REMARKS OF COMMISSIONER STEVEN M.H. WALLMAN Before Stanford Law School's "Tools for Executive Survival" Program Stanford Law School Stanford, California June 22, 1995 The views expressed herein are those of Commissioner Wallman and do not necessarily represent those of the Commission, other Commissioners or the staff. Introduction Thank you for inviting me to speak today. It is a pleasure to participate in Stanford Law School's "Tools for Executive Survival" program, and I appreciate the opportunity to address this knowledgeable audience, especially following such speakers as George Roberts and Robert Bennett. I would like to share a few thoughts with you about two subjects of particular interest to me -- securities litigation reform and preserving the effectiveness of the U.S. capital formation process. Of course, the views I express are solely my own. I. Securities Litigation Reform and the Safe Harbor for Forward-Looking Information First, let me turn to litigation reform and the Commission's efforts to improve its safe-harbors for forward-looking information. A. The Litigation Reform Issues Facing Congress As you know, securities litigation reform has for some time been one of the more hotly debated issues on Capitol Hill. Clearly there is some dysfunction in the present system. Currently, corporations and their shareholders pay other shareholders and their lawyers very large amounts, both in terms of defense costs and settlement fees, while those responsible for perpetrating serious frauds -- sometimes, yes, even corporate executives -- frequently emerge unscathed unless the Commission itself sues them. The costs of these suits are considerable. One study indicates that the average shareholder suit costs $700,000 in legal fees and consumes 1,055 hours of management's time.-[1]- As for the settlements, according to one estimate, between 1988 and 1993, 343 publicly traded companies paid a total of $2.5 billion in settlements alone.-[2]- The American Electronics Association estimates that 93 percent of private class action -------- FOOTNOTES -------- -[1]- Shareholder Suits Common, Costly in Venture Backed Firms, Boston Globe, January 16, 1994, at A4., cited in CONGRESSIONAL RESEARCH SERVICE, SECURITIES LITIGATION REFORM: HAVE FRIVOLOUS SHAREHOLDER SUITS EXPLODED? (May 16, 1995). -[2]- Paul Sweeny, Full Siege Ahead, ACROSS THE BOARD at 31 (Nov./Dec. 1994), cited in SECURITIES LITIGATION REFORM, supra note 1. -------------------- BEGINNING OF PAGE #2 ------------------- securities fraud suits settle out of court at an average settlement of $8.6 million.-[3]- With respect to litigation reform, difficult policy issues confront both Congress and the Commission. How do we preserve meritorious private claims while discouraging or foreclosing frivolous private claims? What is a meritorious claim? To what extent can issuers be protected against liability for false or misleading forward-looking statements without impairing the integrity and liquidity of our capital markets? Would stronger Commission enforcement, at least in the area of forward-looking disclosures, serve as a more effective deterrent against fraud than private litigation? Any resolution of these issues must recognize the interests of small, unsophisticated shareholders who may not have the means of assessing the reliability of soft information. Larger, sophisticated institutions and analysts may have the savvy to discount or dismiss inherently non-credible projections -- but smaller investors often do not. Moreover, given our securities laws and the manner in which they are designed, and given the Commission's resources and enforcement focus, private litigation to enforce the securities laws has traditionally been viewed as a necessary adjunct to public enforcement. The private securities class action bar clearly has helped ensure the integrity of corporate disclosures and the protection of investor interests, thereby advancing the aims that Congress envisioned in the Securities Act and the Exchange Act. That notwithstanding, it is important that we remember that the securities laws are designed to further the interests of investors -- not issuers, and not plaintiffs per se. Obviously, issuers would prefer never to be sued, while plaintiffs would prefer always to win any suit they bring. Neither result is in the interest of investors. Consequently, in furthering investor interests, Congress through the years has sought to engage in appropriate balancing. The basic principles, I believe, are as follows. Clearly, ALL misstatements and omissions made to the public should be discouraged. It does not matter whether the misstatement was made intentionally, recklessly, negligently, or even innocently for that matter. ANY misstatement reduces the integrity of the information in the market, thereby increasing investors' risk. This increased risk causes investors to demand higher returns, which raises a firm's cost of capital. The result is that investors and issuers are both hurt.-[4]- Nevertheless, Congress has acknowledged that exacting too a high a price for a misstatement or omission results in an inappropriate balance that also hurts investors. Information -------- FOOTNOTES -------- -[3]- AEA News Release: Litigation Strangling Silicon Valley, BUSINESS WIRE (March 22, 1995), cited in SECURITIES LITIGATION REFORM, supra note 1. -[4]- An additional adverse consequence of a higher cost of capital is a reduction in the competitiveness of the U.S. securities markets in relation to overseas markets. -------------------- BEGINNING OF PAGE #3 ------------------- with a forward-looking component, although highly valuable to investors is, by definition, information that carries with it a level of uncertainty. Forward-looking information in particular always involves a risk that it may become inaccurate and -- depending on what law we create -- may subject an issuer to liability. If too high a liability cost is placed on the disclosure of inaccurate information, the information required to be provided by an issuer will be subject to so many caveats that it loses much of its benefit as disclosure. There will also be less information voluntarily provided to the market. The lack of full and candid information ultimately can be as harmful to the markets and investors as misleading information. Consequently, in attempting to fashion a safe harbor from liability for forward-looking information that furthers investor interests by assuring meaningful disclosure of forward-looking information to the markets, it may be necessary to fashion rules that protect some disclosures that we might not otherwise have chosen to protect in an ideal world. But no safe harbor will be perfect; and it is simply too easy to continue to insist on a safe harbor that cannot possibly let any improper disclosure through without liability. The result of such a lack of balance hurts investors, not helps them. Any safe harbor that is crafted needs to be consistent. It should turn on the type of information provided, not on its position in an issuer's filing, such as whether it is in the financial statements or the MD&A or whether it is in a Securities Act or an Exchange Act filing. Specifically, if one were to craft a safe harbor, most likely the information you would most like to protect is information that is written, contained in public filings, unambiguous in its meaning, placed in context, independently reviewed, and calculated or generated in accordance with well understood principles and procedures. One might recognize this as the financial statements. The safe harbor might then be extended to other information that is in writing and filed. Finally, one might extend the safe harbor to information that is oral, ambiguous, not necessarily in context, not filed, not independently reviewed, and not produced in accordance with any generally recognized principles or procedures. All the proposals to date, however, provide for the opposite -- they protect the last category of information, but not the first. Why? Because the arguments in favor of a safe harbor started with the proposition that forward-looking information was not being provided to the market voluntarily. The unstated assumption was that this information was not being provided because of the liability associated with making statements that contain inherent uncertainties. But the logic of that unstated assumption -- that the liability associated with information that contains inherent uncertainties may be too high, a proposition by the way on which many still have substantial doubts -- never made it past the articulated complaint about information not being provided voluntarily. And so the focus is on providing relief for the information that may be the most suspect, and not for the information that is least suspect. Perhaps as more thought over the years is given to whatever safe harbor emerges, there will be a better discussion of what should be included in it. Any safe harbor that is crafted also needs to be clear and provide certainty. If the safe harbor is ambiguous, it means -------------------- BEGINNING OF PAGE #4 ------------------- plaintiffs will undergo delays and extensive costs only to discover that their suit cannot be brought, while issuers and their shareholders will bear expensive defense costs merely to prove that they were in fact within the safe harbor. Additionally, and perhaps more importantly, a poorly-crafted safe harbor will not serve its purpose of furthering investor interests by reasonably protecting forward-looking information when it is provided or by promoting and enhancing the dissemination of that information. In that instance, no safe harbor is likely better than an ineffective one. At least then one would know the rules, without falling into traps. There is a flaw, however, in our current system of securities litigation that makes ANY analysis of the appropriate balance more difficult. The problem is that in the normal fraud on the market suit, INNOCENT investors are hurt whenever a claim is filed against the issuer, EVEN IF the claim is a meritorious one. For example, when there is a misstatement that positively affects the market, those shareholders of the company that bought before the misstatement and sold before any corrective disclosure, benefit. Quite simply, these shareholders bought low and sold high, and made a profit they would not have made if the disclosures had been correct. The investors who are hurt are those shareholders who bought from these other shareholders -- in other words, the shareholders that are hurt are those who bought high and now either hold or sold low-priced stock. In these cases, the issuer -- and all the CURRENT shareholders of the issuer -- did not benefit at all. But the lawsuit, of course, is not and cannot be against the benefitting shareholders. Instead it is against the ISSUER and, by extension, all its CURRENT shareholders. The result then is a wealth transfer from one group of innocent shareholders -- the current shareholders (which includes for certain some of the members of the plaintiff class) -- to the defrauded investors. Despite their innocence, the current shareholders pay for the damages award (directly if the issuer is not insured, and indirectly through insurance premiums if it is). This example highlights the dysfunctional economics of the present system -- we have wealth transfers from one group of innocent shareholders -- the current shareholders -- to another - - the defrauded shareholders. The group of shareholders who actually BENEFITTED from the fraud because they bought low and sold prior to the share price correction will not have to pay at all. Although this doesn't make much sense, we have been stymied to date in finding a better alternative. Who else can defrauded shareholders sue? We have no good mechanism to reach the people who actually benefitted from the misleading statement -- namely, the shareholders who bought low and sold high. The corporate spokespersons and officers don't have enough money to pay the damages. So we are left with the innocent shareholders of the company paying. In essence, we have a very crude form of insurance as the foundational idea for our system, with extraordinarily high transaction costs. Ultimately, is this really the best way to serve investor interests? My guess is no one would have intentionally designed such a system except for one problem -- what's the alternative? As a society, are we willing to allow investors who have lost their life's savings to have no recompense? I doubt it; although we -------------------- BEGINNING OF PAGE #5 ------------------- should recognize that is the law NOW when an investor loses everything due to a company's NEGLIGENT statements. What this means is that we should neither give up on efforts to reform the system, but neither should we reform it in such a way that we create a new unfairness for those investors least able to protect themselves. We have to think a lot harder, and try to be a lot more creative, in finding a solution that effectively balances all the competing concerns. For too long, the debate has been whether there is a problem. The debate must now switch to how to make the system better. If we had started that discussion a few years ago, we would be much farther along in furthering investor interests today. In a very real way, I believe this search and examination for better solutions is only just beginning, not ending, with the current Congressional action. Overall, Congress and the Commission must continue to recognize these competing considerations and do their best to further the interests of investors long-term -- not make determinations that further either plaintiffs or issuers in the short term. There may be differences as to the preferred route to further investor interests, but there should be no misunderstanding that it is investor interests, not plaintiff interests or issuer interests that should control. There seems to be a continuing tendency in this context to confuse plaintiff or issuer interests with investor interests. That is a mistake in our basic understanding. Finally, if there is to be a safe harbor from private litigation, then Congress must also ensure that there is effective public enforcement. In that regard it becomes increasingly important to provide the Commission with authority to seek disgorgement where the safe harbor might otherwise apply, provided the disgorgement would not hurt innocent shareholders. In addition, the Commission should clearly have authority to pursue aiding and abetting claims whenever a person engages in action that would constitute a violation of the securities laws if done directly. B. The Commission's Safe Harbor Rulemaking Initiative Last October, as you probably all know, the Commission undertook a re-examination of the Commission's regulatory safe harbor for forward-looking disclosures. For some time, the Commission's safe harbors -- with their standards of reasonableness and good faith -- have been criticized as offering an ineffective defense against securities fraud claims based on unrealized projections or other contingencies that ultimately did not occur as predicted. Since the Supreme Court's decision in Hochfelder, most companies have found it more effective to fight over the adequacy of allegations of scienter than to litigate whether the Commission's safe harbor might be available. In recognition of this reality, the Commission issued a concept release last October, and held extensive hearings in Washington and San Francisco in February. A number of ideas for new and improved safe harbors were suggested by small and emerging companies, large public -------------------- BEGINNING OF PAGE #6 ------------------- companies, public accountants,-[5]- the plaintiffs' bar, investment banking firms, academics, and others. Shareholders weighed in both in support of change and against. In the end, I'm not sure what the Commission will do. Much will depend on whether legislation is passed. But I think that reform of the safe harbor for forward-looking statements should be pursued on a regulatory basis if it is not fully addressed on a statutory basis, because the question of liability for forward- looking statements is too important a part of furthering investor interests. I also think it is unfortunate that the Commission was not able to act on a safe harbor proposal earlier. Had we done so, I believe all participants, and in particular investors, would have benefited. Let me summarize by asserting that investors who cannot trust the integrity and reliability of information disseminated by a company, or who have no effective redress against fraud, will demand higher returns to compensate for higher investment risk. This, of course, will translate into a higher cost of capital that hurts everybody over the long-term. By the same token, imposing too much liability results in reduced information flow, expensive defense costs imposed on companies and their innocent shareholders, and concomitantly higher capital costs. That, too, hurts everybody. We must strive to achieve the right balance. And when the balance struck today becomes a poor one, we must be prepared to re-balance tomorrow. More importantly, we must continue to think of better solutions. II. The U.S. Capital Formation Process Let me now turn to my second, but related, topic. As you know, the primary mandate of the Commission is to ensure the protection of investors and the maintenance of fair and orderly markets. I view the continued efficiency and effectiveness of our capital raising process as essential to attainment of these goals and, therefore, spend a fair amount of time thinking about issues that affect the capital raising process. I would like to focus on three main points in this regard: First, in my view, our ability to raise capital effectively and efficiently not only has been a driving force behind the international preeminence of the U.S. markets, but also has had significant positive ramifications on our quality of life. Second, in order to maintain a robust and effective capital raising system into the Twenty-First Century, we need to devote more attention to a number of matters today. Specifically, market participants need to reassess the adequacy of the current system of capital formation in light of the relatively recent, and rapid, evolution of firms and financial products. This is particularly true in the areas of accounting and corporate governance. -------- FOOTNOTES -------- -[5]- The AICPA has proposed that forward-looking information in audited financials should receive safe harbor coverage. Specifically, they believe that inherently contingent items of information, such as stock option valuation disclosures and the assumptions underlying those disclosures, should continue to be protected by the safe harbor. -------------------- BEGINNING OF PAGE #7 ------------------- Finally, regulators constantly need to reconsider and reevaluate the effect of our regulations on the capital formation process. Wherever possible and consistent with statutory mandates, regulators should streamline and eliminate regulations to avoid imposing excessive costs on firms seeking to raise capital. Of course, in the Commission's case, such deregulatory efforts must always be consistent with the overriding goal of investor protection. A. The Vibrancy of Capital Formation in Our Markets Today By almost any measure, the U.S. capital markets are the strongest markets in the world today. In 1994, domestic public debt offerings totalled $625.5 billion, and public equity offerings were valued at $77.1 billion -- a total of $702.5 billion in underwritten offerings.-[6]- In addition, the value of debt and equity issued in private placements in 1994 amounted to $141 billion.-[7]- Whether determined by market capitalization or value of shares traded, the U.S. markets are the largest and deepest in the world.-[8]- The continued growth of our markets attests to the efficacy, transparency, and integrity of our capital formation process. Market participants seeking to raise capital may do so efficiently, while those providing capital receive a return commensurate with the business risks associated with their investments. The role of securities in the capital formation process is staggering in terms of our standard of living -- in terms of assisting product development, expansion opportunities, job creation, and employee wealth. B. Preparing for the Capital Formation Process in the Twenty First Century A number of recent developments could impact upon the efficiency of capital formation and, therefore, merit thoughtful consideration. The concept of the "firm" has changed. I strongly believe we need to develop a sufficiently dynamic and reliable analytical framework for anticipating and responding to changes in the concept of the business enterprise and the relationship of that enterprise to suppliers of capital (as well as suppliers of goods and services, customers, and other constituencies). Many public companies today have multiple subsidiaries, engage in a variety of joint ventures and licensing arrangements, or are otherwise involved in loose affiliations that make it difficult to define the outer edges of a "traditional" firm. The central assets of these "virtual firms" often consist of soft resources -- human or intellectual capital -- rather than physical assets, and present novel valuation and reporting issues. Our current accounting system simply does not do a good job of describing our newest business enterprises that rely more and more on intellectual capital, as opposed to hard assets, for the production of income. -------- FOOTNOTES -------- -[6]-SIA, 1995 SECURITIES INDUSTRY FACT BOOK 19 (1995). -[7]-Id. at 8. -[8]-Id. at 76-77. -------------------- BEGINNING OF PAGE #8 ------------------- We must also think about whether what we currently require - - even where new types of businesses and capital are not an issue -- is as useful as it could be. For instance, analysts now spend a great deal of their time trying to DISAGGREGATE components of categories of historical financial information that regulators require to be aggregated. We should also think about whether the timing of current periodic reporting appropriately reflects new financial instruments like derivatives that can change a business's risk profile overnight, or short product cycles increasingly prevalent in some industries, and whether, therefore, these reports are still providing timely information to end users. We also need to analyze the impact of institutional investors on the cost of capital. Some assert, for example, that the growth of institutional investing has resulted in more of an emphasis on short-term corporate results, the elimination of long-term capital sources, and a corresponding increase in the cost of capital. Although I believe it likely that just the opposite is occurring, we should consider this assertion and evaluate how best to continue to encourage long-term investment in companies by sophisticated investors. This issue involves more than simply getting the accounting correct, it also entails detailed consideration of various corporate governance issues. Bottom line, I believe that by developing a consensual and fully- informed relationship among users and long-term providers of capital, all parties will benefit. As I mentioned, regulators need to take a hard look at regulations that might adversely affect the capital formation process. In this regard, I want to make you aware of the Commission's Advisory Committee on Capital Formation and Regulatory Processes, which was established earlier this year by the Commission at my urging. I am the Chairman of the Committee. The Committee's current objective is to assist the Commission in evaluating the efficiency and effectiveness of the regulatory process related to public offerings, secondary market trading and corporate reporting. One issue we have been exploring is the potentially revolutionary idea of a company registration model for corporate offerings. Underlying this paradigm shift from securities transaction registration to company registration is that many of the costs, uncertainties, and complexities of a registered offering would be reduced to the extent that issuers were permitted to raise capital publicly without having to register each offering. Perhaps more importantly, however, we must also recognize the huge shift that has occurred in our markets. A few generations ago, the dollar value of securities transactions that involved companies issuing equity, relative to the trading of that equity was approximately one to five. Today, it is close to one to twenty-five or more. An extraordinary focus sixty years ago on twenty percent of the transactions made sense. To continue to give short-shrift today to over ninety-five percent of the transactions makes no sense. We need to reform our efforts to ensure that we raise the standards on which almost all of today's transactions occur. Company registration will give us the opportunity to do that. The result will be a win for investors -- not only in lower capital costs for the companies -------------------- BEGINNING OF PAGE #9 ------------------- they invest in, but more integrity and transparency for the transactions they engage in every day. It will also be a win for issuers due to faster, more certain, less costly, and less complicated capital raising. If we can get there, we will shift from capital being raised in accordance with regulatory constraints to capital being raised in accordance with market needs, and with enhanced investor protection. That really should be extraordinary. C. Conclusion Keeping pace with rapidly changing domestic and global changes will not be an easy task. Our markets are the deepest and most transparent in the world. If we are to retain this advantage, we need to ensure that our system evolves with changes in firms and financial products. But if investors are to continue to provide capital to the market at reasonable costs, they are going to continue to demand an increasingly better understanding of the uses of such capital and the risks associated with a particular investment. If users of capital want access to capital at reasonable costs, they will have to communicate effectively about the nature of their firm and the risks attendant to their capital needs. The benefits of undertaking a closer look at these issues clearly flow both ways. On a broader scale, the cost of not putting more effort into this analysis is simply too great to risk. I realize that I have commented on a number of subjects in a short period of time and I thank you for your attention. I would be happy to take questions on any of these matters as well as any other issues of concern to you.