Wednesday, October 18, 2006

"Paulson Committee" may soon take on the trial lawyers by proposing limit on shareholder lawsuits

Securities Litigation Watch is reporting that the Committee on Capital Markets Regulation may recommend by next month that the SEC undertake certain policies that will reduce the abilities of shareholders to file certain types of class action lawsuits against public companies. This is an interesting shift from the Committee's original implied purpose of lobbying for repeal of the Sarbanes-Oxley Act. It also may represent a shift in focus to better reflect political and regulatory realities. (The Committee apparently is now called the "Paulson Committee" because it will give its report to Treasury Secretary Hank Paulson; but also because, as I discuss here, Hank Paulson himself has a keen interest in "reforming" U.S. financial regulation and has signaled support for the group.)

The Sarbanes-Oxley Act has provoked intense criticism among many public companies (including many foreign companies) because of the costs the Act imposes. However, as I have discussed more in-depth here, the principle costs of the Act involve Section 404, which requires a company's auditors to opine on the company's own assessment of its internal controls. By this December, the Public Company Accounting Oversight Board, which oversees the U.S. audit industry, likely will change the audit standard governing this process (see here).

Yet SOX is hardly the only cost the U.S. system imposes on public companies--nor even the most significant. If you are an issuer, your biggest concern is and long has been private lawsuits. As one securities law partner once told me, when you have an IPO in the United States, it's not a question of whether you will be sued, but when. If a company's stock drops significantly, "strike suit" attorneys have a strong incentive to file a class action lawsuit against the company, because the law firm's take from such suits ranges up to a third of the settlement (and once a judge certifies a class in a shareholder suit, most companies settle).

Of course, many shareholder rights to file private lawsuits are contained directly within the federal securities laws. For example, if a company's prospectus contains wrong information about the company's financial performance (other than inconsequential typos and the like), shareholders have a right to sue the company under the Securities Act of 1933. However, the Paulson Committee is focusing in particular on the SEC's Rule 10b-5. This Rule, which is a jewel of regulatory drafting, states simply:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

a. To employ any device, scheme, or artifice to defraud,

b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

c. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

Isn't that beautiful? Personally, I think it ranks right up there with "Thou shalt not steal" in terms of simplicity and universality. Pretty much anything naughty you can think up involving the stock market or a public company could fall under it.

What the Committee apparently would like to do, however, is have the SEC "dis-imply" that this Rule allows for a private right of action from shareholders. In other words, right now the rule "implies" that individual shareholders can sue a company or individual for a 10b-5 violation, even if the SEC doesn't. If the SEC stated that Rule 10b-5 belongs to it alone, the SEC could sue someone for violating Rule 10b-5, but the courts could say an individual shareholder couldn't. And an investor certainly couldn't if the SEC hadn't also brought a case. Since 10b-5 is so broad, that would mean that "defrauded" shareholders would have to find some other cause of action to sue. Depending on the case, this may not be hard; but it won't necessarily be easy, either.

This proposal (which apparently comes from Columbia Law professor Jack Coffee) is smart--much smarter than proposals to throw out Sarbanes-Oxley. For one thing, SEC Chairman Christopher Cox is well-known for his belief that strike suits should be dramatically scaled back. When he was in Congress, he was the principle author of the 1995 Private Securities Litigation Reform Act, which was designed to do precisely this. Second, it addresses a factor about the U.S. capital market that actually does make it less competitive internationally. (Though one may argue that the private right of action contained within U.S. securities laws acts as a much better policeman of U.S. securities markets than the SEC, Justice Department and Eliot Spitzer combined ever could.)

That said, the trial attorneys are a formidable opponent, and we can expect that they will lobby the SEC (and Congress) hard to make sure this proposal is never made a reality.

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