Request for Rulemaking Requiring Pre-Notification and Disclosure of Certain Communications by Trial Lawyers
Washington Legal Foundation
March 24, 2003
Jonathan G. Katz
Re: Petition for Rulemaking Requiring Pre-Notification and Disclosure of Certain Communications By Trial Lawyers
Dear Mr. Katz:
Pursuant to 5 U.S.C. § 553(e) and Rule 192 of the Securities and Exchange Commission's Rules of Practice, 17 C.F.R. § 201.192, the Washington Legal Foundation (WLF) hereby petitions the Commission to promulgate either a new rule, the substance of which is described more fully below, or amend relevant existing SEC rules, that would require pre-notification to the public and disclosure of communications between trial attorneys who plan to sue or have sued a publicly traded company, and analysts, institutional investors, short-sellers, hedge funds, financial advisers, and other persons, whose recommendations or trading activity about the targeted company, its subsidiaries, or parent company, could likely affect the price of the stock of the company.
Currently, plaintiff's attorneys or their agents can selectively disclose negative material nonpublic information to analysts and traders about a company that they are planning to sue or have sued with the intent to drive down the price of the stock of that company, its subsidiaries, or parent company, in order to force the company to settle the underlying claim or suit. The targeted companies are blindsided by the negative information, and do not have a meaningful opportunity to respond before the damage to the price of the stock has occurred. The entire investment community also does not have a full and fair opportunity to timely obtain and assess this selectively disclosed information. WLF believes that such practice undermines the integrity of our capital markets, leads to a loss of investor confidence, and harms the shareholders and employees of the targeted company.
Just as the SEC deemed it to be in the public interest to enact Regulation FD (Fair Disclosure), 17 C.F.R. Part 243, which requires public disclosure by issuers of heretofore selective disclosure of material nonpublic information (such as advance warnings of earnings results), so too should the SEC require pre-notification to companies and public disclosure of information that is disseminated by plaintiff's attorneys to analysts and others about impending or current lawsuits against publicly traded companies. Similarly, just as the SEC has promulgated rules in response to Sarbanes-Oxley regardingdisclosures to be made by corporate counsel regarding suspected corporate misconduct, so too should trial attorneys who file damaging and potentially ruinous class action lawsuits against corporations be governed by appropriate SEC rules and regulations regarding their conduct, in order to maintain the integrity of the financial markets.
Interests of WLF
WLF is a nonprofit, public interest law and policy center based in Washington, D.C., with supporters nationwide. Since its founding 25 years ago, WLF has advocated free-enterprise principles, responsible government, property rights, a strong national security and defense, and a balanced civil and criminal justice system, all through WLF's Litigation Department, Legal Studies Division, and Civic Communications Program.
Earlier this year, WLF launched its Investor Protection Program. The goals of WLF's Investor Protection Program are comprehensive: to protect the stock markets from manipulation; to protect employees, consumers, pensioners, and investors from stock losses caused by abusive litigation practices; to encourage congressional and regulatory oversight of the conduct of the plaintiffs' bar with the securities industry; and to restore investor confidence in the financial markets through regulatory and judicial reform measures.
As part of WLF's IPP, WLF filed a Complaint dated January 21, 2003 with the SEC calling on the SEC to conduct to formal investigation into the short-selling of J.C. Penney Co. stock shortly before and after a major class action lawsuit was filed against Eckerd Drug Stores which is owned by J.C. Penney. As more fully described in that complaint, there are serious questions about the selective disclosure of the timing of the lawsuit to short-sellers of J.C. Penney Co. stock that warrant further investigation.
In recent years, WLF has also opposed proposed class action settlements on behalf of class members objecting to the award of excessive plaintiffs' attorneys fees, while class members receive little, if any, compensation. See, e.g., In re Synthroid Mkt. Litig., 264 F.3d 712 (7th Cir. 2001); Wilson v. Massachusetts Mutual Life Ins. Co., No. D0101 CV 9802814 (1st Dist., Sante Fe County, NM) (objection filed Feb. 2, 2001); In re Compact Disc Minimum Advertised Price Antitrust Litigation, MDL Docket No. 1361 (D. Me.) (objections filed March 3, 2003). WLF has also participated in litigation opposing the filing of class action lawsuits against companies simply for failing to meet revenue and profitability projections. See, e.g., Cypress Semiconductor Corp. v. Yourman, 2001 Cal. App. Unpub. LEXIS 1963.
In addition, WLF's Legal Studies Division has produced and distributed timely publications on securities regulations. WLF's recently published Legal Backgrounders on the topic include: Peter L.Welsh, Sarbanes-Oxley And The Cost Of Criminalization; Robert A. McTamaney, The Sarbanes-Oxley Act Of 2002: Will It Prevent Future "Enrons?"; and Claudius O. Sokenu, SEC Expands Foreign Corruption Law Beyond Congressional Intent.
Accordingly, WLF has a long-standing interest in ensuring that lawsuits in general, and class actions in particular, are not discussed, drafted, and filed in such a way so as to cause needless harm to shareholders of the targeted company, or to enrich short-sellers who may have improperly received pre-filing information about the lawsuits.
Justification for the Rule
There is no doubt that the filing of a major class action lawsuit against a company can have a devastating effect on the price of its stock. For example, in late September 1999, the share value of national Health Maintenance Organizations (HMOs) lost over $12 billion in stock value in a single day following news of class action lawsuits by a consortium of plaintiffs' lawyers against the companies. See David Segal, Tag-Team Lawyers Make Business Blink: HMOs Latest to Grapple With Threat of Investor-Scaring Mega-Verdicts, Wash. Post, Nov. 12, 1999 at A1 (online copy attached hereto) (hereinafter Segal). According to the Segal article, "By leveraging the might of the stock market, these legal collectives [of plaintiffs' lawyers] are altering the balance of power in the never-ending battles between trial lawyers and the companies they sue." Id. at 1.
Professor George Priest of Yale Law School summarized the power that the filing of these suits have on a company's share price when he stated, "It's the fear of the nuclear-bomb verdict that gives leverage to plaintiffs' lawyers to make threats and play off a company's stock price. . . . Jury verdicts nowadays can put companies out of business." Id. The Segal article also noted another method used by trial lawyers to use Wall Street to depress the price of the stock of a targeted company.
In the HMO suits, Wall Street is playing its most prominent role to date. One lawyer. . . Richard Scruggs of Mississippi, has taken the unusual step of meeting with key HMO analysts at Morgan Stanley Dean Witter and Prudential Securities and even participated in a conference call with dozens of institutional investors.
Id. at 2. According to the article, Scruggs was quoted as saying, "If HMO investors are smart, they'll lean on their companies to see if we can work something out [to settle the class action lawsuits]. Id. at 4. Some industry targets view these tactics to force settlements with alarm. According to Aetna's chief executive Richard L. Huber, "In one day, more than $10 billion in American savings was vaporized just by the bark of the wolf. The brazenness is astounding." Id. at 2.
Clearly these discussions with analysts and institutional investors can have, and do have, asignificant impact on the price of the stock of the targeted company or industry. Just as clearly, it would be in the public interest for the entire investment community, including the targeted company, to be notified ahead of time of these communications and be afforded an opportunity to participate in these heretofore one-sided and biased communications.
In addition to the negative pressure on stock values by trial attorneys such as Mr. Scruggs, there are reports that in other cases, short-sellers have been privy to impending class action lawsuits and, accordingly, sell short the stocks of companies that are the target of the class action lawsuits. For example, with respect to the class action lawsuit filed against J.C. Penney Co., the Wall Street Journal reported earlier this year that shortly before the suit was filed, rumors were circulating that Eckerd overcharged for its drugs, and the stock of J.C. Penney had dropped some 15 percent from mid-November, 2001. David Armstrong & Ann Zimmerman, "Suit Batters Penney Shares, But Serves Short-Sellers Well," Wall St. J., January 6, 2003 (online version attached hereto).
According to Eckerd pharmacist Don Reilly, he was contacted some 30 to 40 times by an analyst for a broker-dealer to be kept up to date on the timing of the filing of the class action suit against Eckerd. Journal at 3. According to Mr. Reilly, the analyst was "communicating with the lead plaintiffs' lawyer in the Eckerd suit before it was filed." The Journal reported that the lead trial attorney "didn't reply to questions about what prompted his interest in the Eckerd case or whether he discussed a possible lawsuit with short-sellers or other investment pros before filing it." Journal at 3.
WLF's Complaint dated January 21, 2003, requests the Commission to investigate the J.C. Penney case to see if there were any violations of SEC laws or regulations, including Rule 10b-5. While our complaint is under review by the Commission, we believe that even if there were substantive violations of SEC rules or regulations, there is still a need to have a prophylactic regulation providing for pre-notification and disclosure. In this particular case, if WLF's petition were to be adopted, the public would be notified beforehand that the trial attorney or his agent were planning to discuss legal matters that could affect the price of J.C. Penney Co. stock.
In that regard, any objections to this petition on the grounds that the SEC could address any disclosure of material nonpublic information under existing Rule 10b-5 insider trading regulations or other provisions should be rejected, just as the Commission rejected similar arguments in adopting Rule FD. There the SEC stated:
Some commenters contended that rulemaking on this topic was an inappropriately broad response to the issue. They suggested instead that we use existing tools (namely, the law of insider trading) to bring individual enforcement actions in those cases that appear to involve significant selective disclosures. While we have considered this approach --and of course we remain free to bring such cases where a selectivedisclosure does violate insider trading laws -- we do not agree that this is the appropriate response to the legal uncertainties posed by current insider trading law. In other contexts, we have been criticized for attempting to "make new law" in an uncertain area by means of enforcement action and urged instead to seek to change the law through notice-and-comment rulemaking. We believe that this rulemaking is the more careful and considered response to the problem presented by selective disclosure.
SEC Final Rule: Selective Disclosure and Insider Trading, reprinted at www.sec.gov/rules/final/33-7881.htm at page 5 (emphasis added).
Accordingly, WLF believes that it is appropriate and in the public interest for the SEC to promulgate a regulation to deter unlawful trading, market manipulation, or other conduct that has the effect of disrupting the securities markets and undermining investor confidence in the market. In that regard, the proposed rule operates in much the same way as SEC Rule FD and for much of the same reasons.
Substance of the Rule
SEC Rule 192, regarding the filing of petitions for rulemaking, specifies that a petitioner should provide the "text or substance" of the proposed rule, in addition to providing reasons for the rule and interests of the petitioner. Rather than provide proposed textual language for the rule, WLF believes that it is more appropriate to provide the substance of the rule from which the Commission can craft appropriate and specific language for the rulemaking.
WLF proposes that before a trial attorney initiates any contact with any analyst, investment advisor, institutional investor, hedge fund, short-seller, and similar persons whose recommendation or trading activity can effect the market, whether that contact is in person, by telephone, email, or written communication, for the purposes of discussing or transmitting information or views about an impending or ongoing lawsuit or claim against a publicly traded company, the attorney shall notify the SEC by email at least three business days beforehand of the proposed communication. The notification shall be posted on the SEC's website in a prominent place, and shall summarize the specifics of proposed communication, such as the name, address, and telephone number of the attorney, the name, address, and telephone number of the analyst, institutional investor, short-seller, trader, or other person; the name of the publicly traded company or companies that are the subject of the proposed communication by the trial attorney; and other information deemed pertinent by the SEC.
At the expiration of the three-day period and the posting of the notice on the SEC website, the trial attorney may then engage in the communication proposed in the notice, provided that suitable arrangements have been made in the interim to give an opportunity for a representative of the subjectcompany to attend or participate in the communication, whether by teleconference, webcasting, or in person. For example, if the trial attorney proposes to discuss a legal case with an analyst by telephone, then the company representative shall also be given an opportunity to participate in that conversation. If the trial attorney proposes to discuss a legal case with an analyst in person, then the company representative may also attend that meeting in person or by teleconference or speakerphone at their election. If the trial attorney proposes to send written or electronic information to the analyst, that same information must be sent in the same format and at the same time to the company's representative. No analyst or other person shall entertain any substantive communications with a trial attorney unless the pre-communication notice has been first posted on the SEC's website.
While we recognize that limits on communications between trial attorneys and analysts have First Amendment implications, we believe that the conditions proposed here are valid time, place, and manner restrictions that can be constitutionally imposed, particularly considering the compelling governmental interest in regulating the securities market and maintaining investor confidence in the integrity of the market. At the same time, this rule would not hamper the ability of an analyst to conduct due diligence in its market research; indeed, the rule would facilitate due diligence by providing the analyst with an opportunity to obtain additional information concerning the charges and claims proffered by the trial attorney about the targeted company.
For the foregoing reasons, we urge the Commission to initiate rulemaking proceedings along the lines suggested by this petition. At a minimum, the Commission should issue this proposal as an SEC "concept" release, a format which the Commission uses from time to time to solicit the public's views on an issue so that the SEC can better evaluate the need for rulemaking in this area. We also reserve our right to modify, supplement, or amend this petition.
Daniel J. Popeo
Paul D. Kamenar
The Honorable William H. Donaldson