The recent Stoneridge decision has the potential to turn insurance class actions on their head

A landmark legal decision last month could have far-reaching consequences throughout not just US businesses but also the insurance and reinsurance industry.

The case, Stoneridge v Scientific-Atlanta Inc was brought by investors seeking to impose liability on two companies whose activities allegedly allowed the investors’ corporation to mislead auditors and file erroneous financial statements.

The US Supreme Court ruled that as investors did not depend on the statements made by the “supplier” or third-party, they did not hold the right to sue a company or individual.

Described by the Wall Street Journal as “the biggest securities-litigation court clash in a generation,” the decision effectively should halt the tidal wave of securities fraud litigation against third parties who did not themselves defraud investors.

The case centered on the controversial Section 10(b) of the Securities Exchange Act which prohibits securities fraud. The court found that Section 10(b) “does not create secondary liability for those who ‘aid and abet’ securities fraud and that only primary violators are subject to investor suits for damages,” according to a Mayer Brown briefing document.

In this particular case investors accused suppliers of cable television company Charter of helping Charter to file misleading statements and mislead auditors, in the end inflating its revenue by $17m and directly impacting the stock price.

The plaintiffs in this case asserted that the suppliers were liable as they had helped Charter to defraud the investors.

However the Supreme Court ruled that under Section 10(b) the plaintiffs must prove that they knew of and relied upon the defendants’ deceptive acts. Unable to satisfy the court’s demands, the case was dismissed against the vendors.

Andrew Pincus, partner at Mayer Brown, told GR that the ruling has established a clear line of demarcation.

“The decision effectively should halt the tidal wave of securities fraud litigation against third parties who did not themselves defraud investors

“If the court had ruled in favour of the plaintiffs it would have opened the floodgates. Anyone who entered into an agreement with a public company which subsequently committed a fraudulent act could then be a potential target for a lawsuit.”

The case has far-reaching consequences in terms of the insurance and reinsurance community too. Had the decision gone the opposite way, for example, insurers would have potential liability that is almost impossible to project.

The Supreme Court has already rejected a class action by former Enron investors in a bid to recover up to $40bn from investment banks with a history of business with the energy company in light of the Stoneridge decision.

In a statement Edward Yingling, president and CEO of the Amercian Bar Association, applauded the decision.

“We are pleased that the Supreme Court rejected attempts by class-action lawyers to tie unknowing third parties to securities fraud schemes. This decision appropriately protects banks and other innocent businesses from weak claims and frivolous lawsuits that increase costs for everyone. If this case had been decided otherwise, investors would have been discouraged from doing business in this country at just the wrong time in our economic cycle.”

Timothy Bishop, also a partner at law firm Mayer Brown, explained that the ruling could also have an effect on insurance companies in light of the credit crunch.

“By the end of 2007 we saw around 35 suits filed related to subprime,” he said. “Investors in the big banks saw that the stock was dropping and alleged that the banks knew and therefore filed a case.”

He adds: "Already the plaintiffs' bar has begun to argue that the Stoneridge decision should be narrowly construed so as not to apply to defendants in 'the financing business' or to third parties named in offering documents, but those arguments are at odds with the Supreme Court's decisions in recent cases and should be rejected by the US courts."