Wednesday, January 16, 2008
The Supreme Court's decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (see earlier post here) to reject "scheme liability" as a means to apply Rule 10b-5 to those who provide some assistance in a company's allegedly fraudulent scheme was hardly a surprise. The tone for the Court's view of the scope of the private right of action for securities fraud was set in its earlier decision in Central Bank v. First Interstate Bank, 511 U.S. 164 (1994), which eliminated aiding and abetting liability and limited Rule 10b-5 actions to those who qualify as so-called "primary violators." After Central Bank, third parties who assist a securities fraud, most importantly accountants and lawyers, cannot be sued unless they participated directly in the misstatement or omission, which effectively requires proof that they disseminated the false statements or omitted material information from a disclosure. The Private Securities Litigation Reform Act (PSLRA), adopted the following year as part of the "Contract With America" agenda advanced by the newly-elected Republican majority in Congress, restored aiding and abetting liability in SEC actions but did not extend it to private suits. As such, it was easy for the Supreme Court to reject "scheme liability" that was little more than a back-door way to impose liability on those who would not otherwise meet the requirements to be a primary violator.
In the last section of the opinion, the majority discounts the idea that denying "scheme liability" effectively makes Rule 10b-5, the primary anti-fraud provision of the federal securities laws, unenforceable. The Court stated, "Secondary actors are subject to criminal penalties, and civil enforcement by the SEC. The enforcement power is not toothless." (Italics added). Is there a cop on the securities beat to ensure that fraudulent schemes do not occur? If enforcement is to be entrusted largely to the government, then the answer may well be that there is a shortfall in policing the public securities markets. As far as criminal enforcement is concerned, securities cases remain fairly uncommon, despite the rash of CEO prosecutions and insider trading cases seen the past few years. Indeed, there has been a consistent clamor that federal prosecutors are "criminalizing ordinary business decisions" by using the criminal laws against corporate officers for conduct that is claimed to be at best a civil regulatory violation. Securities fraud cases are difficult to win because of the problem of proving the requisite intent and the time-consuming nature of the investigations. Criminal prosecution is a necessary weapon to police the capital markets, but is hardly the most effective -- or efficient -- tool because of the costs involved and the limited number of cases that can be pursued.
Surely, then, the SEC can keep the markets honest and safe for investors, can't it? The answer there is a resounding "maybe, but not as much as you might think." To start with, the Commission's budget in FY2007 was $882 million, and it has a total of about 3,500 employees spread across four divisions, eighteen functional offices, and eleven regional offices (see SEC 2007 Annual Report here). That's not a lot of people, and it is not like all, or even most, of them are devoted to enforcing the securities laws. In considering the size of the SEC's annual budget, consider what is being spent in Iraq to fight the war there. In FY2007, according to Congressional Budget Office testimony (here), the government spent $113 billion, and since 2003 a total of $368 billion. What is spent in three days in Iraq is about the SEC's total annual budget, and what has been spent to date on the war probably exceeds the total expenditure on financial regulation by the federal government over the last 100 years. My point is not that one is more important than the other, but that an independent agency viewed as the primary enforcement mechanism for the capital markets operating with a comparatively puny budget and only a few thousand employees (who leave the agency at a clip of about 8.5% a year) is not exactly the toothy enforcer the Supreme Court may be envisioning.
The amount of capital available for investment in United States is staggering in comparison to the size of the SEC, and the securities markets are undergoing a significant transformation. The public markets trade in the trillions of dollars daily, while mutual funds regulated by the SEC control over $10 trillion in assets. Add to that the $14 trillion held by pension funds and an addition $1 trillion+ by hedge funds -- which always have the moniker "lightly regulated" placed in front of them -- and you have massive accumulations of capital that are invested in a wide range of markets subject to varying degrees of SEC oversight. My colleague, Steven Davidoff, argues persuasively that the SEC has not responded to the development of new securities markets, for example those in derivatives, and that the individual investor focus of the law may be out dated. His article, Paradigm Shift: Federal Securities Regulation in the New Millennium (available on SSRN here), asserts that "Congress and the SEC are politically unlikely to rework the entirety of securities regulation to reflect [the new capital markets paradigm]. That is, until a new scandal inevitably arises." When the scandal comes, will the SEC be overwhelmed, so that enforcement may be viewed as "toothless"?
Stoneridge Investment Partners was a correct application of the law in light of Central Bank, and makes sense from an economic point of view because private litigation is hardly an efficient means to regulate the markets. But the SEC may not be up to the task either, not because it is inept or bumbling, but because it is simply overwhelmed by the changes in the marketplace it is charged with regulating and underfunded in its monitoring role. In that sense, then, Stoneridge Investment Partners may effectively insulate those who help other companies cut corners and skirt near the edge of the securities laws because there need not be any real fear of enforcement of the anti-fraud provisions, at least as to those who are not primary violators. Private litigation is not a substitute for the "cop on the beat," but is may be misguided to assert that there is a cop out there when the agency given that job does not have the tools to regulate and enforce the law effectively. One of the great strengths of the capital markets in the United States has been the strong enforcement mentality that gives it credibility, and it is fair to ask whether that view will continue. (ph)
Addendum - See also Robert Barnes & Carrie Johnson, Corporate Fraud Lawsuits Restricted.