Grossman and the plaintiffs thus argued that the defendant vendors were primary actors, claiming that their participation in a "scheme" to defraud investors qualified them as proper targets of a private cause of action. Referred to as "scheme liability," which is different than aiding and abetting liability, Grossman skillfully asserted a claim that has dogged district and circuit courts for 14 years, since Central Bank.
So-called scheme liability arose from language in other sections of the SEC's rule regarding §10(b): In Rule 10(b)5, it's also unlawful "to employ any device, scheme, or artifice to defraud" investors. In addition, dicta in the Central Bank case opened the door to secondary actors like the vendors in Stoneridge being treated like primary actors. A recent Ninth Circuit ruling, in Simpson v. AOL Time Warner, presented a way to read §10(b) that would allow secondary actors to be held liable if they engaged in "conduct...that had the principal purpose and effect of creating a false appearance in deceptive transactions as part of a scheme to defraud." That would qualify, said the Court, as "conduct that uses or employs a deceptive device within the meaning of §10(b)."
The Stoneridge defendants claimed they did not qualify as primary actors and thus could not be held accountable to these private plaintiffs under §10(b). They also argued that the Fifth and Eighth Circuits, not the Ninth, got it right when they read §10(b) strictly, finding no room for scheme liability in the statute.
The Path to the Supreme Court
The district court agreed with the vendors, granting their motion to dismiss for failure to state a claim. The court said that the plaintiffs had, if anything, alleged only an aiding and abetting claim.
The U.S. Court of Appeals for the Eighth Circuit affirmed, focusing on the idea that the vendors failed the test: As secondary actors, said the appeals court, they had nothing to do with Charter's issuance of stock. Because the investors could not show that the vendors made any material misstatements themselves that the investors relied on, or that the vendors had a duty to disclose the sham deals to investors, it could not be shown that the vendors violated §10(b).
The Eighth Circuit's ruling created a circuit split over whether an injured investor could use §10(b) in a private cause of action to recover from a party that does not make a public statement or violate a duty to disclose but does participate in a scheme to violate the act. The Ninth Circuit had recently ruled that §10(b) need not be read so narrowly to cover only misstatements and omissions; it could also cover deceptive conduct. And the Fifth Circuit, in the last of the Enron litigation, then sided with the Eighth Circuit. Thus, there were three cases the Court could take. The securities industry, secondary actors, and securities plaintiffs' lawyers anxiously looked to the Court: Everyone agreed it needed to rule in this area.
The U.S. Supreme Court granted certiorari in March 2007 to hear Grossman's case, and he found himself preparing to argue in front of the highest court in the land. Three months later, Karmel published "'Scheme Liability': Court Actions Against Aiders, Abettors" in the New York Law Journal. In that article, Karmel predicted that the Supreme Court would side with the Fifth and Eighth Circuits in the trio of cases including Stoneridge. "Unless the defendants in these cases owed a duty to the plaintiffs," she wrote, "it is a stretch to claim that the plaintiffs reasonably relied upon them in any way."
Turns out, she was right.
Enter the SEC (Sort Of)
The SEC itself was divided over whether to join the case on behalf of the shareholders. The commissioners voted, 3 to 2, to enter the case, but then U.S. Treasury Secretary Henry M. Paulson Jr. stepped in. Paulson, who is the former head of Goldman Sachs, took issue with the SEC's position, persuading the Bush Administration to prevent the SEC from siding with the plaintiffs. Federal agencies must receive authorization from the solicitor general, who represents the administration before the Supreme Court, to file briefs there. Solicitor General Paul D. Clement refused to authorize the SEC's filing in Stoneridge. Instead, the Department of Justice entered the case on the side of the defendants and strongly argued the reliance issue, which the Supreme Court would seize on in its ruling.
The Solicitor General's position didn't keep the SEC from having its say. A former commissioner and two former chairmen of the SEC signed their names to briefs filed in support of the plaintiffs, and 11 former commissioners, including Professor Karmel, and three former chairmen backed the vendors.
In the latter group's amicus curiae brief, which also included as signers 11 prominent law professors, they argued that the defendants could only be seen as secondary actors. Their conduct then would qualify only as aiding and abetting a securities fraud, which only the SEC could prosecute. In their brief, the amici who supported the vendor-respondents referred to another article by Karmel, one that she says grew from the earlier one in the New York Law Journal.
In the new article, "When Should Investor Reliance Be Presumed in Securities Class Actions?," which was ultimately published in the Business Lawyer's November 2007 issue, Karmel focused again on the "reliance" issue. In any §10(b) action, including a "scheme liability" case, plaintiffs must show that they relied on the defendant's misstatements that caused them to purchase the stock. Courts have recognized and allowed a presumption of that reliance under two circumstances: one, when there is an omission of a material fact by one with a duty to disclose it (under SEC filing rules, for example); or two, under the "fraud-on-the-market" doctrine, which holds that when fraudulent statements become public, as reflected in the market price of the security, it can be assumed that investors who buy or sell stock at the market price relied upon the statements.
The amici siding with the vendors quoted Karmel's Business Lawyer article for the idea that "'extending the fraud-on-the-market doctrine to statements by third parties, who are not required to speak by SEC regulations, or do not owe a duty to investors or shareholders' would be unwise, as it could 'encourage too much questionable litigation.'" This worry over "questionable litigation" would appear again — in the Supreme Court's opinion in Stoneridge.