The most sweeping reform in the federal securities laws in many years -- the "Private Securities Litigation Reform Act" -- was enacted into law last December. In most business quarters, the passage of the bill was greeted with praise. The bill (applicable to publicly traded companies):
- Made significant changes toward preventing abuse in securities litigation under federal law.
- Introduced the concept of proportionate liability under the federal securities laws.
- Implemented "safe harbors" for the disclosure of forward-looking statements.
- Imposed new responsibilities on auditors to detect and report illegal acts.
Litigation Reform
Examples of abuse in securities litigation class actions abound. According to one study, one of every 34 companies whose stock is listed on the Nasdaq National Market System has been faced with a securities fraud lawsuit. The Reform Act eliminates the use of so-called "professional plaintiffs," provides that all discovery must be stayed pending a ruling on a motion to dismiss, and authorizes the court to require parties or their attorneys to post a bond for attorneys' fees and costs. In addition, plaintiffs in their complaint are required to tell "the who, what, when, where, and how," the first paragraph of any newspaper story, and to conduct a pre-filing investigation.
Proportionate Liability
In a major change, which has received widespread praise from accountants, underwriters and attorneys -- the so-called "peripheral, but deep-pocket" defendants in many securities fraud cases -- the Reform Act implements a "fair share" system of proportionate liability. Defendants who are found liable, but have not engaged in knowing violations, will be held responsible only for their "fair share" of any judgment.This major change in the allocation of liability under the federal securities laws will primarily benefit outside directors -- who are often named as defendants in a securities fraud class action but who rarely participate in the day-to-day disclosure decisions giving rise to the lawsuit -- and a corporation's outside auditors.
"Safe Harbor" Provisions for Forward-Looking Statements
In provisions which will have a profound effect on market efficiency, the Reform Act adopted a statutory "safe harbor" which will encourage companies to disclose forward-looking information. These provisions were adopted to address the impact of abusive securities litigation practices on the disclosures made by corporate management. The Reform Act protects from liability written or oral forward-looking statements that are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected in the statement.The "safe harbor" does not protect forward-looking statements included in audited financial statements, contained in an initial public offering registration statement, made in connection with a tender offer, or made under certain other circumstances.
Duty of Auditors to Report Illegal Acts
The Reform Act requires independent public accountants to adopt certain procedures in connection with their audits and to inform the SEC (in certain circumstances) of illegal acts. The legislation does not displace the requirement that audits be conducted in accordance with generally accepted auditing standards (GAAS) and generally accepted accounting principles (GAAP).Recommendations for Action
Clearly, the effect of the Reform Act will be to eliminate many frivolous securities fraud cases. Those cases that are filed will, almost of necessity, be more meritorious. The likely result will be to make settlement of cases filed after passage of the Reform Act more difficult and more expensive.In this era of the emerging professional director, and the continuing trend toward increasing the number of "outside" directors on a company's board, it is imperative that directors not only understand their duties and responsibilities regarding disclosure, but also that directors have an opportunity to provide meaningful input when appropriate. The "safe harbor" provisions of the Reform Act may turn out to be a two-edged sword. Corporate directors, and particularly outside corporate directors, must recall that inaction by members of a corporation's board of directors can have grave consequences. Faced with evidence of fraudulent conduct by corporate management, a company's board of directors cannot remain ambivalent or passive, but must be mindful of its responsibilities to shareholders.
Finally, in light of the new accounting practices imposed by the Reform Act, senior management should consider a review of its working relationship with the company's outside auditors. Lines of communication between and among auditors, the company's senior management and the audit committee, should be reviewed and clarified, and members of the company's audit committee or its board of directors should be made aware of the impact of the Reform Act's changes on an auditor's obligation to report illegal acts.
A more complete summary of the Reform Act is available upon request. For more information, please contact Robert E. Woods at (612) 334-8486, or Avron L. Gordon at (612) 334-8455.