A “Modest Proposal” for Securities Litigation Reform

As The D & O Diary has previously noted (most recently here), the attempts by the Paulson Committee to propose ways to improve the competitiveness of the U. S. securities exchanges in the global marketplace may include securities litigation reform. Interest in the Committee's reform efforts increased substantially as a result of media reports (here) that among other things the Paulson Committee was considering recommending the elimination of a private cause of action under Rule 10b-5. However, in a November 16, 2006 New York Law Journal article entitled "Capital Markets Competitiveness and Securities Litigation" (here, subscription required), Columbia Law School Professor John C. Coffee, Jr. (who supposedly was the source of the recommendation to eliminate private Rule 10b-5 actions) disclaims having made any such recommendation. Instead, Coffee is recommending a "far more modest proposal."

Coffee’s reform proposal begins with his view that the current private securities litigation system is "dysfunctional," but "not because the lawsuits are frivolous or extortionate." Rather, the problem, Coffee believes, is "the circularity of the securities class action." The problem is that

Shareholders are suing shareholders. As a result, diversified shareholders wind up making pocket-shifting wealth transfers to themselves. In the common securities class action dealing with a stock drop in the secondary market, the recovery will go to those shareholders who bought the stock during the "class period"… and the recovery will be bourne by the other shareholders who bought the stock before or after that class period…Inherently, this implies that such an action produces only a shareholder-to-shareholder wealth transfer.

Nevertheless, Coffee thinks that the argument can still be made that securities class action lawsuits may be justified by their deterrence effect. But the problem is that they accomplish deterrence "by punishing the innocent – the shareholders." Coffee proposes a "system of managerial and agent liability that places costs instead on the culpable."

Coffee proposes that the SEC use its regulatory authority under Section 36 of the Securities Exchange Act of 1934 to shield non-trading public corporations from liability under Rule 10b-5. (Section 36 gives the SEC the authority to exempt "any person, security or transaction from any securities laws or regulations, if the exemption is "necessary or appropriate in the public interest, and is consistent with the protection of investors.") According to Coffee, this "would not eliminate a private cause of action under Rule 10b-5, but it would force the plaintiff’s bar to sue and settle with corporate officials and agents – i.e., auditors, underwriters and law firms – instead of treating the corporate entity as the deep pocket."

Coffee anticipates that the targeted directors and officers would seek to rely on indemnification and insurance if they are targeted by the plaintiffs' lawyers. Coffee recommends that the SEC should act to force corporate boards to take their decision whether or not to indemnify much more seriously, as a result of which, Coffee claims, "in some cases, indemnification might not be paid, and in all cases there would be greater uncertainty." With respect to D & O insurance, Coffee anticipates that active wrongdoers would face substantial coverage barriers (such as the conduct exclusions) as a result of which "the insurer and the corporate insider might well settle such an action on a basis that required some payment out the insider’s own pocket." At that point, Coffee says, "real deterrence begins to be generated."

Coffee’s recommendation to exempt companies from private securities lawsuits to force individuals to bear greater personal exposure as a way to increase deterrence is detailed in Coffee’s October 2006 law review article entitled "Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation" (here). Coffee’s law review article has an extensive review of the fact that although corporate insiders are regularly sued "they rarely appear to contribute to settlement," with specific examples. In the law review article, Coffee also examines at greater length the SEC’s authority under Section 36. Coffee’s article anticipates that his recommendation to exempt companies from Rule 10b-5 liability would "alter the market for D & O insurance" because "executives would demand more insurance;" on the other hand, the recommendation would also "eliminate entity insurance." Coffee’s law review article does not examine whether carriers might alter their basic terms and conditions, as insureds maneuver to assure that coverage for their liability would not be excluded and as carriers jockey to recapture premium revenue lost after entity coverage is eliminated.

The D & O Diary thinks Coffee's reform proposal is interesting. We do wonder how all of this would actually improve the competitiveness of the U.S. securities markets. Are the managers of foreign companies more likely to list their companies' shares on U.S. exchanges if the regulatory system is changed to increase their individual liability exposure while at the same time trying to reduce their access to indemnity or insurance? Coffee’s proposal may or may not be a good idea, but it doesn’t seem like it really has anything to do with the reasons for which the Paulson Committee was formed.

Hat tip to the Securities Litigation Watch blog (here) for the links to the New York Law Journal article and Coffee’s law review article.

Thompson Memo Reform?: Reform seems to be today’s theme. According to news reports (here), the U.S. Department of Justice is considering modifying the Thompson Memo to address concerns that prosecutorial pressure is forcing companies to cut off legal support to employees under investigation and to reveal confidential communications with the company’s lawyers. According to the news reports, all prosecutors in each of the 93 U.S. attorneys’ offices would have to get the approval of the attorney general or his top deputy before seeking attorney-client waiver. In addition, companies would not be penalized for refusing to reveal confidential communications with their lawyers – but the could still get credit for cooperation. The Justice Department reportedly is also considering deleting the language in the Thompson Memo referring to legal fees for "culpable employees."

According to the news reports, Deputy Attorney General Paul McNulty has not yet signed off on the proposed changes.

As Professor Ellen Podgor notes on the White Collar Crime Prof blog (here), these proposals represent "baby steps" in the right direction, but they "would not alleviate the problem" that has led to criticisms of the Thompson Memo. For a review of The D & O Diary’s prior posts discussing the Thompson Memo criticisms, refer here and here.

Fortune Smiles on Larry Sonsini: A November 17, 2006 Fortune.com article entitled "Scandals Rock Silicon Valley’s Top Legal Ace" (here) contains a lengthy portrait of Larry Sonsini and discusses his recent involvement in a number of high-profile imbroglios. After reviewing Sonsini’s rise to prominence, the article looks at Sonsini’s involvement, as an NYSE board member, in the dispute over former NYSE CEO Richard Grasso’s compensation; at Sonsini’s connection to the board pretexting scandal at H-P; and Sonsini’s involvement with several companies (including Brocade Communications) implicated in the options backdating scandal. The article essentially exonerates Sonsini on all issues, with the exception of Sonsini’s service on the boards of companies of which he also acted as outside counsel. However, the article reports that Sonsini has resigned or will resign from all of the nine corporate boards on which he previously served.