Current Trends in Federal Securities Litigation
Copyright (c) 2007 Gibson, Dunn & Crutcher, LLP. All Rights Reserved.
By Jonathan C. Dickey
This last year has witnessed some of the most significant developments in securities class action jurisprudence in decades, led by the U.S. Supreme Court's very prominent interest in securities cases, and its decision to grant certiorari in two important cases involving pleading standards (Tellabs) and the scope of liability under Section 10(b) (Charter Communications)--cases that will shape private securities class action litigation for decades to come. Each of these cases is discussed in greater detail below. The importance of these issues is underscored by the aggressive lobbying that the plaintiffs' bar has undertaken to attempt to influence the Securities and Exchange Commission to support the granting of certiorari in the recent decision of the Fifth Circuit in the Enron litigation reversing the trial court's grant of class certification. Ironically, the SEC, through the Office of the Solicitor General, filed an amicus brief earlier this year in the Tellabs case, supporting a fairly rigorous pleading standard under the Private Securities Litigation Reform Act.
At the Court of Appeals level, a number of key decisions have been handed down in the past year interpreting and applying the Supreme Court's 2005 decision in Dura Pharmaceutical, in which the Court set the standards for pleading and proving loss causation. As discussed in Section VI below, the trend of these appellate rulings in the last year is decidedly pro-defense, and augers well for an increased rate of dismissals of securities class actions in the lower courts on loss causation grounds.
In 2006-07, the Courts of Appeal also issued decisions that create a clear conflict among the Circuits on the issue of how trial courts should evaluate class certification issues in securities cases. As discussed in Section V below, increasingly, the courts are adopting more rigorous standards for class certification, and authorizing trial courts to consider the "merits" of cases as they may effect class certification issues such as adequacy, typicality, and predominance of common issues such as reliance. As demonstrated in key decisions this last year from the Second and Fifth Circuits, class certification may now be where the "rubber meets the road" in cases going forward, and many defense counsel believe that this issue may be ripe for Supreme Court review next year.
In the last year, the courts have also continued to struggle with the issue of how state court class actions may run afoul of the Securities Litigation Uniform Standards Act ("SLUSA"). As reported below in Section VII below, a number of cases have come down that suggest that the plaintiffs' bar will continue to be creative in their attempts to circumvent SLUSA and bring securities cases in state court that do not belong there.
We begin this paper with a review of current trends in securities litigation affecting public companies and their auditors, and important reform initiatives currently underway to address the wide-spread concern that private securities litigation continues to impair the competitiveness of the U.S. capital markets.
II. 2006-07 Securities Litigation Reform Efforts
The past year has seen an increased focus on whether the U.S. capital markets are impaired by "over regulation," including reforms adopted as part of the Sarbanes-Oxley Act that arguably have led to more civil actions against public companies and their outside auditors. For the first time since SOX was enacted in 2001, there seems to be mounting concern that the pendulum has swung too far towards "over regulation" in the wake of the collapse of Enron, Worldcom, Adelphia and other companies, and that the net effect has been adverse to economic growth in America. As discussed below, a number of significant reform proposals are now being advanced by various constituencies within the U.S. capital markets, with one common theme--the U.S. needs to take bold steps to avoid the "flight" of capital to foreign markets, and a corresponding loss of competitiveness.
A. Issues Affecting the Exposure of Public Companies and Their Officers and Directors
The headlines in 2006-07 have reported that the level of securities class action litigation in the federal court system has dramatically diminished in the last two years. Various experts have reported the statistics for 2006, and it is true that the sheer number of new class action filings was down in 2006 over the prior year. However, the decline in new filings of federal securities class actions obscures some other counter-veiling trends, a few of which are mentioned here.
First, despite the decline in new filings, the average settlement amount for securities class actions in 2006 was exceedingly large. According to one study, average settlements in 2006 were approximately $ 62 million--far higher than the average settlement amount two years ago of less than $ 28 million.
Second, the number of "mega" settlements increased dramatically in 2006 as a percentage of all settlements--19% were over $ 50 million last year, compared to 9% in 2005.
Third, the statistics reported in these studies do not include the scores of cases filed last year that related to stock option backdating--most of which were filed as "derivative" suits, and frequently brought in state court. As the financial press has reported extensively since 2006, companies are facing major suits over alleged "backdating" practices, often with parallel SEC and U.S. Attorney investigations.
Fourth, the number of cases in which directors and officers have been asked to contribute personal funds towards the settlement of the litigation increased in the last year, including out-of-pocket contributions from former officers of Tenet Healthcare and Krispy Kreme.
No one has a very good explanation for the decline in the number of new case filings in the last two years, and no one is seriously arguing that the era of "bet the company" securities litigation is over. On the contrary, the D&O insurance market remains vibrant in part because public companies and their directors continue to fear being sued in a securities class action lawsuit. Although one commentator has suggested that perhaps the explanation for the decline in suits is because the provisions of the Sarbanes-Oxley Act are actually working--and no doubt there is some truth to that--the fact remains that the plaintiffs' bar is fully employed, and looking to convince the Supreme Court that it should liberalize the laws that allow these suits to be brought in the first place. The next year will provide important guidance on whether the contraction of the securities litigation market will continue or, as some fear, the flood gates will re-open following the Supreme Court's decisions in Tellabs and Charter Communications.
B. Issues Affecting the Exposure of "Big Four" Accounting Firms
1. Civil Claims Against Auditors Continue to Pose Liability Risks
The exposure of audit firms to large claims continues, although in 2006 the number of civil class actions alleging accounting fraud seems to have dropped from the levels of prior years, n1 and certainly has declined in relation to the number of accounting restatements reported by public companies in the last 24 months. n2 The data on how much accounting firms have paid to resolve private litigation and/or regulatory claims is not well compiled. There have a few "mega" settlements in 2006 in which significant settlement payments were made by accounting firms, including several settlements by now-defunct Arthur Andersen. n3 Moreover, according to one study released earlier this year, over 90% of all new class action suits filed in 2006 included allegations of false financial statements. The same study reported a sharp increase in the number of cases alleging specific accounting irregularities, from 44% in 2005 to 68% in 2006. n4
n1 According to the PricewaterhouseCoopers 2006 Securities Litigation Study, securities class action cases based on restatements declined from 82 in 2002 to only 37 in 2006. Similarly, the number of SEC Litigation Releases related to new accounting cases declined from 61 in 2002 to 30 in 2006.
n2 "Glass, Lewis Analyst Says Restatements On Track to Set Another Record in 2006," Securities Regulation & Law (BNA) (Nov. 6, 2006).
n3 Examples include Arthur Andersen's settlement of Enron-related class action claims for the sum of $ 72,500,000.
n4 "Securities Class Action Case Filings: 2006, A Year in Review," at 19 (Cornerstone Research), available online at www.cornerstone.com.
At the same time, however, accounting firms have successfully moved to dismiss a number of class action cases brought them in the last 24 months, an indication that the PSLRA heightened pleading standards, combined with recent decisions narrowly construing the scope of primary liability under Section 10(b) of the 1934 Act, continue to deter at least some meritless claims against accounting firms. n5 Further, the United States Supreme Court will decide important issues over the liability of "secondary actors" sued under Section 10(b) of the Securities Exchange Act, in a case that is closely watched by the accounting profession. n6 If the Court affirms the Court of Appeals decision, the rate of securities class action cases against audit firms may diminish further. In the absence of more concrete reforms, however, audit firms no doubt will continue to face the prospect of catastrophic losses.
n5 See, e.g., Ezra Charitable Trust v. Tyco International Ltd, 466 F.3d 1 (1st Cir. 2006) (dismissing claims against PricewaterhouseCoopers notwithstanding Tyco's restatement of results, and holding, inter alia, that the mere fact of restatement does not give rise a strong inference of scienter).
n6 Stoneridge Insurance v. Scientific Atlanta, docket no. 06-43 (cert. granted March 26, 2007).
2. Contractual Limitations on Auditor Liability
In some cases accounting firms have taken steps to allocate litigation risk by including indemnity agreements in their engagement letters with clients in certain circumstances. Existing AICPA ethics rules permit such indemnification if, for example, there were knowing misrepresentations by management. n7
n7 See, e.g., AICPA Ethics Ruling 94.
The SEC's position on this matter--at least as reflected in the Staff's answers to "Frequently Asked Questions" in 2004-- has been that an accountant's independence may be called into question if the accountant enters into an indemnity agreement with the registrant, if the indemnity purports to provide immunity to the accountant against liability for his or her own negligent acts. Likewise, the SEC has stated that indemnity agreements that protect auditors from liability caused by "knowing misrepresentations by management" may impair independence. n8
n8 Application of the Commission's Rules on Auditor Independence--Frequently Asked Questions (December 13, 2004).
During 2006, the AICPA began a process of reevaluating whether and to what extent audit firms may limit their liability through contractual indemnification agreements with their audit clients. The issue was brought forward most directly in an exposure draft issued by the AICPA's Professional Ethics Executive Committee in September 2005 that would allow auditors to limit liability under certain circumstances. Based on a limited number of comments received, the PEEC issued its proposed Interpretation 101-166 in September 2006. The proposed Interpretation would authorize audit firms to enter into indemnification agreements with their clients only if the audit firm has performed the audit services "in accordance with professional standards, in all material respects." n9 The proposed Interpretation found that certain other actions, however, would not impair independence, including 1) indemnification for punitive damages claims by third parties, 2) "reasonable" time limitations on when an audit client may sue the auditor, and 3) ADR provisions mandating arbitration of auditor malpractice or other claims.
n9 A copy of the PEEC exposure draft is attached as Exhibit A.
The proposed Interpretation has been met with mixed reactions from the accounting profession. Several comment letters on the proposed Interpretation were critical of the conditions placed on indemnification, particularly given the vagueness of the "in accordance with professional standards" condition. n10 Hearings on the proposed Interpretation that were supposed to have been held on November 30-December 1, 2006 were taken off calendar. n11
n10 See, e.g., December 8, 2006 comment letter from Deloitte & Touche. As well, the Technical Issues Committee of the AICPA objected to the proposed deletion of its Ethics Ruling 94.
n11 In the wake of the original PEEC exposure draft in September 2005, various federal agencies with regulatory authority over banking and financial institutions collaborated on an "Interagency Advisory on the Unsafe and Unsound Use of Limitation of Liability Provisions in External Audit Engagement Letters." This advisory declares it to be an "unsafe and unsound" practice for audit firms to use certain "limitation of liability" provisions in connection with audits of financial institutions.
Whether agency actions will affect the use of limitation of liability provisions in the future remains to be seen. In the meantime, the overarching issue remains, and audit firms continue to face liability risks without reliable protections against their own audit clients' misconduct.
3. The Challenge of "Principles-Based" Accounting
In 2002, as part of the enactment of the Sarbanes Oxley Act, Congress directed the SEC to report on efforts to move U.S. GAAP standards from the detailed "standards based" accounting rules now in place, to a more "principles-based" standard of accounting. n12 In July 2003, the SEC released its initial study on principles-based accounting. The SEC Study largely dismissed the concern over increased litigation risks that a "principals-based" accounting system might create. "We believe . . . that the concern over litigation uncertainty is sometimes overstated and may arise our of a confusion between principles-based and principles-only standards." n13
n12 See Section 108(d) of the Sarbanes-Oxley Act of 2002 (requiring the Commission to prepare the study on principles-based accounting by July 31, 2003).
n13 See Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System (July 25, 2003).
Since issuance of the SEC Study, SEC officials have joined with the Financial Accounting Standards Board (FASB) and other market participants to study how to make the nation's accounting standards less complex. n14 In general, "principles based" accounting standards encourages the exercise of accounting judgment, rather than reliance on bright line rules and technical standards. The current GAAP system is based on a myriad of principles, rules, interpretations, and standards. This "standards-based" regime recently was described by former SEC Commissioner Cynthia Glassman as follows:
The financial reporting landscape is littered with pronouncements from the FASB, the AICPA, the EITF, the APB, the SEC and the PCAOB. We have pronouncements, rules, regulations, guides, bulletins, audit standards, interpretations and practice aids in the form of SOPs, FAQs, SABs, Q&As and FSPs. This has been going on for decades. The result today, U.S. GAAP is made up of over 2,000 pronouncements. That's a lot of ABC's, even for a CEO or CFO with a CPA. n15
n14 See Sec. Reg. & L. Rep. (BNA), (June 12, 2006); see also Sec. Reg. & L. Rep. (BNA) (June 19, 2006) quoting former SEC Commissioner Cynthia Glassman.
n15 Cynthia Glassman, former SEC commissioner, speaking at 25th Annual USC Leventhal School of Accounting SEC and Financial Reporting Institute Conference, Sec. Reg. & L. Rep. (BNA) (June 19, 2006).
In contrast to a "standards-based" accounting system, FASB Chairman Robert Herz described "principles-based" accounting this way:
Under a principles-based approach, one starts with laying out the key objectives of good reporting in the subject area and provide them as guidance explaining the objectives and relating it to some common examples. While rules are sometimes unavoidable, the intent is not to try to provide specific guidance or rules for every possible situation. Rather, if in doubt, the reader is directed back to the principles. n16
n16 Remarks of Robert H. Herz, FEI Current Financial Reporting Issues Conference, (Nov. 4, 2002).
Supporters of a principles-based system believe it will foster a more nuanced exercise of accounting judgment. However, certain constituencies have expressed the fear that a "principles based system" may expose them to greater risk of litigation. Without technical standards to point to, these constituents fear that regulators and private plaintiffs' lawyers will have too much latitude to second guess an accountant's exercise of judgment.
SEC officials continue to assure the business community that a "principles-based" system will not result in "gotcha" enforcement actions, n17 but a number of senior executives and accounting professionals are still skeptical. According to a recent survey by CFO.com magazine, 36 percent of CFO's who oppose principles-based accounting cited the risk of major shareholder lawsuits as a reason for concern. "If principles-based accounting is going to work, we need to be presumed to be right," said one financial executive. n18 "The big concern is that we make a legitimate judgment based on the facts as we understand them, in the spirit of tying to comply, and that plaintiffs' attorneys come along later with an expert accountant who says, 'I wouldn't have done it that way,' and aha! - lawsuit! - several billion dollars, please." n19 "CFO's are second-guessed by auditors, who are then third-guessed by the Public Company Accounting Oversight Board [PCAOB], and then fourth- and fifth-guessed by the SEC and the plaintiffs' bar." n20 It is not yet clear that "principles" can stop this pattern of "Monday morning quarterbacking."
n17 Remarks of Linda Thomsen, SEC Director of Enforcement, 2006 Securities Regulation Institute (January 2006).
n18 "Standing on Principles," CFO Magazine (September 1, 2006) quoting David Rickard, CFO of CVS Corp. and Financial Accounting Standards Advisory Committee ("FASAC") member, available at http://www.cfo.com/article.cfm/7852613/c_7850066.
n20 Id. (quoting Colleen Cunningham, president and CEO of Financial Executives International).
The SEC, the FASB, and the PCAOB all appear to have made principles-based accounting a priority issue for the next year. In 2006, principles-based accounting has been promoted in speeches by SEC Chairman Christopher Cox, SEC Commissioner Paul Atkins, FASB chairman Robert Herz, and former SEC deputy chief accountant Scott Taub. n21 On March 23, 2006, for example, Scott Taub, the SEC's then-acting chief accountant, said that he is "a little disheartened" because the implementation of the new "objectives-oriented standards" "to my mind has not been principles-based." n22 In December 2006, the SEC's Chief Accountant, Conrad Hewitt, publicly declared that the issue of accounting complexity will be a leading topic of work by his office in 2007. n23 PCAOB Director of Registration and Inspection, George H Diacon, recently stated, "we shouldn't be second-guessing reasonable decisions made in the accounting field, however, PCAOB inspectors should challenge judgments that are not in the 'reasonable range.'" n24
n21 "Standing on Principles," CFO Magazine (September 1, 2006), available at http://www.cfo.com/article.cfm/7852613/c_7850066.
n22 "Top SEC Accountant Requests 'Principles-Based' Use of Rules," Securities Regulation & Law, (April 3, 2006).
n23 "SEC's Hewitt Says Accounting Complexity is 'High Priority' Issue for Agency in 2007," BNA Corporate Accountability, Vol. 4 No. 48 (December 15, 2006).
n24 Remarks of George H. Diacont, American Institute of Certified Public Accountants conference, Sec. Reg. & L. Rep. (BNA) (Nov. 20, 2006).
John White, director of the SEC Division of Corporation Finance, recently spoke to this topic. In response to the question, "what standard is used by Staff to determine when the company has complied with or failed to comply with principles-based regulation?" He said, "we understand that there is not a specific rule out there for every circumstance" and that the Staff will proceed "in good faith." n25 FASB Chairman Robert Herz seems to have acknowledged the issue when he remarked that "if it turns out some of the obstacles are hardwired into our structure, then maybe we need some legal changes as well." n26
n25 Remarks of John White, director of the SEC's division of corporation finance, speaking at the Annual Securities Regulation Conference of the Practicing Law Institute, Corporate Accountability Report (BNA) (November 17, 2006).
n26 "Standing on Principles," CFO Magazine (September 1, 2006) quoting FASB chairman Robert Herz, available at http://www.cfo.com/article.cfm/7852613/c_7850066.
Will regulators be willing to consider some form of "safe harbor" for auditors exercising judgment under a new "principles-based" accounting system? At least one recent study urges such a solution. In November 2006, the Committee on Capital Markets Regulation made a number of recommendations for adjustments to our regulatory and litigation framework so that public markets are less burdensome. The Committee expressly recognized that regulators must reduce the risk of litigation to corporations, auditors, and outside directors, and specifically recommended that Congress consider enactment of safe harbors for certain auditing practices. n27
n27 Interim Report, supra note 34, at p. 80.
Treasury Secretary Henry Paulson recently stated that auditors must be able to focus on ensuring the integrity and economic substance of management's financial statements. To get there, he said, accounting must be recognized as a profession, and not a science. n28 The goal Treasury Secretary Paulson suggests is an important one. More likely than not, the effort towards implementation of a "principles-based" accounting system will be "a long one." n29 As noted last year by Scott Taub, the SEC's former Interim Chief Accountant:
Unfortunately, we have gotten to a place today where there is something of an aversion to applying judgment. Often, the answer people seek is whichever one is perceived to be the safest, but those answers are not always the most transparent for investors. And we constantly get calls for every potential interpretive matter to be documented and the answer officially blessed. This, of course, leads us further into complexity and rules-based accounting, places that most of us say we don't want to go. n30
n28 "Treasury Secretary Urges Principles-Based Accounting and Internal Controls Reform," SEC Today (Nov. 27, 2006).
n29 Remarks of SEC Chairman, Christopher Cox speaking at the SEC Historical Society Annual Meeting, Securities Regulation & Law Report (BNA) (June 12, 2006).
n30 Remarks of SEC Acting Chief Accountant, Scott Taub, speaking at the SEC Historical Society Annual Meeting, (June 6, 2006).
C. Securities Litigation Reform Proposals
1. Reforms Directed to Protection of Public Companies and Their Directors and Officers
a. The "Paulson Committee" Report
On November 30, 2006, the Committee on Capital Markets Regulation--colloquially referred to as the "Paulson Committee"--issued its "Interim Report of the Committee on Capital Markets Regulation" ("Report"), covering various aspects of the regulation of the capital markets, and proposing various regulatory and market reforms. Several of the reforms pertain to securities litigation and auditor liability. The latter subject is addressed in Section C(2)(a) below. As to securities litigation more generally, the Paulson Committee report notes that although the total number of class action suits has dropped in the last two years, the settlement values have sky-rocketed. The Report notes the threat that, as average settlement values climb, "so too do the incentives for companies to try to evade private litigation under the U.S. securities laws by simply choosing to sell their shares elsewhere." The Report recommends various reforms aimed at making the U.S. trading markets more attractive to companies, including:
- Resolving existing uncertainties in Rule 10b-5 liability, including issues of materiality, scienter and reliance.
- Preventing overlap between private suits and the SEC's "Fair Funds" compensation system for injured investors.
- Prohibiting so-called "pay to play" practices by class representatives, and discouraging the practice of the "lawyers hiring the client."
- Eliminating enhanced criminal penalties against corporations who choose not to waive their attorney-client privilege, or decide to advance defense costs for officers and employees accused of criminal wrongdoing.
- Instituting greater protections for outside directors, including strengthening the ability of such directors to rely upon audited financial statements, and expanding the ability of outside directors to be indemnified against liability under Section 11 of the 1933 Act.
b. The Commission on Regulation of U.S. Capital Markets in the 21st Century
A March 2007 report from the Commission on the Regulation of U.S. Capital Markets in the 21 Century The Commission recommends several broad litigation reforms, and specifically calls upon the SEC to undertake a thorough review of how the Private Securities Litigation Reform Act has addressed the problem of frivolous shareholder litigation since its passage by Congress in 1995. Among the Commission's other recommendations:
- Eliminate public company quarterly earnings guidance; instead, companies would provide investors with "meaningful information on their long-term business strategies." Alternatively, companies could provide no more than annual guidance, expressed as a range of earnings, rather than earnings projections "to the penny."
- Prohibit the Department of Justice seeking privilege waivers from business organizations under threat of indictment or other enforcement action. As well, the DOJ should not be permitted to base charging decisions on whether a corporation advances counsel fees to its executives.
- Permit public companies to selectively waive their privileges, enabling them to produce documents to the SEC but still maintain a privilege as against private litigants.
- Restrict the scope of "scheme" liability under Section 10(b) (along the lines of the Charter Communications case currently before the U.S. Supreme Court).
- Allow a damages offset in private civil litigation for amounts paid by a company in settlement of an SEC action in the form of "Fair Funds."
c. The Bloomberg-Schumer Report
Also in early 2007, Mayor Michael R. Bloomberg of New York City and Senator Charles E. Schumer (D. New York) issued a comprehensive report entitled "Sustaining New York's and the US' Global Financial Services Leadership." The Bloomberg-Schumer Report made a number of recommendations to increase the competitiveness of the U.S. capital markets, a few of which are pertinent here. One key recommendation is to "implement securities litigation reform that has a significant short-term impact," which would include the following:
- Encourage SEC rulemaking to limit the liability of foreign companies with US listings to securities-related damages proportional to their degree of exposure to the US markets;
- Give smaller public companies the ability to "opt out" of some portions of Sarbanes-Oxley;
- Promote arbitration as a means of resolving securities-related disputes, using a charter amendment approved by shareholders;
- Legislatively limit punitive damages in securities cases; and
- Allow parties in federal securities class actions to appeal interlocutory judgments immediately to the courts of appeal.
d. The "Shadow Financial Regulatory Committee
On February 12, 2007, the "Shadow Financial Regulatory Committee issued a short statement on the competitiveness of the U.S. Securities markets, echoing many of the themes of the Paulson Committee report and the Bloomberg-Schumer report. The Shadow Financial Regulatory Committee is an organization comprised of a number of academicians sponsored by the American Enterprise Institute. In its report, the Committee expressed concern that "excessive regulation and large and arbitrary litigation risks appear to be hindering this country's ability to compete." Of all the risks facing the U.S. capital markets, the Committee chose to focus on only one--the litigation risk faced by public companies in the United States, and in particular the regressive economic profile of most securities class action litigation--where "one group of innocent shareholders is often required to pay another group of shareholders" for injuries that are "the responsibility of company managements." The Committee expressed the view that the deterrent value of class actions is small, and that the SEC's enforcement system "could do a better job of punishing wrongdoers and deterring financial manipulation and fraud at much less cost." The Committee recommends therefore that Congress adopt legislation that limits private securities class actions to those cases where insider trading had occurred, but otherwise require that violations of Rule 10b-5 be enforced against companies only by the SEC.
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