TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING LITIGATION REFORM PROPOSALS BEFORE THE SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE COMMITTEE ON COMMERCE UNITED STATES HOUSE OF REPRESENTATIVES FEBRUARY 10, 1995 Chairman Fields and Members of the Subcommittee: I appreciate this opportunity to testify on behalf of the Securities and Exchange Commission regarding legislative proposals to reform the system of private litigation under the federal securities laws.-[1]- As you know, the Commission has consistently stressed the importance of private remedies against securities fraud. 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.-[2]- 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. These hearings are being held in order to consider proposals to make the private litigation system work more effectively. The Commission supports this effort, because private litigation imposes substantial unnecessary costs when it is abused by private plaintiffs or their attorneys. The threat of misdirected litigation also tends to impede beneficial corporate disclosure practices, such as the dissemination of forward-looking information, that the Commission encourages. Finally, meritless lawsuits may adversely affect the development of substantive securities law, as courts develop broad doctrines in an attempt to curb what they perceive to be vexatious litigation. The important task at hand, therefore, is to identify ways to make the system more efficient while preserving the essential role that private actions play in supporting the integrity of our markets. This involves striking a fair balance between competing interests. Although we might strive for a system in which corporate issuers never spend a dime defending meritless claims, we should recognize that it is impossible to eliminate all meritless cases without also affecting the cases that do have merit and thereby eroding the deterrence provided by private actions. In the same vein, we cannot allow investors to seek compensation for their losses in a way that unnecessarily exposes defendants to unproductive litigation and excessive costs. As I stated in testimony before this Subcommittee last July, the Commission believes that meaningful improvements to the existing system can be accomplished through a combination of legislation, increased judicial activism in the case management -------- FOOTNOTES -------- -[1]- I recently discussed securities litigation reform issues in a speech before the Securities Regulation Institute in San Diego, California. A copy of that speech is attached to this testimony as an appendix. -[2]- "Bateman Eichler, Hill Richards, Inc. v. Berner", 472 U.S. 299, 310 (1985); "Blue Chip Stamps v. Manor Drug Stores", 421 U.S. 723, 730 (1975); "J.I. Case Co. v. Borak", 377 U.S. 426, 432 (1964). -------------------- BEGINNING OF PAGE #2 ------------------- process, and the Commission's exercise of its existing rulemaking and interpretative authority. The Commission is already in the process of examining its existing safe harbor for the disclosure of forward-looking information, and we are expanding a program under which Commission attorneys monitor private litigation and select appropriate cases in which to make our views known to the court. With respect to legislation, the Commission supports measures that would eliminate the most prevalent abuses associated with class action lawsuits, provide for greater sanctions or a modified form of fee shifting in appropriate cases, eliminate civil RICO liability predicated on securities law violations, and enact a proportionate scheme of contribution among defendants. Although there are other proposals that the Commission could accept with modifications or that it is still in the process of considering, the enactment of the above proposals alone would significantly improve the system without eradicating any of its benefits. The Commission recognizes that many proponents of litigation reform, including some members of this Subcommittee, regard these measures as an inadequate response to the problems they perceive to be associated with private litigation. The Commission opposes a move to the more drastic measures that have been proposed, however, such as imposing automatic fee shifting under a strict "English Rule," eliminating antifraud liability based on reckless conduct, and eliminating the fraud-on-the-market theory of liability. Proposals such as these, by severely limiting the private remedy against fraud and undermining the incentives for market participants to comply with the disclosure laws, could fundamentally damage the integrity and discipline of our capital markets, which are now the strongest and safest in the world. Just as it is clear that problems exist within our private litigation system, and that constructive action is necessary, it should be equally clear that an overreaction could cause substantial harm to our markets. The Commission therefore urges the Subcommittee to examine the issues carefully and to craft appropriate legislation that improves the system without eliminating its benefits. Before embracing a proposal designed to guarantee that no meritless case will go unpunished, examine how that proposal would affect investor rights in cases of serious fraud. Before concluding that liability should attach only upon proof of actual, subjective knowledge of fraud, examine how such a rule would affect the discipline that corporate executives and professional advisers bring to the disclosure process. Before deciding that investors should have a remedy only if they can establish that they specifically relied on a particular misstatement or omission, examine the ramifications that such a rule would have for the Commission's administration of the disclosure laws. The remainder of this testimony, which discusses various proposals set forth in H.R. 10, the Common Sense Legal Reform Act, as well as other bills currently pending in both the House and the Senate,-[3]- is intended to assist in that effort. I. PROPOSALS TO REDUCE MERITLESS LITIGATION One of the most critical aspects of a fair and efficient litigation system is its ability to identify meritless cases -------- FOOTNOTES -------- -[3]- These bills are H.R. 555, introduced by Congressman Markey; H.R. 681, introduced by Congressman Tauzin; H.R. 675, introduced by Congressman Mineta and Congresswoman Eshoo; and S. 240, introduced by Senators Dodd and Domenici. -------------------- BEGINNING OF PAGE #3 ------------------- early in the process, before the costs associated with protracted litigation are incurred. Critics of the current system contend that it does not effectively screen out the cases that lack merit. These cases are often referred to as "frivolous" in the rhetoric of the litigation reform debate, but the concern extends to cases that may more accurately be characterized as speculative.-[4]- The extent to which frivolous or speculative cases are filed is difficult to quantify, but it appears that the federal courts have recently been dismissing securities cases more frequently than in the past. Meritless litigation may be addressed in a variety of ways. One method is to deter the filing of meritless cases by providing for fee shifting or the imposition of sanctions against plaintiffs or their attorneys. Another method is to establish stringent pleading standards that only the strongest cases can satisfy. Each of these methods has drawbacks. Automatic fee shifting will deter the filing of good cases as well as meritless ones. Overly stringent pleading standards also will preclude meritorious cases from being filed, as plaintiffs often will be unable to plead specific facts regarding a defendant's state of mind without first obtaining access to corporate documents through discovery. It is especially important, before enacting legislation, to consider the effect that fee shifting and stringent pleading requirements would have when used in combination. To the extent that any form of fee shifting is imposed, stringent pleading standards may not be necessary to deter marginal cases. If stringent pleading standards are established, fee shifting will produce inequitable results in a greater proportion of cases. A. FEE SHIFTING Section 203 of H.R. 10 would provide that courts must order the losing party to pay the prevailing party's reasonable attorneys' fees and expenses in any private action brought under the Securities Exchange Act of 1934. This award would be mandatory, and a court would have discretion to reduce the award only to the extent that the prevailing party engaged in conduct that unduly and unreasonably protracted the litigation. In the Commission's view, a strict "English Rule" provision of the type contemplated by H.R. 10 would effectively eliminate the private right of action for small investors. Although major corporations might continue to file suits under Exchange Act Section 10(b) and Rule 10b-5, individual investors would inevitably be deterred from filing meritorious cases because they -------- FOOTNOTES -------- -[4]- In hearings held before this Subcommittee last summer, for example, Professor Langevoort testified that: The primary problem we face is not so much frivolous litigation. Ample mechanisms exist currently to deal with suits that have no merit whatsoever. Rather, the problem is an excess of speculative litigation, where there are small bits and pieces of evidence that, in hindsight, might suggest some possibility that defendants were not completely candid in each one of the many items of information that became available to the investing public. Yet they rarely add up to a serious claim of fraud. Summary of Testimony of Donald C. Langevoort, Vanderbilt University School of Law, Before the Subcommittee on Telecommunications and Finance, Committee on Energy and Commerce, U.S. House of Representatives (August 10, 1994). -------------------- BEGINNING OF PAGE #4 ------------------- could not take the risk of being exposed to a fee award if they failed to prevail. In class action lawsuits, in particular, individual plaintiffs frequently stand to recover only a small amount if they prevail. Their potential liability under an automatic fee shifting provision would be totally disproportionate to their potential recovery. An automatic fee shifting provision of this type also fails to distinguish between cases that deserve to be litigated and cases that are frivolous or speculative. There is a vast difference between cases that are decided as a result of close factual determinations made by a jury after an extended trial and cases that are dismissed on the pleadings because they fail to state a claim. H.R. 10, however, would leave courts without any discretion to make distinctions between such cases. The legislation introduced by Congressman Tauzin would provide that a court must award fees to the prevailing party unless a determination is made that the losing party's position was "substantially justified." The terminology is borrowed from the Equal Access to Justice Act ("EAJA"),-[5]- which provides that certain persons who prevail in a suit brought by the federal government may recover attorneys' fees and costs if a court finds that the litigating position of the government was not "substantially justified." Fee shifting of this type would allow for some element of judicial discretion, and for that reason it would be preferable to the automatic fee shifting contemplated by H.R. 10. At the same time, it is important to note that the "substantially justified" standard under the EAJA applies only against the government, and that the statute was designed to enable individuals and small businesses to defend their rights in litigation with government agencies that have a superior ability to sustain the costs of litigation and usually conduct an investigation prior to filing suit.-[6]- It does not follow that the same standard should govern investor lawsuits brought against corporate defendants. The Commission recommends that the Subcommittee adopt a somewhat different approach and provide courts with express authority to award fees and costs when cases are filed (or defenses raised) without any reasonable prospect of prevailing. Section 11(e) of the Securities Act, for example, already provides that a party may be required to pay the opposing party's costs and reasonable attorneys' fees "if the court believes the suit or the defenses to have been filed without merit." There is no comparable provision for cases brought under Sections 10(b) or 14 of the Exchange Act, and some have suggested that the absence of such a rule has encouraged plaintiffs to proceed under that Act rather than the Securities Act.-[7]- Congress should make it -------- FOOTNOTES -------- -[5]- 5 U.S.C. 504. -[6]- Since the EAJA was adopted in 1985, the Commission has been ordered to pay attorneys' fees and costs in three cases, and it entered into a settlement when fees were sought in one other case. The amount paid by the Commission in these cases ranged from $14,000 to $88,000. -[7]-" The desire to escape the double danger of paying counsel fees and posting security was yet another reason for buyers with complaints to rush to Rule 10b-5 in the face of the express remedies under S. 11 and 12(2) of the Securities Act." 10 Louis Loss & Joel Seligman, Securities Regulation at 4648 (1993) (footnote omitted). -------------------- BEGINNING OF PAGE #5 ------------------- clear, in such a provision, that a court may impose a fee award not only against a party, but also against its counsel.-[8]- The Commission recognizes that the effectiveness of discretionary fee shifting depends on the willingness of courts to exercise their discretion to award fees. Courts already have the authority under Rule 11 of the Federal Rules of Civil Procedure to order limited fee shifting in abusive and meritless cases, but this authority is used relatively infrequently.-[9]- Most federal judges believe that meritless litigation is controlled most effectively by prompt rulings on motions to dismiss or motions for summary judgment,-[10]- and there may be an understandable tendency to avoid fee awards that may themselves lead to ancillary litigation. Congress could ensure that judges do not ignore a fee shifting provision, however, by providing that, where cases are resolved by means of a dispositive motion, the court must make findings as to why fees should or should not be awarded to the prevailing party. Different forms of fee shifting are proposed in the bills introduced by Congressman Markey in the House, and by Senators Dodd and Domenici in the Senate. The Markey Bill provides for a voluntary evaluation procedure using an independent mediator, and a party that chooses to litigate a position which the mediator has determined to be either clearly frivolous or clearly meritorious would be subject to automatic fee shifting. The Dodd/Domenici bill suggests awarding fees to the prevailing party if the losing party has refused to accept an offer to use alternative dispute resolution mechanisms to resolve the case.-[11]- As noted above, however, we believe that a more straightforward approach is to give the courts express authority to shift fees where cases (or defenses) are without merit, provided that a court must make findings on the appropriateness of fee shifting in all cases that are resolved on a dispositive motion. B. PLEADING REQUIREMENTS The device most frequently used to screen out deficient securities fraud claims is Rule 9(b) of the Federal Rules of -------- FOOTNOTES -------- -[8]- See "Healey v. Chelsea Resources, Ltd.", 947 F.2d 611, 624-25 (2d Cir. 1991) (declining to award fees against an attorney under Section 11(e)). -[9]- Prior to 1993, a court was required to impose sanctions under Rule 11 in the case of filings made for an improper purpose, such as to cause unnecessary delay or needless increase in the cost of litigation. In 1993, the Supreme Court adopted significant substantive amendments to Rule 11. Under the revised Rule 11, sanctions are discretionary rather than mandatory, and in cases in which one party has moved for sanctions against another, there is a safe harbor of 21 days following notice of an alleged violation during which a party may withdraw the offending filing before a request for sanctions can be filed. -[10]- Elizabeth C. Wiggins, Thomas E. Willging & Donna Stienstra, Rule 11: Final Report to the Advisory Committee on Civil Rules of the Judicial Conference of the United States, Federal Judicial Center (1991). -[11]- We note that the use of neutral evaluators or alternative dispute resolution mechanisms could be useful in certain types of cases. Consequently, we believe that proposals to encourage their use deserve further consideration. -------------------- BEGINNING OF PAGE #6 ------------------- Civil Procedure, which requires that plaintiffs allege fraud with particularity.-[12]- As a general matter, federal courts today are granting dispositive motions dismissing securities law cases with greater frequency than in the past. Although it is difficult to quantify the extent to which there has been an increase in the percentage of cases dismissed on the pleadings, there is widespread agreement that a trend in this direction exists.-[13]- Although Rule 9(b) requires that fraud be pleaded with particularity, it further provides that "[m]alice, intent, knowledge, and other condition of mind" may be pleaded "generally." Some courts nevertheless require that plaintiffs plead with some particularity facts suggesting that defendant had the requisite scienter. The Second Circuit Court of Appeals, for example, has long required that plaintiffs pleading securities fraud allege facts giving rise to a "strong inference" of fraudulent intent on the part of the defendants.-[14]- In recent years, the First, Fifth, and Seventh Circuits have all started to require a similar "inference" of scienter,-[15]- and this trend has resulted in the dismissal of numerous cases. Other courts of appeal, however, have rejected this approach on the ground that it goes beyond the language of Rule 9(b).-[16]- -------- FOOTNOTES -------- -[12]- See 10 Louis Loss & Joel Seligman, Securities Regulation, at 4526-27 (1993) (citing 5 Charles Wright & Arthur Miller, Federal Practice & Procedure, 1297 at 613-14 (1990)("courts have shown a tendency to be more demanding in their application of Rule 9(b) . . . [to] securities fraud actions."). -[13]- See Jonathan Eisenberg, "Beyond the Basics: 50 Defense Doctrines that Every Securities Litigator Needs to Know", in New Dimensions in Securities Litigation at 611 (ALI-ABA Course Materials 1994) ("many [securities] defendants are having significantly greater success than in the past in having cases dismissed at the motions stage"); Julie Triedman, "Class Warfare" Corporate Counsel, July/Aug. 1994, at 51, 55 ("The trend is toward more dismissals and more summary judgments. We don't like it, but it's a fact") (quoting Leonard Simon of Milberg Weiss Bershad Hynes & Lerach). -[14]- "Ross v. A.H. Robins Co.", 607 F.2d 545, 558 (2d Cir. 1979), cert. denied, 446 U.S. 946 (1980). -[15]- See "Greenstone v. Cambex Corp.", 975 F.2d 22, 25 (1st Cir. 1992) ("The courts have uniformly held inadequate a complaint's general averment of the defendant's `knowledge' of material falsity, unless the complaint also sets forth specific facts that make it reasonable to believe that defendant knew that a statement was materially false or misleading.");"Tuchman v. DSC Communications Corp.," 14 F.3d 1061, 1068 (5th Cir. 1994) ("To plead scienter adequately, a plaintiff must set forth specific facts that support an inference of fraud.");"DiLeo v. Ernst & Young", 901 F.2d 624, 629 (7th Cir.) ("Although Rule 9(b) does not require `particularity' with respect to the defendants' mental state, the complaint still must afford a basis for believing that plaintiffs could prove scienter."), cert. denied, 498 U.S. 941 (1990). -[16]- See "In re Glenfed, Inc.", 1994 U.S. App. LEXIS 34334 at *16 (9th Cir. Dec. 9, 1994) (en banc) ("We conclude that plaintiffs may aver scienter generally, just as the rule states - that is, simply by saying that scienter existed."); Phelps v. Wichita (continued...) -------------------- BEGINNING OF PAGE #7 ------------------- H.R. 10 and three of the other pending bills contain provisions regarding particularity of pleading in private securities fraud actions. H.R. 10 would require plaintiffs to plead specific facts "demonstrating" the state of mind of each defendant --a test which arguably is more severe than that employed in any of the circuits today. It is likely that there would be many cases in which plaintiffs with meritorious claims would be unable to make such a demonstration without an opportunity to conduct discovery. The Commission believes that it would be beneficial to resolve the split between the circuits regarding the proper application of Rule 9(b).-[17]- Before doing so through legislation, however, the Commission recommends that Congress seek the views of the Advisory Committee on Civil Rules of the Judicial Conference of the United States. C. TREATMENT OF FORWARD-LOOKING STATEMENTS Some of the most difficult cases to screen are those involving the disclosure of forward-looking or "soft" information. Issuers frequently complain that they are sued under the antifraud provisions simply because the corporation made a projection that failed to materialize. Besides enforcing pleading requirements strictly, courts have applied substantive securities law principles for the purpose of promptly dismissing cases involving forward-looking statements that they suspect are meritless.-[18]- The Commission recognizes the important role played by projections and other forward-looking statements, as well as the potential for abusive litigation based on a "fraud by hindsight" theory when such projections do not come true. To address this issue, 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 -------- FOOTNOTES -------- -[16]- (...continued) Eagle-Beacon, 886 F.2d 1262, 1270 n.5 (10th Cir. 1989) (strict approach cannot be reconciled with plain language of rule); "Auslender v. Energy Management Corp.", 832 F.2d 354, 356 (6th Cir. 1987) ("[T]he allegation of `recklessness' on the part of [the defendant] is adequate to satisfy the scienter requirement of Rule 10b-5."). -[17]- Although the pleading requirements specified in H.R. 10 would only apply to actions under Section 10(b), any resolution of the proper pleading standard under Rule 9(b) should be equally applicable to other antifraud provisions of the federal securities laws. -[18]- See "Luce v. Edelstein", 802 F.2d 49, 56 (2d Cir. 1986); "Polin v. Conductron Corp.", 552 F.2d 797, 806 n.28 (8th Cir.), cert. denied, 434 U.S. 857 (1977) ("We are not inclined to impose liability on the basis of statements that clearly `bespeak caution.'"); "In re Donald J. Trump Casino Sec. Litig.", 793 F. Supp. 543, 549 (D.N.J. 1992), aff'd, 7 F.3d 357 (3d Cir. 1993). See, also, "Raab v. General Physics Corp.", 4 F.3d 286, 290 (4th Cir. 1993); "Krim v. BancTexas Group, Inc.", 989 F.2d 1435, 1446- 47 (5th Cir. 1993)("projections of future performance not worded as guarantees are generally not actionable under the federal securities laws"). -------------------- BEGINNING OF PAGE #8 ------------------- protection but continues to protect investors.-[19]- Our challenge will be to craft a rule which accomplishes this goal. Changes to the Commission's safe harbor for forward-looking statements may have a significant impact on litigation practices. We are continuing this process with the review by the Commission's staff of the many comments received in response to the concept release and with the public hearings on the issue to be held next week in Washington and San Francisco. D. COMMISSION SCRUTINY OF CASES For many years, the Commission has participated in selected appellate court proceedings by filing briefs AMICUS CURIAE on significant issues arising under the federal securities laws. Because most of the perceived problems associated with private securities litigation arise at the trial court level, however, the Commission has determined that it would be beneficial to monitor district court litigation and select appropriate cases in which we might have the ability to assist in assessing particular claims or defenses, or in protecting the interests of investors. Three months ago, the Commission's General Counsel provided a letter to defense counsel in a class action setting forth the Commission's view that the case should be dismissed.-[20]- In an earlier case, the Prudential Securities litigation,-[21]- the General Counsel presented a letter to the court addressing a fee application submitted by class counsel. Two weeks ago, I announced that the Commission's Office of the General Counsel would establish a Litigation Analysis Unit. Lawyers in the unit will evaluate the claims and the legal support for selected private cases, and provide the Commission's views where appropriate to investors, corporations, lawyers, and judges. Private litigants who believe they are encountering abuses on either side are encouraged to bring them to the General Counsel's attention. The Commission is also considering whether to ask Congress to enact a provision that would allow the Commission to appear and be heard on any issue in a private action brought under the securities laws. This would be modelled on the provision that already exists in the Bankruptcy Code,-[22]- and would ensure that the Commission could express its views in the public interest. -------- FOOTNOTES -------- -[19]- Securities Act Release No. 7101 (Oct. 13, 1994), 59 FR 52723. -[20]- Letter from Simon M. Lorne, General Counsel, Securities and Exchange Commission, to Cooper Industries, Inc., dated November 8, 1994, re Frank v. Cooper Industries, Inc., Civil Action No. H-94-0280 (S.D. Tex.). The Commission has learned that the district court judge denied the defendant's motion to dismiss on February 6, 1995. -[21]- Letter from Simon M. Lorne, General Counsel, Securities and Exchange Commission, to The Honorable Marcel Livaudais, Jr., Untied States District Judge, Eastern District of Louisiana, dated February 24, 1994, re Prudential-Bache Energy Income Partnership Securities Litigation, MDL Docket No. 888. -[22]- 11 U.S.C. 1109(a). -------------------- BEGINNING OF PAGE #9 ------------------- II. PROPOSALS TO CHANGE LIABILITY STANDARDS The Commission has previously urged Congress to weigh the consequences that each litigation reform proposal might have on the existing financial reporting and disclosure system. It has also recommended that, before resorting to any changes in the standards for liability, Congress first determine the effectiveness of measures directly targeted at meritless litigation.-[23]- H.R. 10 would create fundamental changes in the existing standards of liability. First, it would eliminate private liability based on recklessness, a standard that has received the unanimous support of the federal circuit courts. Second, it would effectively eliminate the fraud on the market theory of liability, which has been upheld by the Supreme Court and is consistent with the philosophy underlying the Commission's disclosure program. Finally, it can be read to eliminate liability for certain types of violations, such as market manipulations, which do not necessarily involve a misstatement or omission. The Commission opposes each of these proposals. With respect to other liability issues, the Commission supports removing securities fraud as a predicate offense for purposes of the RICO statute. In addition, as the Commission has testified before this Subcommittee, Congress should restore private aiding and abetting liability. A. SCIENTER Prior to the Supreme Court's decision in "Ernst & Ernst v. Hochfelder",-[24]- courts were divided on whether liability under Rule 10b-5 could be predicated on mere negligence or whether some degree of scienter was required. In "Hochfelder", the Court concluded that "Section 10(b) was addressed to practices that involve some element of scienter and cannot be read to impose liability for negligent conduct alone."-[25]- Because the plaintiffs had proceeded on a theory of liability premised on negligence, the question of whether recklessness could satisfy the scienter requirement of Section 10(b) and Rule 10b-5 was not before the Court in "Hochfelder". The Court explicitly recognized, however, that "in certain areas of the law recklessness is considered to be a form of intentional conduct for purposes of imposing liability for some act."-[26]- The common law has long recognized recklessness as a form of scienter for purposes of proving fraud.-[27]- Under the common law, one who acts with reckless disregard for the potentially harmful consequences of his actions has long been regarded as equally culpable with one who acts with actual knowledge of the -------- FOOTNOTES -------- -[23]- See Testimony of William R. McLucas, Director, Division of Enforcement, Securities and Exchange Commission, Concerning Private Litigation Under the Federal Securities Laws, Before the Securities Subcommittee, Committee on Banking, Housing, and Urban Affairs, U.S. Senate (June 17, 1993). -[24]- 425 U.S. 185 (1976). -[25]- Id. at 201. -[26]- Id. at 193-94 n.12. -[27]- See Restatement (Second) of Torts, S 526(b), comment e (1977); Prosser and Keeton, Law of Torts, S 107 at 741-42. -------------------- BEGINNING OF PAGE #10 ------------------- potential consequences.-[28]- In part, this rule serves to discourage deliberate ignorance of facts indicating fraud. In the 20 years since "Hochfelder", all of the courts of appeal that have considered the question have held that recklessness is sufficient to establish primary liability under Rule 10b-5.-[29]- H.R. 10, however, would reverse this body of law by eliminating liability for reckless conduct and requiring proof that the defendant acted knowingly and intentionally.-[30]- -------- FOOTNOTES -------- -[28]- This concept is not new. In the seminal common law case in this area, Derry v. Peek, 14 App. Cas. 337 (H.L. 1889), the House of Lords stated that: fraud is proved when it is shewn that a false representation has been made (1) knowingly, or (2) without belief in its truth, or (3) recklessly, careless whether it be true or false. Although I have treated the second and third as distinct cases, I think the third is but an instance of the second, for one who makes a statement under such circumstances can have no real belief in the truth of what he states. * * * [I]f I thought that a person making a false statement had shut his eyes to the facts, or purposely abstained from inquiring into them, I should hold that honest belief was absent, and that he was just as fraudulent as if he had knowingly stated that which was false. In another leading case, "State Street Trust Co. v. Ernst", 278 N.Y. 104, 112, 15 N.E.2d 416, 418-19 (1938), the court stated: Accountants, however, may be liable to third parties, even where there is lacking deliberate or active fraud. A representation certified as true to the knowledge of the accountants when knowledge there is none, a reckless misstatement, or an opinion based on grounds so flimsy as to lead to the conclusion that there was no genuine belief in its truth, are all sufficient upon which to base liability. A refusal to see the obvious, a failure to investigate the doubtful, if sufficiently gross, may furnish evidence leading to an inference of fraud so as to impose liability for losses suffered by those who rely on the balance sheet. In other words, heedlessness and reckless disregard of consequence may take the place of deliberate intention. -[29]- See, e.g., "Rolf v. Blyth, Eastman Dillon & Co.", 570 F.2d 38, 46-47 (2d Cir.), cert. denied, 439 U.S. 1039 (1978); "McLean v. Alexander", 599 F.2d 1190, 1197 (3d Cir. 1979); "Broad v. Rockwell Int'l Corp.", 642 F.2d 929, 961-962 (5th Cir.) (en banc), cert. denied, 454 U.S. 965 (1981); "Mansbach v. Prescott, Ball & Turben", 598 F.2d 1017, 1024 (6th Cir. 1979); "Sundstrand Corp. v. Sun Chem. Corp.", 553 F.2d 1033, 1044 (7th Cir.), cert. denied, 434 U.S. 875 (1977); "Van Dyke v. Coburn Enterprises, Inc.", 873 F.2d 1094, 1100 (8th Cir. 1989); "Nelson v. Serwold," 576 F.2d 1332, 1337 (9th Cir.), cert. denied, 439 U.S. 970 (1978); "Hackbart v. Holmes", 675 F.2d 1114, 1117 (10th Cir. 1982); "SEC v. Carriba Air, Inc.", 681 F.2d 1318, 1324 (11th Cir. 1982). -[30]- Although it would not eliminate the recklessness standard, the Tauzin bill would require the plaintiff to establish scienter by clear and convincing evidence rather than by a preponderance of the evidence. This strict standard would greatly curtail (continued...) -------------------- BEGINNING OF PAGE #11 ------------------- Such a retreat from the recklessness standard would greatly erode the deterrent effect of private actions. The Commission has consistently supported a recklessness standard because such a standard is needed to protect the integrity of the disclosure process. The law should sanction corporations and individuals who act recklessly when making disclosures, because that is the only way to assure the markets of a continuous stream of accurate information. Any higher scienter standard would lessen the incentives for corporations and other issuers to conduct a full inquiry into areas of potential exposure, and thus threaten the process that has made our markets a model for nations around the world. Moreover, because an actual knowledge standard would virtually foreclose recovery against attorneys, accountants, and financial advisers, it would reduce the degree to which such professional advisers encourage full and complete disclosure. There are relatively few cases in which it is established that professional advisers acted with actual, subjective knowledge that the representations made by an issuer were false. Rather, the liability of such advisers typically is predicated on a finding that they participated in the dissemination of false statements while recklessly ignoring indications of fraud. While the Commission understands that there are serious concerns that professional advisers are too often unfairly subjected to litigation, those concerns can be addressed without eliminating altogether the incentive to exercise diligence in the preparation of disclosure documents. It is important to recognize that the threshold for a finding of recklessness is quite high. Although the definition of recklessness varies somewhat in different courts, most of the federal courts of appeal follow the standard enunciated by the Seventh Circuit in "Sundstrand Corporation v. Sun Chemical Corporation",-[31]- or some variant thereof.-[32]- In "Sundstrand", the court defined a reckless omission as: a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents 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.-[33]- In short, the recklessness standard requires a high level of culpability -- a form of intent and a standard clearly distinguishable from negligence.-[34]- -------- FOOTNOTES -------- -[30]- (...continued) private actions by making proof of knowing or intentional conduct, as well as reckless conduct, difficult. -[31]- 553 F.2d 1033 (7th Cir.), cert. denied sub nom., "Meers v. Sunstrand Corp.", 434 U.S. 875 (1977). -[32]-See "Hollinger v. Titan Capital Corp.", 914 F.2d 1564, 1569 & n.8 (9th Cir. 1990)(en banc)(citing cases). -[33]- 553 F.2d at 1045 (citation omitted). -[34]- In "Sanders v. John Nuveen & Co.", 554 F.2d 790, 793 (7th Cir. 1977), cert. denied, 450 U.S. 1005 (1981), the court noted that the definition of recklessness "should not be a liberal one lest any discernable distinction between `scienter' and (continued...) -------------------- BEGINNING OF PAGE #12 ------------------- Finally, practical necessities also require a recklessness standard. Proving a defendant's actual knowledge of fraud in a securities case can be a daunting task, particularly when (as is frequently the case) the evidence is entirely circumstantial. As the Second Circuit stated, in deciding that recklessness was the appropriate standard: "To require in all types of 10b-5 cases that a factfinder must find a specific intent to deceive or defraud would for all intents and purposes disembowel the private cause of action under 10(b)."-[35]- The SEC itself often relies on the recklessness standard in its own enforcement program. Critics of the recklessness standard assert that juries fail to make a meaningful distinction between recklessness and negligence. In response to this criticism, some reform proposals would require the jury to make a specific finding that the defendant had indeed acted with the required state of mind. This would serve to deter the jury from simply ignoring the stringent legal standard required in order to hold a reckless defendant liable.-[36]- H.R. 10, as well as the Mineta/Eshoo bill and the Dodd/Domenici bill, has a provision requiring such special verdicts. The Commission supports such a requirement and believes that it may be a useful means for ensuring the proper application of the recklessness standard. B. FRAUD-ON-THE-MARKET Under the fraud-on-the-market theory of liability, a plaintiff who trades in a corporation's stock after the issuance of a material false statement by the corporation is entitled to a -------- FOOTNOTES -------- -[34]- (...continued) `negligence' be obliterated" and, therefore, should be regarded as a "lesser form of intent" rather than "merely a greater degree of ordinary negligence." At common law, recklessness, like conscious intent, involves a culpable mental state, in contrast to negligence, which entails no culpable mental state. See Prosser and Keeton, Law of Torts, S. 107; Restatement (Second) of Torts, S. 552 comment a, S. 526(b) comment e. -[35]- Rolf, 570 F.2d at 47. See also Mansbach, 598 F.2d at 1025 ("Requiring a plaintiff to show that the defendant acted with actual subjective intent to defraud could impose a great burden upon recovery, greatly limiting the 10(b)/Rule 10b-5 claim"); Hackbart, 675 F.2d at 1118 ("requiring the plaintiff to show [conscious] intent would be unduly burdensome"); "G. A. Thompson & Co. v. Partridge", 636 F.2d 945, 961 n.32 (5th Cir. 1981); cf. "Herman & MacLean v. Huddleston," 459 U.S. 375, 390-91 n.30 (1983)("If anything, the difficulty of proving the defendant's state of mind supports a lower standard of proof"). -[36]- The use of special verdicts, has generated a great deal of controversy. The most vocal proponent was Judge Jerome N. Frank, who was an outspoken critic of the jury system. Judge Frank urged that a special verdict is "usually preferable to the opaque general verdict." "Skidmore v. Baltimore & O.R. Co.", 167 F.2d 54, 67 (2d Cir. 1948), cert. denied, 335 U.S. 816 (1948) (footnote omitted). On the other side of the argument were Justices Douglas and Black who believed that the rule allowing special verdicts should be repealed. "One of the ancient, fundamental reasons for having general jury verdicts was to preserve the right of trial by jury as an indispensable part of a free government." 374 U.S. 861, 867-68 (1963) (dissenting from the adoption of amendments to the Federal Rules of Civil Procedure). -------------------- BEGINNING OF PAGE #13 ------------------- rebuttable presumption that he relied on the integrity of the market price in making his investment decision. As the Supreme Court stated in upholding the fraud-on-the-market theory in "Basic Inc. v. Levinson",-[37]- reliance is an element of a Rule 10b-5 action,-[38]- but "[b]ecause most publicly available information is reflected in market price, an investor's reliance on any public material misrepresentations . . . may be presumed for purposes of a Rule 10b-5 action."-[39]- This presumption may be rebutted by the defendant.-[40]- The fraud-on-the-market theory rests on two propositions: that in an active secondary market, the price of a company's stock is determined by all available information regarding the company, its business and general economic conditions; and that investors rely on the integrity of market prices when making investment decisions. Misleading corporate statements or the failure to disclose material information are regarded as a fraud on all stock purchasers, even those who did not personally read the fraudulent information, because the price paid for the stock reflects the misrepresentations. The Commission believes that the ability of investors to rely on the integrity of the market is important for our system of securities regulation. H.R. 10 would effectively eliminate the fraud-on-the-market theory by requiring that each plaintiff prove that he or she had actual knowledge of and actually relied on a misstatement or omission in connection with the purchase or sale of stock. Much of the Commission's disclosure regulation, however, is premised on the assumption that the market will absorb all available information and incorporate it into a company's stock price. We do not, for example, require that companies mail their periodic SEC reports to every shareholder. Rather, we assume that analysts, brokers, and others will obtain and evaluate that information and rely on it in making recommendations to investors. When someone buys stock at a price affected by misrepresentations, the buyer has in effect bought the misrepresentations, whether or not he or she actually read the statements in question. An actual reliance requirement of the type proposed would also make it virtually impossible for investors to assert their claims as part of a class action. As the Supreme Court pointed out in "Basic", "[r]equiring proof of individualized reliance from each member of the proposed plaintiff class effectively would have prevented respondents from proceeding with a class action, since individual issues then would have overwhelmed the common ones."-[41]- In addition to eliminating the fraud-on-the-market theory, H.R. 10 would adopt a much more stringent reliance standard for claims based on omissions (as opposed to misrepresentations) than courts have required. In "Affiliated Ute Citizens v. United -------- FOOTNOTES -------- -[37]- 485 U.S. 224 (1988). -[38]- Id. at 243 ("Reliance provides the requisite causal connection between a defendant's misrepresentation and a plaintiff's injury."). -[39]- Id. at 247. -[40]- Id. at 249. -[41]-I d. at 242. -------------------- BEGINNING OF PAGE #14 ------------------- States",-[42]- a class action under Rule 10b-5 involving alleged material omissions, the Supreme Court held that: Under the circumstances of this case, involving primarily a failure to disclose, positive proof of reliance is not a prerequisite to recovery. All that is necessary is that the facts withheld be material in the sense that a reasonable investor might have considered them important in the making of this decision. [citations omitted.] This obligation to disclose and this withholding of a material fact establish the requisite element of causation in fact.-[43]- By overturning the holdings of the Supreme Court in both "Basic" and "Affiliated Ute", H.R. 10 would fundamentally alter existing law. The Commission believes that such an alteration would have a detrimental effect on our disclosure system, a system that has led to fair and efficient markets in our country. C. AIDING AND ABETTING LIABILITY Last April, the Supreme Court held in "Central Bank of Denver"-[44]- that investors do not have a private right of action against persons who aid and abet violations of Section 10(b) and Rule 10b-5. The decision means that private investors may no longer be able to recover damages against persons who substantially assist the perpetration of a securities fraud, even if such persons act knowingly and intentionally.-[45]- In addition, the decision has created unnecessary uncertainty as to the Commission's ability to use the aiding and abetting theory of liability where it is not expressly provided by statute. For these reasons, the Commission has recommended that Congress enact legislation addressing the "Central Bank of Denver" decision.-[46]- H.R. 10 would limit liability under Rule 10b-5 to an even greater degree than the Supreme Court's holding in the "Central -------- FOOTNOTES -------- -[42]- 406 U.S. 128 (1972). -[43]- Id. at 153-54. -[44]- "Central Bank of Denver, N.A. v. First Interstate Bank of Denver," N.A., 114 S.Ct. 1439 (1994). -[45]- The ultimate impact of the Central Bank of Denver decision is uncertain today because it will depend on the manner in which the federal courts develop the law of primary liability. The distinction between primary and secondary liability was not very important prior to Central Bank of Denver, since a person who was found to have aided and abetted a fraud had joint and several liability with the primary violator. The distinction is crucial today, however, since a participant in a fraud may be totally insulated from liability in private actions if primary liability cannot be established. -[46]- Of the pending bills, only legislation introduced by Congressman Markey would restore aiding and abetting liability as it existed prior to Central Bank of Denver. The legislation introduced by Congressman Tauzin also would restore aiding and abetting liability, but only to the extent that a defendant acted with deliberate intent to defraud for the defendant's own direct pecuniary benefit. The term "direct pecuniary benefit" would be defined to exclude ordinary compensation for services provided by the defendant. -------------------- BEGINNING OF PAGE #15 ------------------- Bank of Denver" case. Section 204 of the bill (adding a new Section 10A(a)) provides that damages may be recovered only against defendants who "make" a material misstatement or omission. Section 10 and Rule 10b-5, by contrast, contain the words "directly or indirectly," which can enable courts to find that persons who participate in the preparation of false statements indirectly "make" those statements. This flexibility is critical, and it should be preserved. An attorney who knowingly prepares a false statement made by a corporate issuer, for example, should not be insulated from liability simply because his or her name is not identified with the statement.-[47]- Finally, as a result of what may have been an unintended drafting error, the language of Section 204 of H.R. 10 could preclude recovery in certain types of cases, such as market manipulations, which are not based on fraudulent misrepresentations. The Supreme Court has described certain types of manipulative activity, such as wash sales, matched orders, and rigged prices, as being inherently deceptive because they are intended to mislead investors by artificially affecting market activity.-[48]- There is no requirement in such cases to allege that the defendant made misstatements or omissions. Because H.R. 10 requires a misstatement or omission, it could prevent a corporate issuer from instituting an action under Rule 10b-5 against persons who manipulate the price of its shares. D. RICO LIABILITY For many years, the Commission has supported legislation to eliminate the overlap between the private remedies under the Racketeer Influenced and Corrupt Organizations Act ("RICO") and under the federal securities laws.-[49]- 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. Although a recent Supreme Court decision substantially narrowed the liability of professional advisers under RICO,-[50]- issuers and other market participants continue to be exposed to -------- FOOTNOTES -------- -[47]- It is unclear whether H.R. 10 is also intended to limit the liability of controlling persons. Section 20(a) of the Exchange Act makes a controlling person liable for the acts of any person under its control, unless the controlling person acted in good faith and did not induce the unlawful conduct. -[48]- See "Santa Fe Industries, Inc. v. Green", 430 U.S. 462, 476 (1977). -[49]- See Testimony of Mary L. Schapiro, Commissioner, Securities and Exchange Commission, Concerning H.R. 1717, the RICO Amendments Act of 1991, Before the Subcommittee on Intellectual Property & Judiciary Administration, Judiciary Committee, U.S. House of Representatives (Apr. 25, 1991). -[50]- The Court held that one must participate in the operation or management of an enterprise in order to be liable under Section 1962(c) of RICO. "Reves v. Ernst & Young," 113 S. Ct. 1163 (1993). -------------------- BEGINNING OF PAGE #16 ------------------- RICO claims in securities cases.-[51]- These claims tend to coerce settlements and force defendants to litigate issues that would not otherwise arise in securities cases. Congressional action continues to be needed, and measures addressing this issue are included in H.R. 10, the Mineta/Eshoo bill, and the Dodd/Domenici bill. III. PROPOSALS TO ALTER THE CONSEQUENCES OF LIABILITY A. LIMITATION ON DAMAGES H.R. 10, the Mineta/Eshoo bill, and the Dodd/Domenici bill each have provisions which would limit damages in actions under Section 10(b) to the lesser of: (1) the difference between the price paid by the plaintiff and the market value of the security immediately after dissemination to the market of information correcting the misstatement or omission, or (2) the difference between the price paid by the plaintiff and the price at which the plaintiff sold the security after dissemination to the market of information correcting the misstatement or omission. These provisions are intended to bring greater certainty to the difficult issue of calculating damages in many securities cases. The Commission has concerns, however, that the proposed measures of damages will not reach the appropriate result in certain types of cases. Between the time that a misrepresentation is made and the time that information correcting the information is disseminated to the market, the price of a security may rise or decline for reasons totally unrelated to the violations. As a result, plaintiffs may be undercompensated under the first proposed measure of damages. In addition, the second proposed measure would reduce damages on the basis of unrelated stock price movements that occur AFTER the dissemination of the corrective information.-[52]- The scope of the provision in H.R. 10 is also problematic because, unlike the provisions in the Mineta/Eshoo bill and the Dodd/Domenici bill, it is not limited to fraud-on-the-market cases. The proposed limitation of damages may be wholly inappropriate in many other sorts of transactions, such as transactions not involving publicly traded securities. B. CONTRIBUTION Securities fraud cases often involve multiple defendants with differing degrees of involvement in, and responsibility for, the fraudulent conduct. If multiple defendants are found liable to the plaintiff in a securities case, however, their liability is joint and several, and the plaintiff may collect the entire amount of the judgment from any one of the defendants. To mitigate the potential unfairness of this approach to defendants, courts have implied a right to contribution in actions under Exchange Act Section 10(b).-[53]- Under this equitable doctrine, -------- FOOTNOTES -------- -[51]- E.g., "Powers v. British Vita", plc, 842 F. Supp. 1573 (S.D.N.Y. 1994); "Aizuss v. Commonwealth Equity Trust", 847 F. Supp. 1482 (E.D. Cal. 1993); "Greenwald v. Manko", 840 F. Supp. 198 (E.D.N.Y. 1993). -[52]- We also note that the proposed measures are directed only at cases in which the plaintiffs' injuries result from the purchase, as opposed to the sale, of securities. -[53]- See "Musick, Peeler & Garrett v. Employers Ins. of Wausau", 113 S. Ct. 2085 (1993). -------------------- BEGINNING OF PAGE #17 ------------------- a defendant against whom judgment has been rendered may seek reimbursement from other persons who are jointly liable with him for payments made in excess of his share of the liability. The Commission has recommended that Congress enact legislation to specify that, as among the contributing defendants, liability should be apportioned on the basis of relative fault.-[54]- This departs from the practice which prevailed at the time the securities laws were first enacted, when liability for contribution (where it existed) was apportioned among defendants in equal shares or PRO RATA. Four of the pending bills address this issue. The Commission also supports legislation that would resolve a split in the circuits by providing that, where one defendant settles a case, the liability of the co-defendants is reduced by an amount equal to the greater of the amount paid or the settling defendant's proportionate responsibility.-[55]- The alternative approach would release the liability of the co-defendants on a PRO TANTO basis, that is, dollar for dollar based on the amount actually paid by the settling defendant.-[56]- While the PRO TANTO method provides greater protection to plaintiffs, the proportionate reduction approach is arguably more fair to non-settling defendants. Under the proportionate reduction approach, defendants cannot be saddled with more than a proportionate share of liability simply because the plaintiff settled part of the case too cheaply. As a result, defendants who believe they have meritorious defenses can litigate a case without having to worry that their exposure will be increased due to settlements made by other defendants. The proportionate reduction approach would inevitably result in some cases where defrauded investors are precluded from recovering all of their damages, but the Commission believes it represents a reasonable compromise.-[57]- The legislation introduced by Congressman Markey, as well as the Mineta/Eshoo bill and the Dodd/Domenici bill, adopt the proportionate reduction approach. H.R. 10 adopts the PRO TANTO approach. C. PROPORTIONATE LIABILITY If Congress enacts a system of proportionate contribution which includes a proportionate reduction approach to partial -------- FOOTNOTES -------- -[54]- Testimony of Arthur Levitt, Chairman, Securities and Exchange Commission, Concerning Litigation Under the Federal Securities Laws, Before the Subcommittee on Telecommunications and Finance, Committee on Energy and Commerce, U.S. House of Representatives (July 22, 1994), at 18. -[55]- The Ninth Circuit has adopted such a proportionate contribution rule. See "Franklin v. Kaypro Corp." 884 F.2d 1222 (9th Cir. 1989), cert. denied sub nom., "Franklin v. Peat Marwick Main & Co.", 498 U.S. 890 (1990). -[56]- The Second Circuit has adopted a pro tanto contribution rule. See "Singer v. Olympia Brewing Co.", 878 F.2d 596 (2d Cir. 1989), cert. denied, 493 U.S. 1024 (1990). -[57]- In "McDermott, Inc. v. AmClyde", 114 S. Ct. 1461 (1994), the Supreme Court recently considered the choice between the proportionate reduction rule and the pro tanto rule in the context of an admiralty case. While noting that the arguments between them were closely matched, the Court chose to apply the proportionate rule, largely because it was deemed to be more consistent with the general policies of contribution. -------------------- BEGINNING OF PAGE #18 ------------------- settlements, a defendant will never be required to pay more than its fair share of damages in a securities fraud case in which all responsible parties are solvent. Securities fraud cases sometimes involve bankrupt issuers or individuals, however, who are unable to pay their fair share of the damages they have jointly caused. Under the existing system of joint and several liability, the solvent defendants in such cases must bear the share of the bankrupt defendants. Under a system of strict proportionate liability, the defrauded investors would be required to absorb the loss. Advocates of proportionate liability argue that joint and several liability produces an inequitable result in such circumstances because it forces parties who are only partially responsible for harm to bear more than their proportionate share of the damages. The accounting profession, in particular, argues that the current system provides plaintiffs with an incentive to join as many "deep pockets" as possible, and compels defendants to settle weak claims in order to avoid disproportionate liability. The response to this argument is that, although the traditional doctrine of joint and several liability may cause accountants and others to bear more than their proportional share of liability in particular cases, this is because the current system is based on equitable principles that operate to protect innocent investors. In essence, the policy underlying the current system is that, as between defrauded investors and the professional advisers who assist a fraud by knowingly or recklessly failing to meet professional standards, the risk of loss should fall on the latter. Defrauded investors should not be denied an opportunity to recover all of their losses simply because some defendants are less capable of paying than others. The legislation introduced by Congressman Tauzin would restrict the application of joint and several liability to defendants who engage in "knowing securities fraud." The Mineta/Eshoo bill and the Dodd/Domenici bill would limit its application to persons defined as "primary wrongdoers" and their controlling persons, as well as secondary participants who engage in "knowing securities fraud." The latter two bills would also provide that, where all or part of a primary wrongdoer's obligation is uncollectible due to insolvency, individual plaintiffs who meet certain criteria may collect additional amounts from the other defendants. Among other things, the plaintiffs must have a net worth of less than $200,000 and must have unrecoverable damages equal to or exceeding 10% of their net worth. Because proportionate liability would affect investors in the most serious cases (e.g., where an issuer becomes bankrupt after a fraud is exposed), the Commission recommends that Congress focus on measures more directly targeted at meritless litigation before considering any changes to the liability rules. Should Congress nevertheless determine to adopt some form of proportionate liability for reckless conduct, the Commission believes that it would be preferable simply to establish a cap on damages (e.g., liability is joint and several except that no defendant shall be forced to pay more than the greater of 50% of the total damages or two times the defendant's proportionate share). This would be far easier to administer than the procedures proposed in the Mineta/Eshoo bill and the Dodd/Domenici bill, and it would avoid affording disparate treatment to plaintiffs based on an economic needs test. The Commission recommends that any form of proportionate liability should be limited to cases based on reckless conduct, as proposed in the pending bills. The Commission also believes that it should be confined to fraud-on-the-market cases brought under -------------------- BEGINNING OF PAGE #19 ------------------- Rule 10b-5. It is in those cases that the scope of liability is least predictable since it depends on the volume of trading and other market factors beyond the control of the potential defendants. IV. CLASS ACTION REFORM PROPOSALS Class action lawsuits generally further judicial efficiency and make it feasible for a broad group of investors who have relatively small individual claims to maintain an action for damages. This aggregation of claims makes class actions a powerful deterrent against fraud. Many critics of the private litigation system express concern, however, that the existing system contains inadequate safeguards against abuse. Reforms designed to eliminate abuses in class action lawsuits are an important area in which it appears that a consensus can be reached. Virtually all parties to the litigation reform debate agree that restrictions should be placed on the manner in which class counsel locate and enlist the "named plaintiffs" for class actions. The "race to the courthouse" phenomenon serves no useful purpose. The Commission has previously endorsed a number of legislative measures included in each of the pending bills.-[58]- These measures would prohibit the payment of additional compensation to a class representative, the payment of referral fees by an attorney seeking to act as class counsel, and service as class counsel by an attorney who has a beneficial interest in the securities that are the subject of the litigation unless specifically authorized by the court.-[59]- The Commission believes that measures such as these would impose some discipline in the system and provide a check against the precipitous filing of class action lawsuits that have not been adequately -------- FOOTNOTES -------- -[58]- Although the bills are limited to certain types of actions, most of these proposals should by applicable to class action lawsuits under all of the private causes of action provided in the federal securities laws. -[59]- The Tauzin bill would prohibit attorneys from representing any party in cases under the Securities Act or the Exchange Act if they knowingly violate the bill's provision barring attorneys from having a beneficial interest in the subject securities. There may be situations in which a lawyer's beneficial ownership of shares is not objectionable, such as where a defendant corporation is represented by its general counsel, who owns shares or options of the company as part of his or her compensation. Therefore, it would be more appropriate to give courts some flexibility to enforce provisions such as this, rather than to mandate a penalty. H.R. 10, the Mineta/Eshoo and Markey bills, as well as the Dodd/Domenici bill, take a more flexible approach on this point, by requiring the court to make a determination of whether the lawyer's beneficial interest constitutes a conflict of interest. The Markey bill would require named plaintiffs in class actions to personally certify, among other things, that they have reviewed and approved the complaint, and that they did not purchase the securities in question in order to commence litigation or at the direction of their lawyers. They would also be required to set forth all of their transactions in the security and information about previous securities suits that they have brought. -------------------- BEGINNING OF PAGE #20 ------------------- investigated.-[60]- The Commission also supports the prohibition on the payment of attorneys' fees from funds disgorged in a Commission action. Several of the pending bills would also require more specific disclosure of settlement terms to class members. The Commission strongly supports efforts to enhance disclosure to class members. Several other class action procedural reforms are proposed in the Markey bill and the Mineta/Eshoo bill, as well as in the Dodd/Domenici bill. Among other things, these bills would restrict settlements under seal in implied private class actions unless good cause is shown for such filing;-[61]- and require that attorneys' fees be calculated as a percentage of the amount actually paid to the class, rather than under the "lodestar" method in which courts review attorneys' time records and multiply the hours worked times a reasonable hourly rate.-[62]- The Commission believes that the overall approach suggested by these proposals deserves further study and careful consideration. The Commission does not oppose any of these proposals and sees some merit in each of them. However, measures such as these may have implications outside the Commission's area of expertise. The Commission recommends that the Committee seek the views of the Judicial Conference of the United States on these points. A number of the proposals for legislation, including H.R. 10 and the Mineta/Eshoo bill, as well as the Dodd/Domenici bill, contain provisions which would mandate some oversight of class counsel by class representatives in securities class actions. Class counsel have incentives that may differ from those of the underlying class members and frequently have a significantly greater interest in the litigation than any individual member of the class. Fees in class action cases are typically determined as part of a settlement negotiation in which the actual plaintiffs, the individual investors, play no role. In addition, class counsel usually advances the costs of litigation, which means that counsel may have a greater incentive than the members of the class to accept a settlement that provides a significant -------- FOOTNOTES -------- -[60]- See Testimony of William R. McLucas, Director, Division of Enforcement, Securities and Exchange Commission, Concerning Private Litigation Under the Federal Securities Laws, Before the Securities Subcommittee, Committee on Banking, Housing, and Urban Affairs, U.S. Senate (June 17, 1993). -[61]- In addition, the Markey bill would restrict the sealing of discovery materials unless the court found that disclosure of the materials would cause direct and substantial harm to the competitive or privacy interests of a person. -[62]- Proponents of the percentage-of-recovery method argue that it better aligns the interests of class members and their lawyers than does the lodestar method. At least two circuits mandate the use of the percentage-of-recovery approach in securities class action and other "common fund" cases. See Swedish Hospital Corporation v. Shalala, 1 F.3d 1261 (D.C. Cir. 1993); Camden I Condominium Association v. Dunkle, 946 F.2d 768, 774 (11th Cir. 1991). An expert task force appointed by the Third Circuit also recommended abandoning the lodestar method for a percentage fee method. See Report of the Third Circuit Task Force, Court Awarded Attorneys' Fees, 108 F.R.D. 237 (1985). -------------------- BEGINNING OF PAGE #21 ------------------- fee and eliminates any risk of failure to recoup funds already invested in the case.-[63]- Under these proposals, the court would be required to appoint either a guardian ad litem or a steering committee of class members to direct class counsel and perform whatever other functions the court may specify. The guardian ad litem or the steering committee would have the authority to retain or dismiss class counsel and to reject offers of settlement or preliminarily accept offers of settlement. These proposals are designed to address the difficulty that investors in the plaintiff class have in exercising any meaningful direction over the case brought on their behalf. The Commission supports greater voluntary involvement by investors, and particularly institutional investors, in class action suits brought on their behalf. Because these specific proposals have not received significant support from parties on either side of the issue, however, it may be more productive to focus on measures as to which a consensus can be reached.-[64]- Finally, both H.R. 10 and the Dodd/Domenici bill contain provisions that would restrict the right of investors to serve as class representatives unless they held a certain minimum amount of the securities at issue. These proposals also have been strongly opposed by parties who believe that it is inconsistent with the goal of protecting the rights of individual investors to require that investors meet a minimum threshold of share ownership before being allowed to initiate an action on behalf of a class. Because there are other ways to ensure the suitability of class representatives, the Commission does not believe that a share ownership threshold is essential. V. STATUTE OF LIMITATIONS In 1991, the Supreme Court held that private actions under Section 10(b) of the Exchange Act must be filed within one year after discovery of the alleged violation, and no more than three years after the violation occurred.-[65]- The Commission has previously urged Congress to address the "Lampf" decision by enacting an express statute of limitations that would allow cases to be filed up to five years after a violation occurs, provided they are brought within two years after discovery of the violation. Extending 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. -------- FOOTNOTES -------- -[63]- For more extensive discussions of the agency problems in class actions, see Jonathan R. Macey & Geoffrey P. Miller, "The Plaintiffs' Attorney's Role in Class Action and Derivative Litigation: Economic Analysis and Recommendations for Reform", 58 U. Chic. L. Rev. 1 (1991); John C. Coffee, Jr., "Understanding the Plaintiff's Attorney: The Implications of Economic Theory for Private Enforcement of Law Through Class and Derivative Actions," 86 Colum. L. Rev. 669 (1986). -[64]- See Association of the Bar of the City of New York, Report on Private Securities Litigation Reform Legislation (S. 1976, the Dodd-Domenici Bill) by the Committee on Securities Litigation and the Committee on Federal Courts (December 19, 1994), at 13-17. -[65]- "Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson," 501 U.S. 350 (1991). -------------------- BEGINNING OF PAGE #22 ------------------- VI. CONCLUSION Our first goal must be to preserve and strengthen our capital markets, which are the deepest and richest in the world. Our markets are the envy of the world precisely because they operate fairly and efficiently under a system in which full disclosure, not inside advantage, is the rule. Private litigation serves as a vital element in the enforcement of the federal securities laws, but a proper balance between encouraging meritorious suits and restricting frivolous or speculative suits must be maintained. There are usually investors on both sides in private securities litigation, and we must ensure that our system works for all of them. There are many proposals for improving private litigation under the securities laws that the Commission supports. We believe that these proposals, if enacted, would significantly improve the system, balancing the need to eliminate abusive litigation practices with the need to preserve the benefits provided by private enforcement of the securities laws. The Commission opposes other proposals under consideration, however, because they would put the system out of balance, and potentially undermine the integrity and discipline of our capital markets. We look forward to working with the Subcommittee in its effort to craft legislation addressing these important issues.