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Primary Liability and In re Charter Communications

We bring readers today the first post written by a student seeking credit in class.  This is written by Seth Gomm, a JD/MBA student who participated in my course on the Securities Exchange Act of 1934, which I taught this Spring.  In addition to a forum for exploring issues of corporate governance, the Blog is a teaching tool, with many of the posts used to generate discussion of relevant legal issues.

On March 26, 2007, the Supreme Court of the United States granted certiorari to a case directly stemming from In re Charter Communications.

In Charter, the plaintiffs claimed that vendors of Charter, who provided Charter with set-top cable television boxes, violated §10(b) of the 1934 Exchange Act. The vendors agreed to charge Charter a $20 premium over their regular market price, the vendors then agreed to return the $20 premium to Charter in the form of advertising fees. Charter allegedly misreported the $20 premium in an attempt to inflate the company’s cash flow by $17,000,000 in the fourth quarter of 2000 in order to meet Wall Street analyst expectations.

The plaintiff’s in Charter claimed that the vendors were primarily liable for the alleged fraud under §10(b). The Supreme Court in Central Bank of Denver v. First Interstate Bank of Denver clarified that §10(b) does not extend to aiding and abetting violations. The Court nonetheless acknowledged that “[a]ny 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 8th Circuit concluded that the vendors could not be sued as primary violators under Section 10(b). The court concluded that to engage in a fraudulent scheme or contrivance required a “misstatement or a failure to disclose by one who has a duty to disclose.” The vendors were not accused of issuing any statements to the investing public and had no duty to disclose any information about Charter’s true financial condition or accounting practices. As the court stated “we are aware of no case imposing §10(b) or Rule 10b-5 liability on a business that entered into an arm’s length non-securities transaction with an entity that then used the transaction to publish false and misleading statements to its investors and analysts.” The court explained that such a finding “would introduce far-reaching duties and uncertainties for those engaged in day-to-day business dealings.”

The Supreme Court has agreed to take up the issue. Chief Justice Roberts and Justice Breyer have recused themselves so that only a majority of 4 is required to decide the potentially far-reaching liability toward vendors and other secondary parties that may have traditionally been viewed simply as aiding and abetting a primary culpable party.

If the Supreme Court rules in favor of the plaintiff in Charter, the decision could impose a heavy burden on businesses since secondary parties such as vendors could be liable under Section 10(b), greatly widening the circle of potential “deep pocket” defendants.  Secondary parties could conceivably find themselves liable for acts that had effect on companies several stages down the supply chain. An entity’s duty could be effectively extended not only to its own shareholders, but also to the shareholders of remote outside companies that it may have done business with.

For primary material on this case, go to the DU Corporate Governance web site.

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