Good morning, Mr. Chairman and members of the Subcommittee. I am Richard I. Miller, General Counsel and Secretary of the American Institute of Certified Public Accountants (AICPA), and appear today to represent the accounting profession. On behalf of the profession, I thank you, Mr. Chairman, and the Subcommittee for this opportunity to present our views on securities litigation reform.
The AICPA is the national professional institute of over 330,000 CPAs in public practice, industry, government and academia. Its service to its members, the accounting profession and the public spans over 100 years. Among the AICPA's principal purposes are the promotion and maintenance of the highest professional standards of practice. It is a leader in establishing requirements for entry into the profession, developing accounting auditing and ethical standards, providing continuing professional education programs, and mandating reviews of the accounting and auditing practices of CPA firms.
Our profession enthusiastically supported your work over the past several years to reform the securities litigation system and applauded the passage of the Private Securities Litigation Reform Act of 1995. That significant achievement was the first time in more than 50 years that Congress had addressed the judicially-created 10b-5 cause of action, and thus is a milestone in the history of civil justice reform. A number of important provisions designed to realign the incentives of the securities litigation system were included in that legislation, including a heightened pleading standard to filter out boilerplate complaints; a safe harbor for forward-looking statements intended to increase disclosure of company information to investors; reform of joint and several liability to reduce coercive settlements; prohibitions on abusive practices to prevent the payment of bounties to lead plaintiffs and other such abuses; and toughened attorney sanction provisions under Federal Rule of Civil Procedure Rule 11 to discourage the filing of frivolous lawsuits.
Before you and your colleagues in the House acted, the securities litigation system had veered far from its intended purposes. The judicially created cause of action under Section 10(b) of the Securities Exchange Act and Rule 10b-5 was exposing the accounting profession and growth businesses to potentially ruinous liability while imposing wasteful transaction costs on the investors the system was supposed to be benefiting. Investors typically recovered only pennies on the dollar while the plaintiffs' lawyers who brought and managed the lawsuits collected seven-figure fees. Rather than protecting investors or enhancing the efficiency of our nation's capital markets, the system had evolved into highly profitable growth business for the securities bar. As Senator Dodd noted in January 1995, "[f]laws in the current [litigation] system deliver a one-two punch to our economy: first by allowing some lawyers to take advantage of investors, and second, by stymieing the ingenuity and creativity of American businesses."
Ironically, we are here today because Senator Dodd's observation of more than two years ago has come true once again. Securities plaintiffs' lawyers now are taking their nationwide class actions to state courts, thereby evading the reforms Congress enacted into federal law. As a result, the "one-two punch" that Senator Dodd described is still delivering a knock-out blow to investors and our economy. This evasion tactic is the accounting profession's primary concern about securities litigation today.
Although the impact of the federal reforms is not yet fully known, two developments are absolutely clear. The federal courthouse door has not been closed to legitimate claims, as opponents of the Reform Act predicted, and, just as important, the shift to state court is thoroughly undermining the primary investor benefits of the legislation. As long as plaintiffs' lawyers are able to replicate in state courts the lawsuits that used to be brought in federal courts before the 1995 legislation, growth companies and investors are still confronted with the same threats from abusive litigation that Congress sought to eradicate. In fact, the situation is worse. Now investors and their companies face the possibility of being sued in 50 different states under 50 different sets of legal and procedural rules. And many issuers have been sued in both federal and state court, forcing them to defend against two parallel actions simultaneously. The uncertainty, cost, and potential exposure of state court litigation force companies to act as if the federal reforms were never passed and deny investors the benefits that Congress intended to provide. The perverse effects of this development are particularly apparent with regard to the safe harbor and discovery stay provisions of the federal law.
Investors are not benefiting from greater company disclosure. In crafting the 1995 Reform Act, Congress found that shareholders were damaged by the "chilling effect" of the securities litigation system on robust and candid corporate disclosure. Despite widespread agreement that investors would benefit from a company's own assessment of its future potential, and that stock prices in growth companies would be less volatile if such disclosures were made, corporate personnel were muzzled by a concern that projections that do not ultimately come to fruition would trigger lawsuits.
To encourage voluntary disclosure and thereby reduce the vulnerability of growth companies to securities class action strike suits, Congress adopted a statutory safe harbor in the 1995 Reform Act . This provision was designed to limit the threat of litigation on the basis of company disclosures about future prospects, such as new information about forthcoming products or projections about future financial performance. Investor organizations, the technology community and the accounting profession were strongly supportive of this provision and hopeful that it would provide investors with the information they sought and deserved. Unfortunately, the safe harbor has never had a chance to be truly tested. I understand that companies in the high-technology sector are reluctant to increase disclosure to their investors with the specter of state law actions hovering. And who can blame them. When a class action can be brought under state law on the basis of inaccurate forecasts, rational corporate managers are going to be cautious even if those statements are protected under federal law. This threat is not merely academic. The Securities and Exchange Commission's report on litigation since the passage of the Reform Act acknowledges that the safe harbor is not working in substantial part due to "fear of state court liability" for forward-looking statements. The Commission also found empirical support for this conclusion, determining that state court complaints "are more likely to be based solely on forecasts which have not materialized." Indeed, its data show that allegations based on projections are more than twice as likely to be filed in state than in federal court. Clearly, state court class actions are defeating the safe harbor and denying investors the benefits of greater disclosure.
Companies can be subjected to burdensome discovery in state-law claims. Congress found that the cost of discovery often forced parties to settle securities class actions regardless of their merit. When plaintiffs' lawyers are given a license to search a company's files and subject company personnel to countless hours of depositions, often an executive's most responsible course is to settle early to minimize investors' losses. To remedy this situation, Congress enacted a stay on discovery pending a ruling on a motion to dismiss, substantially reducing the ability of plaintiffs' lawyers to coerce a settlement simply because of the discovery burden they can impose on defendants.
In state court litigation, however, the federal discovery stay does not apply. And many states, such as California, have no blanket prohibition on discovery prior to the first case management conference, as is normally true under Rule 26 of the Federal Rules of Civil Procedure. As a result, plaintiffs' lawyers can use the state court forum to conduct discovery "fishing expeditions" immediately after suit has been filed. In addition, substantial discovery often is permitted in state court actions even after plaintiffs' complaints have been dismissed with leave to amend and while a motion to certify a class in the case is pending. Thus, in important respects, defendants are in essentially the same position as they were prior to 1995. The prospect of time-consuming, expensive discovery creates the same coercive dynamic as existed in federal law before the Reform Act. Furthermore, discovery in a state case can be used to try to bolster a parallel claim in federal court that otherwise might not survive a dismissal motion. As the SEC itself acknowledged, "[t]o the extent that state court can be used to avoid the discovery stay in cases that would otherwise have been brought under the federal securities laws, one of the goals of the Reform Act may be frustrated."
Uniform Standards Legislation Is Consistent With Long-Standing Principles and Precedents
The accounting profession endorses H.R. 1689, which was introduced in the House by Representatives Rick White and Anna Eshoo, to federalize private securities fraud class actions involving companies issuing nationally traded securities. This particular type of action traditionally has been brought and litigated in federal courts under federal law. The shift to state courts in this type of litigation has arisen just since Congress passed the 1995 Reform Act. The White/Eshoo bill would simply restore the historical practice in this area of the law and ensure that securities fraud class actions would be governed by the reforms that Congress intended
Legislation establishing uniform standards in this area of the law would be consistent with the precedent of the Capital Markets Efficiency Act of 1996, which passed the Congress with overwhelming bipartisan majorities and was signed into law by the President. That measure preempts state laws that require the registration or qualification of nationally traded securities, impose conditions on the use of offering documents or disclosure statements relating to such securities, or limit the offer or sale of those securities. In passing this measure, Congress recognized that the capital markets are national in character and are properly regulated at the federal level. As House Commerce Committee Chairman Thomas Bliley observed, "the most significant change this Act will effect is to create a national unified system of regulation. Securities offerings that are national in character...will now be regulated only by the SEC."
Similar policy considerations are applicable here. Almost everything about the new breed of securities class actions in state court is federal in nature. The parties involved in such lawsuits frequently are pension funds, mutual funds, and individual investors from every state. Statements by the issuers of national securities typically are directed to investors across the country. The allegedly fraudulent statements and omissions are broadcast in various forms across state lines.
Uniformity in this area of the law not only would be consistent with precedent and practice, but it also would promote the efficient functioning of our nation's capital markets. For example, investors in every state would benefit from forward-looking disclosures that the safe harbor in the 1995 Reform Act was designed to encourage. Under the current system, however, issuers must tailor their statements to take account of the most onerous and expansive state liability rules. This means that a single state's refusal to adopt a comparable safe harbor leads issuers to withhold information that is sought by investors across the nation.
In addition, uniform standards legislation would ensure that remedies available to investors in nationally traded securities would not vary depending upon the state in which the investors reside but would be uniform for all similarly-situated persons. Conversely, issuers would not be forced to defend against claims in 50 states under 50 different laws and procedural rules.
We in the accounting profession are accustomed to uniform national standards. Auditors are subject to national standards governing the financial accounting and reporting process for publicly traded companies. These uniform standards ensure that business enterprises report fairly and consistently to investors and help maintain public confidence in the nation's securities markets. Similar public policy purposes would be served by uniform standards governing securities fraud class action litigation.
Uniform Standards Legislation Would Fully Effectuate The 1995 Reform Act
When Congress drafted the 1995 Reform Act, few disagreed with the goal of eliminating abusive securities class action lawsuits. Even opponents of the measure recognized that abusive litigation was draining America's most innovative and dynamic companies of their resources and compromising the integrity of our nation's securities markets. There also was little debate about the need to protect the right of investors to bring legitimate claims and pursue those claims in federal court. The strongest advocates of reform always sought to preserve this fundamental right. And few argued with the goal of increasing disclosures to investors. These unassailable objectives are threatened, however, by the rise of state court litigation. Cases that would not meet the standards Congress established in federal law can still be filed in state courts, imposing the same coercive pressure to settle meritless claims that Congress sought to eliminate. Growth companies, particularly in the technology industry, continue to face the possibility of abusive securities litigation. And disclosure continues to be chilled by the prospect of state court actions.
As Congress recognized just last year in the National Markets Security Act, consistency in securities law is a matter of national economic growth, particularly as America competes for capital in global markets. The rise of state securities class actions, on the other hand, introduces inconsistency and uncertainty in the capital marketplace.
The most important step that Congress could take to fully implement its reforms would be to pass uniform standards legislation, ensuring that nationwide securities class actions replicating federal 10b-5 lawsuits are brought and tried in federal court. A uniform standards bill would not establish new policy or reopen the issues that were overwhelmingly endorsed by Congress in 1995. On the contrary, a uniform standards measure would return securities litigation to the federal courts, restoring the traditional role of federal law in this area. Thus, the issue before the Congress today is not the overhaul of the 1995 Reform Act, but its full implementation. We urge this Subcommittee and the Congress to act on uniform standards legislation in this session to achieve the laudable goals in that historic measure.
On behalf of the accounting profession, I thank the Chairman and the subcommittee for this
opportunity to testify.
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