From the April 2008 issue of Wealth Manager Web • Subscribe!

Buyer Beware

Investing in 2008 isn't getting easier, and thanks to a recent Supreme Court ruling, it may not be getting any safer.

Investor protections took a hit in January when the High Court ruled that shareholders can't bring lawsuits against third parties that engaged in fraud that helped send a stock tumbling. In fact, fraud is not even relevant, the majority pronounced in its decision on Stoneridge Investment Partners LLC v. Scientific-Atlanta, Inc.

Not relevant? How can the Court's verdict square with the applicable securities regulation that outlaws deceptive practices aimed at duping investors? We're talking here of Rule 10b-5 in the Securities Exchange Act of 1934, which labels "unlawful" any deliberate act of making false and misleading statements and engaging in actions intended to con shareholders. Of course that's illegal, as any high school civics class worthy of the name will tell you.

Adding insult to injury, the Justices didn't dispute the presence of fraud in Stoneridge v. Scientific-Atlanta, although they may have suspended common sense. But on to the big mystery: By what legal reasoning did the plaintiff come up short? For the answer, let's return to the beginning.

Charter Communications, a cable company, was playing fast and loose with its financial statements in a bid to impress Wall Street and boost its stock. One of the ploys involved two of the company's vendors, Scientific-Atlanta and Motorola, which supplied cable boxes. Charter paid inflated prices for the boxes, and the vendors conveniently refunded the excess. Charter then reported the rebated funds as revenue. Accounting fraud--pure and simple.

The trickery is a matter of public record. The SEC issued a cease and desist order against Charter a few years back, charging that it "inflated the number of customers who subscribed to its services in an attempt to meet analysts' expectations for subscriber growth and depict itself as a growing company." The SEC also claimed that Charter, through its cable box scheme, "inflated its year-end revenue and operating cash flow by $17 million when it realized its year-end revenue and operating cash flow for 2000 was going to be short of analysts' expectations."

Stoneridge, a Malvern, Pa. money manager and a Charter shareholder, sued-- alleging that the two vendors, Scientific-Atlanta (currently a division of Cisco Systems) and Motorola Inc., were parties to an accounting hoax that crushed the stock price.

Compelling evidence, at least by some accounts, but the Supreme Court didn't bite. In a 5-3 decision, the Court explained that Scientific-Atlanta and Motorola weren't liable because they didn't make false public statements about Charter or its stock in an attempt to run up the share price. The critical point is that the fraud unfolded privately, behind closed doors--a detail that made all the difference in the Court's decision. Even if Charter's shareholders lost money because of the shady deals, the Justices ruled that the vendors aren't culpable if they never publicly misrepresented the truth directly to investors.

To be fair, the Court claimed a precedent for citing a safe haven on behalf of the vendors. That won't soothe investors who lost money, of course. But it gets worse: the Stoneridge case strengthens a precedent that risks chipping away at trust and confidence in America's capital markets.

"Our concern is that [the Court's ruling [in Stoneridge] stymies the ability of shareholders to bring an action against those who are actively and directly involved in a corporate securities fraud case," Kurt Schact, managing director of the CFA Institute's Centre for Financial Market Integrity, tells Wealth Manager.

The opposing view in favor of the decision argues that the High Court's verdict will help restrain frivolous lawsuits brought by trial lawyers. The fear is that if Stoneridge had won, the victory would have fueled more litigation as lawyers chase deep pockets in search of big payoffs built on tenuous connections with corporate fraud. In turn, that would stifle business activity, squeezing job growth and damaging America's competitive edge in the global economy. "Practical consequences," the Supreme Court labeled it. Finding in favor of Stoneridge "could allow plaintiffs with weak claims to extort settlements from innocent companies," the majority wrote.

Yes, that's a risk. But while there's too much litigation in America, surely there's a solution that doesn't come at the expense of preserving legal remedies for investors who've been victimized by financial fraud. Incentives, after all, work both ways and so the Stoneridge case probably won't inspire investor confidence.

Protecting third parties from liability because a fraud unfolded privately sends a troubling message. Yes, reasonable limits on lawsuits should apply, lest we sue ourselves into oblivion. Perhaps it's time to call your representative in Congress and give him or her a piece of your mind. And while you've got the Congressman or Senator on the horn, ask if efforts at restraining bogus lawsuits can only come at the expense of justice for those who were hoodwinked?

Here's a radical idea: Let's try to balance investor and corporate interests. By that standard, the Supreme Court stumbled.

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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