Chairman Gramm, Senator Dodd, Members of the Subcommittee:
I am Joseph Polizzotto, a Managing Director of Lehman Brothers Inc., a national and global leader in corporate and municipal finance, and in securities sales, trading and research. I am testifying today on behalf of the Securities Industry Association ("SIA"). SIA appreciates this opportunity to present its views concerning the impact of the Private Securities Litigation Reform Act of 1995 (the "Reform Act" or the "Act") on investors and the capital markets of the United States. Because SIA members bring together investors and issuers of securities, its members have a fundamental interest in ensuring that the securities laws' private liability system is both fair and effective. SIA commends this Subcommittee for its long-standing interest in this subject, and Chairmen D'Amato and Gramm and Senator Dodd for their leadership in spearheading the passage of the Reform Act.
Without the trust of investors the securities markets could not exist. Therefore, SIA is firmly committed to protecting investors from fraud. Toward that end, we strongly support effective government enforcement, as well as meaningful private remedies for legitimate cases brought by defrauded investors. In adopting the Reform Act, Congress recognized that, while a strong governmental anti-fraud enforcement program is essential, private liability to enforce the law often creates opportunities for abuse by entrepreneurial lawyers without real clients. As former SEC Chairman Richard C. Breeden, told this Committee, "[n]othing in this bill would take the Marshall off duty. All it really does is to make the vigilante committee more accountable for stringing up the wrong person." The primary question that today's hearing should address is whether the Reform Act has made the vigilantes more accountable. SIA believes that the Act has so far had limited success on that score. There are signs that the Act has returned a measure of accountability and responsibility to the conduct of private securities litigation in federal court. Regrettably, as I discuss below, one of the more important provisions of the Reform Act, its safe harbor for forward-looking information, so far has not proven to be as effective as one might hope. One key reason for this appears to be a loophole in the Reform Act seized upon by plaintiffs' lawyers: its failure to address concurrent state law actions. This loophole may become a noose around the necks of high tech firms and other legitimate market participants unless Congress steps in to cut the rope. There are currently two bills pending in the House of Representatives that would close the loophole. SIA urges the Committee to take up companion legislation.
The services that the securities industry provides raising capital, managing risk, offering investment advice, providing and making liquid markets are essential for the U.S. economy to grow and function efficiently. The capital markets of the United States are a tremendous national resource, affecting all areas of the U.S. economy, providing low-cost capital to business and government, and creating new opportunities for private and public investors. During the 1990s, the securities industry have raised a stunning $7.4 trillion for business, and another $5.0 trillion for federal, state and local governments. By way of comparison, it took nearly two centuries, from the first days of trading under the Buttonwood tree on Wall Street until 1982, to reach the first $100 billion-year for capital raising for business. In 1996 alone, the sale and distribution of securities for U.S. business totaled almost $1.4 trillion, and over $800 billion for government. This helped finance an economy that is currently the world's envy, enjoying one of the longest expansions in our Nation's history. In particular, the securities industry has played a critical role in financing the growth of the high technology sector of the economy that has been the cornerstone of this decade's economic growth and rejuvenation of American economic competitiveness.
The American capital markets have maintained their preeminent position in the global economy in large part because investors at home and abroad have total confidence in the integrity of our markets and in our issuers, broker-dealers and other securities professionals. Every day billions of dollars of transactions occur on the stock exchanges and in the debt markets based on a handshake, a nod, a hand signal, or a telephone call. This would not be possible without the public's overwhelming confidence in the U.S. capital markets and the securities industry. Although private remedies for fraud may be one factor that helps to bolster investor confidence in our markets, there is widespread consensus that many alleged claims lack merit. Congress correctly recognized that the need to defend unfounded litigation has imposed unnecessary costs and burdens on issuers and underwriters, which ultimately get paid for by investors.
In numerous Congressional hearings leading up to passage of the Reform Act, SIA and many other witnesses laid out the impact that abusive litigation inflicted on the capital markets. Those hearings showed how meritless litigation resulted in an unproductive wealth transfer from entrepreneurs and investors to professional plaintiffs and their lawyers. The threat of abusive cases discouraged new ventures from entering the capital markets, increased insurance premiums paid by companies, and deterred experienced people from serving as independent directors, resulting in a decrease in the quality of corporate governance. This harm was visited most conspicuously on high-technology firms, which because of the volatile nature of their securities' market value were particularly tempting targets for abusive litigation. In effect, the private liability system had come to equate risk-taking with fraud. The filing, prosecution, and settlement of meritless Rule 10b-5 class actions imposed a corrosive "litigation tax" on capital formation, to the detriment of the investing public and the U.S. economy as a whole.
Congress recognized these concerns when it enacted the Reform Act by a super- majority of both the House of Representatives and the Senate. This Committee played a key role in shaping that legislation. It is therefore appropriate that this Committee should conduct the first hearing on the impact of the Reform Act. Because our members are the intermediaries between those who buy securities and those who issue or sell securities, SIA is uniquely well-positioned to provide an assessment of the impact of the Reform Act up to this point.
The Act's fundamental purpose was to address concerns, raised in a number of Congressional hearings over a 4-year period, that the securities litigation system was misaligned in a way that overcompensated weak cases to the detriment of strong cases, and that served investors poorly. The Statement of Managers accompanying the Conference Report illustrated the careful and balanced approach taken by the Act:
As this Committee noted in its report accompanying the Senate version of the Reform Act, the Act attempts to meet these goals in three ways: (i) by encouraging the voluntary disclosure of information by issuers; (ii) by empowering investors so that they, and not their lawyers, control securities litigation; and (iii) by encouraging plaintiffs' lawyers to pursue valid claims for securities fraud while encouraging defendants to fight abusive claims. Changes made in pursuit of these goals included the following:
While the Reform Act was the first comprehensive effort to overhaul private liability under the federal securities laws, the reforms that were adopted were carefully crafted to reach only the areas where the problems were most clearly identified. A number of legal tools for both private litigants and government authorities were preserved, or even expanded. For example, the Act
The one problem the Reform Act did not anticipate was the movement of cases to state court and the need to curb these parallel and duplicative state class actions.
Although 19 months have elapsed since passage of the Reform Act, in the world of securities class action litigation that is a relatively brief period of time in which to assess the Act's significance. Because of the enormous amounts of time and resources that securities class actions devour, these cases typically take years to resolve. Moreover, many provisions of the Reform Act require interpretation by appellate courts before their full impact on the behavior of litigants can be observed. While the appellate record has started to take shape, the case law construing provisions such as the pleading standard and the preconditions to the safe harbor for forward-looking information is still relatively scant.
In addition, the period since enactment of the Reform Act has seen a continuation of a remarkably strong increase in market values. Since many of the complaints about abusive litigation concerned "fraud by hindsight" - - allegations of fraud instigated by a decline in market value and little else - - the economic environment since passage of the Reform Act may not be the ideal "road test" for the Act's efficacy in deterring abusive litigation. It is a safe assumption that a bear market would cause an increase in abusive cases.
Notwithstanding the brief passage of time, our preliminary observation is that the Reform Act has had a positive effect on the conduct of federal securities class action litigation. In particular, the race to the federal courthouse appears to have abated, cases are now rarely filed within hours of a corporate announcement and when they are filed, they appear generally to be pleaded with more detail than we have seen in the past. Certainly, it is fair to say that the concerns expressed by opponents of the Act that it would radically increase instances of fraud appear to have been completely unfounded.
There is, however, one disappointment. The Act's safe harbor for forward-looking information has not increased disclosure to investors. Issuers have been reluctant to provide substantially more information to the market concerning their anticipated economic performance. This appears to be the result, in whole or in part, of the loophole permitting plaintiffs' lawyers to pursue anti-fraud claims in state court, or to seek to make changes in a single state's laws that could have nationwide effect. Since state laws generally do not have an analog to the federal safe harbor, issuers are apparently intimidated by potential state liability from disclosing any forecasts that turn out to be wrong.
At this point the impact of the Reform Act on corporate disclosure appears to have been quite disappointing. This point, and the reasons behind it, were explained in a recent open letter from 181 corporate officers of high technology firms:
A recent SEC report on the impact of the Reform Act ("SEC Report") suggests that the two most likely reasons for the apparent reluctance to rely on the safe harbor are (i) companies are waiting to see how courts will interpret it and how other companies will use it; and (ii) companies are fearful of state court liability, where the federal safe harbor does not apply. The first condition may be dispelled over time, but the second is likely to persist. SIA members have likewise been told by their corporate clients that concern about state liability has been a major impediment to use of the safe harbor. The evidence strongly suggests that the safe harbor will never fulfill its potential for putting better information in the hands of investors until the issue of state liability is addressed by Congress.
While the Reform Act attempted to comprehensively address problems with private securities litigation at the federal level, it left untouched the ability to plaintiffs' lawyers to file cases based on the same facts in state court. In retrospect it is clear that by focusing exclusively on cases in federal court rather than all securities fraud cases involving national markets, the Reform Act offered a new path of least resistance for meritless litigation. Trial lawyers have seized on this loophole and have begun the process of fashioning a more fractured and dysfunctional liability system than ever existed before the Act's passage.
SIA members have seen a striking rise in the number of securities class actions filed in state court, where the safe harbor for forward-looking information and other federal reforms generally do not apply. Based on information provided by SIA members, the portion of new securities class actions in state courts in which they are involved has risen from less than one-quarter of total class actions in 1995 to between roughly one-half and two-thirds of cases filed in the first half of 1997. Like the 181 high technology executives quoted earlier, SIA believes that this broadened exposure to state liability has drained away the benefits to investors of the safe harbor for forward-looking information.
This "cloning" of one case into two in many instances appears to be done simply to evade the federal reforms, particularly the safe harbor, discovery reforms and pleading standard. The result is two abusive securities class actions instead of one. As one California state judge recently remarked during oral argument in one such case, "[l]et's be frank about it . . . . Tactically, it certainly benefits plaintiffs to have their cake and eat it, too. . . . There certainly could be some abuse there." These concerns are also supported by the SEC Report, which noted an "apparent shift to state court and suggested that this shift "may be the most significant development in securities litigation post-Reform Act." The SEC Report stated that "many of the state cases are filed parallel to a federal court case in an apparent attempt to avoid provisions of the Reform Act." SEC Commission Wallman amplified on the implications of this trend in a statement accompanying the Report:
Indeed, the available data about this phenomenon may understate the trend. Observers have noted that measuring the scope of this trend is difficult because case filings in state court are very difficult to track. Therefore, reports concerning state court filings "may significantly undercount the actual number of state court filings, particularly for states outside California." However difficult this trend may be to measure, SIA views it as a serious concern. It raises the question of whether the increased resort to state courts will result in a fragmented legal structure in which all of the goals of the Act are eventually undone.
In addition to diverting cases from federal to state court, trial lawyers have tried to exploit the state law loophole in at least two other ways. First, trial lawyers last fall made a major effort to enact state legislation calculated to undermine the federal reforms. California Proposition 211, a ballot initiative drafted, promoted and funded by the plaintiffs' securities bar, would have essentially resulted in "reverse preemption" - - the application of California law to virtually every major private securities class action in the nation. Proposition 211 was a stunningly bald attempt to use the state law loophole in the Reform Act to not only undo the Act, but to impose on the national markets new and vastly broader liabilities than ever before existed. Proposition 211 would have radically altered the liability landscape in the following respects, among others:
Fortunately, Proposition 211 was resoundingly defeated by California voters. Since the demise of Proposition 211, the same law firm that largely underwrote the Proposition 211 effort has focused on yet another avenue for exploiting the loophole, by seeking to achieve through judicial interpretation what it was unable to achieve through the ballot box. In Diamond Multimedia Systems v. Superior Court of Santa Clara County, plaintiffs' lawyers are arguing that companies should be subject to suit in California whenever any false statement was deemed to be "made" in California, irrespective of whether any plaintiff resides there, of whether a company has an office there, or whether any stock solicitations or purchases were made through the California wires or mails. If successful, the law firm will have achieved many of the objectives that it sought in Proposition 211.
Even if there had been absolutely no sign of a migration from federal court to state court, legislation to close the state court loophole would be highly appropriate. Reverse preemption requires only that one single state adopt a Proposition 211-type law, or that one state appellate court adopt the sort of over-broad jurisdictional approach urged by trial lawyers in the Diamond Multimedia case. The mere threat that a state might seek to give its laws nationwide effect could adversely affect market participants, as evidenced by reports last fall that a number of companies elected not to release earnings forecasts in anticipation of the possibility that Proposition 211 might pass. Just as one should preferably fix a leaky roof when the sun is shining, this Committee should close the state court loophole now, before a bad state law or judicial decision has inflicted major harm on the American capital markets.
Precluding state liability for securities that are part of the national marketplace also furthers the goals of another important law enacted in the last Congress, the National Securities Markets Improvement Act of 1996 ("NSMIA"). NSMIA preempted a broad range of state regulation for securities listed on national exchanges, in recognition that investors in the national marketplace are better served by one set of rules, rather than 51 separate legal standards. Permitting 51 separate jurisdictions to impose varying standards of liability for participants in the national marketplace is entirely inconsistent with the regulatory scheme that Congress embraced in NSMIA less than one year ago. Indeed, aggressive efforts to use state law to set national standards of liability would not merely threaten the goals of the Reform Act and NSMIA, it would stand federalism on its head and undermine the primacy of the federal securities laws.
SIA urges the Committee to provide the same leadership on this issue that it gave in the original enactment of the Reform Act and in the adoption of NSMIA. There are currently pending in the House of Representatives two bills, HR 1689, introduced by Representatives White and Eshoo and HR 1653, introduced by Representative Campbell, that would effectively close the state law loophole. SIA would be pleased to assist the Committee in any way that it can in considering appropriate remedies to this problem.
SIA's preliminary assessment is that the Reform Act has not affected investor protections against fraud. There are a number of protections in the federal securities laws that are vastly more important in protecting investors from fraud than the ephemeral protection offered by class action lawyers. For instance, the due diligence investigation conducted by underwriters and the work required of lawyers and accountants in preparing the prospectus for a securities offering are not affected by the Reform Act. These activities, and the governmental and private liabilities arising from their malperformance, are unchanged, or strengthened in some respects, by the Reform Act. Nor have the SEC Report or other objective studies shown any impairment of the ability of investors to bring legitimate securities class action claims. Cases are still being brought and, as discussed below, there are even indications that the quality of federal securities class action complaints has improved somewhat, although it is too soon to tell if a higher percentage of the cases being filed have merit.
Perhaps the most persuasive sign that investor protection has not been impaired is continued investor confidence in the markets. This confidence is amply demonstrated by market performance. The Dow Jones Industrial Average has risen from 5117.12 at year-end 1995 to 8061.65 as of July 22, 1997, while the Nasdaq composite index has grown from 1052.13 to 1563.88 over the same time period, fueled by an influx of new money from investors. The average daily value traded on the New York Stock Exchange has risen from $12.2 billion in calendar 1995 to $21.3 billion for the first half of 1997, and from $9.5 billion to $16.4 billion on the Nasdaq exchange. It would be a stretch to attribute the tremendous performance of the capital markets since 1995 to passage of the Reform Act. By the same token, statistics like these simply would not be possible if investors believed that the Reform Act had provided wrongdoers with new opportunities for exploitation and fraud.
There is no question that the environment for capital formation in the United States, which has been positive for most of this decade, has been even more favorable since enactment of the Reform Act. Funds raised in initial public offerings rose from $30.1 billion in 1995 to $49.9 billion in 1996. Total equity offerings rose from $98.3 billion in 1995 to $152.5 billion last year, while U.S. corporate debt underwriting climbed from 602.9 billion to 801.1 billion. Annualizing the first half performance for 1997, IPOs, total equity offerings and total corporate debt offerings in 1997 also appear likely to outperform 1995.
While the full reasons for this impressive performance are best left to economists to debate, it is obvious that a number of macroeconomic factors went into the growth of capital formation, just as many factors pushed the parallel increase in stock indices over the same period. It is impossible to quantify the impact that the Reform Act might have had on capital-raising, if any. It is also hard to say if the perception of an increased threat of state court liability might have dampened what might have been an even better performance.
Another way of measuring the impact of the Reform Act on capital formation is to look at its impact on directors and officers liability insurance premiums ("D&O premiums"). Although D&O premiums are only one of many factors in the cost of raising capital, they are a quantifiable measurement that may be considerably influenced by exposure to unwarranted litigation. A survey of D&O premiums showed that premiums declined by 9 per cent from 1995 to 1996, the first decline since 1984. Strikingly, the survey also revealed that high-technology firms, the favored target of securities class action litigation, were one of only two business groups that saw virtually no decline in premiums. The fact that high technology premiums did not increase is encouraging, but the fact that its premiums did not decline as much as those of other industries may indicate that potential state litigation exposure in this critical industry continues to act as a drag on capital formation.
As indicated previously, the impact of the Act on the conduct of litigation is mixed, but generally favorable. There do appear to have been marked improvements in the conduct of securities class action lawsuits filed in federal court since passage of the Reform Act. Our impression, while somewhat anecdotal, is that federal class action complaints filed since 1995 have tended to be better researched and more carefully written. Likewise, there seems to have been a general slowdown in the "rush to the courthouse" that was notorious for producing lawsuits within days or even hours of corporate announcements. This trend, if it holds, should help to reduce public cynicism about the ethics and motivations of plaintiffs' lawyers that results when lawsuits are filed on a few hours' notice, grossly misidentifying the parties, or without having been reviewed by the putative "client."
The industry's impressions are consistent with other information. The SEC Report "suggests that plaintiffs' lawyers are not filing 'cookie-cutter' complaints and that the race to the courthouse has slowed somewhat." The Grundfest-Perino study notes that the average stock price decline preceding the filing of a claim increased from 19 per cent prior to the Reform Act to 31 per cent in 1996. According to Professors Grundfest and Perino, "[t]his increase is consistent with the observation that heightened pleading requirements induce plaintiffs' counsel to pursue cases that are correlated with larger price declines, and therefore seem to be more apparent instances of fraud."
Another important provision of the Reform Act - - one where the "jury" is still out -- concerns the provision encouraging institutional investors to become the lead plaintiff in class action litigation. The SEC Report and the Grundfest-Perino study suggest that, while there have been a few instances in which institutional investors have sought to take advantage of this provision, it has not yet been heavily utilized. The SEC Report notes that institutional investors have expressed concern that as lead plaintiffs they may be subjected to greater litigation cost or liability exposure for matters such as their selection of lead counsel.
Perhaps some of these concerns could be addressed by further legislation.
Although experience under the Reform Act is still limited, the Act has returned some modicum of responsibility to the conduct of federal securities class action litigation. Regrettably, the full benefits of the Reform Act will not be obtained as long as litigants are able to "game" the liability system by using state laws and state courts to undercut the federal reforms. The aggressive efforts by trial lawyers in California to change that state's laws will not only undermine the Reform Act, but also expose the national securities markets to vast new liabilities -- a clear warning that this problem needs to be addressed before real harm is done to the national economy.
Thank you very much.
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