Remarks of Isaac C. Hunt, Jr. Commissioner* U.S. Securities and Exchange Commission Washington, D.C. Litigation Reform, Safe Harbors, and Other Matters of Interest 1998 Orange County Public Company Forum Orange County, CA February 12, 1998 ______________ * The views expressed herein are those of Commissioner Hunt and do not necessarily represent those of the Commission, other Commissioners or the staff. U.S. Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 Introduction Thank you. I am delighted to be here today. Your program examines public companies' communications challenges stemming from litigation reform, disclosure requirements, and new technologies. I must admit, however, or should I say disclose, that a large portion of my remarks will focus on federal securities litigation reform. There are several reasons why I want to talk about litigation reform today: * First, I wasn't at the SEC when the bills were considered that culminated in Congress's override of President Clinton's veto; * Next, I expect Congress to move again in this area in the near future. When that occurs, I'll feel more restrained about giving my views since I'll be working with my fellow Commissioners towards a consensus SEC position -- if a consensus is at all possible. * Lastly, I want to offer my views because I'm here in California, and the ghost of the 1995 legislation past still seems to hover over this state. I know how passionate Californians are about litigation reform -- why, just last week, I came across several campaign buttons my staff received during the Proposition 211 debate. And, no, I did not save those buttons for posterity. After this discussion, I'll talk about the safe harbor provided for in the 1995 legislation, and why it isn't working as intended. Finally, I'll address the impact of recent technological advances on the markets. Before I begin, two disclaimers. The first is that my views are my own, and not necessarily those of my agency or my fellow Commissioners. The second is that time constraints will prevent me from discussing several initiatives which would seem relevant to your program, such as the SEC's recently adopted Plain English rules (of which I am an ardent supporter). Litigation Reform Background. The Private Securities Litigation Reform Act of 1995 became law following Congressional overrides of the President's veto. The Act applies to private lawsuits only. It does not directly affect the SEC's enforcement program, although it does include a "knowing" aiding and abetting provision for SEC- use. Among the Act's most significant measures are: * a statutory safe harbor for forward-looking statements; * heightened pleading standards, especially as to an alleged violator's "state of mind"; * a discovery stay during the pendency of a motion to dismiss; * proportionate liability for defendants in private actions found not to have "knowingly" committed a violation; and * a requirement that courts choose a lead plaintiff in class actions, with a presumption that the most able representative is the one with the largest financial interest in the case. Absent are two items urged by the SEC: (1) extension of the statute of limitations for private actions, and (2) restoration of the private right of action for aiding and abetting. At President Clinton's request, SEC staff prepared a report on the first year of practice under the Act. That April 1997 report is on our web-site. The staff report concluded that it was too soon to draw definitive conclusions about the Act's impact, especially since appellate courts had little or no opportunity to interpret the Act's provisions. But the staff report did make some preliminary observations. I'll share just a few with you: * despite the Act's safe-harbor provision, companies were not providing much more forward-looking disclosure than they provided before enactment; * institutional investors were not actively seeking to become involved in securities class actions; * the number of state court cases reportedly had increased. Some of those cases were filed parallel to federal claims, perhaps in an effort to gain discovery where discovery in the federal action had been stayed pending a motion to dismiss. The Bills. In response to the reported increase in class actions filed in state courts, and perhaps also in response to Proposition 211, three slightly differing bills were introduced in Congress. Representative Campbell's bill would preempt all private civil actions in state court for fraud violations in a "covered" security, and would define those securities in a manner similar to what Congress used in the National Securities Markets Improvement Act of 1996 ("NSMIA"). In NSMIA, Congress preempted state blue sky laws for some securities (generally those securities trading on the NYSE, the AMEX, and NASDAQ NMS). Representatives White's and Eshoo's bill -- now with more than 160 co-sponsors -- would preempt just private class actions, rather than all private civil actions. The term "class action" would be defined broadly to include, among other things, those seeking damages on behalf of more than 25 persons. Further, the definition of covered security is different from that in the Campbell bill. Finally, Senator Gramm introduced a bill similar to White-Eshoo, although the Gramm bill defines a covered security using a NSMIA approach similar to, but broader than, the Campbell bill. How the Current Debate Should be Framed. Whether we should have a uniform standard for national securities litigation is a complex issue, as the success of our markets is based in large part on investor confidence in our current system of dual federal- state regulation. With NSMIA, however, Congress showed a willingness to re-examine that system, and divided responsibility for securities registration between the SEC and the states. Now, the responsibility for policing fraud stands on different footing than the responsibility for registering securities. Private actions support SEC efforts to combat fraud, and they are the primary way investors are reimbursed for losses caused by fraud. Accordingly, any efforts to craft a uniform standard should not foreclose investors with grievances from obtaining prompt and full redress through the courts. There are two ways to view the preemption debate. The first sees preemption as a reactive solution to problems associated with the 1995 Act. I don't see the debate this way, and I'll explain why later. The second sees the debate as whether, ideally, national markets should be governed by a national standard. I am of this second school of thought, and I believe that we should move towards national standards for some securities litigation for its own sake. At this time, I support preemption of certain securities class action suits against larger issuers. This is generally the approach taken in the White-Eshoo and Gramm bills. But while I support the goals and objectives of these two bills, I'll discuss later why I have some trouble with them as currently drafted. I do not support preemption for individual actions at the state level and, consequently, I can't support the Campbell bill. Preservation of individual actions allows states to regulate fraudulent conduct occurring wholly within their borders, and allows investors to bring individual actions against their brokers and advisers alleging state law claims. The states have strong interests in providing a remedy for their citizens in these classes of cases. In addition, preempting individual actions could significantly exacerbate the problem of over- crowded dockets in federal courts. Now, let's go back to the first school of thought: that greater preemption is needed to cure problems associated with the 1995 Act, and that the pending bills do just that. As I noted earlier, SEC staff identified three areas where the Act wasn't working as intended: the lead plaintiff provision has not encouraged institutions to seek lead plaintiff status, the stay of discovery while a motion to dismiss is pending could be avoided by filing a companion case in state court, and the safe harbor has not produced much additional disclosure. Yet, notably, none of the bills now before Congress directly address these concerns, although it's possible that they all might result in greater use of the safe harbor. Moreover, I don't agree with those who say that there has been a migration of cases to state courts since the Act's adoption. The evidence at best is inconclusive. For example, a recent Price Waterhouse study notes that the number of state securities class-action lawsuits actually has declined since the Act's passage -- Price Waterhouse found 44 state court filings alleging securities fraud in 1997, the lowest number since 1992. Our staff's analysis also suggests that this migration has not occurred in any dramatic fashion. But my staff did call to my attention the fact that over 60% of the state securities cases filed since the Act's adoption have been filed in the State of California! California seems to be attractive to plaintiffs in part because of a relatively liberal reliance standard in securities fraud cases. That 60% figure suggests to me, at least, that California could, if it chose, resolve by itself a large part of the perceived problems associated with the Act. In fact, I understand that a bill has been introduced in the state legislature that generally would import the Act's provisions into state law. I believe that many supporters of the pending Congressional bills know that (perhaps apart from California) there hasn't been a migration to state courts. Many know that the bills don't correct better-documented problems associated with the Act; for example, individual plaintiffs would still be able to file in state court to defeat a discovery stay in a related federal action. I must assume, therefore, that some of these supporters share my view -- that securities, trading over national markets, generally should be governed by a national standard. From my perspective, it would be a better and fairer discussion were we all to agree to frame the current debate in this manner. What Kind of Uniformity? But framing the debate as I have done has some drawbacks. Those of us in the "second school" must decide whether it is worth having a uniform standard at any cost -- whether it is worth having a uniform standard if it is not a good one, or not as good as we would like it to be. We must decide whether we support the pending bills as they are. Those are hard questions and, frankly, I'm still resolving them in my own mind. My preliminary view is that there are four things in particular that I would like to see changed in the current White/Eshoo and Gramm bills. Two are fairly technical, and I hope that a consensus builds for correcting them. The other two are larger, "big ticket" items that would better protect investors if they were included. "Technical" Fixes. The two bills as drafted could eliminate important areas of state corporate governance law, since they'd preempt state class actions for damages based on fraud in proxy and tender offer materials in extraordinary corporate transactions. Class actions challenging such transactions often allege breaches of fiduciary duty by target-company management and directors under state law, since state law imposes duties of care and loyalty, as well as certain additional disclosure obligations. Delaware's courts in particular have developed expertise and a body of case law which lends predictability, and its courts are known for resolving disputes expeditiously. Broad preemption would diminish the value of this body of precedent and specialized courts for resolving disputes and, as a result, corporate transactions could be delayed or thwarted altogether. In addition, I am concerned as to how "class action" is defined in both bills. The bills use a low 25-person threshold, and that quite subjective definition applies to "any single lawsuit, or any group of lawsuits filed in or pending in the same court involving common questions of law or fact." This could have the effect of preempting individual actions in some instances, such as where 25 plaintiffs file separate individual lawsuits arising from the same set of facts in the same state court. Further, broadly grouping such lawsuits might unfairly group an individual fraud action with a non-fraud action (such as one for breach of contract). Pro-Investor Fixes. Turning to the two "big ticket" fixes I alluded to earlier, several cases have raised the issue of whether the Act's heightened pleading standards eliminate recklessness as a theory of liability for fraud-based violations. Some district courts have so held, and the issue is before two Circuit Courts of Appeals, including the 9th Circuit here in California. But most courts seem to agree with the SEC that recklessness continues to suffice for pleading and proving scienter. I strongly believe that liability for recklessness must be preserved as it is essential to investor protection. I testified before Congress that a uniform federal standard that did not include recklessness as a basis for liability would jeopardize the integrity of the markets, and would deal a crippling blow to defrauded investors who have meritorious claims. So, if the courts ultimately eliminate liability for recklessness at the federal level, state law would be the only hope for many defrauded investors. Of course, many states provide other benefits to defrauded investors not available at the federal level, such as causes of action for aiding and abetting, and longer statutes of limitations. While both are important to investor protection, I focus on the limitations period, for it even more directly impacts upon investors with meritorious claims. In 1991, the U.S. Supreme Court in its Lampf decision imposed a uniform limitations period on private securities-fraud cases: one year from the date of discovery of a fraud and three years from its occurrence. The Court chose a period shorter than that applied in most federal circuits, which based their rules on analogous state-law periods. Seven years after Lampf, more than 30 states including California still have longer limitations periods for securities fraud actions than what is provided for in the federal courts. The majority of the states have it right in my view: a 1 year/3 year limitations period is too short. As a former Commissioner once wrote, Lampf "perversely ... reward[s] the most blameworthy connivers: those clever enough to mask the fraud for only three years." Notably, it is not unusual for the Commission to consider cases for enforcement action where the fraudulent conduct was concealed from investors, auditors, or other market participants for three years or more. The SEC could not abide Lampf, and I don't know why investors should either. Several years back, accounting groups and the defense bar lobbied Congress not to fix Lampf on a stand-alone basis but, instead, to consider it as part of a broader package of reforms. But a broader package was adopted in 1995 without any fix. Congress should enact an express statute of limitation that would allow cases to be filed up to two years after discovery and five years after a violation occurs. Safe Harbor Let me now spend a moment on the Act's safe harbor provision. The provision was designed to provide shelter from liability for projections and other forward-looking statements. It generally holds that the maker of such a statement isn't liable if either prong of a two-prong test is met: * the statement is identified as forward-looking and is accompanied by "meaningful cautionary statements" identifying important factors that could cause actual results to differ materially from the projected ones; or * the plaintiff fails to prove that the statement, if made by a natural person, was made with actual knowledge that the statement was false or misleading. As I said earlier, the provision hasn't led to much more disclosure. Companies seem concerned about the lack of judicial guidance as to what "meaningful cautionary language" is required, and about potential liability under state law. Last October, the U.S. District Court for the Middle District of North Carolina was first to apply the safe harbor provision, in Rasheedi v. Cree Research. In that case, the judge dismissed a complaint where plaintiffs alleged, among other things, that the company made misleading statements about its prospects in two press releases and the company's MD&A section of a 10-Q. In its materials, the company asserted that its ability to meet its projected goals depended on it decreasing variability in its manufacturing processes. Plaintiffs claimed, however, that this was misleading because it ignored another factor: design defects known to the company which caused customers to return its products. The judge found that these company statements were protected by the safe harbor because they contained adequate meaningful cautionary language. Although this decision could embolden issuers to provide more forward-looking disclosure, it's precedential value is uncertain. After all, it is the first decision. Moreover, it's analysis is somewhat brief, with no real effort made to define what is meant by meaningful cautionary language. But despite a lack of judicial guidance, many companies are using the safe harbor -- some successfully, some less so. Here are two examples of the latter that our General Counsel's office came across: * How's this for overly broad?: "Although the Company believes that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included ... will prove to be accurate." * On the flip side, laundry lists of all things that can go wrong also are not "meaningful." How about the disclosure I saw explaining that "there may be difficulties in obtaining raw materials, supplies, power, and natural resources and any other items needed for the production" of a company's products? The Commission has seen too much of this "not-too- meaningful" disclosure since the Act's passage. So, while the Act's safe harbor may not be a model of clarity, please do what you can to ensure that your company's cautionary statements are substantive and tailored to the specific projections. Impact of Recent Technological Advances on the Securities Markets I'll conclude with a brief discussion of the impact of recent technological advances on the securities markets. Because of the central role of technology in the securities markets, the Commission always has had to take into account the state of technology in the industry. But, frankly, we may have been a bit slow in reacting to some recent technological advances. I'll accept a share of criticism for being cautious at times when it comes to pushing the regulatory envelope on technological issues. For all I know, the staff may attribute that caution to my grey hair. But I, of course, see it differently. I'm cautious at times because I believe that no matter how committed the Commission is to supporting innovation and new technology, we must balance that commitment with the need to protect investors and the integrity of the markets. Moreover, no matter how committed we are to supporting innovation and new technology, we always must act pursuant to sound legal authority and principles. While I'm delighted to interpret statutes' flexibly to aid technological change, I don't like to read language out of statutes to reach any particular regulatory ends. In part because of Chairman Levitt's and my former colleague Steve Wallman's efforts, the Commission now is addressing technological issues head on, even if we don't always act with the speed and daring that Steve and others might like. In fact, Chairman Levitt just announced an early spring "Roundtable" to discuss technological issues on both a micro- and a macro- level, and I am very much looking forward to that event. As you may know, the Commission has issued several releases with technology themes in the last few years: releases regarding electronic delivery, electronic trading systems, etc. And the staff has issued numerous interpretive and no-action letters on topics as diverse as issuer bulletin boards to promote secondary trading in the issuer's stock, and electronic road shows to aid issuers in primary offerings. The staff also has tried wherever possible to clarify the application of existing legal requirements to securities products or services made possible by new technology. And, of course, the staff now is considering major initiatives to review fundamental elements of the regulatory structure governing public offerings under the Securities Act, and of the regulatory structure governing securities markets under the Exchange Act. Both of these initiatives are, at least in part, technology-driven. Notably, in NSMIA, Congress directed the SEC to study and to report to Congress on the impact of recent technological advances on the securities markets. That October 1997 staff report is on our web-site. The staff noted in its report that in this day and age of exponential technological advances, it could only really offer Congress a "snapshot" photograph in time of its views on this important subject. I agree. Let me close with another sound conclusion from that staff report. As the Commission moves forward to implement the goals of the federal securities laws, it will become increasingly important to keep abreast of changing technologies and developments in related areas of the law. To do so, the Commission must work closely with other governmental regulators, industry participants, and technical specialists. Please help us in this effort. Thank you.