As noted yesterday (here), the Committee on Capital Markets Regulation (often referred to as the Paulson Committee) has released its Interim Report (here). The Report contains much text, many graphics, and 32 recommendations supposedly addressed to how to improve the competitiveness of the U.S. securities markets. As proof that the U.S. markets are losing their competitive edge, the Committee cites two key measures: the decline of U.S. marketshare of global IPOs; and the increase in going private transactions. The Committee correctly observes that there are a variety of factors behind these trends, including improvements to foreign public markets and increased liquidity in foreign and private markets. The Committee nevertheless believes that the U.S. regulatory and litigation systems are also important causes. The Committee’s focus surprisingly is not so much on the Sarbanes-Oxley Act, the discussion of which is relegated to the end of the report. Rather, a much more prominent place is given to reforms of civil and criminal litigation.
By contrast to early leaks suggested that the Committee might recommend far more dramatic revisions (for example, see my prior post here discussing reports that the Committee might recommend eliminating private securities litigation), the Committee’s actual securities litigation reform recommendations are surprisingly modest; the Committee recommends that :
The SEC should proved more guidance, using a risk-based approach, for the elements of a Rule 10b-5 actions, including materiality, scienter, and reliance (a good summary of the Report’s detailed recommendations with respect to these points can be found on The 10b-5 Daily blog, here);
The SEC should require that any private damage awards should be offset by any amount the SEC has collected from the defendants under the SEC’s Fair Funds authority;
The SEC should prohibit certain supposed practices of the plaintiffs’ bar (about which more below);
In order to improve the defenses available for IPO companies’ outside directors, the SEC should revise Rule 176 to clarify that outside directors may conclusively establish their "due diligence" defense (and thereby avoid liability under Section 11) by showing their good faith reliance on the company’s audited financial statements;
As another means of protecting IPO companies’ outside directors, the SEC should reverse its longstanding position (here) that indemnification of directors for damages awarded in Section 11 actions is against public policy, at least if the directors have acted in good faith.
With respect the practices of the plaintiffs’ bar, the Report notes that "some plaintiffs may have private motives for bringing suit that they do not share with other shareholders." The Report examines the possibility that some public institutional shareholders may be motivated to initiate lawsuits as a result of plaintiffs’ lawyers’ contributions to public officials electoral campaigns, a practice the Report calls "pay to play." Without citing any specific data or examples, the Report asserts that "pay to play practices are likely to result in some class actions being filed by pension funds that would not have been filed in the absence of reciprocal arrangements." The Report acknowledges that the extent of these practices is "uncertain," but then goes on to say that "there seems to be little downside to discouraging such practices." The Report recommends that the SEC create regulations specifying that lawyers who directly or indirectly may political contributions to state of municipal pension funds should be prohibited from representing the fund as lead plaintiff in a securities class action. The Report also recommends prohibiting paid plaintiffs.
The Report also recommends that the SEC should permit shareholders to "adopt alternative procedures for resolving disputes with their companies." These alternative remedies might include arbitration or waiver of jury trials. The Report notes the difficulties companies might face in adopting these reforms. The Report recommends that shareholder votes be permitted allowing the revision of companies’ charters or bylaws to permit these alternative procedures.
While most of the Report’s proposed litigation reforms focus on civil lawsuits, the Report also includes recommendations relating to criminal litigation. The Report recommends that the Justice Department "revise its prosecutorial guidelines so that firms are only prosecuted in exceptional circumstances of pervasive culpability throughout all offices and ranks." The Report also recommends that the Justice Department revise the prosecutorial guidelines in the Thompson Memo to "prohibit federal prosecutors from seeking waivers of the attorney-client privilege or the denial of attorneys’ fees to employees, officers or directors."
Perhaps predictably, the Report has triggered a wide variety of responses, as reflected in the December 1, 2006 New York Times article entitled "Sharply Divided Reactions to Reports on U.S. Markets" (here, registration required). The most colorful comments are those of former SEC Commissioner Richard Breeden, who referred to the Report as "very elegant whining" consisting of "a bunch of warmed-over, impractical ideas, many of which have been kicking around for a long time."
The motivations behind the Report have also been questioned because of the Committee’s financial backing. A December 1, 2006 Washington Post article entitled "Report on Corporate Rules is Assailed" (here, registration required) reports that the Committee "received $500,000 in financial support from the C.V. Starr Foundation," described in the article as a charity with "longstanding ties to [former AIG Chairman] Maurice R. Greenberg." The article states that investor groups have "sounded alarms" because of the Committee’s ties to "an executive battling civil charges."
An interesting commentary by Walter Olson of the PointofLaw.com blog about the need for U.S. market to "Learn from London" can be found here.
The D & O Diary is frankly disappointed in the Report’s proposals with respect to litigation reform. After painting a dire picture about the declining fortunes of America’s financial markets, the Report essentially comes up with few litigation reform items that can at best be described as academic tinkering at the margins. Some of the ideas, like the proposal to allow shareholders to adopt alternative dispute resolution mechanisms or waive their rights to a jury trial, are so obviously not going to be adopted you have to wonder why the Committee even bothered to include them. (Jury trial waiver would be of zero practical value anyway, since virtually no securities cases actually go to trial). Other ideas, like the improvement to outside directors’ Section 11 defenses and indemnification rights are unquestionably worthwhile. The suggested revision to the Thompson Memo’s cooperation guidelines concerning the attorney client privilege and the payment of employees’ attorneys fees are absolutely correct.
But event though the Report does have some worthwhile suggestions, as well as others that have been criticized elsewhere (see here and here), the most obvious objection is the question whether any of the proposed litigation reforms would really make any difference for the competitiveness of the U.S. securities markets. The D & O Diary is prepared to concede that America’s peculiar penchant for litigation might well contibute to foreign companies’ decisions to avoid our securities markets. But The D & O Diary doubts that the Report’s proposed litigation reforms, even if adopted verbatim immediately, would improve the competitiveness of the U. S securities markets. Do the managers of foreign companies really weigh the value of outside directors’ indemnification rights or the possibility of a double recovery under the SEC’s Fair Funds authority? Seems pretty unlikely to me, which make me wonder why these kind of marginal reforms are even included in a report intended to address a supposed lack of global competitiveness. All of these proposed bandaids seem poorly calculated to dress the wound. As I have noted elsewhere (here), I am also skeptical that attempts to rollback the currently regulatory rigor are the right approach to improving the competitiveness of the U.S. securities markets.
I also continue to find the timing of this reform initiative puzzling. We are only weeks away from the very public sentencing of the leading figures in the Enron scandal. And we are only in the beginning stages of the unfolding options backdating scandal. There may indeed be a day when it is appropriate for the regulatory pendulum to swing back, but this does not seem like the right time.
The D & O Diary feels compelled to make a final observation. The Report cites the high cost of D & O insurance in the U.S., relative to the much lower cost in Europe, as a factor deterring foreign companies from listing on U.S. exchanges. The D & O Diary concedes, as it must, that there are material differences between D & O pricing in the U.S. and in Europe. But we find it amusing that the Report finds the differential in insurance costs significant, but at the same time concludes that the significant differences in investment bank underwriting fees and exchange listing fees are not a factor. The Report’s observations seem to have been strained through a very peculiar kind of lens.
The Report notes at the outset that "during the next two years, our Committee will continue to explore issues affecting other aspects of the competitiveness of the U.S. capital markets." The Economist magazine reports (here, subscription required) that the Committee’s second report is "due next year," and is likely to call for "better coordination between state and federal regulators by suggesting that the SEC and other agencies merge some operations." The next report "will also tackle other factors considered disadvantageous, such as an insistence on all firms using the GAAP accounting standard."