Congress should not repeal the Private Securities Litigation Reform Act - Law & Justice

THE ENACTMENT of the Private Securities Litigation Reform Act of 1995 (PSLRA) was a victory for accountants, securities firms, and the high-technology industry, who were frequent targets of securities fraud class actions. Subsequent events have substantially diminished the lobbying clout of these industries. Arthur Andersen's involvement in the accounting legerdemain at Enron and its subsequent criminal conviction have discredited the accounting industry as a whole. Incriminating emails from Merrill Lynch, Credit Suisse First Boston, and Salomon Smith Barney suggest that the stock picks that brokers offer their clients may be little more credible than the pitch of the average used-car salesman. The collapse of the high-tech bubble erased 4.3 trillion dollars in market capitalization from the NASDAQ. Those developments have left multitudes of angry investors in their wake.

Opponents of securities fraud class action reform--i.e., the class action bar--see Enron, Worldcom, and the host of lesser scandals that have followed as their great chance to undo securities litigation reform. The Enron fiasco, the plaintiffs' lawyers claim, shows that the curbs on abusive lawsuits created by the PSLRA give corporations carte blanche to engage in fraud. William Lerach, dean of the class action bar, labels PSLRA the "Corporate License to Lie Act." Bills have been introduced in Congress that would repeal its critical provisions.

Evidence does not support repealing PSLRA. In fact, securities class actions are getting filed at a record pace. Although a higher percentage of these lawsuits are being dismissed than prior to the act, the ones that survive lead to larger settlements. The combination of higher settlements in a smaller percentage of cases suggests that the class action lawsuits under PSLRA deterring corporate fraud are more cost effective. This conclusion is bolstered by the fact that post-PSLRA complaints have more delineated allegations that are more highly correlated with factors related to fraud.

Why do we worry about corporate fraud? Most conspicuously, fraud may influence how investors direct their capital. Firms selling securities disclose more information in an effort to attract investors. If those disclosures are fraudulent, investors will pay an inflated price for those securities and companies will invest in projects that are not cost-justified. That risk of fraud will lead investors to discount the value of securities, thus raising the cost of capital for publicly traded firms.

The U.S. scheme of securities regulation deploys a variety of countermeasures to discourage fraud, Reputable accounting firms audit financial statements. Audit committees of outside directors oversee company disclosures. Analysts rate them for credibility and completeness. In addition to those market mechanisms, fraud is further monitored by Securities and Exchange Commission (SEC) enforcement and criminal prosecutions by the Justice Department. Class actions promise additional deterrence as well as compensation to the victims of fraud. That promise of compensation--and the enormous damages necessary to fulfill that promise--strikes genuine fear into the hearts of corporate executives. Yet, the potential for large damages undermines the regulatory value of securities fraud class actions.

Compensation is important when the corporation has been selling securities through fraud, correcting fraud's distortions in two ways. First, requiring compensation to the victim discourages the corporation from committing the fraud. Second, compensation discourages investors from expending resources trying to avoid fraud. Expenditures by both the perpetrator and the victim due to fraud are a social waste, so compensation makes sense in that context. The Federal securities laws encourage such fraud suits with a generous standard for recovery. Despite that encouragement, claims asserting a misrepresentation made by a company in connection with an offering of securities are just a small percentage of securities class actions.

The overwhelming majority of securities fraud class actions do not involve corporations selling securities. In the typical securities fraud class action, plaintiffs' attorneys sue the corporation and its officers for alleged deceptions regarding the company's operations, financial performance, or future prospects that inflate the price of the company's stock in secondary trading markets. Because the corporation has not sold securities (and thereby transferred wealth to itself), it has no institutional incentive to spend real resources in executing the fraud. Commonly referred to as fraud on the market, it does not create a net wealth transfer away from investors, at least in the aggregate. For every shareholder who bought at a fraudulently inflated price, another shareholder has sold: The buyer's individual loss is offset by the seller's gain. Assuming all traders are ignorant of the fraud, over time they will come out winners as often as losers from fraudulently distorted prices. Therefore, shareholders should have no expected loss from fraud on the market, so they would have no incentive to take precautions against the fraud. Diversification protects them.

Despite the lack of gain to the corporation, class action lawsuits allow a full measure of compensation from the corporation to investors who come out on the losing end of a trade at a price distorted by misrepresentation. Given the trading volume in secondary markets, the potential recoverable damages in such suits can be a substantial percentage of the corporation's total capitalization, easily reaching hundreds of millions of dollars. With potential damages in this range, class actions are a big stick to wield against fraud. Punitive sanctions of that sort are only appropriate, however, when they closely correspond to the actual incidence of fraud. Securities fraud class actions fall far short of that ideal. Distinguishing fraud from mere business reversals is difficult. The external observer may not know whether a drop in a company's stock price is due to a prior intentional misstatement about its prospects (fraud) or a result of risky business decisions that did not pan out (misjudgment or bad luck). Unable to distinguish the two, plaintiffs' lawyers must rely on limited publicly available indicia (SEC filings and press releases from the company; evidence of insider trading by the managers alleged to be responsible for the fraud) when deciding whom to sue. Thus, a substantial drop in stock price following news that contradicts a previous optimistic statement may well lead to a lawsuit.

That leaves courts with the unenviable task of sorting the meritorious cases from the strike suits. Courts and jurors, with hindsight, may have difficulty distinguishing knowingly false statements from unfortunate business decisions. Both create a risk of liability and, thus, provide a basis for filing suit. The thinking usually is: Sue all of the plausible candidates and let the courts sort them out. Filing numerous cases is not only reasonable, but profitable for plaintiffs' attorneys because of the incentives that defendants face. If plaintiffs can withstand a motion to dismiss, defendants generally will find settlement cheaper than litigating to a jury verdict, even if the defendants believe that a jury would share their view of the facts. Moreover, any case plausible enough to get past a judge may be worth settling if only to avoid the costs of discovery and attorneys' fees, which can be enormous. Securities fraud class actions are expensive to defend because the focus of litigation will often be scienter, that is the extent and timing of the defendants' knowledge. The most helpful source for uncovering that fact will be the documents in the company's possession. Producing all documents relevant to the knowledge of senior executives over many months or even years can be a massive undertaking for a corporate defendant. Having supplied the documents, the company then can anticipate a seemingly endless series of depositions, as plaintiffs' counsel seeks to determine whether the executives' recollections square with the documents. Beyond the cost in executives' time, the mere existence of the class action may disrupt relationships with suppliers and customers, who understandably will be leery of dealing with a business accused of fraud.

Putting to one side the costs of litigation, the overwhelming potential damages also make settlement an attractive option, even when the company is optimistic that it will prevail at trial. The math is straightforward: a 10% chance of a $250,000,000 judgment means that a settlement for $24,900,000 makes sense. The combination of the cost of litigating securities class actions and the potential for enormous judgments means that even weak cases may produce a settlement if they are not dismissed before trial. If both weak and strong cases lead to settlements, the deterrent effect of class actions is diluted because both innocent and wrongful conduct are punished.

Congress' central goal in enacting PSLRA was to discourage frivolous litigation, believing that class actions were being filed with "a laundry list of cookie-cutter complaints" against companies "within hours or days" of a large drop in the company's stock price. Legislators felt that a substantial number of weak cases settled because the underlying legal merits could not be determined from the complaint alone. Faced with the discovery, defendants found that "the pressure to settle became enormous." Even if a company were willing to bear the expense of litigation, Congress concluded that the company would inevitably settle rather than face a potentially ruinous jury verdict. The overall effect was that liability exposure was chilling issuers from making statements about their business. There was concern as well that innocent bystanders were being caught in the securities fraud class action crossfire. According to the Senate Report, "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." Under the rule of joint and several liability, a secondary defendant could be left holding the bag if the defendant that engaged in the fraud later became insolvent, not an infrequent occurrence.

Congress addressed these problems through a series of procedural obstacles. The first barrier to frivolous class actions is a "sate harbor" provision for projections that are not knowingly false, or that have been qualified by "meaningful cautionary language." That makes it very difficult for plaintiffs to bring lawsuits based on predictions concerning the company's future that have not come true, the archetypal "fraud by hindsight" claim. The second barrier is broader. PSLRA imposes a rigorous pleading standard, requiring plaintiffs to specify in their complaint each statement alleged to have been misleading and the reasons why it is so. It also requires plaintiffs to state with particularity facts giving rise to a "strong inference" that the defendant acted with "the required state of mind." Judges apply these rules in reviewing the complaint before discovery, which is stayed while a motion to dismiss is pending. Thus, the complaint becomes the critical document in the case--if the plaintiffs cannot make out a credible case of fraud when they file their suit, they cannot proceed with the claims. Early dismissal with no discovery greatly reduces the expense to corporations forced to defend such suits, thereby limiting the settlement value of weak cases.

PSLRA limits the liability of certain peripheral defendants as well. The act adopts proportionate, rather than joint and several, liability for defendants who are not found knowingly to have violated the securities laws. That protection is most important for secondary defendants, such as accountants, lawyers, and investment bankers, who may be implicated in fraud by corporate defendants. If those secondary defendants can show that they did not know of the fraud, their liability exposure will be limited substantially.

The average number of suits is up nearly 25% from pre-PSLRA levels, so it does not appear that the law has discouraged plaintiffs' attorneys from filing suit. Yet, that increase in filings does not necessarily translate to greater liability exposure for corporations, as there is evidence that PSLRA has resulted in a higher percentage of cases being dismissed. A study by the National Economics Research Associates reports that the dismissal rate for securities fraud class actions has roughly doubled since the passage of PSLRA, so nearly a quarter of all suits are now dismissed.

The combination of more filings and more dismissals seems contradictory. Why would plaintiffs' lawyers waste time and effort filing suits that are likely to be dismissed? Plaintiffs' attorneys argue that the upsurge in filings simply reflects a massive increase in fraud. The sole difference post-PSLRA, claim the lawyers, is that meritorious suits are being dismissed. An alternative explanation for the surge in filings is that the plaintiffs' counsel is incapable of sorting fraud from misjudgment or bad luck based on the information available to them. Consequently, they sue on the basis of bad news that may reflect either. If they can withstand a motion to dismiss, they can gain access to discovery of the corporation's internal documents in an attempt to determine whether there has been fraud. A higher dismissal rate means that plaintiffs' lawyers need to file more suits in hopes that a reasonable number will make it through to discovery. If plaintiffs' lawyers simply are filing more suits in the hope that a few will "stick," PSLRA may not have achieved its goal of discouraging frivolous class actions. If those actions are quickly dismissed, however, the costs of defending them are greatly diminished. Moreover, the higher dismissal rate suggests that the sanctions that flow from securities fraud class actions are more precisely targeted weaker suits are dismissed more often, while stronger claims proceed.

Deterrence is determined not only by the precision, but the magnitude of sanctions. Studies have found that settlements are larger for post-PSLRA cases. The available evidence points out that suits naming accountants and underwriters lead to greater settlements, suggesting that the PSLRA has not exempted secondary defendants from paying damages.

The impetus for calls to repeal PSLRA is easy to understand. A spate of accounting and corporate governance scandals followed shortly after the passage of a law that made it more difficult to sue for fraud. It's not just the fraud headlines that support this impulse--the number of restatements of accounting results generally has been on the rise. Some conclude from that chronology that PSLRA "caused" corporate fraud. That logic is based on publicity rather than sound statistical inference. After a flurry of headlines trumpeting corporate wrongdoing, it is easy to be misled by a small number of high-profile cases, but the Enrons and Worldcoms are not representative of America's corporations. There are more than 15,000 public companies in the U.S., and a mere handful of them have been implicated in wrongdoing. Fraud always will be present, but it would be a mistake to conclude from what may be little more than a statistically insignificant blip that the U.S. is headed toward a financial apocalypse. The increased number of restatements also is misleading. Many of those are the result of shifts by the SEC in interpreting accounting rules. A company's failure to anticipate a change in the SEC's position does not equate to fraud.

Financial factors

There are other factors in the financial environment that helped lead to these corporate scandals, like the popularization of stock options at the expense of more traditional forms of compensation, such as cash. The stock option craze of the late 1990s was driven in part by companies with good ideas, but little cash, who needed to attract talented employees. In addition, that frenzy was sparked by an excise tax that Congress imposed on "excessive" executive compensation in 1993--yet another example of the law of unintended consequences.

The excise tax excluded "incentive" compensation, which led to an enormous spike in the use of stock options, with a corresponding motivation to keep those options "in the money." For the options to be lucrative, the current price of the stock had to exceed the exercise price of the option. If accounting results had in be massaged a little to inflate the stock price, what was the harm? A dramatic loss in investor confidence, it turns out. Stock options are a useful component of many compensation packages, but whatever the relative merits of options and cash compensation, Congress has no business putting its fat thumb on the scale in favor of one over the other.

A number of bills have been introduced to undo securities class action reform. Not surprisingly, given Arthur Andersen's role in the demise of Enron, accountants were the central target. Those bills include proposals to bring back joint and several liability for secondary defendants and to eliminate the discovery stay if auditors were named as defendants, allowing the plaintiffs' attorney immediate access to the accountants' work papers. Is diminished liability for secondary defendants a real concern? Hardly. The reputational sanction for complicity in fraud is severe, as Andersen's bankruptcy filing after its conviction for obstruction of justice shows. Accountants are in the business of renting their reputation to corporations. Once they lose their reputation for integrity, they have nothing left to sell. The market sanction for misbehavior is swifter and surer than any legal punishment. PSLRA does not let secondary defendants off scot-free, either. Proportionate liability does not signify that accountants, lawyers, and underwriters are immune from liability. Rather it means they are responsible specifically for the incremental harm caused by their participation in the fraud.

Under PSLRA, secondary defendants are only entitled to the protection of proportionate liability when they lack the knowledge of the fraud. Even then they can be required to pay an additional 50% above the damages based on their fault if the issuer is insolvent, Proportionate liability offers no protection at all for secondary defendants if a jury concludes they were knee deep in the fraud. Accountants still must consider the risk of a securities fraud class action when a client tries to pressure them into acquiescing in a dubious interpretation of accounting principles.

Current proposals to repeal securities fraud class actions would give plaintiffs' lawyers another weapon with which to coerce settlements. Strong sanctions are appropriate for defrauders, but it must be ensured that those sanctions are imposed on bad actors only, Honest businesspeople and professionals need to be protected against threats intended solely to generate larger settlements and attorneys' fees, Investors are the intended beneficiaries of the deterrence produced by securities fraud class actions, but they bear the costs when class actions get out of control in the form of higher insurance premiums for directors' and officers' insurance, as well as higher fees that accountants, lawyers, and investment bankers will charge if they face unjustified litigation risk. PSLRA strikes a balance between the goal of deterrence and the costs that securities fraud class actions impose on investors. Congress will not be doing investors a favor if it opens the door to frivolous class action lawsuits and coercive settlements in its desire to get tough on corporate wrongdoers.

Adam C. Pritchard is a professor of law at the University of Michigan, Ann Arbor.

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