“Scheme Liability”: When Can Investors Sue Bad But Silent Actors For Securities Fraud?
ATTORNEY: MICHELE S. CARINO
POMERANTZ MONITOR JANUARY/FEBRUARY 2017
In Pomerantz’s precedent-setting Stoneridge case, the Supreme Court recognized that securities fraud can be committed by people who themselves make no public statements, but who nonetheless deploy a “device, scheme, or artifice to defraud” or engage in “any act, practice, or course of conduct” that defrauds a person in connection with the purchase or sale of a security – socalled “scheme liability.” Because deceptive conduct often accompanies or facilitates false statements, it has been difficult to discern what type of conduct, by itself, can satisfy this “scheme liability” standard. In other words, what is actionable fraudulent or deceptive conduct?
On December 28, 2016, in a case called Medtronic, the Eighth Circuit addressed that question. Medtronic involved claims that the company, its officers and senior managers and certain doctors had engaged in a scheme to defraud investors by concealing information related to Medtronic’s product, INFUSE, which was developed as an alternative to bone grafting procedures in spinal surgery. In particular, plaintiffs alleged that Medtronic violated the securities laws, because not only did it fail to disclose financial ties between the company and doctors who conducted the clinical trials for INFUSE, but it also paid doctors to conceal adverse events, employ weaker safety rules for clinical trials, and publish favorable articles promoting the product. Medtronic sought dismissal of the scheme liability claims, arguing that it could not be held liable for the false or misleading statements made by doctors concerning INFUSE, because it was not the “maker” of those statements. The district court agreed, and dismissed the case.
The Eighth Circuit reversed. In the first instance, it distinguished between scheme liability claims, which may be brought by private investors, and “aiding and abetting” claims, which cannot. The court explained that aiding and abetting refers to situations where “entities … contribute ‘substantial assistance’ to the making of a [false] statement but do not actually make it.” For instance, if a supplier engaged in sham transactions with a company so that the company could boost its revenues and misstate its financials, the supplier cannot be held directly liable for the false statements made by the company. In contrast, scheme liability imposes primary liability “based on conduct beyond misrepresentations or omissions.” Thus, the actor has to actually do something besides knowing that a statement is false. As a result, the Eighth Circuit cautioned that “a plaintiff cannot support a scheme liability claim by simply repackaging a fraudulent misrepresentation as a scheme to defraud.
In Medtronic, the court found that “the act of paying physicians to induce their complicity is the allegation at the heart of the scheme liability claim.” This deceptive con duct was separate and apart from the misrepresentations themselves, and thus, not merely a “repackaging” of allegations to create a scheme.
The Eighth Circuit also reaffirmed that to state a claim based on a deceptive scheme, a plaintiff must allege that the market relied on the fraudulent conduct. Following the Supreme Court’s decision in Stoneridge, the court explained that this “causal connection” between the defendant’s deception and the plaintiffs’ injury was necessary to limit liability to conduct that affected the price of the company’s stock and therefore caused the plaintiff’s loss. Otherwise, scheme liability could be extended to all aiders and abettors whose conduct may have facilitated the fraud, but which did not reach the public. In Stoneridge, the Supreme Court held that the scheme liability claim failed, because investors could not demonstrate that they relied on defendants’ conduct, and thus, the necessary “causal link” was missing. But in Medtronic, the court found that Medtronic’s manipulation of clinical trials and concealment of adverse results directly caused the production of false information on which the market relied. Indeed, the company utilized the fraudulent scheme as a mechanism to convince investors of the company’s competitiveness and sustainability. Because reliance was established, the court upheld the scheme liability claim.
Although potential defendants may characterize the Eighth Circuit’s decision as a “back-door” to circumvent the restrictions on bringing claims against aiders and abettors, it is no such thing. Rather, the Eighth Circuit carefully defined the requirements for bringing a scheme liability claim consistent with the language of the securities laws, as well as the recognition by numerous courts that “conduct itself can be deceptive.” The Eighth Circuit’s decision highlights an important mechanism for investor recovery, because actors can and should be held accountable for their actions, as well as their words, particularly when markets are affected.