraud, and determining whether the costs of this liability outweigh the benefits.

This is demonstrated clearly by the argument against scheme liability that Steve Bainbridge just posted:

The . . . lack of transparency into contracting partners internal control environments has seriously hampered many corporation’s section 404 compliance efforts. They are often unable to identify or document, let alone evaluate, the internal control processes of partner firms.

If scheme liability is imposed, however, the risks associated with these practices will escalate significantly. To be sure, there are already some risk that the SEC or Justice Department will pursue these roundtrip transactions, but it seems safe to assume that private party liability exposure would raise the stakes significantly.

The net effect will be to bring significant pressure to bear on the Motorola’s of the world to subject these sort of contracts to effective internal audits. In turn, because nobody will want to sign off on the accounting treatment for transactions that might push the edge of the envelope without clearing it with their auditors, there will be even greater involvement of external auditors in the contracting process.

Steve thus points out both that SOX already provides a check on the sort of conduct involved in Stoneridge and, more importantly, a non-obvious but real risk of imposing 10b-5 liability on vendors and other participants.

But it gets worse, because liability in Stoneridge would give the go-ahead to trial lawyers to continue to push the envelope in ways that create additional costs and risks, with uncertain benefits.

The basic problem in Stoneridge, then, is that liability in this situation would be legislation by litigation – indeed, a judicial expansion of the judicial legislation involved in the creation of the 10(b) cause of action. Whatever we think about the underlying policies, this is an issue that should be decided by Congress, not by the Court.