Wednesday, November 30, 2011
William W. Bratton and Michael L. Wachter’s recent article, The Political Economy of Fraud on the Market (appearing in 160 U. Pa. L. Rev. 69), is a thoughtful and thought-provoking critique of the federal securities class action. Their criticism is harsh. Indeed, they flatly declare that “[t]he fraud-on-the-market (FOTM) cause of action just doesn’t work” because it poorly serves both the compensatory and the deterrence function. They propose a bargain: the SEC should propose a rule eliminating the FOTM presumption in exchange for which Congress should increase the budget of the SEC’s enforcement division and the agency should increase its efforts to hold individuals liable for corporate wrongdoing. Expensive private litigation of marginal utility will be substantially reduced, and fraud will be more effectively deterred.
After reading the article, I have serious misgivings about their proposal because I am skeptical that SEC enforcement alone can adequately protect investors and deter fraud. I am not alone in this concern. James D. Cox has written an eloquent response to Bratton & Wachter, Securities Class Actions as Public Law (160 U. Pa. L. Rev. PENNumbra 73), in which he argues that the authors “commit an even more fundamental error by taking the narrow view that securities class actions have only a private and not a public mission.” Because Professor Cox has effectively developed the policy implications, I want to focus here on three practical concerns: money, Janus, and Judge Rakoff.
1. Money. Frankly, it is simply not realistic to think that Congress will ever commit, on a long-term basis, sufficient funds for effective enforcement. The infusions of money after Enron were reduced in subsequent years, and every year there is a prolonged colloquy between the SEC Chair and Congressional leaders over the SEC budget. Congress has refused to give the SEC control over its budget, and perhaps maintaining Congressional oversight through the power of the purse is justified, given the agency’s record of failures. Congress remains committed to a lean SEC budget, despite the fact that the agency is funded by industry fees.
The current debate over who should examine investment advisers illustrates this reality. A recent SEC staff study reports that the agency does not have sufficient resources to conduct effective examinations of registered investment advisers with adequate frequency; no one seriously disputes this. In recent months, the Consumer Federation of America, which has long opposed the creation of an SRO to examine investment advisers, acknowledged the reality that years of advocating for increased SEC resources for examinations had achieved no results and reluctantly concluded that an SRO was realistically the only option.
2. Janus. Academics on both sides of the debate over securities fraud class actions agree that deterrence would be improved if more corporate officials and other individuals complicit in the fraud were held accountable. Unfortunately, the Supreme Court, in a trilogy of cases (Janus, Stoneridge, Central Bank) has made it exceedingly difficult to hold individuals primarily liable for securities fraud. In the recent Janus opinion, the Court articulates its most restrictive reading of the securities statute and defines the “maker” of a statement as “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it….One who prepares or publishes a statement on behalf of another is not its maker.” At least the SEC, unlike private parties, has the power to impose liability on secondary participants. Nevertheless, since Janus was handed down, corporate officers named as defendants in SEC enforcement actions have sought to have complaints against them dismissed because they did not have ultimate authority over the alleged misstatements. The Supreme Court thus has thwarted enhancing the deterrence function, particularly with respect to private litigation. While Congress could remedy this situation, it has not chosen to do so.
3. Judge Rakoff. I have great respect for Judge Rakoff and admire his efforts to improve transparency and accountability in the settlement of SEC claims. To date, he remains an outlier. If other judges start to apply a more rigorous standard of review, however, fewer SEC enforcement actions will settle (at least at the early stages of litigation), and the SEC’s caseload will necessarily have to shrink. In particular, if defendants are no longer permitted to deny liability, settlement may become virtually a thing of the past. Even if Judge Rakoff’s standard of review does not become prevalent, individual defendants are less likely to settle as readily as corporate defendants do, so an SEC enforcement policy targeting individual defendants will result in more protracted litigation and fewer actions.
Finally, elimination of the private securities fraud class action may be only the first battle in a war against investor protection. I have previously written that I view with great suspicion arguments that SEC enforcement can provide adequate deterrence as well as compensation for investors (Should the SEC Be a Collection Agency for Defrauded Investors?, 63 Bus. Law. 317). As Judge Rakoff suggests, business may consider quick SEC settlements with relatively modest fines a cost of doing business that it can live with. When the SEC starts to exert its muscle, however, and makes life difficult for corporate America, business groups call for changes at the SEC. Thus, when in the aftermath of Enron, the SEC substantially increased the amount of penalties it collected in settlements, there was an uproar and calls for the agency to mitigate its anti-business policies. I worry that if the SEC ever really became an effective investor protection agency, we would see a concerted campaign to hobble it.