104th Congress: Democratic Perspectives 103rd-107th
Congress Committee Activity We strongly support the goal of deterring meritless securities class action lawsuits. The record before this Committee establishes that such lawsuits can be costly to defend and may needlessly distract corporate officials who work honestly and diligently to help their companies prosper in an increasingly competitive economic climate.
But the record before this Committee also establishes--unequivocally--that our system of private litigation under the federal securities laws has functioned effectively as a `necessary' 1
[Footnote] and `essential' 2
[Footnote] supplement to the enforcement program of the U.S. Securities and Exchange Commission (SEC). Private class actions are `crucial to the integrity of our disclosure system ' 3
[Footnote] because they provide a `powerful deterrent' 4
[Footnote] to those who might consider ignoring or fraudulently evading their obligations to the investing public. Private class actions also provide an irreplaceable means of compensating millions of defrauded individual investors. According to a staff report on private securities litigation prepared by the Senate Subcommittee on Securities, `a long list of notorious cases have recovered billions of dollars for defrauded investors.' 5
[Footnote]
[Footnote 1: See, e.g., Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 310 (1985); Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 730 (1975); J.I. Case Co. v. Borak, 377 U.S. 426, 432 (1964).]
[Footnote 2: See e.g., `Hearing on Securities Fraud Litigation Reform Proposals Before the Subcommittee on Telecommunications & Finance of the House Committee on Commerce,' (Feb. 10, 1995) (Oral testimony of Arthur Levitt, Chairman, SEC); `Securities Investor Protection Act of 1991: Hearing Before the Subcommittee on Securities of the Senate Committee on Banking, Housing & Urban Affairs,' (Oct. 2, 1991) at 3-4 (Testimony of Richard C. Breeden, Chairman, SEC) (`[p]rivate litigation is an essential element in enforcing the rights of the more than 50 million Americans who participate in the U.S. securities markets').]
[Footnote 3: `Hearing on Securities Fraud Litigation Reform Proposals Before the Subcommittee on Telecommunications & Finance of the House Committee on Commerce,' (Feb. 10, 1995) (Testimony of Arthur Levitt, Chairman, SEC) at 1.]
[Footnote 4: Id. at 30.]
[Footnote 5: `Private Securities Litigation, Staff Report Prepared At The Direction of Senator Christopher J. Dodd, Chairman, Subcommittee on Securities of the Committee on Banking, Housing and Urban Affairs,' United States Senate, (May 17, 1994) at 10.]
The conclusion to be drawn from these facts is clear. Legislative reforms aimed at frivolous or meritless securities class action lawsuits are needed. But the reforms must be carefully crafted, because the antifraud provisions of the federal securities laws are one of the nation's most important weapons in the continuing response to ever larger and more complex financial scandals that recur too frequently on Wall Street. At the first hearing on the subject of securities litigation reform held by the Subcommittee on Telecommunications and Finance last year, Arthur Levitt, Chairman of the SEC implored Members to keep these facts in mind:
I thought during my service as head of Shearson and then head of the American Stock Exchange, that I had seen just about every kind of public fraud that could possible be perpetrated on individual investors. And then I came to the Commission, and week by week hearing cases, seeing what is going on in this country, how many people are out there taking advantage of innocent individual shareholders dwarfed anything I had ever experienced before and convinced me in a way that no amount of experience or reading or anecdotal information could possibly have persuaded me of the vital and compelling importance and mandate of the Commission, above everything else that it has to do in terms of governance issues and legislative issues, the critical important of protecting individual investors.
So anything that is suggested which raises the hurdle for those investors to right these wrongs is something that I have to look at with great care and circumspection. The abuses you speak of are there. * * * But, again, in the balance between the interests of investors and the interests of a better system, a better system is important, but it can't be at the expense of those investors.
Rather than cutting off access to the courts, we must ensure that the private litigation system works more responsibly and effectively. Abusive practices must be deterred and, where appropriate, sternly sanctioned. But individual investors, who honestly believe they have been defrauded, must also be assured that the doorway to the American system of civil justice remains open, and that the law remains available to protect them and their families. Every Democrat on this Committee is prepared to support enthusiastically legislation that strikes this crucial balance. But legislation that succeeds in stopping frivolous cases only by making it equally impossible to pursue those who were responsible for calamities like the billion dollar frauds at Drexel Burnham Lambert, Lincoln Savings and Loan, Prudential Securities, the Washington Public Power Supply System, Salomon Brothers, CenTrust Savings, and perhaps even the Orange County bankruptcy, to name but a few, obviously fails to achieve this needed balance and will not have our support.
In our judgment, Title II of H.R. 10, as reported by the Committee, utterly fails to pass this simple test of balance and fairness. Notwithstanding hastily drafted last-minute changes, 6
[Footnote] this bill represents a drastic overreaction to the problem of meritless class action lawsuits. 7
[Footnote] The misguided and counterproductive approach set forth in the bill will have profoundly harmful consequences for small individual investors and, ultimately, for their confidence in the fairness of our capital markets. Many of the bill's sweeping provisions bear no logical relation to the evidence and testimony presented to the Congress during the last two years. 8
[Footnote] And, paradoxically, the bill's contradictory, confused, and ambiguous provisions, if enacted, would cause years of needless and enormously wasteful litigation in the federal courts.
[Footnote 6: As enshrined in the Republicans' Contract With America, Title II of H.R. 10 was even more draconian. It removed from the securities laws prohibitions against reckless conduct by corporate officials and their financial advisers. In effect, it also ensured that no class action lawsuit for securities fraud would or could be brought in the federal courts. It accomplished this by eliminating the ability of investors to argue that the market itself had been defrauded, by imposing an absolute `loser pays' attorney fee shifting requirement in all securities fraud cases, and by requiring that investors plead at the outset of the case specific facts demonstrating a defendant's state of mind, a task most legal experts view as impossible at any time during a lawsuit.]
[Footnote 7: In a speech delivered in early 1994, SEC Chairman Levitt noted that `the number of securities law cases has not increased during the past two decades. Class action filings have increased over the past three years, but they do not exceed the levels that prevailed during the 1970's. When measured against the number of public offerings and the volume of trading on NASDAQ and the exchanges, the amount of securities litigation has actually declined.' Speech by Arthur Levitt, Chairman, SEC, January 26, 1994.]
[Footnote 8: For example, the onerous new rules established by this legislation are not limited to class actions brought under Section 10(b) of the Securities Exchange Act of 1934 (`Exchange Act'), about which the Subcommittee on Telecommunications and Finance received ample testimony. Instead, for reasons that have never been explained and have no basis in the record, they will apply to all private actions brought under the Exchange Act.
We have been unable to locate any testimony presented to the Subcommittee which analyzes or argues in support of these changes. Moreover, the most significant decisions in the federal courts draw important distinctions between, for example, the culpability standards under Sections 10(b) and 14(e) of the Exchange Act. Yet, with one entirely unexplained sweep of its hand, the Committee upsets decades of thoughtful and careful securities caselaw by superimposing it proposed new Section 10(b) requirements to actions brought under Section 14(a).]
In light of the failure of the Republicans to respond adequately to concerns about the egregious impact this bill will have on average investors and on the integrity of the market, 9
[Footnote] the breadth of opposition to the bill that continues to emerge is not surprising. On the day before this Committee marked up Title II of H.R. 10, the SEC stated that:
[Footnote 9: Among other things, the Republicans made changes that deleted the guardian ad litem and the alternative dispute resolution procedure provisions; deleted the discriminatory investment restrictions on potential named plaintiffs with small holdings; ameliorated the potentially unconstitutional aspects of the restrictions on professional plaintiffs; removed SEC enforcement actions from the bill's restrictions; restored controlling person liability, liability for recklessness, and the fraud on the market theory of reliance; and modified the loser pays, scienter, pleading, and safe harbor for predictive statement provisions. However, as discussed infra, some of these revisions have served to make the bill worse rather than better.]
Because of the potential impact on U.S. investors and markets, the Commission cannot support the proposed provisions. * * * While the SEC supports Congressional efforts to curb abuses, we reiterate our first priority: the rights of American investors and the integrity of the American capital markets must be held paramount.
We agree:
In addition to the SEC, the securities regulators from the fifty states, and municipal finance officers from across the nation oppose all of the key elements of Title II of H.R. 10. So do groups that represent retirees, many of whom have invested their life's savings, or insurance proceeds, or the equity from their homes in the securities market. These groups include the American Association of Retired Persons, the National Council of Senior Citizens, and the Gray Panthers. As of February 22, 1995, ninety-five of the nation's leading scholars in the field of corporate and securities law had signed a petition opposing the enactment of H.R. 10. Major consumer organizations, including the Consumer Federation of America, Consumer's Union (publisher of the widely respected Consumer Reports), Public Citizen, and the U.S. Public Interest Research Group, are unified in their opposition to Title II of H.R. 10. So too are many large pension funds, including those representing present and future retirees from the AFL-CIO, the Teamsters, the Machinists, and the Fraternal Order of Police. The American Bar Association, the well respected group that represents lawyers from every field of law, and the Association of the Bar of the City of New York, the nation's most respected group of securities law experts, also oppose the key elements of H.R. 10.
Even Herbert Stein, a resident scholar at the conservative American Enterprise Institute and former Chairman of the Council of Economic Advisers under Presidents Nixon and Ford, believes that Title II of H.R. 10 is badly out of balance. In a recent article in The New York Times, 10
[Footnote] he suggests that H.R. 10's authors and principal supporters have lost touch with the real concerns of middle class Americans and the complex realities of our financial markets.
[Footnote 10: `Letting Wall Street Off Easy,' New York Times, Wednesday, February 15, 1995, at A21.]
[F]rivolous lawsuits can be an unnecessary drain on the system. But a much more serious problem is assuring the middle-class investor that the people to whom he entrusts his money will look after his interest honestly and diligently. The possibility of recourse to the judicial system is integral to that assurance, and the proposals in the [Contract With America] would weaken it.
Since the nation's founding over 200 years ago, our national policy has consistently favored fair and equal access to justice. Title II of H.R. 10 would significantly undermine this longstanding and treasured national policy by imposing a version of the so-called `English Rule' on American litigants and federal courts. Under the English Rule, the losing party must pay all of the attorneys' fees and other costs and expenses of the prevailing party.
Contrary to claims advanced in support of H.R. 10's version of the English Rule, the award of fees to the prevailing party will be mandatory. A court would be able to prevent the shifting of fees to the losing party only if each of three demanding (and somewhat confusing) conditions are met. First, the court must conclude that the losing party's `position' was `substantially justified.' Second, the court must find that imposing the fees on the losing party is not unjust. And third, the court must find that the prevailing party would be substantially burdensome or unjust if imposed on the losing party. Again, unless all three requirements are satisfied, the court must shift all of the prevailing party's fees and expenses to the losing party.
In addition to establishing a `loser almost always pays' rule of fee shifting, H.R. 10 imposes a costly and hopelessly burdensome requirement applicable only to the investors. Either the investors or their attorneys will be required to post security at the beginning of the case to provide for the payment of the defendant's attorneys' fees and other expenses in the event that fees are shifted. While no such requirement is imposed on defendants (even though, in almost all instances, it would be much easier for them to do so), the lack of equivalent treatment misses the point.
During hearings before the Subcommittee on Telecommunications and Finance, numerous witnesses and Members warned that this fee shifting provision (and its even more onerous predecessor) would effectively end all private actions by small investors who are victims of fraud. 11
[Footnote] Victims--including even those with the strongest cases--will not be able to stand up and sue, either on their own, or as the champion of a class of similarly situated investors, if by doing so they are exposed to the risk of paying millions in legal fees to large public corporations, investment banking houses, accounting firms, and law firms. 12
[Footnote]
[Footnote 11: See, e.g., `Hearings on Federal Securities Fraud Litigation Before the Subcommittee on Telecommunications and Finance of the House Committee on Energy and Commerce.' (Aug. 10, 1994) (testimony of Professor Arthur Miller) at 14 (`As a practical matter, fee shifting is almost invariably in intimidation device designed to inhibit people from seeking access to the courts. Fee shifting would eviscerate all--or virtually all--plaintiffs' securities claims, the meritorious along with the meritless.'); (testimony of Professor John Coffee, Jr.) at 16 (`Clearly, some proposed reforms--such as the English rule under which the loser pays the winner's legal expenses--would probably end securities class actions in all except rare cases of flagrant fraud.'); (oral testimony of Professor Joel Seligman) (`[T]he one proposal that is on the table that I find most objectionable and [am] most strongly troubled by is the English fee shifting rule. * * * This is the rule, if adopted, that would basically have the tendency to prevent meritorious lawsuits from going forward.'). It should be noted that this testimony was received in opposition to the fee shifting provision in H.R. 417 in the 103d Congress, a proposal that was less demanding on investors than the provision presently contained in H.R. 10.]
[Footnote 12: See, e.g., `Hearings on Private Litigation Under the Federal Securities Laws, Senate Subcommittee on Securities of the Senate Committee on Banking, Housing & Urban Affairs,' (June 17 & July 21, 1993) (testimony of Gordon Billip, defrauded investor) at 71 (`If the law had required [my wife] Betty and me and other bond-holders and our lawyers to pay the defendants' exorbitant legal fees if we were to lose the case, we never would have stuck our necks out to represent the 2,000 investors, many of whom had invested the savings of a lifetime.'); (testimony of Russell E. Ramser, Jr., defrauded investor) at 74 (`Although I was comfortable in my belief that the bondholders had been wronged by the accounting firms, I would not have filed this suit if, in addition to devoting my time to the case, I would have been required to pay their millions of dollars of attorneys' fees in the event that the jury, or a judge, did not agree with me.').]
SEC Chairman Arthur Levitt emphasized this point in his recent appearance before the Subcommittee. `In class action lawsuits, in particular, individual plaintiffs frequently stand to recover only a small amount if they prevail. Their potential liability under an automatic fee shifting provision would be totally disproportionate to their potential recovery.'
The arguments in opposition to the various forms of the English Rule that have been proposed were also recently buttressed by a surprising but powerful and authoritative source: the respected conservative weekly, The Economist. In its British edition of January 14, 1995, the magazine forcefully argued that Britain should abandon its `loser pays' rule. According to The Economist, this rule was dramatically eroding the legitimacy of the British civil justice system. `Enormous numbers of mostly middle-class people' simply cannot use the courts, The Economist said, because they must pay for the other side's lawyers if they lose. `For most people, this means that they are risking financial ruin' if they choose to go to court, no matter how justified or serious their underlying complaint may be. Today in Britain, The Economist noted, `only the very wealthy can afford the costs and risks of most litigation. This offends one of the most basic principles of a free society: equality before the law.'
Common sense suggests to us that the standards for shifting fees and the provision requiring investors to post security that are contained in the present version of H.R. 10 have been poorly thought out and will likely have highly undesirable consequences. For example, while the term `substantially justified' is apparently borrowed from the Equal Access to Justice Act (`EAJA'), none of the provisions of that statute that modify and limit its applicability have been included in H.R. 10. 13
[Footnote]
[Footnote 13: See Pub. L. No. 96-481, 94 Stat. 2325 (1980) (codified at 5 U.S.C. Sec. 504 and 28 U.S.C. 2412). Under the EAJA, the federal government can be required to pay a private party's attorneys' fees and other costs if a court determines that the government's position was not `substantially justified.' But fees cannot be shifted onto any party other than the government. And attorneys' fees and costs may only be pursued against the government under this unusual statute if the party seeking the sanction is either an individual with a net worth of under $200,000, a tax-exempt organization, or a business with a net worth of under $7 million and fewer than 500 employees. While we obviously are not familiar with all the details that led to the promulgation of the EAJA's `substantially justified' standard, it is evident that care was taken to limit its applicability so as not to preclude the government from pursuing legitimate cases. There are no such limitations in this bill.]
Notwithstanding our objections to the `loser almost always pays' provision in H.R. 10, we would support a reasonable fee-shifting proposal. In fact, Congressman Manton offered an amendment at the full Committee mark-up that would have established a fair and balanced mandatory fee-shifting scheme for cases (or defenses) that were frivolous or asserted in bad faith. But, because debate was cut off by the Republicans, there was no opportunity for Mr. Manton or his colleagues to present to the Committee the strong policy arguments that support his approach. In the absence of any debate on the issue, it came as no surprise that Mr. Manton's amendment was defeated in a straight party line vote.
Because of the deep and lasting chilling effect it will have on investors who have a legitimate basis for pursuing a securities fraud claim in court, we strongly oppose H.R. 10's `lower almost always pays' provision and its requirement that investors post security before being allowed to proceed with their case.
As introduced, Title II of H.R. 10 proposed to radically increase the burden on investors seeking to prove a case of fraud under the federal securities laws, and to dramatically restrict the circumstances in which a corporation or one of its financial advisors could be charged with fraud. 14
[Footnote] One of the bill's most troubling provisions was its extraordinary reversal of an unbroken string of court rulings over the last twenty years. In this long series of decisions, every federal appellate court that considered the issue concluded that a defendant who acted recklessly would be deemed to have acted with the `scienter' needed to prove securities fraud. 15
[Footnote]
[Footnote 14: As originally drafted, these new liability standards were intended to cut back on the ability of the SEC to bring enforcement actions as well as to restrict individual investors who sought to bring private actions. In part because of strenuous objections from Members and other concerned observers, the language that had applied these provisions to the SEC was removed. We have now been assured by the Republicans that H.R. 10 will not affect (and is not intended to affect) any aspect of the SEC's enforcement of the antifraud provisions of the securities laws.]
[Footnote 15: See, e.g., Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 46-47 (2d Cir.), cert. denied, 439 U.S. 1039 (1978); McLean v. Alexander, 599 F.2d 1190, 1197 (3d Cir. 1979); Broad v. Rockwell Int'l Corp., 642 F.2d 929, 961-962 (5th Cir.) (en banc), cert. denied, 454 U.S. 965 (1981); Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1024 (6th Cir. 1979); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1044 (7th Cir.), cert. denied, 434 U.S. 875 (1977); Van Dyke v. Coburn Enterprises, Inc., 873 F.2d 1094, 1100 (8th Cir. 1989); Nelson v. Serwold, 576 F.2d 1332, 1337 (9th Cir.), cert. denied, 439 U.S. 970 (1978); Hackbart v. Holmes, 675 F.2d 1114, 1117 (10th Cir. 1982); SEC v. Carriba Air, Inc., 681 F.2d 1318, 1324 (11th Cir. 1982).]
The original version of H.R. 10 assigned no value to the fact that the recklessness standard had for twenty years been a crucial element of our public policy of maintaining fair and honest financial markets. As initially proposed in the Contract With America, even extreme types of recklessness would no longer have been prohibited by the antifraud provisions of the securities laws.
But virtually all experts in the field of securities law believe that liability for recklessness is critical if the antifraud laws are to successfully deter fraudulent activity in the market. Indeed, providing that defendants who recklessly disregard the truth may be liable to investors, or subject to an enforcement action by the SEC, discourages `head in the sand' passivity on the part of senior corporate officials and their financial advisers, and creates an essential and powerful incentive to proper disclosure and good corporate governance.
During a Subcommittee hearing on H.R. 10, several witnesses and Members advanced similar reservations about the consequences of abandoning the recklessness standard. Member were particularly concerned that abandoning all liability for reckless conduct would effectively inoculate auditors, underwriters, and corporate counsel from any risks associated with fraudulent misstatements, and thus greatly erode the ability of private actions to deter fraud and defrauded investors to obtain justice. Chairman Levitt made it clear that this proposal would make it virtually impossible for investors who had clearly been defrauded and suffered substantial losses from pursuing compensation from professionals whose work may have been instrumental to the fraud's success:
[Abandoning the recklessness standard] would reduce the degree to which such professional advisers encourage full and complete disclosure. There are relatively few cases in which it is established that professional advisers acted with actual, subjective knowledge that the representations made by an issuer were false. Rather, the liability of such advisers typically is predicated on a finding that they participated in the dissemination of false statements while recklessly ignoring indications of fraud.
We have written at some length about H.R. 10's initial proposal to eliminate the recklessness standard, even though amendments at both the Subcommittee and Committee mark-ups were said to have restored the standard to the antifraud laws. However, the language that supposedly restored recklessness at the Subcommittee mark-up, was, we believe, a charade. It established extraordinary and utterly unattainable requirements of proof that no investor could ever satisfy.
The recklessness standard that was proposed and enacted by the Committee is, at first glance, a considerable improvement over the language adopted by the Subcommittee. The first sentence in the definition, with one significant exception, 16
[Footnote] codifies the recklessness standard that was adopted by the Seventh Circuit Court of Appeals in Sundstrand Corp. v. Sun Chemical Corp., 17
[Footnote] a version of which is applied by at least 75% of the nation's federal courts. We believe that the original Sundstrand standard represents a perfectly adequate definition of recklessness, and we would all be pleased to support it.
[Footnote 16: The only material change to the first sentence of the definition is the addition of the word `consciously' to modify the word `aware.' We believe this is a last-ditch effort to ratchet up the burdens placed on investors who have been defrauded because of reckless conduct, and is entirely unnecessary. We therefore continue to oppose this formulation of the Sundstrand standard.]
[Footnote 17: 553 F.2d 1033 (7th Cir.), cert. denied sub nom., Meers v. Sundstrand Corp., 434 U.S. 875 (1977).]
Unfortunately the amendment that was adopted by the Committee purporting to restore liability for recklessness to the antifraud laws contained two sentences rather than one. And the second sentence included in the amendment takes away virtually everything that was provided by the first.
The second sentence establishes as a matter of federal law the following unprecedented affirmative defense to a claim of reckless securities fraud: `For example, a defendant who genuinely forgot to disclose, or to whom disclosure did not come to mind, is not reckless.'
This `I forgot' defense is not only unprecedented under federal securities law, it does not appear to be recognized in any other area of federal law, or in any other jurisdiction in this country. We are not aware of a single securities fraud case in which any defendant has ever successfully argued that he or she was excused from and not responsible for their otherwise reckless conduct because they `forgot' to obey the law, or because fulfilling their legal responsibilities to shareholders just `did not come to mind.'
For centuries this country has, with great justification, prided itself on the fact that we are governed by the rule of law rather than by the whim of individuals. With just one sentence, however, the majority proposes a complete reversal of this principle, and its corollary, which is that ignorance of the law is no excuse. From now on in federal securities fraud cases--where during the course of the last ten years hundreds of thousands of small investors have lost their life's savings and seen their faith in the American dream shaken--the Committee proposes to sanctify ignorance of the law by elevating it into the statute that has been our most important weapon against fraud.
We strenuously object.
As reported by the Committee, the scienter provisions in title II of H.R. 10 apply to `any private action' arising under the Securities Exchange Act of 1934 (Exchange Act). By extending the bill's application to `any private action,' the bill will have the effect of requiring proof of scienter in proxy cases brought under Section 14 and disclosure cases brought under Section 8, neither of which currently has a scienter requirement. This is absurd public policy. It is entirely unrelated to the objective of reducing meritless securities fraud lawsuits, and has no support in the otherwise voluminous record assembled by this Committee over the course of the last year.
It also appears that H.R. 10 may redefine the elements of a violation under the proxy provisions. Current law allows a case to be brought under Section 14(a) against any person who solicits or permits the use of his name to solicit a proxy by means of a proxy statement that is false or misleading. H.R. 10 would limit recovery to cases against persons who directly or indirectly `make' a fraudulent statement.
Again, this has nothing to do with the stated goals of this legislation and would only serve to shield unlawful conduct from liability. Because there is no information in the record describing or discussing these matters, we do not know if these effects are intended. We do know that unintended consequences are the foreseeable result when politics rather than policy directs the process.
This provision was poorly thought out, and we are convinced that H.R. 10's supporters are not aware of the many harmful effects it may have. We oppose the provision.
In its original form, Title II of H.R. 10 required investors to plead `specific facts demonstrating the state of mind of each defendant at the time the alleged violation occurred.' At one point during Committee consideration, we were informed that the bill would likely be amended to require that investors allege specific facts giving rise to a `strong inference' that the defendant acted knowingly or recklessly. This is the test used today by the Second Circuit Court of Appeals, and it is generally regarded as more stringent than the test used by the other circuits.
H.R. 10 as reported does not codify the Second Circuit test. It provides that investors who bring securities fraud cases must make specific allegations which, if true, would be sufficient to `establish' that the defendant acted knowingly or recklessly. It than adds that `it shall not be sufficient for this purpose to plead the mere presence of facts inconsistent with a statement of omission alleged to have been misleading.'
There is a significant difference between having to allege facts that give rise to a `strong inference' that the defendant acted knowingly or recklessly, and having to plead facts that `establish' that the defendant had the requisite state of mind. We believe that it is inappropriate to establish any test more stringent than the Second Circuit test, which many experts already believe is already too severe.
Because we believe that the bill as reported may result in meritorious fraud cases being dismissed, we are unable to support this provision.
Title II of H.R. 10 as introduced would have eliminated the ability of defrauded investors to demonstrate that they relied on the market price of a security, which in turn relied on or was adversely affected by a fraudulent misstatement or omission. This method of establishing indirect reliance was accepted by the Supreme Court in the landmark case of Basic v. Levinson, and is popularly known as the fraud on the market theory. By repealing the Basic decision, H.R. 10 would have required that each of the thousands of investors who typically comprise a class present proof to the court that they actually relied on a specific fraudulent misstatement or omission made by a defendant. Because such a requirement destroys one of the foundational elements needed to proceed on a classwide basis, this requirement by itself would have precluded all future class actions for securities fraud.
As reported by the Committee, however, H.R. 10 has, at least in part, reversed its approach to this issue. The bill now appears to preserve the ability of investors to plead fraud on the market in many cases, a welcome and laudable development, and the Republicans deserve thanks for recognizing the importance of this issue.
Despite this important improvement, however, a serious problem remains. H.R. 10 as reported appears to attempt to limit the availability of the fraud on the market theory for fraud cases involving securities that are deemed to be `illiquid.' While, in theory, such a limitation may be justified, attempting to formulate the complex contours of such a limitation virtually overnight, without doing more harm than good, strikes us as virtually impossible.
An article in the February 23, 1995 Bond Buyer appears to prove the point. The article reports that this provision may preclude any class action from ever proceeding if the underlying security is a municipal bond. 18
[Footnote] The article notes, rather ironically, that two of the largest securities fraud cases in history--the litigation surrounding the default by the Washington Public Power Supply System, and the developing litigation resulting from Orange County's bankruptcy--both involved municipal securities. The idea that investors in these securities will be precluded from pursuing their case as a class because of this provision strikes us as absurd, and cannot possibly be the result intended by the Republicans.
[Footnote 18: `House Panel's Bill Could Prohibit Class Action Suits in Muni Market,' The Bond Buyer, February 23, 1995.]
We think a much simpler approach is to assign responsibility to the SEC to develop rules that determine when the fraud on the market theory should be available to protect investors, and when it might be unfair to permit them to use it. Unfortunately, the Republicans opposed a sensible amendment that would have permitted this issue to be analyzed in a more thoughtful and deliberate way.
We continue to believe that this provision is seriously flawed.
The provision in section 204 addressing the calculation of damages has been amended to apply only to fraud on the market cases, which is an improvement. The provision continues to place somewhat arbitrary limits on recoverable damages, however, for reasons that are unclear. In a typical case, damages are based on the difference between the price paid for a security and the market value of that security after information correcting prior fraudulent statements is disclosed. H.R. 10 as reported would provide that, if the plaintiff subsequently sells the stock at a higher price, the plaintiff's recoverable damages must be offset by the amount by which the stock price increased after the corrective information was disclosed. Because this subsequent increase in the price will, by definition, be unrelated to the fraud, there is no apparent justification for offsetting it against the plaintiff's damages.
We believe that this provision is unfair to defrauded investors.
As this legislation advances to the floor of the House, we will continue to support meaningful efforts to deter the filing of meritless securities fraud class action lawsuits, and to sanction those who proceed in bad faith and abuse the process. We cannot, however, countenance efforts that promise to eviscerate the ability of individual investors to protect themselves in the guise of remedying what we all agree have sometimes been excessive and abusive litigation practices.
As we have repeated in the past and will repeat again in the future, the provisions of our securities laws that prohibit fraud are one of this country's most important and powerful weapons in the battle against financial wrongdoing. The record of enforcement of these laws, whether by the SEC, by state securities regulators, or by groups of small individual investors who in effect serve as private attorneys general, demonstrates overwhelmingly that effective laws against fraudulent and corrupt practices are essential to maintaining honest, fair and efficient financial markets.
Legislation that would substantially alter the well-established enforcement mechanisms that exist under the antifraud provisions of the nation's securities laws must be closely scrutinized to ensure that it is has been carefully drafted and is well-tailored to the problems it seeks to address. Title II of H.R. 10 as reported by the Committee fails this crucial test. We again express our hope that our Republican colleagues, who in the past have expressed great concern with undertaking grand social experiments through ill-conceived but well-intended legislation, will abandon their newly found affection for their unprecedented effort to severely cut back the laws that protect investors against financial fraud. If they are willing to commit themselves to working cooperatively with us to develop a careful and responsible bill, we will commit ourselves to working with them to ensure that it is enacted into law.
John D. Dingell.
Edward J. Markey.
Ron Klink.
Gerry Studds.
John Bryant.
Elizabeth Furse.
Henry A. Waxman.
Bart Stupak.
Rick Boucher.
Ron Wyden.
Edolphus Towns.
Bart Gordon.
I find it curious that a securities litigation reform bill as broad in scope as Title II of H.R. 10 entirely ignores the devastating practical effects of one of the most important securities-related decisions to be handed down in years by the U.S. Supreme Court. I am referring to the Central Bank of Denver 1
[Footnote] decision in which a divided Court held that there is no implied private right of action for aiding and abetting under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.
[Footnote 1: Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. 114 S. Ct. 1439 (1994).]
Aiding and abetting is rooted in the common-law doctrine that provides liability for those who do not directly violate the law but who provide assistance to the unlawful acts of others. Until the Supreme Court altered the landscape in May 1994, aiding and abetting liability was an important tool in encouraging honesty and high professional standards by individual professionals--such as lawyers and accountants--who facilitate access to the capital markets. Aiding and abetting played a crucial role in helping taxpayers and investors recover some of their losses from the unprecedented financial frauds of the last decade. Perhaps even more important, the prospect of potential liability for aiding and abetting has served as a powerful deterrent to wrongdoing.
Investors in publicly traded securities often rely on professionals when evaluating investments. Recent scandals on Wall Street, and in the savings and loan debacle, illustrate how important it is for these professional roles to be fulfilled responsibly. Judge Stanley Sporkin--a Reagan appointee who served as General Counsel of the Central Intelligence Agency under William Casey and former head of the Enforcement Division of the SEC--focused the issue with crystal clarity in the Charles Keating securities fraud case (in connection with the Lincoln Savings and Loan debacle) in a series of pointed questions:
There are other unanswered questions presented by this case. Keating testified that he was so bent on doing the `right thing' that he surrounded himself with literally scores of accountants and lawyers to make sure all the transactions were legal. The questions that must be asked are:
Where were these professionals, a number of whom are now asserting their rights under the Fifth Amendment, when these clearly improper transactions were being consummated?
Why didn't any of them speak up or disassociate themselves from the transaction?
Where also were the outside accountants and attorneys when these transactions were effectuated?
What is difficult to understand is that with all the professional talent involved (both accounting and legal), why at least one professional would not have blown the whistle to stop the overreaching that took place in this case.
Absent aiding and abetting civil liability, many of the professionals who act as `gatekeepers,' and on whose credibility both buyers and sellers depend, may be essentially immune from liability.
While the Central Bank decision clearly foreclosed the ability of private litigants to pursue aiders and abettors, it was less clear in its application to actions initiated by the SEC. However, the decision created enough uncertainty that the Securities and Exchange Commission (SEC) asked Congress to provide explicit authority for the SEC to pursue aiders and abettors directly. SEC Chairman Arthur Levitt testified before the Telecommunications and Finance Subcommittee that: `Legislation expressly providing that the Commission can seek injunctions and other relief against aiders and abettors is necessary to preserve fully the strength and flexibility that Congress intended to provide when it enacted the Securities Enforcement Remedies and Penny Stock Reform Act of 1990.'
Echoing these sentiments were the state securities regulators and several prominent legal scholars. Toward that end, I offered an amendment at the full Committee markup to provide explicit authority for the SEC to pursue aiders and abettors. While many commentators urged that aiding and abetting also be restored for private actions, and I offered such an amendment at the Subcommittee markup, I chose to focus my amendment at full Committee on what should have been the non-controversial issue of restoring this legal remedy to the SEC's arsenal against wrongdoers. However, I was unable to present the strong public policy case for this amendment because the Republicans Majority inexplicably and unfairly cut off debate. It should come as no surprise, therefore, that my amendment was defeated on a party line vote. The rejection of this amendment vividly demonstrates that H.R. 10 is not about `reform' or about protecting the rights of truly defrauded investors; it is about protecting a class of special interests who want immunity from all lawsuits, no matter how meritorious.
EDWARD J. MARKEY.
At the full Committee markup of H.R. 10, I offered an amendment that would have amended the Securities Exchange Act of 1934 (Exchange Act) to improve fraud detection and disclosure with respect to public companies in order to facilitate the detection of fraudulent financial reports and assist the Securities and Exchange Commission (SEC) in meeting its responsibility to enforce the antifraud provisions of the Exchange Act. It would accomplish this by codifying existing auditing standards that are pertinent to the detection of financial fraud, and by requiring earlier and more direct reporting to the SEC when independent accountants uncover financial fraud during their audits of Exchange Act registrants.
The Republicans cut off debate and, since there was no opportunity for me or my colleagues to explain to the Committee the strong policy arguments supporting my amendment, it was defeated in a straight party line vote.
The amendment was based on legislation (H.R. 725) that I introduced on January 30, 1995 along with Reps. Dingell and Markey. This legislation represents the response of this Committee 1
[Footnote] to the public record, including extensive Congressional hearings, 2
[Footnote] regarding the administration and enforcement of the antifraud and other provisions of the federal securities laws in the areas of auditing, accounting, and financial reporting. One of the major problems reflected in the record is the rather widespread perception that the accounting profession has filed in its responsibilities, as evidenced by a succession of business failures seemingly related to negligent audits. The Oversight and Investigations Subcommittee hearings, for example, closely examined auditing and accounting problems associated with the failures, among others, of E.S.M. Government Securities Inc., American Savings and Loan Association of Florida, Home State Savings and Loan of Ohio, Beverly Hills Savings and Loan Association, ZZZZ-Best Company, Mission Insurance Company, Transit Casualty Company, and First Executive Corporation.
`Investors, regulators, politicians, and accountants themselves are asking how so many insolvent and fraud-riddled industrial corporations, banks, savings-and-loan associations, and insurance companies could have received clean audits from major firms shortly before they collapsed. 3
[Footnote] Such failures have resulted in substantial harm to the investing public and increased financial burdens on the taxpayer.
[Footnote 1: Substantially similar legislation has been reported unanimously by this Committee and passed by the House previously. During House consideration of the Comprehensive Crime Control Act of 1990 (H.R. 5269), the House adopted an amendment based on auditor responsibility legislation (H.R. 4886 and H.R. 5439) that I introduced in the 99th Congress. That provision was dropped in conference with the Senate. Similar legislation was included as section 487 of the Financial Institutions Safety and Consumer Choice Act of 1991 (H.R. 6), an early version of banking reform legislation that was defeated for reasons unrelated to the auditing provisions. Title II to the Securities Investor Protection Amendments of 1992 (H.R. 5726), passed by the House on September 22, 1992, included the Financial Fraud Detection and Disclosure Act (H.R. 4313, H. Rpt. 102-890) as amended. The legislation, however, failed to pass in the Senate. And in the 103rd Congress, this Committee ordered reported a substantially similar bill (H.R. 574) but no further action was taken due to a jurisdictional dispute involving the House Banking Committee.]
[Footnote 2: Since 1985, the Committee's Subcommittee on Oversight and Investigations has held 34 days of hearings on the accuracy and quality of audits and financial reporting by publicly owned companies and the independent public accountants which are hired to complete the audit. Testimony was received from approximately 200 witnesses.]
[Footnote 3: See William Sternberg, `Washington: Cooked Books,' The Atlantic, Volume 269, No. 1 (January 1992) at 20.]
Last year, this legislation was supported by the accounting profession. The opposition of the Republican Majority to this common sense provision is inexplicable, and only enhances my serious concerns about whether H.R. 10 represents the best public policy that this Committee could report. I strongly believe that it is not. I hope by Republican colleagues will consider working with me cooperatively to secure passage of my amendment when the bill is taken up on the floor of the House. My amendment will help detect and correct frauds before they become private lawsuits and thus will further the goals of H.R. 10.
RON WYDEN.
104th Congress: Democratic Perspectives
103rd-107th
Congress Committee Activity