The U.S. Supreme Court last week issued a decision upholding protections that shield secondary players from liability in securities fraud cases--an action welcomed by insurers providing directors and officers liability coverage.

In Stoneridge Inv. Partners, LLC vs. Scientific-Atlanta Inc. (No. 06-43), the Supreme Court, in a 5-3 decision, affirmed lower court decisions throwing out a lawsuit by shareholders of Charter Communications Inc. against two of the companies' suppliers.

The plaintiffs in the case had sued the two cable television equipment suppliers--Motorola and Scientific-Atlanta--that were allegedly involved in deceptive transactions that helped Charter, a cable television company, inflate its earnings and hide its failure to achieve its financial goals.

The Supreme Court majority opinion upheld a federal district court in Missouri, which had dismissed the suit, and the 8th U.S. Circuit Court of Appeals, which had upheld the dismissal.

Supporting its decision, the Supreme Court majority said Charter shareholders didn't show they relied on the alleged deception by the suppliers in making investment decisions.

"Reliance by the plaintiff upon the defendant's deceptive acts is an essential element of the...private cause of action" under securities laws, the majority said.

Motorola and Scientific-Atlanta "had no duty to disclose; and their deceptive acts were not communicated to the public," the majority continued, noting the investors "as a result cannot show reliance upon any of [those] actions except in an indirect chain that we find too remote for liability."

In the underlying case, it was alleged that the cable company made agreements with the two suppliers to pay inflated prices for cable boxes. The suppliers then turned around and used the excess cash to advertise on the Charter's cable system.

The inflated prices were listed as a capital expense, and the advertising was added to revenues helping Charter meet securities analysts' expectations.

The term of art involved in the case is "scheme liability," according to lawyers active in securities litigation. That is the idea that third parties can be held liable for securities fraud committed by companies with which they do business.

A ruling allowing the Charter case to proceed not only would have made suppliers liable for securities fraud committed by their public company clients, but also could have made investment bankers, accountants and law firms liable as well.

The D&O insurance industry had been awaiting the decision with bated breath.

Commenting on the ruling, Kevin M. LaCroix, an attorney and a director of OakBridge Insurance Services, a Beachwood, Ohio brokerage, noted that a different ruling by the Supreme Court--one supporting the position that the investors urged--"would have had a dramatic impact on the cost of liability insurance."

On his Web blog, "The D&O Diary" (at http://dandodiary.blogspot.com), Mr. LaCroix said one notable aspect of the majority opinion was its reference to "extrajudicial considerations," which seem to have influenced the decision, such as the potential impact that supporting the Charter investors' positions might have had on the relative competitiveness of U.S. financial markets.

In the ruling, for example, the majority noted that if the investors' position were recognized, "then contracting parties might find it necessary to protect against the threats, raising the cost of doing business."

Although Mr. LaCroix noted that while such considerations "arguably are irrelevant" to the central question in the case--whether the claimants have a remedy under Section 10-b of the Securities and Exchange Act of 1934, which imposes liability for manipulative devices and material misstatements made in connection with registered securities--the majority was correct about the business costs.

In fact, Mr. LaCroix continued, if companies had been forced to get insurance to protect against not only the securities liability arising from their own conduct but also with respect to every company to which they are a customer or vendor, "the cost of liability insurance would have soared."

Moreover, he added, "the burden of trying to underwrite this exposure would have been enormous as well, not to mention extremely challenging."

During the Professional Liability Underwriting Society International conference last November, insurer representatives offered similar observations in advance of the Supreme Court ruling.

Heather Fox, senior vice president and chief underwriting officer for AIG's National Union Fire Insurance Company of Pittsburgh, based in New York, said that if the Supreme Court allowed suits against secondary actors, D&O and professional liability underwriters could face "exponential exposure."

Insurers would have to look beyond the internal controls of their own clients to underwrite the coverage--forced to underwrite the internal controls of their clients' vendors and business partners as well, she said.

Following the decision, an AIG representative, Chris Winans, said that although the Supreme Court delivered "an important decision thwarting an attempt to broaden management liability, it is unlikely to have any impact on D&O claims trends."

"At AIG, our underwriting already assumed that the case would be decided this way, so it doesn't affect our book of business," Mr. Winans said.

Mr. LaCroix also noted the unsurprising overall case outcome, writing that "more expansive possibilities may never really have been in the cards, given the lineup of the court."

"Yes, the decision could have changed things, but in the end, it did not," he wrote. "In effect, Stoneridge represents a 5-3 vote for the status quo. While a decision for the investors could have increased the cost of insurance, the actual outcome on behalf of the vendors is unlikely to impact the cost."

Amy Goodman, a lawyer with Gibson, Dunn & Crutcher LLP, in Washington, D.C., said that before the case was decided, there was concern by D&O insurers "of additional liability beyond which they had contemplated." The Supreme Court decision "should dissipate that concern," she added.

Also reacting to the decision, Greg Flood, president of IronPro, the professional/management liability division of Ironshore Holdings U.S., told NU that "as a layman underwriter, I think the decision gives us some certainty as to the potential liability of suppliers, consultants and vendors as contributors to securities fraud."

"It appears the court is saying that the SEC has to deal with such issues--not private securities lawyers," he continued. However, he added, "there is still the potential for the SEC to act, which would create more complexities."

Outside the insurance industry, the Supreme Court majority's ruling has detractors, including Democrats in Congress such as Sen. Chris Dodd, D-Conn., chair of the Senate Banking Committee.

"As the author of the Private Securities Litigation Reform Act, I stand second to none in my commitment to protect American businesses from frivolous litigation, but today's decision goes beyond that common-sense law," Sen. Dodd said.

"Instead of protecting innocent businesses, it would protect wrongdoers from the consequences of their actions," he added. "Such a misguided standard will do nothing to strengthen the competitive position of America's businesses and capital markets."

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