[Senate Report 104-98]
[From the U.S. Government Publishing Office]
Calendar No. 128
104th Congress Report
SENATE
1st Session 104-98
_______________________________________________________________________
PRIVATE SECURITIES LITIGATION
REFORM ACT OF 1995
__________
R E P O R T
of the
COMMITTEE ON BANKING, HOUSING,
AND URBAN AFFAIRS
UNITED STATES SENATE
to accompany
S. 240
together with
ADDITIONAL VIEWS
June 19, 1995.--Ordered to be printed
__________
U.S. GOVERNMENT PRINTING OFFICE
99-010 WASHINGTON : 1995
(Star Print)
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
ALFONSE M. D'AMATO, New York, Chairman
PHIL, GRAMM, Texas PAUL S. SARBANES, Maryland
RICHARD C. SHELBY, Alabama CHRISTOPHER J. DODD, Connecticut
CHRISTOPHER S. BOND, Missouri JOHN F. KERRY, Massachusetts
CONNIE MACK, Florida RICHARD H. BRYAN, Nevada
LAUCH FAIRCLOTH, North Carolina BARBARA BOXER, California
ROBERT F. BENNETT, Utah CAROL MOSELEY-BRAUN, Illinois
ROD GRAMS, Minnesota PATTY MURRAY, Washington
BILL FRIST, Tennessee
Howard A. Menell, Staff Director
Robert J. Giuffra, Jr., Chief Counsel
Philip E. Bechtel, Deputy Staff Director
Steven B. Harris, Democratic Staff Director and Chief Counsel
------
Subcommittee on Securities
PHIL GRAMM, Texas, Chairman
ROBERT F. BENNETT, Utah CHRISTOPHER J. DODD, Connecticut
RICHARD C. SHELBY, Alabama PATTY MURRAY, Washington
LAUCH FAIRCLOTH, North Carolina BARBARA BOXER, California
ROD GRAMS, Minnesota RICHARD H. BRYAN, Nevada
Wayne A. Abernathy, Staff Director
Laura S. Unger, Counsel
Courtney Ward, Democratic Professional Staff Member
Mitchell Feuer, Democratic Counsel
C O N T E N T S
----------
Page
History of the legislation....................................... 1
Purpose and summary.............................................. 4
Purpose and scope of the legislation:
Background................................................... 8
Elimination of abusive practices in securities litigation.... 10
Removing the incentives to participate in abusive class
action litigation.......................................... 10
New rules relating to the settlement process................. 12
Attorney Sanctions for pursuing meritless litigation......... 13
Stay of discovery............................................ 14
A strong pleading requirement................................ 15
A safe harbor for forward-looking statements or projections.. 15
Written interrogatories...................................... 18
Limiting civil RICO actions.................................. 19
A grant of authority to the SEC to prosecute certain aiding
and abetting cases......................................... 19
Limitation on damages........................................ 19
Modification of joint and several liability.................. 20
Loss Causation requirement for section 12(2) of the 1933 Act. 23
Auditor disclosure of corporate fraud............................ 23
Section-by-section analysis of S. 240............................ 24
Title I--Reduction of Abusive Litigation:
Section 101. Elimination of Certain Abusive Practices.... 24
Section 102. Securities Class Action Reform.............. 24
Section 103. Sanctions for Abusive Litigation............ 26
Section 104. Requirements for Securities Fraud Actions... 26
Section 105. Safe Harbor for Forward-Looking Statements.. 26
Section 106. Written Interrogatories..................... 27
Section 107. Amendment to Racketeer Influenced and
Corrupt Organizations Act.............................. 28
Section 108. Authority of Commission to Prosecute Aiding
and Abetting........................................... 28
Section 109. Limitation on Rescission.................... 28
Section 110. Applicability............................... 28
Title II--Reduction of Coercive Settlements:
Section 201. Limitation on Damages....................... 28
Section 202. Proportionate Liability..................... 29
Section 203. Applicability............................... 29
Title III--Auditor Disclosure of Corporate Fraud:
Section 301. Fraud Detection and Disclosure.............. 29
Regulatory impact statement...................................... 30
Changes in existing law.......................................... 30
Cost of the legislation.......................................... 30
Additional views of Senators Gramm, Mack, Faircloth, Bennett,
Grams, and Frist............................................... 33
Additional views of Senators Sarbanes, Bryan, and Boxer.......... 36
Additional views of Senator Dodd................................. 51
Calendar No. 128
104th Congress Report
SENATE
1st Session 104-98
======================================================================
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
_______
June 19, 1995.--Ordered to be printed
_______
Mr. D'Amato, from the Committee on Banking, Housing, and Urban Affairs,
submitted the following
R E P O R T
together with
ADDITIONAL VIEWS
[To accompany S. 240]
The Committee on Banking, Housing and Urban Affairs, to
which was referred the bill (S. 240), to amend the Securities
Exchange Act of 1934 to establish a filing deadline and to
provide certain safeguards to ensure that the interests of
investors are well protected under the implied private action
provisions of the Act, having considered the same, reports
favorably thereon with an amendment in the nature of a
substitute, and recommends that the bill as amended do pass.
history of the legislation
On January 18, 1995, Senators Domenici and Dodd introduced
S. 240, the ``Private Securities Litigation Reform Act of
1995.'' This legislation, which was cosponsored by Senators
Hatch, Mikulski, Bennett, Moseley-Braun, Lott, Murray, Mack,
Johnston, Faircloth, Conrad, Burns, Chafee, Gorton, Helms, Kyl,
Thomas, Hutchinson, Santorum, and Pell, contains provisions
identical to those contained in S. 1976, which was introduced
in the 103d Congress. Legislation to reform private litigation
under the Federal securities laws, S. 3181, also was introduced
in the 102d Congress.
On June 17, 1993 and July 21, 1993, the Subcommittee on
Securities held hearings on private securities litigation.
Witnesses testifying on June 17 included Edward R. McCracken,
President and
CEO, Silicon Graphics, Inc.; John G. Adler, President and CEO,
Asaptec, Inc.; Richard J. Egan, Chairman, EMC Corp.; Thomas
Dunlap, Jr., General Counsel, Intel Corp.; William R. McLucas,
Director of the Division of Enforcement, Securities and
Exchange Commission (``SEC''); Mark J. Griffin, Director,
Securities Division of the Department of Commerce of the State
of Utah, who testified on behalf of the North American
Securities Administrators Association, Inc.; Joel Seligman,
Professor, University of Michigan Law School; Patricia Reilly,
an investor; Vincent E. O'Brien, Law and Economics Consulting
Group, Inc.; William S. Lerach, Partner, Milberg Weiss Bershad
Hynes & Lerach; Gordon K. Billipp, an investor; Russell E.
Ramser, Jr., an investor; and Edward J. Radetich, President,
Heffler & Co.
Witnesses testifying on July 21 included Representative
W.J. ``Billy'' Tauzin; Representative Ron Wyden; Jake L.
Netterville, Managing Partner, Postlethwaite & Netterville, who
testified on behalf of the American Institute of Certified
Public Accountants; A.A. Sommer, Jr., Chairman, Public
Oversight Board, American Institute of Certified Public
Accountants; Ralph V. Whitworth, President, United Shareholders
Association; Abraham J. Briloff, Professor, Baruch College,
CUNY; Melvyn I. Weiss, Partner, Milberg Weiss Bershad Hynes &
Lerach; Richard A. Bowman, Executive Vice President and CFO,
ITT Corp., who testified on behalf of the Financial Executives
Institute; Marc E. Lackritz, President, Securities Industry
Association; Ralph Nader, Public Citizen; and Maryellen F.
Andersen, Investor and Corporate Relations Director,
Connecticut Retirement & Trust Funds and Treasurer of the
Council of Institutional Investors. Additional material was
supplied for the record by a large number of parties.
On March 24, 1994, Senators Dodd, Domenici, Mikulski,
Johnston, and Faircloth introduced S. 1976, the ``Private
Securities Litigation Reform Act of 1994.''
On May 12, 1994, the Subcommittee on Securities held a
hearing on the Supreme Court's decision in Central Bank of
Denver v. First Interstate Bank of Denver,\1\ which held that
private parties could not bring suit under Section 10(b) of the
Securities Exchange Act of 1934 (the ``1934 Act'') and SEC Rule
10b-5 against alleged aiders and abettors of persons violating
the Federal securities laws. Witnesses included Senator Howard
Metzenbaum; Arthur Levitt, Chairman, SEC; Donald C. Langevoort,
Professor, Vanderbilt Law School; Mark J. Griffin, Director,
Securities Division of the Department of Commerce of the State
of Utah, who testified on behalf of the North American
Securities Administrators Association, Inc.; Stuart J. Kaswell,
Senior Vice President and General Counsel, Securities Industry
Association; Harvey J. Goldschmid, Professor, Columbia
University School of Law; Eugene I. Goldman, Partner,
McDermott, Will & Emery; and David S. Ruder, former Chairman,
SEC, and Professor, Northwestern University School of Law.
Harvey I. Pitt, Partner, Fried, Frank, Harris, Shriver &
Jacobson, and Joel Seligman, Professor, University of Michigan
Law School supplied additional material for the record.
---------------------------------------------------------------------------
\1\ 114 S. Ct. 1439 (1994).
---------------------------------------------------------------------------
On May 17, 1994, the Subcommittee on Securities issued a
163 page Staff Report on private securities litigation.
On March 2, and 22, 1995, and April 6, 1995, the
Subcommittee on Securities held hearings on securities
litigation reform legislation. Witnesses testifying on March 2
included Senator Christopher J. Dodd; Senator Pete V. Domenici;
Marc E. Lackritz, President, Securities Industry Association;
J. Carter Beese, former Commissioner, SEC, and Chairman,
Capital Markets Regulatory Reform Project of the Center for
Strategic and International Studies; Nell Minow, Principal,
LENS, Inc.; James F. Morgan, Founder and Chairman, Morgan,
Holland Ventures, who testified on behalf of the National
Venture Capital Association; Christopher J. Murphy III,
President and CEO, 1st Source Corp., who testified on behalf of
the Association of Publicly Traded Companies; and George
Sollman, CEO, Centigram Communications Corp., who testified on
behalf of the American Electronics Association.
Witnesses testifying on March 22 included mark J. Griffin,
Director, Securities Division of the Department of Commerce of
the State of Utah, who testified on behalf of the North
American Securities Administrators Association, Inc.; Joan R.
Gallo, City Attorney, San Jose, California; Sheldon H. Elsen,
who testified on behalf of The Association of the Bar of the
City of New York; David Guin, Partner, Ritchie and Rediker, who
testified on behalf of the National Association of Securities
and Commercial Law Attorneys; and Bartlett Naylor, National
Coordinator, Office of Corporate Affairs, International
Brotherhood of Teamsters.
Witnesses testifying on April 6 included Senator Barbara
Mikulski; The Honorable Arthur Levitt, Chairman, SEC; Richard
C. Breeden, former Chairman, SEC; and Charles Cox, former
Commissioner and former Acting Chairman, SEC.
On May 25, 1995, the Committee met in Executive Session to
consider S. 240 and adopted an amendment in the nature of a
substitute that was offered by Chairman Alfonse M. D'Amato and,
by a vote of 11-4, ordered S. 240 favorably reported. Senators
Shelby, Sarbanes, Bryan, and Boxer voted against this
legislation. Senator Bond recused himself from voting. The
Committee adopted by a voice vote an amendment offered by
Senator Bennett to amend section 12(2) of the Securities Act of
1933 (the ``1933 Act''). The Committee did not adopt amendments
offered by Senator Bryan to extend the statute of limitations
for private actions under the 1934 Act (6-9) (with Senators
Shelby, Sarbanes, Dodd, Kerry, Bryan, and Boxer voting in favor
of the amendment); by Senator Sarbanes to delegate promulgation
of a safe harbor provision for forward looking statements to
SEC rulemaking (5-10) (with Senators Sarbanes, Kerry, Bryan,
Boxer and Murray voting in favor of the amendment); by Senator
Sarbanes to revise the scienter language of the safe harbor
provision adopted by the Committee (4-11) (with Senators
Sarbanes, Kerry, Bryan and Boxer voting in favor of the
amendment); by Senator Boxer to exempt from the statutory safe
harbor retirement plans for senior citizens (4-11) (with
Senators Sarbanes, Kerry, Bryan, and Boxer voting in favor of
the amendment); and by Senator Bryan to revise the
proportionate liability provision adopted by the Committee (5-
10) (with Senators Shelby,
Sarbanes, Kerry, Bryan, and Boxer voting in favor of the
amendment).
The Committee withheld consideration of two amendments
pending further review: (i) to increase the uncollectible share
provision for proportionate liability from 50% to 100%; and
(ii) to provide for liability in private actions under Rule
10b-5 for aiders and abettors of primary securities law
violators.
purpose and summary
During the Great Depression, Congress enacted the 1933 and
1934 Acts to promote investor confidence in the United States
securities markets and thereby to encourage the investment
necessary for capital formation, economic growth, and job
creation. The Committee heard substantial testimony that today
certain lawyers file frivolous ``strike'' suits alleging
violations of the Federal securities laws in the hope that
defendants will quickly settle to avoid the expense of
litigation. These suits, which unnecessarily increase the cost
of raising capital and chill corporate disclosure, are often
based on nothing more than a company's announcement of bad
news, not evidence of fraud. All too often, the same
``professional'' plaintiffs appear as name plaintiffs in suit
after suit.
S. 240, the ``Private Securities Litigation Reform Act of
1995,'' is intended to lower the cost of raising capital by
combatting these abuses, while maintaining the incentive for
bringing meritorious actions. Specifically, S. 240 intends: (1)
to encourage the voluntary disclosure of information by
corporate issuers; (2) to empower investors so that they--not
their lawyers--exercise primary control over private securities
litigation; and (3) to encourage plaintiffs' lawyers to pursue
valid claims and defendants to fight abusive claims. Senator
Pete Domenici, one of two original co-sponsors of this
legislation, expects that S. 240 ``will return some fairness
and common sense to our broken securities class action
litigation system, while continuing to provide the highest
level of protection to investors in our capital markets.'' \2\
---------------------------------------------------------------------------
\2\ Statement of Senator Pete Domenici, Hearing on Securities
Litigation Reform Proposals: Subcommittee on Securities, Senate
Committee on Banking, Housing, and Urban Affairs, March 2, 1995.
---------------------------------------------------------------------------
The federal securities laws and SEC rules prohibit the
making of false and misleading statements or omissions in
connection with the purchase and sale of securities. Under
these provisions, the SEC has broad regulatory and enforcement
powers. In addition, investors may bring private actions for
violations of the federal securities laws. These actions
typically rest upon the so called ``catch-all'' fraud provision
in Section 10(b) of the 1934 Act and SEC Rule 10b-5.
Congress has never expressly provided for private rights of
action when it enacted Section 10(b). Instead, courts have held
that Congress impliedly authorized such actions. As a result,
10(b) litigation has evolved out of judicial decisionmaking,
not specific legislative action. The lack of congressional
involvement has left judges free to develop conflicting legal
standards, thereby creating substantial uncertainties and
opportunities for abuses of investors, issuers, professional
firms and others.
The Committee has determined that now is the time for
Congress to reassert its authority in this area. As Chairman
D'Amato made clear: ``There is broad agreement on the need for
reform. Shareholders' groups, Corporate America, the SEC, and
even lawyers all want to curb abusive practices. Lawyers who
bring meritorious suits do not benefit when strike suit artists
wreak havoc on the Nation's boardrooms and courthouses. Our
economy does not benefit when the threat of litigation deters
capital formation.'' \3\ Senator Dodd similarly said: ``The
flaws in the current private securities litigation system are
simply too obvious to deny. The record is replete with examples
of how the system is being abused and misused.'' \4\ SEC
Chairman Arthur Levitt concurred: ``[T]here is no denying that
there are real problems in the current system--problems that
need to be addressed not just because of abstract rights and
responsibilities, but because investors and markets are being
hurt by litigation excesses.'' \5\
---------------------------------------------------------------------------
\3\ Statement of Chairman Alfonse M. D'Amato, Hearing on Securities
Litigation Reform Proposals: Subcommittee on Securities, Senate
Committee on Banking, Housing, and Urban Affairs, March 2, 1995.
\4\ Statement of Senator Christopher J. Dodd, Hearing on Securities
Litigation Reform Proposals: Subcommittee on Securities, Senate
Committee on Banking, Housing, and Urban Affairs, March 2, 1995.
\5\ Arthur Levitt, ``Between Caveat Emptor and Caveat Vendor: The
Middle Ground of Litigation Reform,'' Remarks at the 22nd Annual
Securities Regulation Institute, San Diego, California (January 25,
1995).
---------------------------------------------------------------------------
The purposes of S. 240 are threefold.
1.--S. 240 is intended to encourage the voluntary
disclosure of information by issuers. The hallmark of our
securities laws is broad, timely disclosure to investors of
information about the financial condition of publicly traded
companies. The mere specter of 10b-5 liability, however, has
become more than a deterrent to fraud. Private securities class
actions under 10b-5 inhibit free and open communication among
management, analysts, and investors. This has caused corporate
management to refrain from providing shareholders forward-
looking information about companies. According to the SEC:
``the threat of mass shareholder litigation, whether real or
perceived,'' has had adverse effects, especially in ``chilling
* * * disclosure of forward-looking information.'' \6\ Public
companies--particularly high-tech, bio-tech and other growth
companies, which are sued disproportionately in 10b-5
litigation--fear that releasing such information makes them
even more vulnerable to attack. As a result, investors often
receive less, not more, information, which makes investing more
risky and increases the cost of raising capital.
---------------------------------------------------------------------------
\6\ Safe Harbor for Forward-Looking Statements, Exchange Act Rel.
No. 33-7107 (October 13, 1994).
---------------------------------------------------------------------------
To reduce this chill on voluntary disclosures by issuers,
S. 240 creates a carefully tailored safe harbor for forward-
looking statements. This safe harbor applies only to
projections or estimates that are identified as forward-looking
statements and that refer ``clearly'' and ``proximately'' to
``the risk that actual results may differ materially from'' the
projection or estimate. The safe harbor has several other
important limitations. For example, the safe harbor would not
apply to initial public offerings of securities. In addition,
the SEC's enforcement authority would not be limited by the
provisions in S. 240. To the contrary, S. 240 expands the SEC's
enforce-
ment authority with respect to forward-looking statements by
authorizing the SEC to recover damages on behalf of investors
injured by such statements.
2.--S. 240 is intended to empower investors so that they,
not their lawyers, control securities litigation. Under the
current system, the initiative for filing 10b-5 suits comes
almost entirely from the lawyers, not from genuine investors.
Lawyers typically rely on repeat, or ``professional,''
plaintiffs who, because they own a token number of shares in
many companies, regularly lend their names to lawsuits. Even
worse, investors in the class usually have great difficulty
exercising any meaningful direction over the case brought on
their behalf. The lawyers can decide when to sue and when to
settle, based largely on their own financial interests, not the
interests of their purported clients.
Numerous studies show that investors recover only 7 to 14
cents for every dollar lost as a result of securities fraud.
Indeed, a 1994 Securities Subcommittee Staff Report found
``evidence * * * that plaintiffs' counsel in many instances
litigate with a view toward ensuring payment for their services
without sufficient regard to whether their clients are
receiving adequate compensation in light of evidence of
wrongdoing.'' \7\ The comment by one plaintiffs' lawyer--``I
have the greatest practice of law in the world. I have no
clients.'' \8\--aptly summarizes this flaw in the current
system.
---------------------------------------------------------------------------
\7\ ``Majority Staff of the Subcommittee on Securities of the
Senate Committee on Banking, Housing, and Urban Affairs, Report on
Private Securities Litigation,'' 103d Congress, 2d Session (1994).
\8\ William P. Barrett, ``I Have No Clients,'' Forbes, October 11,
1993.
---------------------------------------------------------------------------
S. 240 contains several provisions to transfer primary
control of private securities litigation from lawyers to
investors. First, S. 240 creates a presumption, rebuttable
under certain conditions, that the member of a purported class
of investors with the largest financial interest in the case
will serve as the lead plaintiff, thereby increasing the role
of institutional investors in securities class actions. Second,
S. 240 requires greater disclosure of settlement terms,
including the reasons for a settlement, to class members,
allowing them to object to, or raise questions about, the
settlement. Third, S. 240 prohibits several abusive practices,
such as the payment of bounties to named plaintiffs, that have
enabled lawyers to exercise nearly total fiat over the course
of private securities litigation.
3.--S. 240 is intended to encourage plaintiffs' lawyers to
pursue valid claims for securities fraud and to encourage
defendants to fight abusive claims. The dynamics of private
securities litigation create powerful incentives to settle,
causing securities class actions to have a much higher
settlement rate than other types of class actions. Many such
actions are brought on the basis of their settlement value. The
settlement value to defendants turns more on the expected costs
of defense than the merits of the underlying claim. The Supreme
Court has recognized that ``litigation under Rule 10b-5
presents a danger of vexatiousness different in degree and in
kind from that which accompanies litigation in general.'' \9\
---------------------------------------------------------------------------
\9\ Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 185, 739
(1975).
---------------------------------------------------------------------------
As SEC Chairman Levitt explained, because class counsel
usually advances the costs of litigation, ``counsel may have a
greater
incentive than the members of the class to accept a settlement
that provides a significant fee and eliminates any risk of
failure to recoup funds already invested in the case.'' \10\ If
a defendant cannot win an early dismissal of the case, ``the
economics of litigation may dictate a settlement even if the
defendant is relatively confident that it would prevail a
trial.'' \11\
---------------------------------------------------------------------------
\10\ ``Securities Litigation Reform: Hearings Before the
Subcommittee on Telecommunications and Finance of the House Committee
on Energy and Commerce,'' 103d Congress, 2d Session, 35-36 (1994).
\11\ Id. at 36.
---------------------------------------------------------------------------
This incentive to settle stems not only from legal fees
incurred but also from the doctrine of joint and several
liability, which requires a defendant to pay 100 percent of the
damages even if the defendant is only one percent responsible.
As Chairman D'Amato stressed: ``the threat of such liability
often forces innocent `deep pocket' defendants to settle
frivolous suits.'' \12\ Chairman Levitt similarly concluded:
``Because the existing safeguards provided by the system are
imperfect, there is a danger that weak claims may be
overcompensated while strong claims are undercompensated.''
\13\
---------------------------------------------------------------------------
\12\ D'Amato Statement, supra, note 3.
\13\ House hearings, note 10, supra, at 36.
---------------------------------------------------------------------------
S. 240 includes several provisions to reduce the settlement
value of frivolous securities class actions. First, S. 240,
while retaining joint and several liability for defendants who
knowingly engage in securities fraud, adopts a modified
proportionate liability standard for defendants found to be
less culpable. In cases involving insolvent co-defendants who
are found to be proportionately liable, a remaining defendant
must pay the share reflecting his or her degree of
responsibility plus all or part of the uncollectible amount but
only up to 50 percent of its share of the original judgment.
Joint and several liability is also retained for all small
investors whose net worth is $200,000 or less and who lose more
than ten percent of their net worth as a result of the fraud.
Second, S. 240 clarifies the pleading requirements for bringing
securities fraud claims by adopting a standard modelled on that
currently applied by the United States Court of Appeals for the
Second Circuit, the leading circuit court in this area. Third,
S. 240 requires courts to make findings regarding compliance by
all attorneys and all parties with Rule 11(b) of the Federal
Rules of Civil Procedure, which authorizes the imposition of
sanctions when a complaint is legally frivolous, lacks
evidentiary support, or is otherwise abusive.
S. 240 includes several other provisions intended to reduce
the cost of raising capital. These provisions include
establishing guidelines for calculating damages; codifying the
requirement under current law that plaintiffs prove that the
loss in the value of their stock was caused by the Section
10(b) violation and not by other factors; requiring auditors to
notify the SEC of illegal acts that management has not
adequately addressed; prohibiting the use of conduct actionable
as securities fraud as the basis of private treble damages
actions under the Racketeer Influenced and Corrupt
Organizations Act (``RICO''); and clarifying the ability of the
SEC to bring aiding and abetting claims. None of the provisions
in S. 240 affects the SEC's ability to bring enforcement
actions.
Purpose and Scope of the Legislation
background
The United States securities markets are the most liquid
and deep in the world. In just the past ten years, capital
raised has risen by 1,000%. Over the last three years, the U.S.
securities industry has set new records in corporate
underwriting and raising capital for new businesses.\14\ In
1994, the industry raised $1 trillion for businesses, including
$34 billion for small businesses making their first foray into
the capital markets.\15\
---------------------------------------------------------------------------
\14\ Through the U.S. securities markets, corporate issuers raised
$76 billion in 1992, $102 billion in 1993, and $130 billion in 1994.
Small businesses making initial public offerings of stock raised $40
billion in 1992, $57 billion in 1993, and $34 billion in 1994.
``Securities Industry Trends,'' Securities Industry Association
Newsletter, April 5, 1995.
\15\ Id. The $1 trillion figure includes private placements,
underwriting and domestic medium-term note programs.
---------------------------------------------------------------------------
The Nation's capital markets play a critical role in our
domestic economy by creating jobs and expanding businesses.
Small and emerging businesses now account for two-thirds of the
new jobs in America.\16\ Strong capital markets enhance the
United States' competitiveness in the global markets.
---------------------------------------------------------------------------
\16\ Testimony of James F. Morgan on behalf of the National Venture
Capital Association, Hearings on Securities Litigation Reform
Proposals: Subcommittee on Securities, Senate Committee on Banking,
Housing, and Urban Affairs, March 2, 1995.
---------------------------------------------------------------------------
The success of the U.S. securities markets is largely the
result of a high level of investor confidence in the integrity
and efficiency of our markets. The SEC enforcement program and
the availability of private rights of action together provide a
means for defrauded investors to recover damages and a powerful
deterrent against violations of the securities laws. As noted
by SEC Chairman Levitt, ``private rights of action are not only
fundamental to the success of our securities markets, they are
an essential complement to the SEC's own enforcement program.''
\17\ The Supreme Court has also described private securities
actions as a ``necessary supplement'' to the SEC's enforcement
regime.\18\
---------------------------------------------------------------------------
\17\ Arthur Levitt, ``Between Caveat Emptor and Caveat Vendor''
supra, note 5.
\18\ 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. Barak, 377 U.S. 426, 432 (1964).
---------------------------------------------------------------------------
Although private securities class actions can complement
SEC enforcement actions, the evils flowing from abusive
securities litigation start with the filing of the complaint
and continue through to the final disposition of the action. A
complaint alleging violations of the Federal securities laws is
easy to craft and can be filed with little or no due diligence.
A drop in a public company's stock price, a failed product
development project, or even unpredictable adverse market
conditions that affect earnings results for a quarter can
trigger numerous securities fraud lawsuits against a company.
One study concluded that, in the early 1980's every company
in one business sector that suffered a market loss of $20
million or more in its capitalization was sued.\19\ Another
survey of venture-backed companies in existence for less than
ten years revealed that one in six had been sued at least once,
and that such lawsuits had already consumed an average of 1,055
hours of management time and $692,000 in legal fees.\20\
---------------------------------------------------------------------------
\19\ Janet Cooper Alexander, ``Do the Merits Matter? A Study of
Settlements in Securities Class Actions,'' 43 Stan. L. Rev. 497, 551-
13 (1991).
\20\ Many of these lawsuits are still pending. Testimony of James
F. Morgan, supra, note 16.
---------------------------------------------------------------------------
Most defendants in securities class action lawsuits choose
to settle rather than face the enormous expense of discovery
and trial. Of the approximately 300 securities lawsuits filed
each year, almost 93% settle at an average settlement cost of
$8.6 million.\21\ These cases are generally settled based not
on the merits but on the size of the defendant's pocketbook.
---------------------------------------------------------------------------
\21\ Testimony of George H. Sollman on behalf of the American
Electronics Association: Hearings on Securities Litigation Reform
Proposals: Subcommittee on Securities, Senate Committee on Banking,
Housing, and Urban Affairs, March 2, 1995.
---------------------------------------------------------------------------
The fact that many of these lawsuits are filed as class
actions has had an in terrorem effect on Corporate America. A
whole stable of ``professional plaintiffs,'' who own shares--or
sometimes fractions of shares--in many companies, stand ready
to lend their names to class action complaints. These lawsuits
have added significantly to the cost of raising capital and
represent a ``litigation tax'' on business.\22\ Smaller start-
up companies bear the brunt of abusive securities fraud
lawsuits. Many of these companies are high-technology companies
which, by their very nature, have unpredictable business
prospects and, consequently, volatile stock prices.\23\
---------------------------------------------------------------------------
\22\ Testimony of Marc E. Lackritz, on behalf of the Securities
Industry Association: Hearings on Securities Litigation Reform
Proposals: Subcommittee on Securities, Senate Committee on Banking,
Housing, and Urban Affairs, March 2, 1995. Testimony of former SEC
Commissioner J. Carter Beese, on behalf of the Center for Strategic and
International Studies, Hearings on Securities Litigation Reform
Proposals: Subcommittee on Securities, Senate Committee on Banking,
Housing, and Urban Affairs, March 2, 1995.
\23\ Testimony of Edward R. McCracken, President and Chief
Executive Officer of Silicon Graphics, Inc. and Co-Chairman of the
American Entrepreneurs for Economic Growth, Hearings on Private
Litigation Under Federal Securities Laws: Subcommittee on Securities,
Senate Committee on Banking, Housing, and Urban Affairs, June 17, 1993.
---------------------------------------------------------------------------
This abusive litigation also threatens to undermine one of
the underpinnings of the Federal securities laws--disclosure to
investors. Risk-averse corporate management avoid discussions
of future business plans. Many companies refuse to talk or
write about future business plans, knowing that projections
that fail to materialize will inevitably result in a
lawsuit.\24\
---------------------------------------------------------------------------
\24\ Testimony of George H. Sollman, supra, note 21.
---------------------------------------------------------------------------
Underwriters, lawyers, accountants, and other professionals
are prime targets of abusive securities lawsuits. The deeper
the pocket, the greater the likelihood that a marginal party
will be named as a defendant in a securities class action. The
availability of insurance also drives these lawsuits. In 1994
alone, $1.4 billion was paid out by corporations or their
insurers to settle securities lawsuits.\25\
---------------------------------------------------------------------------
\25\ ``GOP Targets Shareholder Suits,'' Investors Business Daily,
February 26, 1995, p. A1.
---------------------------------------------------------------------------
The ``victims'' on whose behalf these lawsuits are
allegedly brought often receive only pennies on the dollar in
damages.\26\ Even worse, long-term investors ultimately end up
paying the costs associated with the lawsuits. As the Council
for Institutional Investors advised: ``We are * * * hurt if a
system allows someone to force us to spend huge sums of money
in legal costs by merely paying ten dollars and filing a
meritless cookie cutter complaint against a company or its
accountants when that plaintiff is disappointed in his or her
investment.'' \27\
---------------------------------------------------------------------------
\26\ Testimony of Patricia Reilly, ``Hearing on Private Litigation
Under Federal Securities Laws: Subcommittee on Securities, Senate
Committee on Banking, Housing, and Urban Affairs,'' June 17, 1993; See,
Majority Staff Report, supra, note 7.
\27\ Testimony of Maryellen Andersen, Council of Institutional
Investors, Hearing on Private Litigation Under Federal Securities Laws:
Subcommittee on Securities, Senate Committee on Banking, Housing, and
Urban Affairs, July 21, 1993.
---------------------------------------------------------------------------
In crafting this legislation, the Committee has sought to
strike the appropriate balance between protecting the rights of
victims of securities fraud and the rights of public companies
to avoid costly and meritless litigation. Our economy does not
benefit when strike suit artists wreak havoc on our Nation's
boardrooms and deter capital formation.
elimination of abusive practices in securities litigation
Removing the incentives to participate in abusive class action
litigation
The Securities Subcommittee heard extensive testimony
concerning certain areas of abuse involving class actions.
These abuses include the use of professional plaintiffs and the
race to the courthouse to be the first to file the
complaint.\28\ State securities regulators testified that
reform in both of these areas would ``create a more rational
system for the filing of these cases.'' \29\
---------------------------------------------------------------------------
\28\ See, Testimony of Arthur Levitt, Hearings on H.R. 10, the
Common Sense Legal Reform Act of 1995, Subcommittee on
Telecommunications and Finance, House Commerce Committee, February 10,
1995.
\29\ Testimony of Mark J. Griffin, Director of Utah Department of
Commerce, Division of Securities, on behalf of the North American
Securities Administrators Association, Hearings on Securities
Litigation Reform Proposals: Subcommittee on Securities, Senate
Committee on Banking, Housing, and Urban Affairs, March 22, 1995.
---------------------------------------------------------------------------
The proliferation of ``professional'' plaintiffs has made
it particularly easy for lawyers to find individuals willing to
play the role of wronged investor for purposes of filing a
class action lawsuit. Professional plaintiffs often are
motivated by the payment of a ``bonus'' far in excess of their
share of any recovery.
The Committee believes that lead plaintiffs are not
entitled to a bounty for their service. Thus, the lead
plaintiff's share of any final judgment of any settlement
should be calculated in the same manner as the shares of the
other class members. Recognizing that service as the lead
plaintiff may require court appearances or other duties
involving time away from work, the Committee grants courts
discretion to award the lead plaintiff reimbursement for
``reasonable costs and expenses'' (including lost wages)
directly relating to representation of the class.
The Committee recognizes that certain basic information
about the lead plaintiff should be provided at the outset of
litigation. Accordingly, the Committee requires that the lead
plaintiff file a sworn certified statement with the complaint.
The plaintiff must certify that he or she: (a) reviewed and
authorized the filing of the complaint; (b) did not purchase
the securities at the direction of counsel or to participate in
a lawsuit; and (c) is willing to serve on behalf of the class.
To further deter professional plaintiffs, the plaintiff must
also identify any transactions in the securities covered by the
class period, and the other lawsuits in which the plaintiff has
sought to serve as lead plaintiff in the last three years.
The lead plaintiff should actively represent the class. The
Committee believes that the lead plaintiff--not lawyers--should
drive the litigation. As one witness testified: ``One way of
addressing this problem is to restore lawyers and clients to
their traditional roles by making it harder for lawyers to
invent a suit and then attach a plaintiff.'' \30\
---------------------------------------------------------------------------
\30\ Testimony of Mark E. Lackritz, supra, note 22.
---------------------------------------------------------------------------
Courts traditionally appoint the lead plaintiff and lead
counsel in class action lawsuits on a ``first come, first
serve'' basis. Since no deference is given to the most
thoroughly researched complaint, the lawyers spend minimal time
preparing complaints in securities class actions. The first
lawsuit filed also renders the lead plaintiff.
The Committee believes that the selection of the lead
plaintiff should rest on considerations other than a speedy
filing of the complaint. The Committee establishes procedures
for the appointment of the lead plaintiff in class actions
brought under both the 1933 Act and 1934 Act. Within 20 days of
filing a complaint, the plaintiff must publish in a widely
circulated business publication notice of the complaint, and
that members of the purported class may move the court to serve
as lead plaintiff within 60 days. The Committee does not intend
for the members of the purported class who seek to serve as
lead plaintiff to file with this motion the certification
described above. The Committee intends ``publication'' to
encompass a variety of mediums, including wire, electronic, or
computer services.
The Committee intends to increase the likelihood that
institutional investors will serve as lead plaintiffs by
requiring the court to presume that the member of the purported
class with the largest financial stake in the relief sought is
the ``most adequate plaintiff.'' Institutional investors are
America's largest shareholders, with about $9.5 trillion in
assets, accounting for 51% of the equity market. Pension Funds
total $4.5 trillion of institutional assets.\31\ The current
system often works to prevent institutional investors from
selecting counsel or serving as lead plaintiff in class
actions.\32\
---------------------------------------------------------------------------
\31\ The Brancato Report on Institutional Investment, ``Total
Assets and Equity Holdings'' Volume 2, Edition 1.
\32\ Elliott J. Weiss and John S. Beckerman, ``Let the Money Do the
Monitoring: How Institutional Investors Can Reduce Agency Costs in
Securities Class Actions' '' 104 The Yale Law Journal (1995). This
article provided the basis for the ``most adequate plaintiff''
provision.
---------------------------------------------------------------------------
The Committee believes that increasing the role of
institutional investors in class actions will ultimately
benefit the class and assist the courts. According to one
representative of institutional investors: ``As the largest
shareholders in most companies, we are the ones who have the
most to gain from meritorious securities litigation.'' \33\
---------------------------------------------------------------------------
\33\ Testimony of Maryellen Anderson, supra, note 27.
---------------------------------------------------------------------------
Scholars predict that increasing the role of institutional
investors will benefit both injured shareholders and courts:
``Institutions with large stakes in class actions have much the
same interests as the plaintiff class generally; thus, courts
could be more confident settlements negotiated under the
supervision of institutional plaintiffs were `fair and
reasonable' than is the case with settlements negotiated by
unsupervised plaintiffs' attorneys'' \34\ The Committee
believes that an institutional investor acting as lead
plaintiff can, consistent with its fiduciary obligations,
balance the interests of the class with the long-term interests
of the company and its public investors.
---------------------------------------------------------------------------
\34\ ``Let the Money Do the Monitoring,'' supra, note 32.
---------------------------------------------------------------------------
Finally, the Committee permits the lead plaintiff to choose
the class counsel. This provision is intended to permit the
plaintiff to choose counsel rather than have counsel choose the
plaintiff. Although the Committee permits the most adequate
plaintiff to
choose class counsel, the Committee does not intend to disturb
the court's discretion under existing law to approve or
disapprove the lead plaintiff's choice of counsel when
necessary to protect the interests of the plaintiff class.
New rules relating to the settlement process
The Securities Subcommittee also heard testimony that
counsel in securities class actions receive a disproportionate
share of the settlement award and that class members frequently
lack meaningful information about the terms of the proposed
settlement.\35\
---------------------------------------------------------------------------
\35\ Testimony of Patricia Reilly, supra, note 26.
---------------------------------------------------------------------------
Under current practice, courts generally award attorney's
fees based on the so-called ``lodestar'' approach--i.e., the
court multiplies the attorney's hours by a reasonable hourly
fee, which may be increased by an additional amount based on
risk or other relevant factors.\36\ As a result of this
methodology, attorney's fees have exceeded 50% or more of the
settlement awarded to the class. The Committee limits the award
of attorney's fees and costs to a reasonable percentage of the
amount of recovery awarded to the class. By not fixing the
percentage of attorney's fees and costs that may be awarded,
the Committee intends to give the court flexibility in
determining what is reasonable on a case-by-case basis. The
provision focuses on the final amount of damages awarded, not
the means by which they are calculated.
---------------------------------------------------------------------------
\36\ See generally, Majority Staff Report, supra note 7, at 81 et
seq.
---------------------------------------------------------------------------
Class members often receive insufficient notice of the
terms of a proposed settlement and, thus, have little basis to
evaluate the settlement. As one bar association advised,
``settlement notices provided to class members are often obtuse
and confusing, and should be written in plain English.'' \37\
The Committee received similar testimony from an investor who
was a class member in two separate securities fraud lawsuits:
``Nowhere in the settlement notices were the stockholders told
of how much they could expect to recover of their losses. * * *
I feel that the settlement offer should have told the
stockholders how little of their losses will be recovered in
the settlement, and that this is a material fact to the
shareholder's decision to approve or disapprove the
settlement.'' \38\
---------------------------------------------------------------------------
\37\ NASCAT Analysis of Pending Legislation on Securities Fraud
Litigation, hearing on Securities Litigation Reform Proposals:
Subcommittee on Securities, Senate Committee on Banking, Housing, and
Urban Affairs, March 2, 1995.
\38\ Testimony of Patricia Reilly, supra, note 26.
---------------------------------------------------------------------------
The Committee requires that certain information be included
in any proposed or final settlement agreement disseminated to
class members. To ensure that critical information is readily
ascertainable to class members, the Committee requires that
such information appear in summary form on the cover page of
the notice. The notice must contain a statement of the average
amount of damages per share that would be recoverable if the
settling parties can agree on a figure, or a statement from
each settling party on why there is disagreement. It must also
explain the attorney's fees and costs sought. The name,
telephone number, and address of counsel for the class must be
provided, and such counsel must be reasonably available to
answer class members' questions about the settlement. Perhaps
most importantly, the notice must include a brief statement
explaining the reason for the proposed settlement.
Although generally barring the filing of settlement
agreements under seal, the Committee recognizes that legitimate
reasons may exist for the court to permit the entry of a
settlement or portions of a settlement under seal. A party must
show ``good cause,'' i.e., that the publication of a portion or
portions of the settlement agreement would result in direct and
substantial harm. The Committee intends that ``direct and
substantial harm'' would include reputational injury to a
party.
Attorney sanctions for pursuing meritless litigation
The Securities Subcommittee heard ample testimony on the
need to reduce the economic incentive to file meritless claims.
Under Rule 11 of the Federal Rules of Civil Procedure, the
courts may impose sanctions against an attorney or party for
the filing of an abusive lawsuit.\39\ Many believe that Rule 11
has not been an effective tool in limiting abusive litigation.
Complaints about the current system include the high cost of
making a Rule 11 motion, and the unwillingness of courts to
impose sanctions, even when the rule is violated.\40\
---------------------------------------------------------------------------
\39\ Rule 11 governs all pleadings, written motions and other
papers filed with the court. Under Rule 11(b), the attorney's signature
on such papers certifies that:
(1) it is not being presented for an improper purpose, such as to
harass or to cause unnecessary delay or needless increase in the cost
of litigation;
(2) the claims, defenses, and other legal contentions therein are
warranted by existing law or by a non-frivolous argument for the
extension, modification, or reversal of existing law or the
establishment of new law;
(3) the allegations and other factual contentions have evidentiary
support or, if specifically so identified, are likely to have
evidentiary support after a reasonable opportunity for further
investigation or discovery; and
(4) the denials of factual contentions are warranted on the
evidence or, if specifically so identified are reasonably based on a
lack of information or belief.
\40\ See, response by Thomas Dunlap, Jr., General Counsel, Intel
Corporation, to Written Questions of Senator Domenici, ``Private
Litigation Under the Federal Securities Laws: Hearings Before the
Subcommittee on Securities of the Senate Committee on Banking, Housing,
and Urban Affairs,'' 103d Cong., 1st Session. S. Hrg. No. 103-431
(1993) (noting that ``Rule 11 is rarely enforced in Federal Courts'').
---------------------------------------------------------------------------
Several proposals have been advanced to reduce the economic
incentive to file abusive securities fraud suits.\41\ The
Committee recognizes the need to reduce significantly the
economic incentive to file meritless lawsuits without hindering
the ability of the victims of fraud to pursue legitimate
claims.
---------------------------------------------------------------------------
\41\ See, Majority Staff Report, 45-48, supra, note 7.
The original S. 240 contained a provision allowed for fee shifting
in cases where a party unreasonably refused to enter into Alternative
Dispute Resolution (``ADR''), if that party pursued a claim or defense
later deemed ``not substantially justified.'' Because the Committee has
determined to retain the voluntary nature of ADR, it has not included
the original S. 240's fee shifting mechanism in the final bill. The
Committee, however, supports the increased use of ADR to reduce the
time and expense associated with securities fraud litigation and
encourages courts to explore new and innovative methods of ADR.
---------------------------------------------------------------------------
Upon the final adjudication of an action, the Committee
requires the court to include in the record specific findings
as to whether all parties and all attorneys have complied with
the requirements of Rule 11(b) of the Federal Rules of Civil
Procedure. If the court finds that either a party or an
attorney violated Rule 11(b), the court must impose sanctions.
Section 103 adopts a rebuttable presumption that the
appropriate sanction for the filing of a complaint in violation
of Rule 11(b) is an award of attorney's fees and costs. A party
may rebut this presumption by proof: (i) that the violation was
de minimis, or (ii) that the imposition of fees and costs would
impose an undue burden on that party. The Committee does not
in-
tend the court to establish a specific income or other
financial threshold that would automatically carve out a
category of individuals for which imposing sanctions would
always cause an ``undue burden.'' Rather, the Committee expects
that the court will take into account the relevant
circumstances of each case.
If a party successfully rebuts the presumption, the court
then must impose sanctions consistent with Rule 11(c)(2).\42\
The Committee intends for this provision to impose upon courts
the affirmative duty to scrutinize closely filings and to
sanction attorneys whenever their conduct violates Rule 11(b).
---------------------------------------------------------------------------
\42\ Rule 11(c)(2) limits sanctions to ``what is sufficient to
deter the repetition of such conduct or comparable conduct by others
similarly situated.''
---------------------------------------------------------------------------
Stay of discovery
The cost of discovery often forces defendants to settle
abusive securities class actions. According to the general
counsel of an investment bank, ``discovery costs account for
roughly 80% of total litigation costs in securities fraud
cases.'' \43\ In addition, the threat that the time of key
employees will be spent responding to discovery requests, such
as providing deposition testimony, may force coercive
settlements.
---------------------------------------------------------------------------
\43\ Testimony of former SEC Commissioner J. Carter Beese, Jr.,
Chairman of the Capital Markets Regulatory Reform Project Center for
Strategic and International Studies, before the Securities Subcommittee
of the Senate Committee on Banking, Housing, and Urban Affairs, March
2, 1995 (citing testimony of Philip A. Lacovara, Hearing on H.R. 3185:
Telecommunications and Finance Subcommittee of the House Committee on
Energy and Commerce).
---------------------------------------------------------------------------
The Securities Subcommittee heard testimony that discovery
in securities class actions resembles a fishing expedition. As
one corporate executive testified, ``once the suit is filed,
the plaintiff's law firm proceeds to search through all of the
company's documents and take endless depositions for the
slightest positive comment which they can claim induced the
plantiff to invest and any shred of evidence that the company
knew a downturn was coming.'' \44\ Thus, plaintiffs sometimes
file frivolous lawsuits in order to conduct discovery in the
hopes of finding a sustainable claim not alleged in the
complaint. Accordingly, the Committee has determined that
discovery should be permitted in securities class actions only
after the court has sustained the legal sufficiency of the
complaint. Courts should stay all discovery pending a ruling on
a motion to dismiss a securities class action, except in the
exceptional circumstance where particularized discovery is
necessary to preserve evidence or to prevent undue prejudice to
a party. The Committee recognizes, for example, that a motion
to dismiss may remain pending for a period of time, and that
the terminal illness of an important witness may necessitate
the deposition of the witness prior to ruling on the motion to
dismiss.
---------------------------------------------------------------------------
\44\ Testimony of Richard J. Egan, Chairman of the Board of EMC
Corporation, Hearing on Private Litigation Under Federal Securities
Laws: Subcommittee on Securities, Senate Committee on Banking, Housing,
and Urban Affairs, June 17, 1993.
---------------------------------------------------------------------------
Because the imposition of a stay of discovery may increase
the likelihood that relevant evidence may be lost, the
Committee makes it unlawful for any person, upon receiving
actual notice that names that person as a defendant, to destroy
or otherwise alter relevant evidence. The Committee intends
this provision to prohibit only the willful alteration or
destruction of evidence relevant to the allegations in the
complaint. This provision does not impose liabil-
ity for the inadvertent or unintentional destruction of
documents. Although this prohibition expressly applies only to
defendants, the Committee believes that the willful destruction
of evidence by a plaintiff would be equally improper, and that
courts have ample authority to prevent such conduct or to apply
sanctions as appropriate.
A strong pleading requirement
The Securities Subcommittee has heard ample testimony on
the need to establish a uniform and stringent pleading
requirement to curtail the filing of abusive lawsuits. Rule
9(b) of the Federal Rules of Civil Procedure requires a
plaintiff to plead allegations of fraud with ``particularity.''
The courts of appeals have interpreted Rule 9(b) in different
ways, creating distinctly different pleading standards among
the circuits.
The Committee does not adopt a new and untested pleading
standard that would generate additional litigation. Instead,
the Committee chose a uniform standard modeled upon the
pleading standard of the Second Circuit. Regarded as the most
stringent pleading standard,\45\ the Second Circuit requires
that the plaintiff plead facts that give rise to a ``strong
inference'' of defendant's fraudulent intent.\46\ The Committee
does not intend to codify the Second Circuit's caselaw
interpreting this pleading standard, although courts may find
this body of law instructive.
---------------------------------------------------------------------------
\45\ Testimony of Arthur Levitt, Chairman of the U.S. Securities
and Exchange Commission: Hearing on Securities Litigation Reform
Proposals: Subcommittee on Securities, Senate Committee on Banking,
Housing, and Urban Affairs, April 6, 1995.
\46\ In Re Time Warner, Inc. Securities Litigation, 9 F.3d 259, 268
(2d Cir. 1993) (citations omitted).
---------------------------------------------------------------------------
The plaintiff must also specifically identify each
statement alleged to have been misleading, the reason or
reasons why the statement is misleading, and, if the allegation
is made on information and belief, the plaintiff must set forth
all information in plaintiff's possession on which the belief
is formed.
The Committee also requires the plaintiff to show that the
misstatement or loss alleged in the complaint caused the loss
incurred by the plaintiff. For example, the plaintiff would
have to prove that the price at which the plaintiff bought the
stock was artificially inflated as the result of the
misstatement or omission. The defendant would then have the
opportunity to prove any mitigating circumstances, or that
factors unrelated to the fraud contributed to the loss.
A safe harbor for forward-looking statements or projections
Abusive litigation severely impacts the willingness of
corporate managers to disclose information to the marketplace.
Former SEC Chairman Richard Breeden testified: ``Shareholders
are also damaged due to the chilling effect of the current
system on the robustness and candor of disclosure. * * *
Understanding a company's own assessment of its future
potential would be among the
most valuable information shareholders and potential investors
could have about a firm.'' \47\
---------------------------------------------------------------------------
\47\ Testimony of Richard C. Breeden, Hearing on Securities
Litigation Reform Proposals: Sub-committee on Securities, Senate
Committee on Banking, Housing, and Urban Affairs, April 6, 1995.
---------------------------------------------------------------------------
Fear that inaccurate projections will trigger the filing of
a securities fraud lawsuit has muzzled corporate management.
One study found that over two-thirds of venture capital firms
were reluctant to discuss their performance with analysts or
the public because of the threat of litigation.\48\ Anecdotal
evidence similarly indicates company's counsel advises clients
to say as little as possible, because ``legions of lawyers
scrub required filings to ensure that disclosures are as
milquetoast as possible, so as to provide no grist for the
litigation mill.'' \49\
---------------------------------------------------------------------------
\48\ Testimony of James F. Morgan supra, note 16.
\49\ Testimony of J. Carter Beese, supra, note 43.
---------------------------------------------------------------------------
Small, high-growth businesses--because of the volatility of
their stock prices--are particularly vulnerable to securities
fraud law-suits when projections do not materialize. If a
company fails to satisfy its announced earnings projections--
perhaps because of changes in the business cycle or a change in
the timing of an order or new product--the company is likely to
face a lawsuit. In many cases, the discovery process is then
used to look for evidence of fraud. One witness described the
broad discovery requests that resulted in the company producing
over 1,500 boxes of documents at an expense of $1.4
million.\50\
---------------------------------------------------------------------------
\50\ Testimony of John G. Adler, Hearing on Private Litigation
Under Federal Securities Laws, Subcommittee on Securities, Senate
Committee on Banking, Housing, and Urban Affairs, June 17, 1993.
---------------------------------------------------------------------------
The Committee's statutory ``safe harbor'' is intended to
enhance market efficiency by encouraging companies to disclose
forward-looking information. This provision protects from
liability certain ``forward-looking'' statements that are
accompanied by sufficient cautionary language.
The concept of a safe harbor for forward-looking statements
made under certain conditions is not new. In 1979, the SEC
promulgated Rule 175 to provide a safe harbor for certain
forward-looking statements made with a ``reasonable basis'' and
in ``good faith.'' This safe harbor has not provided companies
meaningful protection from litigation. In a February 1995
letter to the SEC, a leading pension fund stated: ``A major
failing of the existing safe harbor is that while it may
provide theoretical protection to issuers from liability when
disclosing projections, it fails to prevent the threat of
frivolous lawsuits that arises every time a legitimate
projection is not realized.'' \51\
---------------------------------------------------------------------------
\51\ February 14, 1995 letter from the California Public Employees'
Retirement System to the SEC on SEC ``safe harbor'' proposal. See, note
6, supra.
---------------------------------------------------------------------------
Courts have also crafted a safe harbor for forward-looking
statements or projections accompanied by sufficient cautionary
language. At least five courts of appeals have recognized the
so-called
``bespeaks caution.'' doctrine.\52\ In an oft-cited case,\53\
the Third Circuit articulated this doctrine as follows:
---------------------------------------------------------------------------
\52\ The First, Second, Third, Sixth, and Ninth Circuits have
adopted a version of the bespeaks caution doctrine. See e.g., In Re
Worlds of Wonder Securities Litigation, 35 F.3d 1407 (9th Cir. 1994);
Rubinstein v. Collins, 20 F.3d 160 (5th Cir. 1994); Kline v. First
Western Government Securities, Inc., 24 F.3d 480 (3d Cir. 1994); Sinay
v. Lamson & Sessions Company, 948 F.2d 1037 (6th Cir. 1991); I. Meyer
Pincus & Associates v. Oppenheimer & Co., Inc., 936 F.2d 759 (2d Cir.
1991); Romani v. Shearson Lehman Hutton, 929 F.2d 875 (1st Cir. 1991);
Luce v. Edelstein, 802 F.2d 49 (2d Cir. 1986);
\53\ In Re Donald J. Trump Casino, 7 F.3d 357 (3d Cir. 1993).
We can state as a general matter that, when an
offering document's forecasts, opinions, or projections
are accompanied by meaningful cautionary statements,
the forward-looking statements will not form the basis
for a securities fraud claim if those statements did
not affect the ``total mix'' of information the
document provides investors. In other words, cautionary
language, if sufficient, renders the alleged omissions
or misrepresentations immaterial as a matter of
law.\54\
---------------------------------------------------------------------------
\54\ Id. at 371.
The Committee's safe harbor is based on aspects of SEC Rule
175 and the bespeaks caution doctrine. This provision applies
to both oral and written statements that describe, project or
estimate future events. The Committee adopts the SEC's present
definition as set forth in Rule 175, of forward-looking
information. The SEC's definition covers: (i) certain financial
items, including projections of revenues, income, and earnings,
capital expenditures, dividends, and capital structure; (ii)
management's statement of future business plans and objectives;
and (iii) certain statements made in SEC required disclosures,
including management's discussion and analysis and results of
operations; and (iv) any statement disclosing the assumptions
underlying the forward-looking statement.
The safe harbor provision protects written and oral
forward-looking statements made by issuers and certain persons
retained or acting on behalf of the issuer. To come within the
safe harbor, the statement must ``project, estimate, or
describe'' future events and be accompanied by sufficient
notice that the information is forward-looking and that actual
results may be materially different from such projections. In
the case of oral statements, the Committee expects that the
notice will be provided at the outset of any general discussion
of future events and that further notice will not be necessary
during the course of that discussion.
The Committee intends that the phrase ``a person acting on
behalf of such issuer'' be construed in a manner that will
promote the purposes of the safe harbor in accordance with
securities industry practice. In this regard, the Committee
intends that the safe harbor protect, not merely the statements
of the issuer, but also those of employees of the issuer and of
persons acting on the issuer's behalf.
The Committee has determined that the statutory safe harbor
should not apply to certain forward-looking statements Thus,
the statutory safe harbor does not protect forward-looking
statements: (1) included in financial statements prepared in
accordance with generally accepted accounting principles; (2)
contained in an initial public offering registration statement;
(3) make in connection with
a tender offer; (4) made in connection with a partnership,
limited liability corporation, or direct participation program
offering; or (5) made in beneficial ownership disclosure
statements filed with the SEC under Section 13(d) of the 1934
Act. The Committee expressly authorizes the SEC to consider the
adoption of a regulatory safe harbor for such statements.
Moreover, the Committee has determined to extend the
statutory safe harbor only to forward-looking information of
certain established issuers subject to the reporting
requirements of Section 15(d) of the 1934 Act. Except as
provided by SEC rule or regulation, the safe harbor does not
extend to an issuer who: (a) during the three year period
preceding the date on which the statement was first made, has
been convicted of a felony or misdemeanor described in clauses
(i) through (iv) of Section 15(b)(4) of the 1934 Act or is the
subject of a decree or order involving a violation of the
federal securities laws; (b) makes the statement in connection
with a ``blank check'' securities offering, ``rollup
transaction,'' or ``going private'' transaction; or (c) issues
penny stock.
Although the Committee believes that market discipline will
most likely provide sufficient disincentives for using the safe
harbor as a ``license to lie,'' the safe harbor does not
protect forward-looking statements ``knowingly made with the
expectation, purpose, and actual intent of misleading
investors.'' The Committee intends that the pleading
requirements under new Section 36 of the 1934 Act will apply to
a complaint alleging that a forward-looking statement is not
within the safe harbor. Accordingly, the plaintiff would have
to allege ``facts giving rise to a strong inference'' that the
forward-looking statement was ``knowingly made with the
expectation, purpose, and actual intent of misleading
investors.'' ``Expectation,'' ``purpose,'' and ``actual
intent'' are independent elements of the exclusion, and
plaintiffs have the burden of pleading and proving each of
these elements.
The court must stay discovery (other than discovery that is
specifically directed to the applicability of the safe harbor)
when a defendant moves for summary judgment based on the ground
that the safe harbor bars a claim for relief. Courts should, to
the fullest extent possible, limit discovery to facts directly
bearing upon the applicability of the safe harbor and not
permit plaintiffs to engage in fishing expeditions. The
Committee expects that the stay will significantly reduce the
costs of discovery.
The Committee intends for its statutory safe harbor
provisions to serve as a starting point and fully expects the
SEC to continue its rulemaking proceedings in this area. The
SEC should, as appropriate, promulgate rules or regulations to
expand the statutory safe harbor by providing additional
exemptions from liability or extending its coverage to
additional types of information.
Written interrogatories
In an action to recover money damages, the Committee
requires the court to submit written interrogatories to the
jury on the issue of defendant's state of mind at the time of
the violation. In expressly providing for certain
interrogatories, the Committee does not intend to prohibit
otherwise or discourage the submission of interrogatories
concerning the mental state or relative fault of the
plaintiff and of persons who could have been joined as
defendants. For example, interrogatories may be appropriate in
contribution proceedings among defendants or in computing
liability when some of the defendants have entered into
settlement with the plaintiff prior to verdict or judgment.
Limiting civil RICO actions
The SEC has supported removing securities fraud as a
predicate act of racketeering in a civil action under the
Racketeer Influenced and Corrupt Organizations Act (``RICO'').
SEC Chairman Arthur Levitt testified: ``Because the securities
laws generally provide adequate remedies for those injured by
securities fraud, it is both unnecessary and unfair to expose
defendants in securities cases to the threat of treble damages
and other extraordinary remedies provided by RICO.'' \55\
---------------------------------------------------------------------------
\55\ Testimony of Arthur Levitt, February 10, 1995, supra, note 28.
---------------------------------------------------------------------------
The Committee amends Section 1964(c) of Title 18 of the
U.S. Code to remove any conduct that would have been actionable
as fraud in the purchase or sale of securities as a predicate
act of racketeering under civil RICO. The Committee intends
this amendment to eliminate securities fraud as a predicate act
of racketeering in a civil RICO action. In addition, a
plaintiff may not plead other specified offenses, such as mail
or wire fraud, as predicate acts of racketeering under civil
RICO if such offenses are based on conduct that would have been
actionable as securities fraud.
A grant of authority to the SEC to prosecute certain aiding and
abetting cases
Prior to the Supreme Court's decision in Central Bank of
Denver v. First Interstate Bank of Denver,\56\ courts of
appeals had recognized that private parties could bring actions
against persons who ``aided and abetted'' primary violators of
the securities laws. In Central Bank, the Court held that there
was no aiding and abetting liability for private lawsuits
involving violations of the securities antifraud provisions.
---------------------------------------------------------------------------
\56\ 114 S. Ct. 1439 (1994).
---------------------------------------------------------------------------
The Committee considered testimony endorsing the result in
Central Bank and testimony seeking to overturn this decision.
The committee believes that amending the 1934 Act to provide
explicitly for private aiding and abetting liability actions
under Section 10(b) would be contrary to S. 240's goal of
reducing meritless securities ligation. The Committee does,
however, grant the SEC express authority to bring actions
seeking injunctive relief or money damages against persons who
knowingly aid and abet primary violators of the securities
laws.
Limitation on damages
The current method of calculating damages in 1934 Act
securities fraud cases is complex, with no statutory guidance
to provide certainty. As a result, there are often substantial
variations in the damages calculated by the defendants and the
plaintiffs. Typically, in an action involving a fraudulent
misstatement or omission, the investor's damages are presumed
to be the difference between the
price he or she paid for the security and the price of the
security on the date the corrective information is disseminated
to the market.
Between the time a misrepresentation is made and the time
the market receives corrected information, however, the price
of the security may rise or fall for reasons unrelated to the
alleged fraud. According to an analysis provided to the
Securities Subcommittee, damages in securities litigation
amount to approximately 27.7% \57\ of an investor's market
loss. Calculating damages based on the date corrective
information is disclosed may substantially overestimate
plaintiff's actual damages.\58\ The Committee intends a rectify
the uncertainty in calculating damages by providing a ``bounce
back'' period, thereby limiting damages to those losses caused
by the fraud and not by other market conditions.
---------------------------------------------------------------------------
\57\ The percentages of damages as market losses in the analysis
ranged from 7.9% to 100%. See Princeton Venture Research, Inc., ``PVR
Analysis, Securities Law Class Actions, Damages as a Percent of Market
Losses,'' June 15, 1993.
\58\ Lev and de Villers, ``Stock Price Crashes and 10b-5 Damages: A
Legal, Economic and Policy Analysis,'' Stanford Law Review, 7, 9-11
(1994).
---------------------------------------------------------------------------
This provision requires that plaintiff's damages be
calculated by taking into account the value of the security on
the date plaintiff originally bought or sold the security and
the median market value of the security during the 90-day
period after dissemination of any information correcting the
misleading statement or omission. If the plaintiff sells those
securities or repurchases the subject securities during the 90-
day period, damages will be calculated based on the price of
that transaction and the median market value of the security
immediately after the dissemination of corrective information
and ending with the plaintiff's sale or repurchase of the
security.
Modification of joint and several liability
The Committee heard considerable testimony about the impact
of joint and several liability on private actions under the
Federal securities laws. Under joint and several liability,
each defendant is liable for all of the damages awarded to the
plaintiff. Thus, a defendant found responsible for only 1% of
the harm could be required to pay 100% of the damages.
Former SEC Commissioner J. Carter Beese, Jr., observed that
``[t]his principle has a legitimate public policy purpose, but,
in practice, it encourages plaintiffs to name as many deep-
pocket defendants as possible, even though some of these
defendants may bear very little responsibility for any injuries
suffered by the plaintiff.'' \59\ He noted that ``[a]s a
result, whenever a company is sued under Rule 10b-5, there is a
strong likelihood that lawyers, accountants, underwriters and
directors will be sued, as well.'' \60\ Several other
witnesses, including former SEC Chairmen David S. Ruder and
Richard C. Breeden and former SEC Commissioner Charles C. Cox,
acknowledged this problem.\61\
---------------------------------------------------------------------------
\59\ Testimony of J. Carter Beese, Jr., supra, note 43.
\60\ Id.
\61\ See, Testimony of Richard C. Breeden, supra, note 47;
Testimony of David S. Ruder, Hearing on Securities Litigation: Impact
of U.S. Supreme Court Decision: Central Bank of Denver v. First
Interstate of Denver, Subcommittee on Securities, Senate Committee on
Banking, Housing, and Urban Affairs, May 12, 1994. Testimony of Charles
C. Cox, Hearing on Securities Litigation Reform Proposals: Subcommittee
on Securities, Senate Committee on Banking, Housing, and Urban Affairs,
April 6, 1995.
---------------------------------------------------------------------------
When peripheral defendants are sued, the pressure to settle
is overwhelming--regardless of the defendant's culpability.
Former SEC Chairman Ruder stated that defendants are under
``enormous pressure to settle'' because of ``the possibility
that they will be required to pay the entire amount claimed.''
\62\ The exposure in securities fraud class actions is enormous
because of the amount of total damages claimed. In one sample
of cases the average claim was $40 million, with 10% of the
cases seeking more than $100 million in damages.\63\ The cost
of discovery also contributes to this pressure to settle.\64\
As a result, oftentimes peripheral defendants are joined simply
to obtain a settlement. As Chairman D'Amato observed, ``[t]he
threat of [joint and several] liability often forces innocent
`deep pocket' defendants to settle frivolous suits.'' \65\
---------------------------------------------------------------------------
\62\ Testimony of David Ruder, see id.
\63\ Majority Report, supra. note 7.
\64\ Testimony of Marc E. Lackritz, supra, note 22.
\65\ Statement of Senator D'Amato supra, note 3.
---------------------------------------------------------------------------
The resulting litigation burden--the combination of legal
fees and settlement costs--on peripheral defendants has
significant consequences. ``The fact that a director of a
publicly-held company faces the prospect of being sued
regardless of how well he or she performs is driving some
directors off corporate boards, and precluding other companies
from attracting qualified board members.'' \66\ Jean Head
Sisco, testifying on behalf of the National Association of
Corporate Directors, stated that ``the proliferation of abusive
10b-5 securities suits is making it extremely difficult to
attract qualified, independent people to sit on corporate
boards.'' \67\ Several surveys have confirmed that directors
are increasingly concerned about litigation risk and are
reluctant to serve on boards of start-up and high-technology
companies.\68\
---------------------------------------------------------------------------
\66\ Testimony of J. Carter Beese, Jr., supra, note 43.
\67\ Hearing Report, supra, note 40.
\68\ Hearing Report, supra, note 40 at 104. Testimony of J. Carter
Beese, Jr., supra, note 43 (discussing surveys).
---------------------------------------------------------------------------
At a minimum, qualified individuals insist that the company
obtain substantial D&O insurance coverage, SEC Chairman Levitt
himself refused to serve on boards of companies with
insufficient insurance.\69\ But that prerequisite imposes a
high cost: D&O insurance premiums have increased seven-fold
over the last decade,\70\ in large part because of the cost of
this litigation. ``Within the past two years, several of the
major D&O insurers have priced D&O insurance out of existence
for many companies, or have stopped writing policies for
companies in particular industries, such as the technology
sector. All investors are at risk at these growing companies
put increasingly large sums of money into D&O polices instead
of into developing the long-term strength of the company.''
\71\
---------------------------------------------------------------------------
\69\ Statement of Arthur Levitt, April 6, 1995, supra, note 45.
\70\ See, Testimony of Marc E. Lackritz, supra, note 22. Nearly
two-thirds of the companies responding in a 1994 survey reported
substantial increases in D&O insurance premiums, with an average
increase of 94%. Testimony of James Morgan, supra, note 16.
\71\ Testimony of James Morgan, supra, note 16.
---------------------------------------------------------------------------
Accounting firms particularly have been hard hit by
securities litigation. The six largest firms face $10 billion
in 10b-5 claims.\72\ Their gross audit-related litigation costs
amounted to $783 million in 1992--more than 14% of their audit
revenues for that year.\73\
---------------------------------------------------------------------------
\72\ Hearing Report (statement of Jake L. Netterville), supra, note
40.
\73\ Id.
---------------------------------------------------------------------------
Former SEC Commissioner A.A. Sommer, who heads the Public
Oversight Board, the independent body that oversees the
accounting profession's self-regulatory efforts, testified
that, in view of ``some recent judgments and the amounts being
sought in pending cases, it is not beyond the pale to believe,
and some responsible people do believe--that one or more major
[accounting] firms may ultimately be bankrupted.\74\
---------------------------------------------------------------------------
\74\ Id.
---------------------------------------------------------------------------
Because of concern about the fairness of 10b-5 litigation
and because of concern about the adverse consequences of joint
and several liability, a number of witnesses, including SEC
Chairman Levitt,\75\ former SEC Chairmen Ruder and Breeden,\76\
and former SEC Commissioners Beese and Sommer,\77\ advocated
modification of the doctrine of joint and several liability in
securities actions. For example, Ralph V. Whitworth, president
of the United Shareholders Association, stated that in cases
where there was no proof of actual fraud ``[e]liminating joint
and several liability * * * will significantly reduce the
number of strike suits brought against defendants who have done
nothing wrong but are seen as having deep pockets.'' \78\ Marc
Lackritz, President of the Securities Industry Association,
identified proportionate liability as the most important
provision to be included in securities litigation reform
legislation.\79\
---------------------------------------------------------------------------
\75\ Testimony of Arthur Levitt, supra, note 45.
\76\ Testimony of Richard C. Breeden, supra, note 47. Testimony of
David S. Ruder, supra, note 61.
\77\ Testimony of J. Carter Beese, Jr., supra, note 43; Hearing
Report (testimony of A.A. Sommer, Jr.), supra, note 40 at 353-4.
\78\ Hearing Report, supra, note 40 at 465.
\79\ Testimony of Marc Lackritz, supra, note 22.
---------------------------------------------------------------------------
The Committee modifies joint and several liability to
eliminate unfairness and to reconcile the conflicting interests
of investors in a manner designed to best protect the interests
of all investors--those who are plaintiffs in a particular
case, those who are investors in the defendant company, and
those who invest in other companies.
The provision imposes full joint and several liability, as
under current law, on all defendants who engage in knowing
securities fraud. Defendants who are found liable but who did
not engage in knowing securities fraud are liable only for
their share of the judgment (based upon the fact finder's
apportionment of responsibility), with two key exceptions.
First, in the event some defendant is insolvent, and therefore
cannot pay his or her share of the liability, and the jointly
and severally liable defendants cannot make up the difference,
each of the other proportionally liable defendants must make an
additional payment--up to 50% of his or her own liability--to
make up the shortfall in the plaintiff's recovery.
Second, proportionally liable defendants will be liable for
the uncollectible share if the plaintiff establishes that (i)
the damages are more than 10% of the plaintiff's net worth, and
(ii) the plaintiff's net financial worth is less than $200,000.
In this scenario, there is no limitation on the amount
proportionally liable defendants will be required to pay. The
$200,000 financial net worth test does not reflect a judgment
by the Committee that investors who fall below this standard
are ``small,'' unsophisticated, or in need of,
or entitled to, special protection under the securities laws.
The Committee intends ``financial net worth'' in include all of
the plaintiff's financial assets including stocks, bonds, real
estate, and jewelry.
Loss causation requirement for Section 12(2) of the 1933 Act
Congress adopted Section 12(2) of the 1933 Act to deter
material misrepresentations and omissions in the purchase or
sale of securities. Some courts have held that a plaintiff
suing under Section 12(2) need not prove that the misstatement
or omission caused the loss.\80\ As a result, issuers have been
put in the position of insuring shareholders and purchasers
against normal market risk. An issuer that makes a material
misstatement or omission in its prospectus can be liable for
losses to shareholders--even if the losses have nothing to do
with the misstatement or omission.
---------------------------------------------------------------------------
\80\ See e.g., Wilson v. Saintine Exploration & Drilling Corp., 872
F.2d 1124, 1126 (2d Cir. 1989).
---------------------------------------------------------------------------
This interpretation of Section 12(2) provides an unfair
windfall to shareholders who have not in any way been harmed by
the misstatement or omission. For example, a company might fail
to state in a public offering prospectus that it conducts
business in a foreign country. Even if the company's foreign
business is highly profitable, if its overall profits decline
as the result of unrelated factors (such as a downturn in its
domestic business), any purchaser of the securities in the
offering could rescind his or her purchase.
The Committee amends Section 12(2) to clarify that
defendants may raise the absence of ``loss causation'' as an
affirmative defense. If a defendant in a Section 12(2) action
demonstrates that part or all of the decline in the value of
the security was caused by factors other than the misstatement
or omission alleged in the complaint, the plaintiff may not
recover damages based on that portion of the decline. The
defendant must bear the burden of affirmatively demonstrating
the absence of loss causation. This provision does not place
any additional burden on plaintiffs to demonstrate that loss
causation existed, nor does it deprive investors of Section
12(2) remedies when they have incurred losses caused by
inadequate disclosure. The amendment to Section 12(2) is
modeled after Section 11 of the Securities Act, which provides
for a similar affirmative defense.
Auditor Disclosure of Corporate Fraud
This provision requires independent public accountants to
adopt certain procedures in connection with their audits and to
inform the SEC of illegal acts of their auditing clients. These
requirements should be carried out in accordance with generally
accepted auditing standards for audits of SEC registrants--as
modified from time to time by the Commission--on the detection
of illegal acts, related party transactions and relationships,
and evaluation of an issuer's ability to continue as a going
concern.
The Committee does not intend to affect the Commission's
authority in areas not specifically addressed by this
provision. The Committee expects that the SEC will continue its
long-standing
practice of looking to the private sector to set and to improve
auditing standards. The SEC should not act to ``modify'' or
``supplement'' generally accepted auditing standards for SEC
registrants until after it has determined that the private
sector is unable or unwilling to do so on a timely basis. The
Committee intends for the SEC to have discretion, however, to
determine the appropriateness and timeliness of the private
sector response. The SEC should act promptly if required by the
public interest or for the protection of investors.
Section-by-Section Analysis of S. 240, the ``Private Securities
Litigation Reform Act of 1995''
Section 1. Short title; table of contents
Section 1 provides that S. 240 may be cited as the
``Private Securities Litigation Reform Act of 1995'' (the
``Act'') and sets out a table of contents for the Act.
title i--reduction of abusive litigation
Section 101. Elimination of certain abusive practices
Section 101(a) amends the Securities Exchange Act of 1934
(the ``1934 Act'') by adding a new paragraph (8) to Section
15(c), prohibiting brokers or dealers or any associated persons
from soliciting or receiving any type of fee or remuneration
for assisting an attorney in obtaining representation of any
person in private actions under the Securities Act of 1933 (the
``1933 Act'') or the 1934 Act.
Section 101(b) amends Section 20 of the 1933 Act by adding
a new subsection (f) and Section 21 of the 1934 Act by adding a
new subsection (i), requiring the court to determine whether a
plaintiff's attorney who owns, or has a beneficial interest in,
securities that are the subject of litigation has a
disqualifying conflict of interest.
Section 101(c) amends Section 20 of the 1933 Act by adding
a new subsection (g) and Section 21(d) of the 1934 Act by
adding new paragraph (4), prohibiting the payment of attorneys'
fees or expenses incurred by private parties out of funds
disgorged as the result of action by the Securities and
Exchange Commission (the ``Commission'' or ``SEC''), except as
otherwise ordered by the court upon motion by the Commission
and, in the case of SEC administrative actions, by order of the
Commission.
Section 102. Securities class action reform
Section 102(a) establishes five new recovery rules for
private class actions under the 1933 and 1934 Acts. Section
102(a)(1) of the Act amends Section 20 of the 1933 Act by
adding a new subsection (h) and Section 102(a)(2) of the Act
amends Section 21 of the 1934 Act by adding new subsection (j).
The first rule requires every plaintiff seeking to serve as
a representative party on behalf of a class to file a sworn
certification with the complaint, stating: (i) the plaintiff
reviewed the complaint and authorized its filing; (ii) the
plaintiff did not purchase the securities at the direction of
counsel or to participate in a lawsuit; (iii) the plaintiff is
willing to serve as a representative party on behalf of the
class; (iv) the plaintiff's transactions during the class
period in the security that is the subject of the complaint;
(v) other law-
suits in which the plaintiff has sought to serve as
representative party in the prior three years; and (vi) the
plaintiff will not receive any bonus for serving as the class
representative. This certification will not be construed to
waive the attorney-client privilege.
The second rule limits the class representative's recovery
to his or her pro rata share of the settlement or final
judgment. The court may also reimburse the class representative
for ``reasonable costs and expenses,'' including lost wages
directly relating to the representation of the class.
The third rule prohibits the filing of settlements under
seal except if ``good cause'' is shown, i.e., publication of a
portion or portions of the settlement agreement would result in
direct and substantial harm to a party.
The fourth rule limits the award of fees and expenses to
counsel for a plaintiff class to a reasonable percentage of the
amount of recovery awarded to the class.
The fifth rule specifies the information that must be
included in any proposed or final settlement agreement
disseminated to the class. The rule requires the settling
parties, if they can agree, to state the average amount of
damages per share that would be recoverable if the plaintiff
prevailed. If the parties cannot agree, each party must provide
a statement on the issues on which they disagree. Such
statements are inadmissible in any court action or
administrative proceeding unless the action or proceeding
concerns the statement itself. The rule also requires the
parties or counsel who intend to seek an award of attorneys'
fees or costs to state the amount sought--on an average per
share basis--and to provide an explanation supporting the fees
and costs sought. Any settlement agreement must also include
the name, telephone number, and address of plaintiff class
counsel who will answer questions from class members, and a
brief statement explaining the reasons for the proposed
settlement. The required information must appear, in summary
form, on a cover page. The court may order disclosure of
additional information.
Section 102(b)(1) amends the 1933 Act by adding a new
subsection (i) to Section 20, and Section 102(b)(2) amends the
1934 Act by adding a new subsection (k) to Section 21;
establishing procedures for the appointment of the lead
plaintiff in class actions. A plaintiff filing a securities
class action must, within 20 days of filing a complaint,
provide notice to members of the purported class in a widely
circulated business publication. This notice must: (i) identify
the claims alleged in the lawsuit and the purported class
period, and (ii) inform potential class members that, within 60
days, they may move to serve as the lead plaintiff. The notice
provisions in this subsection do not replace or supersede other
notice provisions provided in the Federal Rules of Civil
Procedure.
Within 90 days of the published notice, the court must
consider motions made under this section and appoint the lead
plaintiff. If a motion has been filed to consolidate multiple
class actions brought on behalf of the same class, the court
shall not appoint a lead plaintiff until after consideration of
any such motion. In appointing the lead plaintiff, the court
shall presume that the ``most adequate plaintiff'' is the
member of the purported class (who has moved for such
appointment and otherwise satisfies Rule 23 of the
Federal Rules of Civil Procedure) with the largest financial
interest in the relief sought by the class. This presumption
may be rebutted by evidence that the plaintiff would not fairly
and adequately represent the interests of the class or is
subject to unique defenses.
Members of the purported class may seek discovery into
whether the presumptively most adequate plaintiff would not
adequately represent the class. Subject to court approval, the
most adequate plaintiff shall retain class counsel.
Section 103. Sanctions for abusive litigation
Section 103(a) amends Section 20 of the 1933 Act by adding
a new subsection (j) and Section 103(b) amends Section 21 of
the 1934 Act by adding a new subsection (l), requiring the
court (i) to make specific findings, upon adjudication of a
private action, regarding compliance by all parties and all
attorneys with each requirement of Rule 11(b), and (ii) to
impose sanctions for any violations. In imposing sanctions for
failure of the complaint to comply with Rule 11(b), the court
will presume that the appropriate sanction is the reasonable
attorneys' fees and expenses of the opposing party. This
presumption may be rebutted by evidence that the imposition of
sanctions would impose an undue burden on the violator or that
the Rule 11 violation was de minimis.
Section 104. Requirements for securities fraud actions
Section 104(a)(1) amends Section 20 of the 1933 Act by
adding a new subsection (k) and (l) and adds a new Section
36(c) to the 1934 Act, (i) requiring the court to stay
discovery during the pendency of any motion to dismiss the
complaint, unless particularized discovery is needed to
preserve evidence or prevent undue prejudice, and (ii)
prohibiting parties from willfully destroying or altering
evidence they know is relevant to the allegations in the
complaint.
Section 104(b) amends the 1934 Act by adding a new Section
36, establishing pleading standards for Section 10(b) actions
alleging untrue statements or omissions of a material fact. The
complaint must specifically identify each misleading statement
and the reason or reasons why it is misleading. In any private
action to recover money damages, the plaintiff must, for each
misstatement or omission, specifically allege facts giving rise
to a strong inference that the defendant acted with the
required state of mind.
This section also requires plaintiffs to show ``loss
causation,'' i.e., that the alleged violation caused
plaintiff's loss. The defendant may mitigate the damages
arising from such loss by showing that unrelated factors
contributed to the loss.
Section 105. Safe harbor for forward-looking statements
Section 105 establishes a ``safe harbor'' protecting
certain forward-looking statements from liability in private
actions under the 1933 Act and the 1934 Act and grants the SEC
authority to promulgate safe harbor rules under the Investment
Company Act of 1940. Section 105(a) amends the 1933 Act by
adding a new Section 13A; Section 105(b) amends the 1934 Act by
adding a new Section 37; and Section 105(c) amends Section 24
of the Investment Company Act by adding a new subsection (g).
The safe harbor provision protects written and oral
forward-looking statements that ``project, estimate, or
describe'' future events made by issuers and certain persons
retained or acting on behalf of issuers. To be protected, the
statement must be accompanied by sufficient notice that the
information is forward-looking and that actual results may be
materially different from such projections, estimates, or
descriptions.
The definition of ``forward-looking'' information is the
same as contained in the SEC's present Rule 175 safe harbor.
The definition includes: (i) certain financial items, including
projections of revenues, income, earnings, capital
expenditures, dividends, and capital structure; (ii)
management's statement of future business plans and objectives;
(iii) certain statements made in required SEC disclosures,
including managements's discussion and analysis and results of
operations; and (iv) any disclosed statement of the assumptions
underlying the forward-looking statement. The SEC may expand
the definition by rule or regulation.
The safe harbor does not protect forward-looking statements
``knowingly made with the expectation, purpose, and actual
intent of misleading investors.''
In order to quality for the safe harbor, the issuer must be
subject to the reporting requirements of Section 13(a) or
Section 15(d) of the 1934 Act. Except as provided by SEC rule
or regulation, the safe harbor does not extend to an issuer
who: (a) during the three year period preceding the date on
which the statement was first made, has been convicted of a
felony or misdemeanor described in clauses (i) through (iv) of
Section 15(b)(4) or is the subject of a decree or order
involving a violation of the securities laws; (b) makes the
statement in connection with a ``blank check'' securities
offering, ``rollup transaction,'' or ``going private''
transaction; or (c) issues penny stock.
The safe harbor does not cover certain statements that may
otherwise qualify as forward-looking statements. Except as
provided by SEC rule or regulation, the safe harbor does not
cover forward-looking statements: (i) included in financial
statements prepared in accordance with generally accepted
accounting principles; (ii) contained in an initial public
offering registration statement; (iii) made in connection with
a tender offer; (iv) made in connection with a partnership,
limited liability corporation or direct participation program
offering; or (v) made in beneficial ownership disclosure
statements filed with the SEC under Section 13(d) of the 1934
Act.
The court must stay discovery (other than discovery that is
specifically directed to the applicability of the safe harbor)
pending its decision on a motion for summary judgment based on
the grounds that the statement or omission is protected by the
safe harbor.
The SEC may promulgate rules or regulations to expand the
statutory safe harbor by providing additional exemptions from
liability. This section also grants the SEC authority to
recover damages on behalf of investors injured by reason of
violations involving a forward-looking statement not protected
by the safe harbor.
Section 106. Written interrogatories
Section 106(a) amends Section 20 of the 1933 Act by adding
a new subsection (m) and Section 21 of the 1934 Act by adding a
new
subsection (m), requiring the court, in actions in which the
plaintiff may recover money damages, to submit written
interrogatories to the jury on the issue of defendant's state
of mind at the time of the violation.
Section 107. Amendment to Racketeer Influenced and Corrupt
Organizations Act
Section 107 amends Section 1964(c) of Title 18 of the U.S.
Code to conduct that would have been actionable as fraud in the
purchase or sale of a security as a predicate offense under
civil RICO.
Section 108. Authority of Commission to prosecute aiding and abetting
Section 108 amends Section 20 of the 1934 Act by adding a
new subsection (e), authorizing the SEC to bring an action
seeking injunctive relief or money penalties against persons
who knowingly ``aid and abet'' primary violators of the
securities laws.
Section 109. Limitation on rescission
Section 109 amends Section 12 of the 1933 Act by adding a
provision at the end of the section allowing a defendant to
avoid the remedy of rescission under certain circumstances. In
an action based on a misstatement or omission contained in a
prospectus, a defendant may avoid rescissionary damages if the
defendant proves that the depreciation in the value of the
security resulted from factors unrelated to the alleged
misstatement or omission. If the defendant shows there is no
``loss causation'' the purchaser may recover damages only for
the remaining portion of the depreciation in the security's
value.
Section 110. Applicability
The provisions included in Title I of this Act apply to any
private action commenced after the date of enactment.
TITLE II--REDUCTION OF COERCIVE SETTLEMENTS
Section 201. Limitation on damages
Section 201 amends Section 36 of the 1934 Act by adding a
new subsection (e), providing for a ``look back'' period in
calculating damages in a private action involving a
misstatement or omission under the 1934 Act. This provision is
intended to limit damages to those losses caused by the fraud
and not by other market conditions.
Plaintiff's damages will be calculated by taking into
account the value of the security on the date plaintiff
originally bought or sold the security and the value of the
security during the 90-day period after dissemination of any
information correcting the misleading statement or omission. If
the plaintiff sells those securities or repurchases the subject
securities during the 90-day period, damages will be calculated
based on the price of that transaction and the value of the
security immediately after the dissemination of corrective
information.
Section 202. Proportionate liability
Section 202 amends the 1934 Act by adding a new Section 38,
establishing a system for allocating damages in private actions
brought under the 1934 Act. Under this section, a defendant who
commits ``knowing'' securities fraud is jointly and severally
liable for the full amount of the damages. To commit
``knowing'' securities fraud, a defendant must make a
``material representation or omission with actual knowledge
that the information is false,'' and ``actually know that
persons are likely to rely on'' the false information. Reckless
conduct would not constitute knowing securities fraud.
In cases involving multiple defendants, the court shall
instruct the jury to determine (i) each defendant's percentage
of responsibility, including any settling defendants, and (ii)
whether each defendant committed knowing securities fraud. The
defendants who did not commit knowing securities fraud will
only be liable for the portion of damages attributable to their
percentage of responsibility.
If there are uncollectible shares because the defendants
who have committed knowing securities fraud are ``judgment
proof,'' the proportionally liable defendants may be liable for
an additional amount of up to 50% of their total share of
damages.
In addition, proportionally liable defendants will be
liable for the uncollectible share if, within six months of
entry of final judgment, the plaintiff establishes that (i) the
damages are more than 10% of the plaintiff's net worth, and
(ii) the plaintiff's net financial worth is less than $200,000.
Defendants who make an additional payment may, within six
months of the date of the payment, seek contribution from other
defendants in the action. A defendant who settles the action
before verdict or judgment will not be subject to any claim of
contribution. In determining the amount of the final judgment,
the court will reduce the final judgment to take into account
the settling party's percentage of responsibility and the
amount the settling defendant paid to the plaintiff. A person
who is liable for damages under this section may seek, within
six months of entry of the final judgment, contribution from
persons who were not parties to the lawsuit.
Section 203. Applicability
The provisions included in Title II of this Act apply to
any private action commenced after the date of enactment.
title iii--auditor disclosure of corporate fraud
Section 301. Fraud detection and disclosure
This section amends the 1934 Act by adding a new Section
10A, requiring independent public accountants to institute
certain procedures in connection with their activities. If an
accountant learns of an illegal act that may be
``consequential'' to the company, the accountant must provide
this information to the company's management. If management
fails to act, and the accountant determines that the illegal
act would have a material effect on the issuer's financial
statements, the accountant must report the information to the
board of directors. If the board fails to notify the Commission
within one day, the accountant must notify the Commission the
following day. Failure to provide this notification will
subject the accountant to civil penalties.
The provisions in this section apply to annual reports
filed with the Commission after July 1, 1996 for registrants
that file quarterly reports and January 1, 1997 for all other
registrants.
REGULATORY IMPACT STATEMENT
This legislation seeks to reform private securities
litigation and thus it has limited regulatory impact.
Generally, there is little or no requirement for regulatory
implementation of the provisions of the bill.
Some provisions, in fact, would reduce regulatory
requirements. For example, the SEC is directed in Section 105
of the legislation to provide by regulation safe harbors for
forward-looking statements comprehended by the Investment
Company Act of 1940, and is authorized to provide for statutory
safe harbors for forward-looking statements under the 1933 and
1934 Acts.
Two provisions would, however, have some regulatory impact.
First, Section 105 of the legislation would broaden the SEC's
authority to seek and to obtain disgorgement under the 1933 and
1934 Acts. This section authorizes the SEC to recover damages
on behalf of investors involving a forward-looking statement
not protected by the statutory safe harbor. Under current law,
SEC disgorgement is generally limited to any ill-gotten gains.
It is not possible to estimate the number of persons to whom
this provision would apply. Second, Title III of this
legislation would impose new reporting obligations on public
accountants. Although these obligations will increase the costs
of conducting audits, it is not possible to estimate precisely
the extent of these new costs.
CHANGES IN EXISTING LAW
In the opinion of the Committee, it is necessary to
dispense with the requirement of subsection 12 of rule XXVI of
the Standing Rules of the Senate in order to expedite the
business of the Senate.
COST OF THE LEGISLATION
The Committee has requested a cost estimate of this
legislation under the provisions of Section 403 of the
Congressional Budget Act of 1974. The cost estimate of the
Congressional Budget Office follows.
U.S. Congress,
Congressional Budget Office,
Washington, DC, June 19, 1995.
Hon. Alfonse M. D'Amato,
Chairman, Committee on Banking, Housing, and Urban Affairs, U.S.
Senate, Washington, DC.
Dear Mr. Chairman: The Congressional Budget Office has
reviewed S. 240, the Private Securities Litigation Reform Act
of 1995, as ordered reported by the Senate Committee on
Banking, Housing, and Urban Affairs on May 25, 1995. CBO
estimates that enacting S. 240 would cost the federal
government between $125 million and
$250 million over the next five years, assuming appropriation
of the necessary amounts. Because enacting S. 240 would affect
receipts, pay-as-you-go procedures would apply to the bill.
Enacting S. 240 would not affect the budgets of state or local
governments.
Bill purpose
Title I of S. 240 would require a court, when hearing class
action litigation brought under the Securities Exchange Act of
1934, to appoint a lead plaintiff for the class under certain
circumstances. The bill would require the full disclosure of
the terms of settlement for any such class action lawsuit and
would prohibit the payment of attorneys' fees from certain
funds. In addition, the bill would establish various procedures
and restrictions to discourage litigation, restrict the
liability of those persons who make forward-looking statements
regarding securities or markets, and require the Securities and
Exchange Commission (SEC) to promulgate rules establishing such
limited liability. The bill would amend the Racketeer
Influenced and Corrupt Organizations statute to exclude from
its purview an action involving fraud in the sale of
securities. Title II of S. 240 would limit the amount of
damages that could be awarded in certain securities litigation
cases, and would limit the application of joint and several
liability in those cases. Title III would include certain
procedures to be followed during a required audit of a
securities issuer, and would provide civil penalties for
violations of those procedures.
Federal budgetary impact
CBO estimates that promulgating the rules required by the
bill would result in increased costs to the federal government
of approximately $300,000 in 1996, primarily for personnel
costs, assuming appropriation of the necessary amounts.
By discouraging private litigation under the Securities
Exchange Act of 1934, enacting S. 240 would result in an
increase in the number of enforcement actions brought by the
SEC. In 1994, there were about 50 enforcement actions due to
financial fraud, resulting in administrative costs to the
federal government of approximately $24 million. Although the
impact on the SEC's workload from enacting S. 240 is highly
uncertain, CBO expects that financial fraud enforcement actions
would number at least 100, and possibly up to 150. Therefore,
CBO estimates that enactment of S. 240 would increase costs to
the SEC for enforcement actions by $25 million to $50 million
annually, or $125 million to $250 million over the next five
years, assuming appropriation of the necessary amounts.
Pay-as-you-go impact
S. 240 would require civil penalties for violations of
certain of its provisions. These civil penalties would count as
governmental receipts, and thus would be subject to pay-as-you-
go provisions. CBO estimates, however, that no significant
additional amount of receipts would be collected.
Previous CBO estimate
On February 23, 1995, CBO provided an estimate for Title II
of H.R. 10, the Securities Litigation Reform Act, as ordered
reported
by the House Committee on the Judiciary, to that committee. S.
240 differs from that bill primarily in that S. 240 would
require civil penalties for violations of the provisions of
Title III, and it would require additional rulemakings by the
SEC. In other respects the bills are substantially similar, and
CBO's estimate of the SEC's enforcement costs under S. 240 is
unchanged from our estimate for Title II of H.R. 10.
If you wish further details on this estimate, we will be
pleased to provide them. The CBO staff contacts are John Webb
and Melissa Sampson.
Sincerely,
June E. O'Neill, Director.
ADDITIONAL VIEWS OF SENATORS GRAMM, MACK, FAIRCLOTH, BENNETT, GRAMS,
AND FRIST
The Hippocratic Oath begins with the admonition to do no
harm. The bill reported by the Committee follows that mandate.
Unlike much of the legislation of past Congresses, this bill is
not ``two-steps-forward, one-step-back'' legislation. The
improvements that the bill makes over current law are not
eroded by new legislative injuries.
While the bill provides significant incremental relief from
abusive securities lawsuits, the costs of these lawsuits are so
high that stronger reform is needed. Information presented to
the Subcommittee on Securities indicates that approximately 300
securities litigation cases are filed each year. Few of these
cases are brought to trial. Instead, the high costs of
litigation normally induce settlements of the cases, at an
average amounting to $8.6 million per case, for a combined
total of nearly $2.5 billion per year. Even with settlements,
the legal costs for defendants average an additional $700,000
per case.
Perhaps the most destructive aspect of securities strike
suits is the disruption that they cause to company operations.
For example, defendant companies devote an average of 1,000
management and employee hours to each case. This amounts to
37,500 workdays each year consumed by securities lawsuits.
Moreover, there seems to be a pattern of targeting high
technology companies. A survey conducted by the American
Electronics Association of their forty largest firms found that
twenty-four had been sued for securities fraud, including nine
out of the top ten. Either the securities litigation system is
broken, or there is an enormous disrespect for the law in
Silicon Valley. We believe that the problem lies with the
system of litigation.
We therefore recommend that the bill's provisions be
strengthened. Among such changes, particular attention should
be given to (1) strengthening the proportionate liability
provisions of section 202, (2) strengthening the sanctions for
abusive litigation provision of section 103, (3) strengthening
the safe harbor for forward-looking statements in section 105,
and (4) delineate more clearly the standard of liability
provisions of section 104.
proportionate liability (section 202)
No reform was more strongly supported by witnesses and
members during subcommittee hearings than the concept of
introducing proportionate liability for securities lawsuits.
Currently, defendants have joint and several liability, which
means that any person found to have any liability at all,
regardless of how insignificant, can be liable for all of the
damages awarded in these securities cases. The effect of this
has been to add to the lawsuit ``deep-pocket'' plaintiffs who
have at most a marginal involvement in the alleged wrongdoing,
such as accounting firms, securities houses, banks, investment
partners and others. Faced with (1) the risk of being jointly
and severally liable for the entire settlement amount and (2)
the high cost of litigation, such peripherally involved
defendants frequently decide to settle the case rather than
proceed to trial.
The concept of proportionate liability is that no one
should be required to compensate for injuries for which they
are not responsible. Unfortunately, the bill's proportionate
liability provisions contain exceptions that leave deep-pocket
parties still within reach of the strike-suit attorneys. Under
the bill's provisions, if a clearly guilty defendant's share of
a court's judgment is not collectible, every other peripherally
involved defendant is jointly and severally liable for the
uncollectible share if the financial net worth of the plaintiff
is $200,000 or less, that is, most individual investors.
This exception to proportionate liability is open-ended,
with no limitations on liability for defendants with minor
fault, and no practical means of verifying the net worth or
losses of those claiming to be such small investors. This is an
exception with the potential for swallowing the rule and should
be corrected.
attorney sanctions for abusive lawsuits (section 103)
The bill contains a very modest provision to penalize
attorneys who promote abusive securities suits. Currently,
strike suit attorneys face little cost or risk in filing
lawsuits on flimsy pretexts. Rule 11 of the Federal Rules of
Civil Procedure purportedly applies penalties against attorneys
for abusive litigation. But investigation by the Congressional
Research Service could find only three cases in history in
which Rule 11 attorneys sanctions were ever actually applied in
securities Rule 10b-5 cases. We advocated and support the
directive in the bill that requires judges to review Rule 11
issues in every case and provide a written statement regarding
compliance with Rule 11, with mandatory sanctions in the case
of a violation. However, we fear that this provision by itself
will not be enough to end the ``winner pays'' reality of
securities suits and alter the imbalance in the economics of
securities litigation. This is particularly true, since the
provision still relies upon the action of judges who have so
far demonstrated little interest in imposing such sanctions.
Innocent defendants will continue to be left in most cases to
carry the expensive burden of proving their innocence.
safe harbor for forward-looking statements (section 105)
The safe-harbor provisions of the bill must be
strengthened. Currently, there is impaired communication
between investors and management regarding the forward-looking
views and plans of corporations. Under the fear of costly
abusive lawsuits filed when predictions of the future do not
materialize, corporate representatives prefer to guard their
silence or hide behind meaningless generic statements about the
future. A statement from a recent securities filing by a
financial services corporation is typical: ``The amount of
future provisions will continue to be a function of regular
quarterly review of the reserve for credit losses, based upon
management's assessment of risk at that time, and, as such,
there can be no assurance as to the level of future
provisions.'' Investors and analysts are left wondering.
While the provisions of the bill may allow for some degree
of freer communication between corporate management and
investors, we believe that the provisions have been so narrowly
constrained and burdened with vague terms and standards that
they are unlikely to provide in many cases adequate protection
against abusive lawsuits. We are concerned that innocent
corporations may still be subject to expensive and time-
consuming litigation and detailed fact-finding over the terms
and restrictions of the safe harbor provisions and the extent
of their application. In order to be effective, a safe harbor
must have a bright line that is unmistakable to all parties.
Otherwise, the utility of a safe harbor for obtaining early
dismissal of abusive securities suits, or discouraging them
entirely, may be elusive.
standard of liability (section 104)
Curiously, under current law, it is often not clear just
what constitutes a violation of Rule 10b-5. The current
ambiguity is one of the contributing factors allowing for the
filing of abusive, meritless, strike suits. Without a clear
line as to what is and what is not a violation, the issue is
left to the trial process. That is to say, meritless claims are
given too long of a ride, all the while imposing costs on
innocent defendants. Moreover, different courts in different
judicial circuits have applied different interpretations of the
standard of liability. A clear standard of liability would give
greater protection to the innocent while allowing courts to
focus on genuine cases of securities fraud.
The legislation reported by the Committee would establish a
single standard of liability. Unfortunately, it is still a
vague standard that will require further judicial
interpretation. Congress should provide clearer guidance to the
courts than that provided in this bill. Otherwise, we will
continue to provide too much legal confusion and too much room
for the pursuit of meritless lawsuits. All of that imposes an
unnecessary cost on the innocent and on our economy.
room for improvement
While we support reporting this bill, we hope that in the
remaining steps in the legislative process its provisions will
be improved. At the same time, the legislation should remain
free from provisions that take us backwards in the effort to
eliminate abusive securities lawsuits.
Phil Gramm.
Connie Mack.
Lauch Faircloth.
Robert F. Bennett.
Rod Grams.
Bill Frist.
ADDITIONAL VIEWS OF SENATORS SARBANES, BRYAN, AND BOXER
introduction
We support the goal of deterring frivolous lawsuits and
sanctioning appropriate parties when such lawsuits are filed. A
number of the provisions in this bill are designed to achieve
that goal. We support these provisions, and those that will
improve class action procedures.
This legislation, however, will affect far more than
frivolous suits:
The safe harbor provision will, for the first time, provide
immunity under the Federal securities laws for fraudulent
statements.
The proportionate liability provision will, for the first
time, transfer responsibility from participants in a fraud to
innocent victims of that fraud. These provisions will make it
more difficult for investors to bring fraud actions, and will
reduce recoveries in such actions.
The bill also fails to include provisions necessary to
ensure that victims of securities fraud have adequate remedies:
The bill does not extend the statute of limitations for
securities fraud actions imposed by the Supreme Court in 1991,
which the SEC and the State securities regulators believe is
too short.
Ignoring the recommendation of the securities regulators,
the bill does not restore the ability of investors to sue
individuals who aid and abet violations of the securities laws.
This legislation threatens the capital formation process by
undermining the confidence on which our markets depend. We are
not alone in this conclusion. In a June 8, 1995 letter, the
Government Finance Officers Association (``GFOA'') strongly
agreed with this assessment. Consisting of more than 13,000
state and local government financial officials, the GFOA's
members both issue securities and invest billions of dollars of
public pension and taxpayer funds. In its letter, the GFOA
opposed S. 240 as reported:
We support efforts to deter frivolous securities
lawsuits, but we believe that any legislation to
accomplish this must also maintain an appropriate
balance that ensures the rights of investors to seek
recovery against those who engage in fraud in the
securities markets. We believe that S. 240 does not
achieve this balance, but rather erodes the ability of
investors to seek recovery in cases of fraud.
Securities regulators, bar associations, consumer groups, and
state and local government officials share this opinion, as
discussed below. We reach the same conclusion, and accordingly
voted against the legislation.
strength of u.s. capital markets
By every measure, the United States capital markets are the
largest and strongest in the world. In size, the U.S. markets
remain preeminent: for 1993, U.S. equity market capitalization
stood at $5.2 trillion, over one-third of the world
total.1 The U.S. markets continue to grow: the
combined total of equity and debt filings for 1994, over $810
billion, was exceeded only by the record level set in
1993.2 So attractive are the U.S. capital markets
that more than 600 foreign companies from 41 different
countries have tapped them, a level matched only in London, and
more continue to come.3
---------------------------------------------------------------------------
\1\ U.S. Securities and Exchange Commission 1994 Annual Report, at
28.
\2\ Id. at 53.
\3\ Id.
---------------------------------------------------------------------------
The growth of trading on our exchanges is a sign of the
strength of our markets. Average daily trading volume on the
New York Stock Exchange increased from 44.9 million shares in
1980, to 156.8 million shares in 1990, to 291.4 million shares
in 1994.4 The NASDAQ and American Stock Exchanges
have experienced similar gains in trading volume.5
---------------------------------------------------------------------------
\4\ Securities Industry TRENDS, Vol. XXI, No. 3, April 5, 1995.
\5\ Id.
---------------------------------------------------------------------------
Another sign of the strength of our markets is the rise of
the mutual fund industry, one of the fastest-growing segments
of the financial services industry. From 1980 to 1993, mutual
fund assets increased by more than 10 times, to $1.9
trillion.6 Approximately 38 million Americans,
representing 27 percent of American households, own mutual
funds.
---------------------------------------------------------------------------
\6\ See Testimony of Arthur Levitt before the Senate Securities
Subcommittee, November 10, 1993.
---------------------------------------------------------------------------
Role of the Federal Securities Laws
Our securities markets have been operating under the
Federal securities laws since those laws were enacted over 60
years ago. As discussed above, our markets today are the
largest and most vibrant in the world. This is so not in spite
of the Federal securities laws, but in part because of the
Federal securities laws. The Federal securities laws generally
provide for sensible regulation, and self-regulation, of
exchanges, brokers, dealers and issuers.
Even more important to ensuring the success of our markets
is investor confidence. That confidence is maintained because
investors know they have effective remedies against persons who
would defraud them. Both Republican and Democratic Chairmen of
the Securities and Exchange Commission have stressed the
integral role of the private right of action in maintaining
investor confidence. In 1991, then-Chairman Richard Breeden
testified before the Banking Committee:
Private actions under Sections 10(b) and 14(a) of the
Exchange Act have long been recognized as a ``necessary
supplement'' to actions brought by the Commission and
as an ``essential tool'' in the enforcement of the
federal securities laws. Because the Commission does
not have adequate resources to detect and prosecute all
violations of the federal securities laws, private
actions perform a critical role in preserving the
integrity of our securities markets.
Current Chairman Arthur Levitt reiterated that point in
testimony before the House Subcommittee on Telecommunications
and Finance on February 10, 1995:
Besides serving as the primary vehicle for
compensating defrauded investors, private actions also
provide a ``necessary supplement'' to the Commission's
own enforcement activities by serving to deter
securities law violations. Private actions are crucial
to the integrity of our disclosure system because they
provide a direct incentive for issuers and other market
participants to meet their obligations under the
securities laws.
The importance of the private right of action is likely to
increase, given the budgetary constraints on SEC resources.
Testifying in 1993, the Director of the SEC's Division of
Enforcement noted,
Given the continued growth in the size and complexity
of our securities markets, and the absolute certainty
that persons seeking to perpetrate financial fraud will
always be among us, private actions will continue to be
essential to the maintenance of investor protection.
State of the Securities Litigation System
The Securities Subcommittee has held hearings over the past
two years reviewing the health of the Federal securities
litigation system. The Subcommittee received testimony from
plaintiffs' lawyers, from corporate defendants, from
accountants, academics, securities regulators and investors.
There was sharp disagreement among the witnesses over how well
the securities litigation system is functioning, and over what
policy responses are appropriate.
Some argue that American business, particularly younger
companies in the high-tech area, face a rising tide of
frivolous securities litigation. A number of corporate
executives told the Securities Subcommittee of their
experiences. The American Electronics Association decried what
it described as the ``current practice of filing off-the-shelf
legal complaints when a company announces a downturn in
performance [that] amounts to an uncontrolled `tax on
innovation.' ''
Clearly some frivolous securities cases are filed, as
indeed some frivolous cases of every sort are filed. However,
frivolous securities litigation does not appear to be at the
crisis levels which some assert. Presenting statistics obtained
from the Administrative Office of the U.S. Courts, the Director
of the SEC's Division of Enforcement testified in June 1993
that:
the approximate aggregate number of securities cases
(including Commission cases) filed in Federal district
courts does not appear to have increased over the past
two decades. Similarly, while the approximate number of
securities class actions filed during the past three
years is significantly higher than during the 1980's,
the numbers do not reveal the type of increase that
ordinarily would be characterized as an ``explosion.''
Professor Joel Seligman of the University of Michigan Law
School, one of the leading experts on the Federal securities
laws, testified at the same hearing, ``there is little
objective data at this time that suggests there is a need for
significant reform of the federal securities laws, either to
benefit plaintiffs or defendants.''
The Committee Report states that it is easy to craft
complaints alleging violations of the Federal securities laws.
However, the Committee received evidence that it is difficult
to bring even a meritorious securities action under the current
system. Rule 9 of Federal Rules of Civil Procedure requires
fraud to be pled with specificity. Joan Gallo, City Attorney
for the City of San Jose, testified on March 22, 1995 about the
successful securities fraud suit that San Jose brought against
a number of brokers in the 1980's. She said, ``[u]nder current
law, despite the fact that the City had very experienced legal
counsel, it was not until February 1986 that our third amended
complaint was finally found sufficient by the Federal Court.''
Some argue that securities fraud class actions are
inhibiting the capital formation process. Marc Lackritz,
President of the Securities Industry Association, testified on
March 2, 1995 that ``new or innovative ventures are foregone
because of the litigation risks involved in capital
formation.'' James F. Morgan testified on behalf of the
National Venture Capital Association that the big accounting
firms are ``winnowing out'' growth companies because of their
riskiness.
In fact, initial public offerings have been setting records
in recent years: the record $39 billion in initial public
offerings in 1992 was in turn exceeded by a record $57 billion
in IPO's in 1993.7 The $34 billion in IPO's in 1994
was exceeded only by the records set in 1992 and
1993.8 Less than one month ago, on May 22, 1995, the
New York Times reported:
---------------------------------------------------------------------------
\7\ ``Securities Industry TRENDS,'' Vol. XXI, No. 3, April 5, 1995
(Source: Securities Data Company).
\8\ Id.
One of the great booms in initial public offerings is
now under way, providing hundreds of millions in new
capital for high-tech companies, windfalls for those
with good enough connections to get in on the offerings
and millions in profit for the Wall Street firms
---------------------------------------------------------------------------
underwriting the deals.
The Securities Industry Association's own publications describe
the boom in initial public offerings:
``After years of weakness in the late 1980s,
investment in new securities and IPOs accelerated
dramatically from 1990-1993. During that time, the
securities industry raised a record $130 billion for
small business through IPOs. Again, this was more than
was raised in America's first two centuries!''
9
---------------------------------------------------------------------------
\9\ The Securities Industry Briefing Book, A Partnership with
America (1994), at 11.
---------------------------------------------------------------------------
PROVISIONS OF S. 240
To be sure, frivolous litigation should be deterred and
sanctioned. Some of the provisions in S. 240 as reported appear
to be directed toward this goal. The requirement that courts
include specific findings in securities class actions regarding
compliance by all parties and attorneys with Rule 11(b) of the
Federal Rules of Civil Procedure should act as a powerful
deterrent to frivolous cases. Should a court find a violation
of Rule 11, the court is required to impose sanctions.
The bill also prohibits payments to lead plaintiffs in
class actions of additional compensation, other than
``reasonable costs and expenses.'' This will help ensure that
class actions are brought by real parties in interest, rather
than ``professional plaintiffs.'' To the same end, the bill
requires that the plaintiff file a sworn statement that he or
she authorized the filing of the complaint and did not purchase
the securities at the direction of counsel or to participate in
a lawsuit. The bill also prohibits attorneys from paying
brokers for referring clients.
The bill also seeks to improve the procedures governing
class action lawsuits. The new procedures contained in the bill
for selecting a lead plaintiff in class actions are designed to
encourage participation by institutional investors. We are
pleased that this provision contains safeguards intended to
ensure that a lead plaintiff must continue to represent the
class fairly and adequately, as required under the Federal
Rules of Civil Procedure.
The bill also seeks to improve the quality of information
provided to investors when a securities fraud action is
settled. The bill requires that a notice of a proposed
settlement provided to investors must include clear information
to allow investors to make an informed decision on the
settlement. The statement must include the reason for the
proposed settlement, the average damages recoverable per share
if the settling parties can agree, and the attorneys' fees and
costs.
Provisions of S. 240 will hurt investors
Other provisions in S. 240, however, are not tailored to
deterring or sanctioning frivolous litigation. Instead, they
will make it more difficult to bring all securities fraud
suits, including meritorious cases, and reduce recoveries
across the board.
Safe harbor provision will undermine market confidence by protecting
fraudulent statements
Contrary to the advice of the SEC, the North American
Securities Administrators Association, the Government Finance
Officers Association and others, S. 240 as reported creates a
statutory exemption from liability for certain ``forward
looking statements.'' Not only will this provision immunize
reckless statements, but Chairman Levitt has warned that as
drafted it will immunize fraudulent statements as well. By
undermining confidence in our markets, such a return to the
pre-Federal securities laws days of ``buyer beware'' would not
benefit investors or issuers.
``Forward looking statements'' are broadly defined in the
bill, to include projections of financial items such as
revenues, income and dividends as well as statements of future
economic performance required in documents filed with the SEC.
As with any attempt to foresee the future, such statements
always have an element of risk to them, and prudent investors
must be careful in relying on them. In fact, until 1979 the SEC
prohibited disclosure of forward looking information. The SEC
believed that forward looking information was inherently
unreliable, and that investors would place too much emphasis on
such information in making investment decisions.
After reviewing the matter extensively in the 1970's, the
SEC adopted a ``safe harbor'' regulation for forward looking
statements.10 The regulation (known as ``Rule 175'')
generally offers protection for specified forward looking
statements when made in documents filed with the SEC. To
sustain a fraud suit, the investor must show that the forward
looking information lacked a reasonable basis and was not made
in good faith.
---------------------------------------------------------------------------
\10\ See Securities Act Release No. 6084 (June 25, 1979); 17 CFR
230.175 (1994), 17 CFR 240.3b-6 (1994).
---------------------------------------------------------------------------
There is a wide body of opinion that the current regulatory
safe harbor does not provide sufficient protection for good
faith corporate projections. In a May 19, 1995 letter to the
members of the Senate Banking Committee, Chairman Levitt
acknowledged ``a need for a stronger safe harbor than currently
exists.'' Indeed, the SEC has been conducting a comprehensive
review of its safe harbor regulation.11 Testifying
before the Securities Subcommittee in April, Chairman Levitt
said:
---------------------------------------------------------------------------
\11\ See Securities Act Release No. 33-7101 (October 13, 1994).
The Commission recently published a ``concept'' release
soliciting comments on current practices relating to
disclosure of forward-looking information, with a view
to developing a new safe harbor for projections that
provides issuers with meaningful protection but
continues to protect investors. The Commission has
received approximately 150 comment letters in response
to the release, and public hearings on the issue were
conducted in Washington, DC and San Francisco during
---------------------------------------------------------------------------
February.
As originally introduced by Senators Domenici and Dodd, S.
240 would have allowed the SEC to continue this regulatory
effort. The bill as introduced required that the SEC consider
adopting rules or making legislative recommendations
identifying criteria for exempting ``forward-looking statements
concerning * * * future economic performance'' from antifraud
liability under the Federal securities laws. S. 240 provided
that if the SEC adopted such a rule, a defendant could request
a stay of discovery while the court considered a motion for
summary judgment on the grounds that the forward looking
statement was within the coverage of the rule.
Chairman Levitt endorsed this approach in his April 1995
testimony before the Securities Subcommittee:
From the Commission's perspective, an appropriate
legislative approach is contained in the Domenici/Dodd
bill. This provision would allow the Commission to
complete its rulemaking proceeding and take appropriate
action after its evaluation of the extensive comments
and testimony already received. Based on the
Commission's experience with this issue to date, we
believe that there is considerable value in proceeding
with rulemaking, which can more efficiently be
administered, interpreted and, if needed, modified,
than can legislation.
In a May 23, 1995 letter, the North American Securities
Administrators Association, the Government Finance Officers
Association, the National League of Cities and nine other
groups expressed the same view (``we believe the more
appropriate response is SEC rulemaking in this area'').
However, the Committee Print substitute to S. 240, unlike
the bill as introduced, abandoned this approach in favor of
enacting a statutory safe harbor. Like the bill passed by the
House, S. 240 as reported will for the first time shield
fraudulent statements from liability under the Federal
securities laws. This provision constitutes an ill-advised
break with 60 years experience under the Federal securities
laws.
Under the original Committee Print, forward looking
statements were immunized from antifraud liability under the
Federal securities laws unless they were ``knowingly made with
the expectation, purpose, and actual intent of misleading
investors,'' and unless an investor could prove that he or she
``had actual knowledge of and actually relied on'' the
statement.12
---------------------------------------------------------------------------
\12\ In Basic, Inc. v. Levinson, 485 U.S. 224 (1988), the Supreme
Court rejected this requirement of ``actual knowledge of and actual
reliance on'' fraudulent statements in most circumstances. Instead, the
Supreme Court recognized a doctrine called ``fraud on the market'' that
had previously been adopted by a majority of Federal circuit courts.
The Court held that:
[a]n investor who buys or sells stock at the price set by
the market does so in reliance on the integrity of that
price. Because most publicly available information is
reflected in the market price, an investor's reliance on
any public material misrepresentations, therefore, may be
---------------------------------------------------------------------------
presumed for purposes of a[n antifraud] action.
485 U.S. at 247.
In a May 19, 1995 letter to the members of the Senate
Banking Committee, SEC Chairman Levitt expressed his ``personal
views about a legislative approach to a safe harbor.'' He
suggested that:
[a] carefully crafted safe harbor protection from
meritless private lawsuits should encourage public
companies to make additional forward-looking disclosure
that would benefit investors. At the same time, it
should not compromise the integrity of such information
which is vital to both investor protection and the
efficiency of the capital markets--the two goals of the
federal securities laws.
He stated, ``[a] safe harbor must be thoughtful--so that it
protects considered projections, but never fraudulent ones.''
He indicated he would support a safe harbor containing ``a
scienter standard other than recklessness.''
As explained above, the safe harbor provision in the
original Committee Print did not adhere to Chairman Levitt's
suggestions: the safe harbor in the original Committee Print
would have protected fraudulent projections if an investor
could not prove ``actual knowledge'' of and ``actual reliance''
on the projection. The substitute Committee Print offered at
the Committee's May 25, 1995 mark up deleted the requirement
that an investor prove he or she ``had actual knowledge of and
actually relied on'' a fraudulent statement.
As amended, however, the substitute Committee Print
continued to exclude from the safe harbor protection only
statements ``knowingly made with the expectation, purpose, and
actual intent of misleading investors.'' The Committee Report
states that ``expectation,'' ``purpose,'' and ``actual intent''
are separate elements, each of which must be proven by the
investor. This language so troubled Chairman Levitt that he
wrote to Committee members again, on May 25, 1995, the morning
of the markup. He stressed that even the substitute Committee
Print failed to adhere to his belief that a safe harbor should
never protect fraudulent statements:
I continue to have serious concerns about the safe
harbor fraud exclusion as it relates to the stringent
standard of proof that must be satisfied before a
private plaintiff can prevail. As Chairman of the
Securities and Exchange Commission, I cannot embrace
proposals which allow willful fraud to receive the
benefit of safe harbor protection. The scienter
standard in the amendment may be so high as to preclude
all but the most obvious frauds.
He warned that the bill's standard of ``knowingly made with the
expectation, purpose and actual intent of misleading
investors'' is a more stringent standard than currently used by
the SEC and the courts. Given the broad definition of ``forward
looking statement'' discussed above, it is crucial that the
legislation not shield such statements from antifraud
liability.
The Committee Report states that the safe harbor provision
in the bill is based on current Rule 175, and a legal doctrine
known as ``bespeaks caution.'' Neither the SEC rule nor the
court decisions cited, however, provide protection to
fraudulent statements as the bill does.
As discussed above, the SEC's Rule 175 does not immunize
fraudulent statements. It requires forward looking statements
to be reasonable and made in good faith.
The courts have imposed a similar requirement on forward
looking statements. The Third Circuit case cited by the
majority, In re Donald J. Trump Casino Securities Litigation, 7
F.3d 357 (3rd Cir. 1991), states:
We have squarely held that opinions, predictions and
other forward-looking statements are not per se
inactionable under the securities laws. Rather, such
statements * * * may be actionable misrepresentations
if the speaker does not genuinely and reasonably
believe them.13
---------------------------------------------------------------------------
\13\ 7 F.3d at 368.
Rubenstein v. Collins, 20 F.3d 160 (5th Cir. 1994), also cited
in the Committee Report, reaches the same conclusion. The Fifth
---------------------------------------------------------------------------
Circuit held that a forward looking statement
contains at least three factual assertions that may be
actionable: (1) The speaker genuinely believes the
statement is accurate; (2) there is a reasonable basis
for that belief; and (3) the speaker is unaware of any
undisclosed facts that would tend seriously to
undermine the accuracy of the statement.14
---------------------------------------------------------------------------
\14\ 20 F.3d at 166.
The Third Circuit stated that to be immunized from
liability the forward looking statements must be accompanied by
cautionary statements ``substantive and tailored to the
specific future projections estimates or opinions
* * *.''15 The bill omits this requirement. Instead,
it allows forward looking statements to be accompanied by
general words of caution that will likely be boilerplate
language, of little use to investors.
---------------------------------------------------------------------------
\15\ 7 F.3d at 371-72.
---------------------------------------------------------------------------
The Committee Report states that the safe harbor provision
is intended to encourage disclosure of information by issuers.
Encouraging companies to make fraudulent projections would hurt
investors trying to make intelligent investment decisions and
penalize companies trying to communicate honestly with their
shareholders. We hope the majority of the Committee did not
intend to achieve such a result. A safe harbor for fraudulent
statements runs counter to the entire philosophy of the Federal
securities laws, that fraud must be deterred and punished when
it occurs. As described above, this philosophy has helped build
the most vibrant securities markets in the world. While the
majority of the Committee did not accept an amendment to this
provision at the markup, we hope that the flaw in this
provision identified by Chairman Levitt will be corrected.
Proportionate liability provision transfers losses from fraud
perpetrators to fraud victims
Predating the Federal securities laws, courts have
traditionally held parties who commit fraud to be ``jointly and
severally'' liable. Under joint and several liability, each
person who participates in a fraud is liable for the entire
amount of the victim's damages. Mark Griffin, Securities
Commissioner for the State of Utah, testified before the
Securities Subcommittee on March 22, 1995 on behalf of the 50
State securities commissioners. He explained why the law
currently holds all parties who participate in a securities
fraud jointly and severally liable:
Under current law, each defendant who conspires to
commit a violation of the securities law is jointly and
severally liable for all the damages resulting from the
violation. The underlying rationale of this concept is
that a fraud will fail if one of the participants
reveals its existence and, as a result, all wrongdoers
are held equally culpable if the fraud achieves its
aims. (emphasis in original)
In Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), the
Supreme Court held that a defendant is liable under the Federal
securities antifraud provision only if he or she possesses a
state of mind known in the law as ``scienter.'' Conduct
intended to deceive or mislead investors satisfies the scienter
requirement.
While the Supreme Court did not decide the question in
Hochfelder, courts in every Federal circuit have held that
reckless conduct also satisfies the scienter requirement. These
courts have followed the guidance of hundreds of years of court
decisions in fraud cases. As the Restatement of Torts, states,
``The common law has long recognized recklessness as a form of
scienter for purposes of proving fraud.''16
---------------------------------------------------------------------------
\16\ See Restatement (Second) of Torts, Sec. 526(b), comment e;
Prosser and Keeton, Law of Torts, Sec. 107.
---------------------------------------------------------------------------
The most commonly accepted definition of reckless conduct
that constitutes securities fraud was enunciated by the Seventh
Circuit in Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d
1033 (7th Cir. 1977), cert. denied, 434 U.S. 875. This
demanding standard defines reckless conduct as:
Highly unreasonable [conduct], involving not merely
simple, or even gross negligence, but an extreme
departure from the standards of ordinary care, and
which present a danger of misleading buyers or sellers
that is either known to the defendant or is so obvious
that the actor must have been aware of it.
Under current law, then, individuals who participate in a fraud
through their reckless conduct are fully liable to the victims.
Recklessness liability is generally applied to an issuer's
professional advisers, such as accountants, attorneys and
underwriters.
The bill limits joint and several liability under the
Federal securities laws to persons who committed ``knowing
securities fraud.'' All other violators will generally be
liable only for their proportionate share of the fraud victim's
losses. ``Knowing securities fraud'' is defined in the
legislation specifically to exclude reckless conduct. S. 240
thus reduces the liability for reckless violators from joint
and several liability to proportionate liability.
When investors' damages can be paid by a violator who is
jointly and severally liable, this change will not affect the
recovery available to investors. In cases where the architect
of the fraud is bankrupt, has fled, or otherwise cannot pay the
investors' damages, though, this change will harm investors. In
those cases, innocent victims of fraud will be denied full
recovery of their damages. Testifying before the Securities
Subcommittee on April 6, 1995, Chairman Levitt said:
Proportionate liability would inevitably have the
greatest effect on investors in the most serious cases
(e.g., where an issuer becomes bankrupt after a fraud
is exposed). It is for this reason that the Commission
has recommended that Congress focus on measures
directly targeted at meritless litigation before
considering any changes to the liability rules.
Perhaps recognizing this unfairness to investors, S. 240
would require violators who are proportionately liable to pay
more than their proportionate share in two circumstances.
Neither provision, however, goes very far toward making fraud
victims whole. First, if part of the judgment is uncollectible,
defendants who are proportionately liable would be jointly and
severally liable to investors whose net worths are each under
$200,000 and who each lost more than 10 percent of that net
worth in the fraud. In our view, this will protect only a tiny
number of investors. In many parts of the country, few
investors who own their own homes will have net worths under
$200,000. Further, very few such investors will invest 10
percent of their net worth in a single stock or bond issue.
Second, if part of the judgment is uncollectible, defendants
who are proportionately liable would also be liable for an
additional amount, not to exceed 50 percent of their
proportionate share. For example, a defendant found to be 10
percent responsible for the commission of a fraud would be
liable for up to 15 percent of the investors' losses. This
provision therefore will likely increase the recovery of
defrauded victims only marginally, leaving the balance of
losses uncollectible.
In a February 23, 1995 letter to House Commerce Committee
Chairman Thomas J. Bliley, Jr., Chairman Levitt wrote, ``[t]he
Commission has consistently opposed proportionate liability.''
The Association of the Bar of the City of New York agreed ``it
is critical that all defendants remain jointly and severally
liable to the plaintiff when a wrongdoer is unable to pay his
or her share of any judgment.'' In their June 8, 1995 letter,
the Government Finance Officers Association also identified the
restriction of joint and several liability as a reason for
their opposition to the bill.
Accountants are the class of defendants most likely to be
affected by a change to proportionate liability. Dr. Abraham J.
Briloff, CPA, the Emanuel Saxe Distinguished Professor Emeritus
of Baruch College, City University of New York and a respected
authority on accounting, testified before the Banking
Committee. He stressed the crucial role accountants play in
preventing fraudulent financial statements from reaching the
investing public. He stated that the accountant
is presumed to stand as the ``sentinel at the gates'';
it is he who holds the passkey required for the history
of the enterprise's management and accountability, its
financial statements, to become acceptable for the
purposes of the securities laws.
If * * * he has permitted the passkey to be used
irresponsibly, then he should be held fully liable for
any resultant harm to those who relied on his
professional undertaking.
To the extent he may identify those who overtly
created the underlying quagmire, well, then, the
auditor should have the right of subrogation. But
again, as in negotiable instruments law, if you cannot
find the ``maker'', you proceed against the ``last
endorser''--in the circumstances before us that ``last
endorser'' is presumed to be the certified public
accountant who has undertaken the independent audit
function.
The bill would undermine the independent auditor's role as the
last line of defense against fraud.
The legislation reported provides that defendants who meet
the Sundstrand definition of recklessness, that is, who know of
a fraud but in an extreme departure from the standards of
ordinary care do nothing about it, will no longer be
responsible for the result of their conduct. Instead, innocent
investors--individuals, pension funds, county governments--will
have to make up the loss. This legislation would, for the first
time in our legal history, transfer responsibility for bearing
the results of a fraud from participants in the fraud to
innocent victims of the fraud. Such a change would be neither
fair to investors nor beneficial to our markets, and is opposed
by a host of consumer groups, labor unions, and government
officials.17
---------------------------------------------------------------------------
\17\ See May 23, 1995 letter to Committee Members from American
Council on Education, California Labor Federation--AFL-CIO, Congress of
California Seniors--LA County, Consumer Federation of America,
Consumers for Civil Justice, International Brotherhood of Teamsters,
Government Finance Officers Association, Gray Panthers, National League
of Cities, New York State Council of Senior Citizens, North American
Securities Administrators Association, and U.S. Public Interest
Research Group (``primary concerns with respect to the provisions of S.
240 * * * include * * * Limits on joint and several liability. * *
*''); May 24, 1995 letter to Committee Members from Citizen Action,
Consumer Federation of America, Consumers Union, Public Citizen, U.S.
Public Interest Research Group, Violence Policy Center (``Abrogation of
joint and several liability * * * would effectively immunize
professional wrongdoers.'').
---------------------------------------------------------------------------
S. 240 DOES NOT CONTAIN PROVISIONS NEEDED TO PROTECT INVESTORS
We are concerned about the provisions of S. 240 described
above, which in our view will harm investors bringing
meritorious suits. We also are disappointed that S. 240 as
reported does not contain provisions that would aid investors
bringing meritorious suits.
Failure to extend the statute of limitations
Chairman Levitt's May 25, 1995 letter to the members of the
Banking Committee stated, ``[i]n addition to my concerns about
the safe harbor, there is not complete resolution of two
important issues for the Commission. First, there is no
extension of the statute of limitations for private fraud
actions from three to five years.''
For over 40 years, courts held that the statute of
limitations for private rights of action under Section 10(b) of
the Securities Exchange Act of 1934, the principal antifraud
provision of the Federal securities laws, was the statute of
limitations determined by applicable State law. While these
statutes varied, they generally afforded securities fraud
victims sufficient time to discover and bring suit. Indeed, 13
States recognize the concept of equitable tolling, under which
the statute of limitations does not begin to run until the
fraud is discovered, for private securities fraud
cases.18
---------------------------------------------------------------------------
\18\ See June 14, 1995 letter from the North American Securities
Administrators Association.
---------------------------------------------------------------------------
In Lampf v. Gilbertson, 501 U.S. 350 (1991), the Supreme
Court significantly shortened the period of time in which
investors may bring such securities fraud actions. By a five to
four vote, the Court held that the applicable statute of
limitations is one year after the plaintiff knew of the
violation and in no event more than three years after the
violation occurred. This is shorter than the statute of
limitations for private securities actions under the law of 31
of the 50 States.19
---------------------------------------------------------------------------
\19\ Id.
---------------------------------------------------------------------------
Lampf 's shorter period does not allow individual investors
adequate time to discover and pursue violations of securities
laws. Testifying before the Banking Committee in 1991, SEC
Chairman Richard Breeden stated ``the timeframes set forth in
the [Supreme] Court's decision is unrealistically short and
will do undue damage to the ability of private litigants to
sue.'' Chairman Breeden pointed out that in many cases,
Events only come to light years after the original
distribution of securities and the Lampf cases could
well mean that by the time investors discover they have
a case, they are already barred from the courthouse.
The FDIC and the State securities regulators joined the SEC in
favor of overturning the Lampf decision.
On this basis, the Banking Committee in 1991 without
opposition adopted an amendment to the bill later enacted as
the FDIC Improvement Act (``FDICIA''). The amendment lengthened
the statute of limitations for all Section 10(b) rights of
action to two years after the plaintiff knew of the securities
law violation, but in no event more than five years after the
violation occurred. In a letter to Senator Bryan, Chairman
Breeden stated that ``[a]doption of these measures would give
private litigants a more realistic time frame in which to
discover that they have been defrauded, while also
accommodating legitimate interests in providing finality to
business transactions and avoiding stale claims.''
When FDICIA reached the Senate floor in November 1991, some
Senators indicated they would seek to attach additional
provisions relating to securities litigation. They argued that
the statute of limitations should not be lengthened without
additional reform of the litigation system. No arguments were
raised specifically against the extension of the statute of
limitations. In order to expedite consideration of FDICIA, the
extension of the statute of limitations was dropped. Senators
Domenici and Dodd included the extended statute of limitations
in their comprehensive securities litigation reform bill,
introduced as S. 1976 in the 103rd Congress and as S. 240 in
this Congress.
Now that the Congress is acting on comprehensive changes to
the securities litigation system, it should include the longer
statute of limitations in keeping with the 1991 agreement.
Chairman Levitt testified before the Securities Subcommittee in
April 1995, ``[e]xtending the statute of limitations is
warranted because many securities frauds are inherently
complex, and the law should not reward the perpetrator of a
fraud who successfully conceals its existence for more than
three years.''
We are deeply disappointed that the Committee did not
include the extension of the statute of limitations in S. 240
as reported, and consider it imperative that the full Senate
restore some balance to the legislation by voting to adopt the
extension.
Failure to restore aiding and abetting liability
Chairman Levitt's May 25, 1995 letter to Banking Committee
Members stated that, in addition to his concerns about the safe
harbor, the Committee Print substitute did not resolve two
important issues for the Commission. The first of these,
discussed above, was the statute of limitations; the second was
aiding and abetting liability. Chairman Levitt expressed his
disappointment that ``the draft bill does not fully restore the
aiding and abetting liability eliminated in the Supreme Court's
Central Bank of Denver opinion.''
Prior to 1994, courts in every circuit in the country had
recognized the ability of investors to sue aiders and abettors
of securities frauds. The courts derived aiding and abetting
liability from traditional principles of common law and
criminal law. The notion attaches liability to those who
provide assistance to the unlawful acts of others. To be held
liable, most courts required that an investor show that a
securities fraud was committed, that the aider and abettor gave
substantial assistance to the fraud, and that the aider and
abettor had some degree of scienter (intent to deceive or
recklessness toward the fraud).\20\
---------------------------------------------------------------------------
\20\ See, e.g., IIT v. Cornfeld, 619 F.2d 909, 992 (2nd Cir. 1980).
---------------------------------------------------------------------------
In Central Bank of Denver v. First Interstate Bank of
Denver, 114 S. Ct. 1439 (1994), the Supreme Court eliminated
the right of investors to sue aiders and abettors of securities
fraud. Writing for four dissenters, Justice Stevens criticized
the five member majority for ``reach[ing] out to overturn a
most considerable body of precedent.'' While the issue was not
directly before the Court, Justice Stevens warned that the
decision would also eliminate the SEC's ability to pursue
aiders and abettors of securities fraud.
As Senator Dodd stated at a May 12, 1994 Securities
Subcommittee hearing, ``aiding and abetting liability has been
critically important in deterring individuals from assisting
possible fraudulent acts by others.'' Testifying at that
hearing, Chairman Levitt stressed the importance of restoring
aiding and abetting liability for private investors:
Persons who knowingly or recklessly assist the
perpetration of a fraud may be insulated from liability
to private parties if they act behind the scenes and do
not themselves make statements, directly or indirectly,
that are relied upon by investors. Because this is
conduct that should be deterred, Congress should enact
legislation to restore aiding and abetting liability in
private actions.
The North American Securities Administrators Association and
the Association of the Bar of the City of New York also
endorsed restoration of aiding and abetting liability in
private actions.
The bill reported by the Committee restores, in part, the
SEC's ability to sue parties who aid and abet violations of the
securities laws. The provision in the bill is limited to
violations of Section 10(b) of the Securities Exchange Act, and
to individuals who act ``knowingly.'' It ignores the
recommendation made by the SEC, the State securities regulators
and the bar association that aiding and abetting liability be
fully restored for the SEC and private litigants as well. While
the provision in the bill is of some help, the deterrent effect
of the securities laws would be strengthened if aiding and
abetting liability were restored in private actions as well.
CONCLUSION
Our capital markets depend on investor confidence.
Individuals and institutions are motivated to place their funds
in our markets, in part because they believe in the efficiency
and fairness of those markets. Their confidence depends also on
the existence of effective remedies against persons who commit
securities fraud.
While we support the goal of deterring and sanctioning
frivolous securities litigation, provisions in this bill will
deter meritorious fraud actions as well. By protecting
fraudulent forward looking statements, and by restricting the
application of joint and several liability, this bill may
undermine investor confidence. These changes are likely to fall
hardest on the elderly, who often are targeted as fraud
victims.\21\ Further, it fails to include provisions that are
needed to ensure that investors have adequate time and means to
pursue securities fraud actions.
---------------------------------------------------------------------------
\21\ See ``If the Hair is Gray, Con Artists See Green,'' The New
York Times, May 21, 1995.
---------------------------------------------------------------------------
The securities markets are crucial to our economic
performance as a nation; we should evaluate efforts to tamper
with them very carefully. Because this legislation may reduce
investor confidence in the capital formation process it seeks
to promote, we oppose it and hope it will be improved by the
full Senate.
Paul Sarbanes.
Barbara Boxer.
Richard Bryan.
ADDITIONAL VIEWS OF SENATOR DODD
I share the view of the Committee majority that this bill
carefully addresses the flaws in the current securities
litigation system, without limiting the rights of investors to
bring actions to recover damages. Striking the balance between
protecting the rights of victims of securities fraud and the
rights of public companies to avoid costly and meritless
lawsuits was difficult, but on balance, I believe the Committee
has succeeded.
The measure adopted by the Committee is based on a bill
that Senator Domenici and I introduced in the past two
Congresses. The bill, as reported, contains several substantial
improvements to S. 240 as introduced this year in the Senate.
However, there are several provisions of the original bill that
I wish had also been included, although I understand the need
to produce a consensus document.
Specifically, I have pressed for an extension of the
current statute of limitations for private actions under the
Securities Exchange Act of 1934. The Committee rejected an
amendment to do that, and I expect this issue will be raised
again when this bill is considered by the entire Senate.
Another issue of concern to me involves liability in
private actions under 10b-5 for aiders and abettors of primary
securities law violators. As chairman of the Subcommittee on
Securities, I held a hearing on this issue in May 1994, after
the Supreme Court ruled that private parties could not bring
suit against alleged aiders and abettors. I am pleased that the
Committee bill grants the Securities and Exchange Commission
explicit authority to bring actions against those who knowingly
aid and abet primary violators. However, I remain concerned
about liability in private actions and will continue to work
with other Committee members on this issue as we move to floor
consideration.
A final provision, which would have created a self-
disciplinary organization for auditors, is also not part of the
bill.
I favor all three of these provisions because of my belief
that as we properly make it more difficult to bring meritless
lawsuits, we must do all that we can to ensure that legitimate
victims can continue to sue and can recover damages quickly. It
is appropriate to ``raise the bar,'' but we must provide the
careful balance that is needed to protect the rights of fraud
victims.
Chris Dodd.