The Committee on Capital Markets Regulation has issued its interim report. While there is no call for an abolition of private securities litigation (as had been suggested in the media), the report does contain a number of findings and recommendations regarding securities class actions that are likely to be controversial.
The basic premise of the “Civil Enforcement” section (pp. 74-84) is that the “public value of the securities class action litigation is questionable.” The Committee cites three reasons for this conclusion. First, “virtually all of the costs” of securities class actions fall on the corporation and its insurers, which means they are ultimately borne by the shareholders. Second, securities class actions do a poor job of compensating investors (average settlement of “between two percent and three percent of the investors’ economic losses”) and there are high transactions costs (attorney fees, business disruption, etc.). Finally, any recovery is “largely paid by diversified shareholders to diversified shareholders and thus represents a pocket-shifting wealth transfer that compensates no one in any meaningful sense.”
In keeping with this assessment, the Committee recommends that the SEC: (1) resolve certain judicial conflicts over Rule 10b-5 liability; (2) limit the amount of damages recoverable in private litigation when it has already provided investor compensation; and (3) encourage courts (perhaps with the assistance of new legislation) to stop pay-to-play practices in which plaintiffs’ firms make political contributions in exchange for lead counsel positions. In particular:
Materiality – The SEC should clarify whether a misstatement can be material if its disclosure does not have an “effect on the market,” thereby resolving a circuit split between the 9th Circuit (yes) and the 3rd Circuit (no).
Scienter – The SEC should clarify whether the fraudulent intent (i.e., scienter) element of a securities fraud claim can be demonstrated by “recklessness.” At least, that is what the Committee appears to be suggesting. The discussion of the current state of the law in this section is simply wrong, with the report stating that there is a split between the Second Circuit’s more strenuous “strong inference of fraudulent intent” standard and the Ninth Circuit’s more lenient “deliberate recklessness” standard. The Committee confuses the Second Circuit’s description of the relevant pleading standard for fraudulent intent (which is mandated by the PSLRA and applicable in every circuit) with the court’s substantive standard for fraudulent intent. In fact, every federal circuit court (including the Second Circuit) has found that recklessness is sufficient to establish fraudulent intent. It is the Ninth Circuit’s “deliberate recklessness” standard, i.e., recklessness so severe that it “strongly suggests actual intent,” that is generally believed to be the most strenuous version of this standard in the country. (For more on this issue, the author of The 10b-5 Daily has co-written an article that discusses the differences between the pleading and substantive standards for scienter applied by the various circuits.)
Efficient Market – The SEC should clarify what constitutes an efficient market for purposes of applying the fraud-on-the market theory. The Committee discusses the recent PolyMedica decision in the First Circuit.
Overlap between SEC and Private Lawsuits – The SEC should “prohibit double recoveries against defendants by requiring that private damages awards be offset by any Fair Funds collections [by the SEC] applied for victim compensation.” Interestingly, the Committee suggests that the SEC has the authority to do this pursuant to Section 36 of the Securities Exchange Act, which states that the SEC can “unconditionally exempt any person, security, or transaction from any provision [of the Act].” Although the recommended reform seems like a stretch of the SEC’s authority pursuant to Section 36, the Committee does not offer any further discussion of this point. (The author of The 10b-5 Daily provided his take on the overlap issue in a National Law Journal op-ed published last year.)
Prohibit Pay-To-Play – Either through legislation or SEC advocacy in the courts, lawyers that make political contributions to individuals in charge of a state of municipal pension fund “should not be permitted to represent the fund as a lead plaintiff in a securities class action.” The Committee notes that the Municipal Securities Rulemaking Board has adopted a rule that prevents pay-to-play in municipal underwriting that could serve as a model for successful reform in this area.
Other recommendations in the interim report would impact securities class actions. They include recommendations that Congress should explore protecting auditing firms from catastrophic loss (p. 88), that the SEC should (a) clarify that an outside director’s good-faith reliance on an audited financial statement or auditor report is conclusive evidence of good faith, and (b) reverse its position that indemnification of outside directors for Section 11 damages is against public policy (p. 91), and that public companies should be permitted to contract with their investors to provide for alternative dispute resolutions for securities litigations (p. 109).