Capital Markets Reports' Recommendations: The Litigation Climate

Sunday, July 1, 2007 - 00:00

The outside counsel interviewed for this Special Section discuss civil justice and litigation-relatedrecommendations designed to improve the competitiveness of U.S. capital markets and the institutions that use them. These recommendations, which were also highlighted in our May and June issues, are contained in one or more of the following reports: (1) Report and Recommendations of the Commission on the Regulation of U.S. Capital Markets in the 21st Century established by the U.S. Chamber of Commerce ("Chamber Report"), (2) Interim Report of the Committee on Capital Markets Regulation ("CCMR Report") and (3) Sustaining New York's and the U.S.' Global Financial Services Leadership ("Bloomberg/Schumer Report").

Beginning with our September issue, we will run a monthly Special Feature to keep our readers informed of developments relating to the recommendations covered in the reports.

Editor: Is securities class action litigation a major problem?

Schaerr: Yes, and our lawyers at Winston & Strawn are seeing an increase in this type of litigation. It is disruptive to companies and very expensive to defend. Securities class actions and the uncertainty they cause drive issuers to choose foreign markets like London or go to private equity investors. The growth of private equity investing and the increase in large deals moving to foreign markets is a direct response to the mounting costs that have been imposed on public companies through litigation and through increased regulation under Sarbanes-Oxley.

Editor: Would a limitation on punitive damages be desirable?

Schaerr: Very much so. The problem with excessive punitive damage awards is that they give plaintiffs' lawyers an incentive to go after a big jackpot. The threat of large punitive damages means that companies are forced to settle frivolous lawsuits of all kinds. A cap on punitive damages would reduce the number of suits being filed. The treble-damages "cap" in the antitrust laws is a good example of what should be done. A true violation of the antitrust laws results in a recovery of actual damages sustained by a plaintiff, with exemplary damages capped at three times that amount. That's enough to give people an incentive to bring legitimate cases, but small enough to avoid the lottery mentality that you see in a lot of plaintiffs' cases.

Editor: Should the SEC modify Rule 176 issued pursuant to Section 11 of the Securities Act to make an outside director's good faith reliance on (1) an audited financial statement or an auditor's SAS 100 review report or (2) representations of senior officers, conclusive of due diligence?

Schaerr: Yes. The success of our business system is based on companies' continued ability to attract highly qualified and independent directors. In the wake of recent scandals and Sarbanes-Oxley, there have been a number of situations in which directors' personal assets have been exposed to risk. Given the importance of attracting the best people to serve as directors, it doesn't make sense to assume that they are as knowledgeable as corporate insiders or a company's auditors. And so I agree with any proposal that would allow outside directors to rely in good faith on senior company officers. It's difficult for company directors to second-guess what they're told by company insiders, unless they are actually aware of a "red flag." Also, directors should be able to rely on audited financial statements or reports from an outside auditor.

Editor: What impact does the current split in authority on "scheme" liability for third parties under Rule 10b-5 have on the legal system?

Schaerr: With respect to scheme liability, the Supreme Court decision in Central Bank determined that a third party cannot be held liable under Rule 10b-5 for aiding and abetting. I agree with the Eighth Circuit's position that scheme liability is essentially a way of creating liability for aiding and abetting. Plaintiffs should not be permitted to sue third parties, whether lawyers, accountants or business partners, in situations where they have not made a material misstatement on which investors relied. Such suits would create great uncertainty for such third parties about what actions would expose them to liability. The reason we have laws is that they enable people to determine without too much effort the boundary between legal and illegal conduct. If we always need to consult with lawyers before engaging in particular activities, then our laws are not as clear as they should be.

Editor: Would permitting shareholders to adopt alternative procedures for resolving disputes with their companies, including arbitration and the waiver of jury trials, improve the current litigation environment?

Schaerr: I think it's a good idea. Companies and their shareholders should have the option of adopting mechanisms that will reduce the cost of resolving disputes between a company and its shareholders. As long as there's full disclosure to potential shareholders that a company's charter has an arbitration provision, people can make their own decisions as to whether they're comfortable owning shares in that company.

Editor: Should attorneys who make political contributions to candidates be prohibited from representing a state or municipal pension fund controlled by that candidate as lead counsel in securities class action litigation?

Schaerr: Absolutely. Allowing lawyers to make political contributions to people who will later be deciding whether to hire those same lawyers creates a terrible conflict of interest. It has the potential of influencing not only the decision about whom to hire, but also the decision whether to litigate at all. Decisions about whether to litigate should not be based on a desire to repay a favor to a campaign contributor. The existing system seems to foster that.

Editor: Should the SEC adopt a prudential regulatory system?

Schaerr: I think a prudential model for regulation is the right way to go. Banking regulation provides a good example of a regulator and enforcement agency trying to promote compliance with the law rather than using prosecutions and enforcement actions as a means of creating the law.

Previously acceptable behavior should not be subjected to civil or criminal sanctions when new rules or interpretations result from enforcement or prosecutorial action. Companies should be put on notice of a change in the rules as a result of rule-making governed by established processes. The consistent goal of regulation, enforcement and prosecution should be to encourage compliance with existing law.

Editor: Should there be a federal self-evaluation privilege for SEC-regulated institutions?

Schaerr: That proposal makes sense because, again, the goal of regulators and prosecutors ought to be to encourage people to comply with the law and to facilitate their efforts to do that. If a company discovers something of questionable legality, the company should be able to communicate with auditors and regulators about the situation and get answers to its questions without fear that the information provided will be used against it in a civil case. The current system, however, forces companies to conduct all of their communications in connection with internal investigations orally because of fear that any written documentation of the investigation will be turned over to a plaintiff.

I would argue that, even though the self-evaluation privilege proposed in the U.S. Chamber Report is limited to SEC- regulated institutions (e.g., broker dealers and investment advisors), it should be extended to all U.S. corporations. We should encourage companies to ferret out compliance issues without concern about having the materials generated by such efforts become available in litigation. I would therefore support a self-evaluation privilege that would cover such materials even if a communication to the SEC or other regulatory body is not involved. For a further discussion of the self-evaluation privilege see "Good Corporate Behavior Redux - The Federal Self-Evaluation Privilege," by my colleagues Chris Edwards and John Court on page 13 of the June issue of The Metropolitan Corporate Counsel.

Editor: Critics of the self-evaluation privilege suggest that its creation would result in a selective waiver that would jeopardize the attorney-client privilege. Do you agree?

Schaerr: There is a potential for this, but it can be addressed through legislation, regulation, or even sensible judicial decisions. An SEC rule that allowed companies to share the results of their self-evaluations with the SEC without resulting in a waiver of the attorney-client privilege in that setting would likely be followed by most federal courts around the country. In state court, a company would also have a good argument that the SEC rule preempts any contrary state law requiring disclosure of information protected under the self-evaluation privilege. Certainly the recent Supreme Court opinion in the Credit Suisse case supports the overarching regulatory role of the SEC and its ability to preempt even other federal regulatory efforts in the capital markets area.

Editor: Are there instances where organizations should be held vicariously liable for the activities of their officers or directors?

Schaerr: The Arthur Andersen case was one of the most remarkable abuses of prosecutorial discretion I've ever seen. When determining whether a business entity should be indicted, prosecutors should look at the collateral damage that would result to innocent third parties from that prosecution. A criminal indictment of a business imposes enormous costs on innocent employees and other stakeholders who had nothing to do with the wrongdoing. Customers of the organization are hit with the costs of trying to find another organization to provide the same goods or services, often at a higher price. The cost is even higher when the company being indicted is one of a few organizations providing similar services, as in the case of Arthur Andersen.

Editor: Should a corporation be indicted only if there is pervasive culpability through all offices and ranks?

Schaerr: If an entire enterprise is bad to its roots, then there won't likely be much collateral damage to innocent third parties. Nevertheless, even in this situation, prosecutors should still try to accomplish their intended result by indicting all individuals involved in the wrongdoing without indicting the organization. In a company where there has been extensive wrongdoing, and a criminal prosecution has been brought, it may make sense to subject it to a court-appointed monitor accompanied by a court order replacing culpable personnel at all levels. This would reduce collateral damage not only to the company's customers and other innocent stakeholders, but also in situations like that of Arthur Andersen, to the entire market in which it operates.

Editor: Should regulatory and prosecutorial agencies use the threat of indictment to coerce organizations into waiving the attorney-client privilege or work product protection?

Schaerr: I don't think so. The problem with treating a company's waiver of the attorney-client privilege as a cooperation factor is that failure to comply with a waiver request may trigger an indictment of the company, which can then expose its officers and directors to litigation and potential personal liability. The practice of coercing a waiver under these circumstances undermines our tradition of encouraging open and candid communications between lawyers and their clients.

Editor: Do policies asking corporations to refrain from advancing attorneys fees to officers, directors and employees elicit similar concerns? What about the SEC's position with respect to indemnifying directors for damages awarded in Section 11 actions?

Schaerr: Such policies are similarly problematic. If officers, directors or other employees are being prosecuted for activities within the scope of their employment, there is a presumption that the company will defend them. This presumption applies also where the corporation itself is subject to criminal proceedings, and officers, directors or employees are called upon to testify. Advancing attorneys' fees in these situations is an ordinary cost of business for corporations and in many instances mandated by state law or the corporate charter or bylaws. A policy of asking companies to refrain from advancing counsel fees is coercive, and it may be unlawful in that it forces the company to violate its legal or contractual obligations to the individual and deprives the individual of his or her expectation that quality counsel would be available.

I also agree with the recommendation that the SEC should reverse its position that indemnification of directors for Section 11 damages is against public policy, at least in cases where the director acted in good faith.

Gene Schaerr is a litigation partner in the firm's Washington, D.C. office and chair of the firm's nationwide appellate and critical motions practice. He focuses his practice on appellate proceedings of all kinds; on the preparation of high-risk cases for an eventual appeal; and on motions that may prove critical to the outcome of a case at the trial court level.