OT - Enron? Don't Waste Our Time

Shielding Wall Street, US Supreme Court rejects Enron fraud case
by Don Knowland
January 23, 2008

Without explanation, the US Supreme Court Tuesday dismissed a lawsuit
brought by pension and investment funds against major Wall Street
banks for their part in the massive financial fraud carried out by the
Enron Corporation, the Houston-based energy trading giant.

The suit sought to recover some $40 billion that were lost when Enron
went bankrupt in late 2001. It charged the banks, including Merrill
Lynch, Credit Suisse Group, Barclays Plc and other leading financial
houses, with helping company executives cover up a mounting cash flow
problem by disguising loans as revenues, setting up off-the-books
partnerships and hiding losses in order to defraud investors.

The rejection of the case--an appeal of a lower court ruling barring
the funds from suing the banks--came just one week after a 5-3 ruling
that protected banks and other businesses that help companies falsify
their financial pictures in order to defraud investors from lawsuits
based on the federal securities fraud laws.

That ruling, issued in the case of Stoneridge Investment Partners, LLC
v. Scientific-Atlanta, Inc., together with the dismissal of the Enron
appeal are only the latest in a series of pro-business, anti-investor
decisions from the Court designed to kill securities fraud lawsuits.

The Stonebridge decision was written by Justice Anthony Kennedy, who
failed to take part in the deliberations on the Enron case. While
Kennedy offered no explanation for his absence, the justice's son is
an investment banker at Credit Suisse in New York City.

The Stonebridge case charged that an accounting fraud by Charter
Communications Inc., a St. Louis cable operator, was carried out with
the collaboration of cable-television box manufacturers Motorola and
Scientific-Atlanta (now owned by Cisco systems).

According to the lawsuit, Charter overpaid Motorola and Scientific-
Atlanta $17 million for cable boxes, which the two manufacturers then
kicked back to the operators by purchasing advertising, allowing
Charter to add the money to its books as phony revenue.

In writing the majority decision, Kennedy made it clear that a key
consideration was that holding such companies accountable for
investment fraud could be bad for Wall Street. Allowing shareholder
suits in such cases, he wrote, "may raise the cost of being a publicly
traded company under our law and shift securities offerings away from
domestic capital markets."

Justice Stephen Breyer did not participate in the case, because he is
a stockholder in Cisco Systems Inc., Scientific-Atlanta's parent
company.

Even a brief review of the decision and the history of the federal
antifraud securities laws reveals that the ruling is utterly cynical,
dishonest and result-driven.

In the wake of the 1929 stock market crash and in response to
widespread fraud in the securities industry, the US Congress enacted
the Securities Act of 1933 and the Securities Exchange Act of 1934.
The 1933 law regulates the initial distribution of company shares, and
the 1934 Act, for the most part, regulates post-distribution trading.

The general anti-fraud provision of the 1934 Act, Section 10(b),
states:

"It shall be unlawful for any person, directly or indirectly, by the
use of any means or instrumentality of interstate commerce or of the
mails, or of any facility of any national securities exchange... To
use or employ, in connection with the purchase or sale of any security
registered on a national securities exchange or any security not so
registered, any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the Securities and
Exchange Commission [the SEC, a federal agency] may prescribe."

In 1942 the SEC adopted such a Rule, 10b-5, which provides that "It
shall be unlawful for any person, directly or indirectly, by the use
of any means or instrumentality of interstate commerce, or of the
mails or of any facility of any national securities exchange, (a) To
employ any device, scheme, or artifice to defraud, (b) To make any
untrue statement of a material fact or to omit to state a material
fact necessary in order to make the statements made, in the light of
the circumstances under which they were made, not misleading, or (c)
To engage in any act, practice, or course of business which operates
or would operate as a fraud or deceit upon any person in connection
with the purchase or sale of any security."

Long ago, the Supreme Court approved suits for damages by private
investors for violations of section 10(b) and SEC Rule 10b-5.
Typically investors sue under the portion of Rule 10b-5 that forbids
making false or incomplete statements. In those cases, the courts have
required that the investors prove that they relied on fraudulent
statements or a cover-up of information when buying or selling shares.

In a 1994 case, Central Bank of Denver v. First Interstate Bank, the
Supreme Court decided that persons or businesses that knowingly or
recklessly give "substantial assistance" to a company engaged in such
deception cannot be held liable for defrauding investors. In a
decision written by Justice Anthony Kennedy and backed by four other
right-wing justices (former Chief Justice Rehnquist, retired Justice
Sandra Day O'Connor and present Justices Antonin Scalia and Clarence
Thomas), the Court refused, in the absence of a specific law passed by
Congress, to apply the longstanding legal principle of aiding and
abetting to those who help companies misrepresent or omit information
in order to defraud investors, even if they themselves are not
directly responsible for giving investors the misinformation.

In deciding the Central Bank case the Court however expressly
recognized that the "commission of a manipulative act" was another,
alternative basis for liability under 10(b) apart from directly making
a misstatement. The Court decision said: "The absence of 10(b) aiding
and abetting liability does not mean that secondary actors in the
securities markets are always free from liability under the securities
Acts. Any person or entity, including a lawyer, accountant, or bank,
who employs a manipulative device or makes a material misstatement (or
omission) on which a purchaser or seller of securities relies may be
liable as a primary violator under 10b-5." The Court stressed that the
plaintiffs in the Central Bank case had conceded that the defendant
bank had not committed a manipulative or deceptive act within the
meaning of 10(b).

But in the Stoneridge case decided last week, the cable box
manufacturers were charged with engaging precisely in such a
manipulative or deceptive act.

The box suppliers knew that Charter wanted to use the kickback of
money from the inflated cable box purchases in the form of advertising
sales to inflate the company's revenue picture by $17 million. Charter
used the scheme to issue quarterly reports that would meet Wall Street
expectations for operating cash flow and maintain its share price.

In order to keep Charter's auditing firm from discovering 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. The cable box companies sent documents to Charter falsely
stating they had increased production costs on the boxes. Also, the
new set-top box agreements were also backdated to make it appear that
they were negotiated a month before the advertising agreements.

A class action lawsuit was filed on behalf of purchasers of Charter's
shares against not only Charter, but the cable box companies as well.
The lawsuit charged that the companies were liable because they
knowingly participated in a scheme that was aimed at and succeeded in
inflating Charter's revenue. If the companies had not assisted
Charter, Charter's auditor would not have been fooled, and the false
financial statements would not have been issued.

Under this "scheme liability" legal theory, many banks and other
companies had been successfully sued for assisting in massive
accounting fraud by the likes of Enron and WorldCom in the 1990s.
Nonetheless, the cable box companies succeed in getting the case
dismissed in the lower courts.

Justice Kennedy, who wrote the majority decision in the Stonebridge
case, was also the author of the 1994 decision. This time Kennedy was
again joined by the far-right wing bloc of Justices--Scalia and Thomas,
along with current Chief Justice John Roberts and Justice Samuel
Alito.

In refusing to hold the cable box companies liable, Kennedy wrote that
since they had not themselves made the public misstatements as to
Charter's revenues, to hold them liable would in effect permit the
sort of aider and abettor liability thrown out in the Central Bank
case. The investors, Kennedy wrote, were required to show they relied
on these the manufacturing companies' deceptive actions but could not
do so "except in an indirect chain that we find too remote for
liability."

This is legal sophistry. Kennedy and the majority ignored that the
conduct alleged was critically different from the Central Bank case
because the bank in that case did not itself engage in a proscribed
deceptive act and, therefore, did not itself directly violate section
10(b) and Rule 10b-5. In other words, they ignored their express
recognition in Central Bank that such conduct is an additional ground
for liability beyond that arising from publicly making a misstatement.

There is no reason to impose the requirement that investors prove they
relied on misinformation produced by the companies' actions to find
them liable. Under the plain language of the statute banning deceptive
practices, the real question is instead whether the defendants'
conduct caused the investors to purchase their shares under false
pretenses.

In a dissenting opinion in the Stoneridge case, Justice John Paul
Stevens argued that the acts of the cable box companies were enough to
impose liability because they had the foreseeable effect of causing
investors to purchase their shares under false pretenses. The law has
long treated a misrepresentation made to a third person the maker
intends or has reason to expect will be repeated or its substance
communicated to the victim the same as direct falsehoods for liability
purposes. For all practical purposes the sham transactions the
manufacturing companies engaged in had the same effect on Charter's
profit and loss statement as if they had themselves made false entries
directly on Charter's books.

The Stoneridge ruling cannot be seen as anything other than a
political decision to serve the reactionary economic interests of
finance capital. In an interview with the New York Times, J. Edward
Ketz, an associate professor of accounting at Pennsylvania State
University's Smeal College of Business, called the ruling "a travesty
of justice" and a "huge step backwards in the fight to prevent further
accounting frauds from harming investors and the American economy."

The ruling provoked an audible sigh of relief on Wall Street and from
such employers' groups as the National Association of Manufacturers,
because of fear that a ruling in the investors' favor would have left
large numbers of companies and banks vulnerable to lawsuits over the
massive fraud that has characterized the US economy.

The ruling is particularly timely given the unwinding of the sub-prime
mortgage scandal. Many investment and commercial banks that might
otherwise face liability to investors under the securities laws will
be able now to dodge it. The banks created all sorts of formally
separate "off balance sheet" entities to foist packages of such
mortgages onto investors. They will argue that, as in Stoneridge, only
those entities and not the banks themselves should be liable for any
fraud relating to the real value of these mortgages.
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